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Economy, Investing, Links, Markets

Art And Shipping Bellwethers Send An Ominous Signal For Markets And The Economy

This week two companies had some very interesting things to say about their respective markets that have implications far beyond their individual niches.

First, AP Moller-Maersk, owner of the largest container shipping company in the world, said it saw, “massive deterioration,” in its business last quarter, even, “worse than in 2008.”

Next, Sotheby’s most recent London art auction was held on Tuesday where the company saw sales fall by nearly 50% from the very same auction last year. Furthermore, the famed auction house is now seeing former buyers turn into forced sellers.

Investors should pay close attention to these two ominous warnings for one very simple reason: These companies have been very effective leading indicators for the both the global economy and the financial markets for quite a long time.

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Economy, Investing, Markets, Posts

Why Comparing Dividend Yields To Interest Rates Is A Dumb Idea

I’m hearing a lot of folks these days draw attention to the fact that the dividend yield on the S&P 500 (2.17%) is now greater than the yield on the 10-year treasury note (1.7%). In doing so, they are obviously making the case that stocks are undervalued relative to bonds.

There are a few problems with this line of thought. First, just because the dividend yield is currently higher than the 10-year treasury yield doesn’t mean stocks will necessarily outperform risk-free treasury notes going forward. If you hold that treasury note to maturity you know exactly what you’re going to get over that time. The same can’t be said for owning stocks which carry far more risk.

To get an idea of what to expect from stocks, you need to study valuations. Personally, I like to use the Buffett Indicator (market cap-to-GDP) because it’s about 90% negatively correlated to 10-year future returns. History shows that the higher starting valuations are the lower your future returns will be and vice versa. This has been true regardless of where interest rates have been or where they are going.

Right now valuations, based upon this measure, suggest the total return from owning stocks is likely to be less than the risk-free return on 10-year treasury notes. So why, you might ask, should you take far more risk in owning stocks when you are likely to do better in risk-free treasuries? Good question.

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Some might say that high valuations today are justified by low interest rates. And this is really the case folks are making when they compare the dividend yield in owning stocks to the interest rate on the 10-year treasury note. Well, there are a few guys plenty smarter than I am that have demonstrated why this is such a, ‘dumb idea.’ I would mainly direct you to Cliff Asness’ now classic treatise on the subject, “Fight the Fed Model.”

To boil it down to the simplest argument, Cliff shows that low interest rates imply low future inflation and concomitant low earnings growth. High valuations in equities, on the other hand, imply high future growth. Thus, the idea that low interest rates, which imply low growth, somehow justify high valuations, which are completely dependent upon on high-growth, is faulty, at best.

But probably the best real world example of the inanity of this argument is the experience of Japan over the past couple of decades or so. The interest rate on the Japanese 10-year bond in 1990 was 7%. At the same time, the Nikkei stock market index stood at 39,000 and carried a CAPE ratio of 90. Today, that yield has fallen from 7% to below zero. At the same time, the Nikkei has fallen 60% to 16,000 and a CAPE ratio of 25.

Over the past 25 years, then, both interest rates and stock market valuations have fallen together. According to the Fed Model, this should never happen. Intuitively, though, it makes perfect sense. Japanese inflation and economic growth have fallen dramatically over that time so both of these asset classes have reflected this development in their valuations.

If the Fed Model were a viable way to forecast equities, Japanese stock market valuations should have soared in reaction to such an massive drop in interest rates. In fact, according to the Fed Model, Japanese equity valuations should have no upper limit today. At the very least, they should be trending higher as interest rates have trended lower yet just the opposite has happened. Sadly, even massive buying of equities by the Bank of Japan, which now owns more than half of the country’s outstanding equity ETFs, hasn’t been enough to make this theory a reality.

So even though it’s been demonstrated to be false in both the academic realm an in the financial markets, that clearly hasn’t stopped investors from continuing to embrace it and making costly errors in the process. But before you go buying stocks believing that falling interest rates will support prices you might want to ask yourself this very basic question: “Are plunging interest rates and, perhaps more importantly, a plunging yield curve bullish signs for economic and business fundamentals?” Because those are what really matter to stock market valuations, not some theory that both defies common sense and also has no historical validation anywhere in the real world.

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RAMALLAH, WEST BANK - JANUARY 10: US President George W. Bush holds a news conference with Palestinian President Mahmoud Abbas (not pictured) at Abbas's Muqata headquarters on January 10, 2008 in Ramallah, West Bank. Bush is on his second day of his first visit to the Middle East aimed at advancing peace negotiations. After talks with Israeli Prime Minister Ehud Olmert yesterday, he vowed to apply pressure if it is needed in finding a lasting peace  (Photo by Uriel Sinai/Getty Images) *** Local Caption *** George W. Bush
Charts, Economy, Investing, Markets, Posts

Don’t Dismiss The Systemic Risk Of A Corporate Credit Bust

After the worst start to a new stock market year in history, some have begun to wonder if the unusual weakness is a sign of larger problems in the economy or financial system. Certainly, the growing strains in the credit market suggest it’s more than, “just an energy thing.”

These worries have been met with a popular response. I’ve seen a variety of headlines conclude, “why this market meltdown isn’t a repeat of 2008,” or something along those lines. But this rush to judge may be premature.

The incredible boom we have seen in corporate credit in recent years is actually very similar to the boom in the mortgage market which led to the financial crisis. As Jeff Snider noted yesterday, just the past few years issuance of lower-rated corporate debt dwarfs the size of the entire subprime mortgage market in 2007.

ABOOK-Feb-2016-DB-Corporate-Bubble-JunkAt the same time, lenders’ underwriting standards have never been more lenient. Covenant-lite lending, as a percent of total leveraged loans, has absolutely exploded in recent years. In effect, corporations have had access to their own version of NINJA (no income, no job, no assets) loans.

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Finally, sub-prime mortgages were highly-levered (in terms of loan-to-value) and built upon inflated home prices compounding the problem. Similarly, corporate leverage is now off the chart.

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At the same time, these soaring leverage ratios are built upon similarly inflated profit margins.

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So it’s probably far too early to say that the current weakness in risk assets, especially in the credit markets, is in any way, “contained,” as of yet. In fact, there are many similarities between today’s corporate credit boom and the mortgage boom that led to the financial crisis nearly a decade ago. And to dismiss the systemic risk once again? Shame on you.

RELATED:

The Only Guy On The FOMC With Any Experience Actually Managing Risk Is Sounding The Alarm

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Charts, Economy, Investing, Markets, Posts

Corporate Bonds Pass An Ominous Milestone

The spread between the yield on corporate bonds and that on treasuries passed the 2% mark yesterday for the first time in over three years yesterday.

In the chart above I’ve annotated with red vertical lines the prior two occasions when spreads widened to this degree for the first time in at least two years. Notice that each of the two prior occurrences led to painful bear markets and recessions.

Now this indicator alone isn’t sufficient evidence that another painful bear market and concomitant recession are on their way. However, when you pair it with the all the other data out there, it’s confirmation of the growing probability of both.

See:

Why Recession Is More Likely Than You Think

This Chart Suggests A Bear Market Could Be Lurking

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Charts, Economy, Investing, Posts

Don’t Believe The Hype Of Rising Interest Rates

“Best investments for a rising rate environment” “The coming crash in the bond market” “How to prepare for an interest rate spike”

I’m seeing these kinds of headlines and stories everywhere. Everyone and their mom is expecting long-term interest rates to rise now that the Fed is tapering its bond buying programs. (Actually, interest in the term “bond market crash” peaked last Summer, ironically right at the time bonds bottomed in price. See chart below.)

Screen Shot 2014-03-26 at 2.13.00 PMI have a couple of problems with this line of thinking. First, although it seems like reducing demand for a security (i.e. tapering QE) would result in a drop in price, when you really think about how quantitative easing works this makes no sense. Second, the market is telling us this makes no sense. Let me explain.

To the first point, quantitative easing has been effective in supporting the economy through the wealth effect. It has encouraged investors to shun low-risk, low-yielding investments for higher-risk investments (if you can even classify them as investments). This has resulted in a surge in the prices of stocks, corporate bonds, real estate, etc. over the past five years with a greater effect on the riskiest categories within those asset classes: money-losing tech and biotech stocks, junk bonds and leveraged loans, etc. As a result investors feel wealthier and thus they spend more. They’re happy and the Fed’s happy because the economy’s happy.

But now that all of this is ending what should we reasonably expect as a result? To my mind, if QE is an inflationary force, intended to boost the economy, its removal can only have a net deflationary effect on the economy. For those unaware, inflation is bearish for bonds (rising rates = lower bond prices) and deflation is bullish (lower rates = higher bond prices).

To the second point, this isn’t just my personal opinion. This is exactly what the market is telling us. I’ve shared this chart before. It shows the history of quantitative easing and how various assets have been affected:

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At the end of the prior QE programs it’s plain to see that not only did bonds fail to “crash” they actually surged in price. I believe investors fled to bonds in these two prior circumstances for two reasons: First, many traders were heavily short bonds anticipating a fall in price as the Fed ended purchases:

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All these shorts were forced to cover when… Second, the economy showed brief signs of weakness, aka deflation, which sent bond prices higher/rates lower inspiring the Fed to take up QE yet again. (This is probably what Richard Koo means when he says the Fed is in a “QE trap.” They can’t end their bond purchases without harming the economy.)

Notice that traders are once again heavily short the long bond. In the past this sort of positioning has led to strong moves higher as traders cover their shorts.

Now the Fed isn’t technically ending QE right now; it’s merely tapering it’s purchases. I think this is why this trade has been a bit messier than those QE end trades of the past few years. Bonds have risen but they haven’t quite “surged” as they have in the past. Still, Janet Yellen has said that the Fed intends to continue tapering until the bond buying is ceased entirely so the result should eventually be the same. (Time will tell if they are actually capable of removing this stimulus completely without seeing the economy stumble.)

This is exactly what the charts are saying. JC Parets, of All Star Charts, recently called the daily chart of the long bond, “one of my favorite charts in the world,” as it looks like it is now breaking out to new highs, a very bullish development:

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Conversely a long-term look at the yield on the 10-year treasury bond shows it is still well within a very clear downtrend:

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I wouldn’t consider this a “rising rate environment” until this downtrend is convincingly broken. In fact, the only rates that seem to be rising lately are on the short end of the yield curve which has flattened considerably since the Fed began its tapering its QE program:

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Note that, “the slope of the yield curve is one of the most powerful predictors of economic growth, inflation and recessions.” The curve is still positive but the fact that it’s flattening suggests we should be more worried about a reduction in “economic growth” and “inflation” than the opposite.

The bottom line is I just don’t see any evidence to suggest that we are in anything resembling a “rising rate environment” or that one is even anywhere on the horizon. This is not to say that somewhere down the road there may be consequences for the Fed’s easy policies and one of those may be rising rates. It’s just not happening right now.

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