Edge and Odds

The enemy of knowledge is not ignorance, it’s the illusion of knowledge (Stephen Hawking)

It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so (Mark Twain)

Edge and Odds

Invest with smart knowledge and objective odds

RISING LONG-TERM RATES: THE SCARY FACTS!

In my December 15 post THE TRUMP LOVE-IN, I produced a 50-year chart showing how equity markets behaved during periods of rising long-term rates, concluding that

In the 12 periods of rapidly rising long-term rates between 1965 and 1996 (I grouped a few short periods on the chart), not one was accompanied with any meaningful gains in equities while most saw equities perform a really deep dive (average –14.5%).

(…) Since 1996, there were some instances when rising rates coincided with higher equity prices, like in 1998-2000, maybe 2005-06,  and 2010. The first two instances saw equity valuations truly explode as investors bought into “great stories”, only to totally deflate when the dreams turned into terrible nightmares.

A few days ago, I stumbled on a similar analysis by LPL Financial, a brokerage with over 14,000 financial advisors and a book of $500 billions, which appeared in a December 12 Weekly Market Commentary and which covered the past 55 years:

The results offer generally good news, as stocks have mostly interpreted rising interest rates as a signal of better economic growth rather than harmful inflation. During the 23 periods analyzed, the average gain in the S&P 500, excluding dividends, has been 5.7% (median 3.8%). The average duration of the periods is 1.06 years and stocks rose in 83% of the periods. (…)

Recent history has been better in general, as stocks have risen in all 11 rising rate periods since 1996, with an average gain of 9% (median 5.4%). These periods have been shorter in duration (average half a year) and seen slightly smaller rate moves, a reflection of the low inflation and low interest rate environment over the past 20 years.

Bottom line, we believe the bull market in stocks can coexist with the bear market in bonds and we interpret the move in rates as an indication of improving economic growth prospects rather than of worrisome inflation.

Same data, very different conclusions on a crucial matter.

Let’s look at the facts, all the facts.

In the following charts, I plot the S&P 500 Index and the 10Yr Treasury yields for each time-frame considered by LPL. The periods measured by LPL are within the red rectangles while the black rectangles cover the periods I find most relevant for a complete, objective and realistic analysis.

For those who would not want to peruse all 16 charts, my conclusion is that:

  1. Beginning and/or ending dates can make a big difference.
  2. Chosen periods can influence the analysis.
  3. Sometimes it is best to consider what happened immediately following the rate peaks. Unsurprisingly, the effects often carry beyond the end date.
  4. As Mark Twain said, facts are stubborn, but statistics are more pliable.
  5. I stick with my conclusion: beware rapidly rising long-term rates.
  • 1962-1966: LPL starts the period in December 1962 but I consider the 30 bps rise in rates between 12’62 and 06’65 to be inconsequential. The big move began in September 1965 when rates rose from 4.3% to 5.2% in August 1966 (month-end data only). Equities lost 14.4% during these 12 months.

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  • 1967-1969: there are really 2 periods here, the first producing flat equity markets and the second –17.5% (with a subsequent additional –14.3% through June 1970). LPL began the count mid-March 1967 and ended it December 29, 1969, producing a positive 1.3% return for the whole period.

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  • 1971-1974: I grouped 2 of LPL’S  periods here, which really are 3 for me. Nothing positive.

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  • 1974-1975: Strangely, LPL starts mid-December 1974 even though rates kept declining through February 1975, and ends mid-September 1975. From 03’75 to 09’75, equities were +2.4%, much different than LPL’s +22.5%.

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  • 1976-1980: Similar periods except that LPL’s ends Feb. 27, 1980 even though rates peaked end of March 1980. The volatile equities lost 10.5% during March 1980, resulting in a 4.7% loss for the whole period vs +5.1% during LPL’s period.

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  • 1980-1981: periods concur. Equities flat beginning to end.

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  • 1983-1984: periods concur. Equities –7.9%.

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  • 1986-1987: LPL’s period starts August 1986, even though rates staid flat for another 15 months while equities rose. Shockingly, LPL’s analysis stops October 16, 1987, the Friday before Black Monday when the S&P 500 collapsed 20%! How could LPL simply dismiss that? LPL’s analysis: equities +11.8%. My analysis: equities –13.7%.

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  • 1988: periods concur. Equities +1.0% using LPL’s specific dates. Using my month-end dates: –2.2%.

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  • 1989-1990: interest rates declined 32 bps after LPL stopped counting in early May 1990. But rates really peaked out in September 1990. Equities cratered 15.7% after LPL closed its books.

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  • 1993-1994: almost identical periods. Mine ends after rates peaked at the end of November 1994, a month during which equities lost 3.8%.

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  • 1996: LPL’s period: equities +6.7%. But equities lost 4.6% in July 1996.

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  • 1998-2000: identical periods. Equities up 45.8% to reach their most expensive levels of the 20th century. BTW, equities peaked in August 2000 and went on to deflate 20% before reaching the next chart…

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  • 2001-2002: technically, rising rates did not hurt equities during LPL’s specific period…but if you elected to stay in after the first 20% setback (above), this last rate burst terminated you…

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  • 2003-2006: I grouped 3 LPL periods on the same chart. Periods concur. Equities + 3.8%, +1.3% and + 3.6%. Risk vs reward???

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  • 2008: LPL breaks this period in two. In the mean time, peak to trough: –47.5%! Can’t miss a beat, can you?

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This is how LPL summarizes its analysis:

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A casual observer can only conclude that higher rates are clearly positive for equities. I wish LPL clients all the best for 2017.  They may think they have a strong edge. But with really poor odds, they better hedge.

Fingers crossed Unless this is the new normal because, maybe, this time is different. The last 3 spikes in LT rates did not stop equities:

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But this time is no different. Rising rates are not good for indebted governments, companies and individuals and not good for equities based on common sense backed by 55 years of data analysed objectively. Rising interest rates bring the sea level down, exposing all naked swimmers. There currently are quite a few of these out there…

Finally, if you are wondering what rising short term rates can do to equities, the complete, objective analysis is here: EQUITIES AFTER FIRST RATE HIKES: THE CHARTS SINCE 1954. Here’s the conclusion:

To be brief, in layman’s terms, in reality, there seems to be no consistent nor typical pattern after the first rate hikes.

However, digging a little more into the history book, I found that in 6 of the 8 years when the S&P 500 rose during the initial rate hike, inflation was actually diminishing or stable (2004). This did not verify in 1987, although the market eventually avenged itself and in 1999 when internet speculation blinded everybody.

Maybe we got ourselves a bit of a rule here: rate hike cycles are not damaging to equities in as much as inflation is not rising at the time. Since profits are generally still rising when the Fed takes its foot off the pedal, stable or declining inflation rates help sustain P/E ratios as demonstrated by the Rule of 20.

THE DAILY EDGE (21 December 2016)

Chemical Activity Barometer Ends Year on Strong Note; Suggests Expanded Business Growth in Early 2017

The Chemical Activity Barometer (CAB), a leading economic indicator created by the American Chemistry Council (ACC), ended the year on a strong note, posting a monthly gain of 0.3 percent and a year-over-year gain of 4.4 percent, a significant improvement over the first half of the year, and a pace not seen since September 2010. All data is measured on a three-month moving average (3MMA). On an unadjusted basis the CAB climbed 0.6 percent in December, and 4.8 percent for the year. 

The Chemical Activity Barometer has four primary components, each consisting of a variety of indicators: 1) production; 2) equity prices; 3) product prices; and 4) inventories and other indicators. 

In December all of the four core categories for the CAB improved. (…)

The chemical industry has been found to consistently lead the U.S. economy’s business cycle given its early position in the supply chain, and this barometer can be used to determine turning points and likely trends in the wider economy. Month-to-month movements can be volatile so a three-month moving average of the barometer is provided. This provides a more consistent and illustrative picture of national economic trends.

Applying the CAB back to 1912, it has been shown to provide a lead of two to fourteen months, with an average lead of eight months at cycle peaks as determined by the National Bureau of Economic Research. The median lead was also eight months. At business cycle troughs, the CAB leads by one to seven months, with an average lead of four months. The median lead was three months. The CAB is rebased to the average lead (in months) of an average 100 in the base year (the year 2012 was used) of a reference time series. The latter is the Federal Reserve’s Industrial Production Index.

This has historically been a very good indicator although it missed a few beats more recently. Great chart from CalculatedRisk (H/T):

Young Americans Living With Parents at a 75-Year High Almost 40% of young Americans were living with their parents, siblings or other relatives in 2015, the largest percentage since 1940, according to an analysis of census data by real estate tracker Trulia.

Almost 40% of young Americans were living with their parents, siblings or other relatives in 2015, the largest percentage since 1940, according to an analysis of census data by real estate tracker Trulia.

Despite a rebounding economy and recent job growth, the share of those between the ages of 18 and 34 doubling up with parents or other family members has been rising since 2005. Back then, before the start of the last recession, roughly one out of three were living with family. (…)

The number of adults under age 30 has increased by 5 million over the last decade, but the number of households for that age group grew by just 200,000 over the same period, according to the Harvard Joint Center for Housing Studies. (…)

Household formation is closely correlated with housing affordability and income. Among those aged 25 to 34, 40% of those earning less than $25,000 headed their own household. The share rose to 50% for those earning between $25,000 and $50,000, and 58% for those with incomes above $50,000, according to the Harvard Joint Center.

Census data also show younger Americans are getting married and having children later in life than previous generations. Even so, economists project the historically large millennial generation will more than double its current number of households through 2025.

Rising mortgage rates won’t help. Results from a Redfin survey conducted Dec. 2-14 among 3300 respondents:

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Census Says U.S. Population Grew at Lowest Rate Since Great Depression This Year The U.S. population this year grew at its lowest rate since the Great Depression, and the state of New York shrunk for the first time in a decade, according to Census Bureau figures.

An uptick in deaths, a slowdown in births and a slight drop in immigration all damped American population growth for the year ended July 1. The 0.7% increase, to 323.1 million, was the smallest on record since 1936-37, according to William Frey, a demographer at the Brookings Institution. (…)

Besides New York, Pennsylvania and Illinois also shrunk in notable ways, with the land of Lincoln losing more people than any other state. (…)

The Census Bureau revised downward its estimates of immigration for each year since 2010 by an average of 10%. For this year, it estimated that 999,000 immigrants arrived, down 4% from the prior year.

Full US Census release here.

 
CHINA: THAT CAN’T BE GOOD!

The corporate bond selloff is forcing some deleveraging, and it’s not clear how far it will spread. Here is the AA+ corporate yield. (The Daily Shot)

   

Pointing up Largest U.S. Pension Fund Eyes Drop in Investment Target to 7% Officers of the largest U.S. pension fund recommended that their investment targets drop to 7% because of a cash crunch and changing market conditions, a move that would set a more cautious tone for those who manage retirement assets around the country.

The proposal to abandon a long-held goal of 7.5% over three years came during a board committee meeting of the California Public Employees’ Retirement System in Sacramento. The rate would drop to 7.375% in fiscal 2017-18, 7.25% in fiscal 2018-19, and 7% in fiscal 2019-20. (…)

A reduction would have real-life consequences for taxpayers and cities. It would likely trigger an increase in yearly pension bills for the towns, counties and school districts that participate in California’s state pension plan. Any loss in expected investment earnings must be made up with significantly-higher annual contributions from public employers as well as the state.

A drop in Calpers’s return assumptions could also put pressure on other pension funds to be more aggressive about their reductions and concede that investment gains alone won’t be enough to fund hundreds of billions in liabilities. (…)

If the rate drops to 7%, the state and school districts participating in Calpers would have to pay at least $15 billion more over the next 20 years, said spokeswoman Amy Morgan. That number doesn’t include cities and local agencies.

(…) more than two thirds of state retirement systems have trimmed their assumptions since 2008, according to an analysis of 127 plans by the National Association of State Retirement Administrators, and some are now dropping to 7% and lower.

Earlier this month, Connecticut’s state employee fund dropped its assumption to 6.9% from 8%. The Hawaii Employees’ Retirement System had been scheduled to drop its rate only slightly, to 7.5% in 2017, from 7.55%, but the board this month voted to instead drop the rate to 7%.

The average target among 127 plans surveyed by the National Association of State Retirement Administrators is currently 7.56%. That is the lowest since at least 1989.

THE BIG SHIFT

The global stock market capitalization has increased by $3 trillion recently, while the global bond market value declined by roughly the same amount. (The Daily Shot)

Pointing up Ray Dalio: Reflections on the Trump Presidency, One Month after the Election

Now that we’re a month past the election and most of the cabinet posts have been filled, it is increasingly obvious that we are about to experience a profound, president-led ideological shift that will have a big impact on both the US and the world. This will not just be a shift in government policy, but also a shift in how government policy is pursued. Trump is a deal maker who negotiates hard, and doesn’t mind getting banged around or banging others around. Similarly, the people he chose are bold and hell-bent on playing hardball to make big changes happen in economics and in foreign policy (as well as other areas such as education, environmental policies, etc.). They also have different temperaments and different views that will have to be resolved. (…)