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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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Investing, Markets

Mind The Gaps

A version of this post first appeared in The Felder Report PREMIUM.

About a month ago former Fed head, Richard Fisher, came out and confirmed the idea that the FOMC’s quantitative easing policies over the past seven years have pushed prices of risk assets, including stocks, beyond what would otherwise be supported by their fundamentals.

There are a few ways to visualize this. The first comes from Dr. Ed Yardeni who tracks a fundamental indicator shown below. Notice the yawning gap between the S&P 500 Index and the major economic fundamentals.

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We can also just look at the index versus its components’ earnings. Here’s another gap:

And if you prefer to look at forward earnings estimates, you’ll find another massive gap:

Specifically, Fisher said that the Fed had, “front-loaded a tremendous rally.” All this means is that the Fed pulled returns forward from the future to generate larger gains today. Notice in the chart below that returns have recently been significantly better than valuations (using the Buffett indicator) 10 years ago justified. This is exactly what Fisher is referring to.

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The last time this happened was in the late 1990’s. From that peak, stocks fell more quickly than forecast in order to play, “catch up,” to the downside. Interestingly, the 3-year forecasts I generate using margin data show the very same gaps in the late 1990’s and today.

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And there are other indicators suggesting these gaps could close sooner rather than later. Bond market risk appetites (very similar to spreads in corporate bonds, junk bonds and leveraged loans) have been falling farther and for a longer period of time than stocks. These are normally very highly correlated to stock prices yet here is another major gap.

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Another way to visualize this is to compare bond market risk appetites to stock market volatility. While fear in the bond market has soared recently, fear in stocks is relatively subdued. Notice the gap between them in the chart below.

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So when Richard Fisher says he, “can see significant downside,” in the stock market right now, he’s probably thinking about these sort of gaps between stocks prices and economic fundamentals. Between stocks and their earnings. Between stocks and the corporate credit markets. Because he helped create them. And, like Dr. Frankenstein and his monster, nobody knows better what they’re capable of.

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Investing

Are Passive Investors Taking On Far More Risk Than They Realize?

“The average American is from Missouri everywhere and at all times except when he goes to the brokers’ offices and looks at the tape, whether it is in stocks or commodities. The one game of all games that really requires study before making a play is the one he goes into without his usual highly intelligent preliminary and precautionary doubts. He will risk half his fortune in the stock market with less reflection than he devotes to the selection of a medium-priced automobile.” -Jesse Livermore

These days, the sort of reckless financial abandon Livermore describes is on prominent display in the rapidly rising popularity of, “passive investing.” I first addressed this issue two years ago in a post titled, “one reason I’m worried about the rise of the robo-adviser,” writing:

…as this form of investing becomes more and more popular, the risk of mispricings (and even bubbles) in the markets grows with it because it completely abandons the basic process of analyzing value and risk. When you have a growing stream of buyers who are agnostic when it comes to value – meaning they will continue to buy regardless of price – it’s hard not to see problems arising.

Hedge fund manager, Bill Ackman, recently attempted to quantify the growth of this style of investing, writing, “Last year, index funds were allocated nearly 20% of every dollar invested in the market. That is up from 10% fifteen years ago.” Considering the rapid growth in this form of price-insensitive buyers, he comes to a very similar conclusion:

We believe that it is axiomatic that while capital flows will drive market values in the short term, valuations will drive market values over the long term. As a result, large and growing inflows to index funds, coupled with their market-cap driven allocation policies, drive index component valuations upwards and reduce their potential long-term rates of return. As the most popular index funds’ constituent companies become overvalued, these funds long-term rates of returns will likely decline, reducing investor appeal and increasing capital outflows. When capital flows reverse, index fund returns will likely decline, reducing investor interest, further increasing capital outflows, and so on.

In other words, “passive investing” will ultimately become a victim of its own success. The massive shift to index funds over the past 15 years or so drove the valuations of the largest index components to levels which guarantee poor returns going forward. Poor returns, in turn, will guarantee these inflows will turn to outflows and the virtuous cycle becomes a vicious one.

Danielle DiMartino Booth, formerly of the Dallas Fed, takes it another step further suggesting the rise in index investing is, to a great degree, a result of the Fed’s conscious efforts to stoke, “animal spirits,” over the past seven years or so. As such, it is directly in the crosshairs of its consequences:

“…Investors must reckon with the systemic risk that permeates the markets when boom turn to bust. The bullish cabal continues to insist that if you exclude energy from your calculus, all is hunky dory in the markets. The flaw in such naïve guidance is that excluding energy extends to excluding the commodities supercycle, the emerging markets renaissance it induced and the ‘miracle’ of China’s emergence onto the global economic stage that ignited the engine to begin with. Hence the ultimately systemic outcome of lax monetary policy and the animal spirits it emboldens when seeking out the philosopher’s stone. Maybe a bit more business cycle and less artificiality would have left investors in a better place. One thing is for sure – there wouldn’t have been the wholesale herding into passive funds these last few years. Market behavior suggests that an entire generation of passive investors is about to discover the downside risk of holding highly concentrated positions that have flown blind, free of price discovery. Call the highly correlated nature of their supposed prudent asset allocation a systemic-risk chaser.” [Emphasis mine.]

Ultimately, it’s very difficult to argue that, in pursuing passive investing strategies to the degree they have recently, investors haven’t, ‘risked half their fortune in the stock market with less reflection than they devote to the selection of a medium-priced automobile.’ And, after witnessing first hand the disastrous consequences of such actions nearly a century ago, Jesse Livermore would be shaking his head right now.

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Owning Stocks Today Is Risking Dollars To Make Pennies

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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.

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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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