Now that Ms. Yellen has shown her inclination, economists and strategists are scrambling to “educate” investors on the investment implications of the coming first rate hike.
Why fret about the first rate hike? As shown by this ScotiaMcLeod table, equities of all kinds rise before, during and well after the first hike. Commodities as well. But understand that these are averages over 11 cycles, which can mask deviations around the average…(see below).
Star strategist David Rosenberg offered his reassuring bull-speak in a recent Financial Post article (my emphasis):
First, the Fed is not hiking rates until next year, at the earliest in the first half. (…)
A dive into the history books shows that at no time did a bull market end after the first rate hike. Typically, in terms of trough-to-peak moves in the S&P 500, we are only one-third of the way into the bull run on the eve of the first Fed tightening in rates. That is an average, but the median is almost identical and there was never a time when the cycle was more than halfway through at that point of the first rate increase.
It could be different this time given the magnitude and duration of this cyclical surge. (…) Even so, the peak in the market is usually a good three years after that initial Fed volley, with the shortest lag being a year-and-a-half in the late 1960s.
The historical record also shows that only when we are deep into the Fed rate-raising cycle does the stock market begin to peak out and roll over in terms of magnitude, not just duration.
The average increase in the Fed funds rate is 350 basis points and the median is 220 basis points from the lows before the S&P 500 finally begins to succumb to the liquidity squeeze. The smallest run-up that induced a bear market since 1960 was 130 basis points.
I always say that we should let the yield curve do the talking and at the historic peaks in the S&P 500, both on a median and average basis, the gap between 10-year U.S. Treasury note yields and two-year comparables is inside of 50 basis points. That curve today is 230 basis points. Wake us up when the war begins.
At some point, yes, Fed rate hikes will cause a market setback, but that is usually in the mature stages of the tightening cycle as the yield curve flattens. I see that more as a 2016 story, which means the market won’t have to deal with it until it starts to price in the growth implications of that flatter curve, likely in the second half of 2015. (…)
In other words, sit back, relax, and enjoy the ride.
Hmmm…before getting too comfy based on this Rosy scenario, lets consider certain facts that might help you understand what “usually” sometimes means:
- After the Dec. 76 first rate hike, equities went south almost non-stop for 14 months, losing 18% in the process.
- After the Aug. 80 first rate hike, equities jumped 15% over 3 months, only to skid 26% during the next 20 months.
- After the May 83 first rate hike, equities nervously marked time for 5 months before slipping 13% during the next 9 months.
- After the April 87 first rate hike, equities rose 11% in 4 months before cratering 33% between August and December 1987.
- After the June 99 first rate hike, equities fluctuated nervously for 6 months before the 11% final speculative spike to the hugely overvalued September 2000 peak of 1518. It then lost 46% during the next 2 years.
Things were probably different in the 1950s and 1960s but they sure became rather unusual since the 1970s. True, the first rate hike was always followed by more hikes so one could elect to wait and see when the actual peak will be…or actually was…
During the 5 rate cycles following 1976, equities stayed flat in 2 and kept rising in 3 (+10% average) for an average gain of 6% over the 5 cycles. The subsequent loss averaged 27%. Better be safe than sorry, unless you are a star strategist and you know exactly when to quit (I excluded the 2004-09 boom-bust speculative cycle here).
The other option is to “let the yield curve do the talking” like Rosenberg strongly suggests:
(…) at the historic peaks in the S&P 500, both on a median and average basis, the gap between 10-year U.S. Treasury note yields and two-year comparables is inside of 50 basis points. That curve today is 230 basis points. Wake us up when the war begins.
I only went back to 1976 because of my above findings but at those 6 past market peaks the gap between 10-year U.S. Treasury note yields and two-year comparables ranged between –140 and +195 basis points, averaging +65 (!): Dec. 76: +160, Nov. 80: –140, Oct. 83: +115, Sep. 87: +115, Sep 00: –50, Mar. 08: +195.
I don’t know when the war begins but I know that from the March 2008 curve at +195, a far cry from 50 bps, the S&P 500 went on to lose 50%. Rude wake-up call if there is one!
I also know that the current +230 bps curve is heavily influenced by the Fed’s artificially keeping short term rates near zero. Where would the curve be in normal times? A good economist like David Rosenberg should be able to tell us but my sense is that 2-year Treasuries would normally be somewhere between 1.5% and 2.5% compared with their current 0.45% level. Given 10-y Treasuries at 2.7%, the “normalized” curve is much closer to being inverted than raw numbers show.
Big data is usually useful, providing one goes beyond averages and medians. Too many people play admirals directing skippers from their onshore ivory tower. For them, missing high waves or hurricanes while staring at average historical weather data has as much consequence as when video gamers duck too late. But there are real skippers out there, surfing treacherous, uncharted seas. A wise, humble and practical admiral would shun cocky and sarcastic comments in favour of down-to-earth (!) analysis and prognostics that would allow investors to better understand the true risk/reward equation.
The current reality is that
- from just about every angle, equity markets are at best fairly valued;
- growth in corporate revenues and profits is slow;
- the four largest world economies are under artificial respirators each boosted by untested financial heroin, monetary policies and/or economic/financial management;
- geopolitical risks are growing;
- the Fed has begun tapering and is openly talking about normalizing U.S. interest rates;
- all central banks are fighting hard to push inflation higher.
Given the above, it seems wiser to remain well awake.
Market timing is part of the job for strategists. It is unfortunate that missing important beats is not as forgiving to investors as it can be to pundits. Strategists should be more cautious and understanding that this is a game of probabilities and that risk management is usually very different from the stupid “risk on/risk off” stuff.
Understanding The Rule Of 20 Equity Valuation Barometer
The OECD pointed out last week that the ratio of public debt/GDP will reach all time historic highs in 2014, at about 120 per cent. Taken in isolation, this could certainly viewed as a worrying fact, with bad implications for the future of real interest rates and possibly inflation. A couple of days later, however, the IMF published a fascinating chapter in its latest World Economic Outlook (WEO) on global real interest rates, showing that the global real rate has fallen from about 6 per cent in the early 1980s to about zero today.
A drop in investment demand in the advanced economies. This is very similar to the secular stagnation hypothesis, recently advanced by Larry Summers and Paul Krugman. On this view, real rates have been reduced by low rates of investment, which are in turn due to the global recession post 2008 and to the IT revolution. The latter has cut the prices of investment goods (think more computers and less steel mills), and this has cut the demand for loanable funds. The IMF says that these effects are unlikely to be reversed very rapidly in the years ahead. In fact, they expect the investment ratio in the advanced economies to stay well below pre-crash levels, while the savings ratio begins to rise moderately. Overall, this might even exert some downward pressure on real rates from here.
