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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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2 Questions To Ask Yourself If You’re Worried About Your Investments Right Now

“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” -Benjamin Graham, The Intelligent Investor

Are you concerned about the markets right now? Do you worry about how your investments might fair in a prolonged decline? If so, I encourage you to think them in terms of that quote above.

According to Ben Graham, Warren Buffett’s teacher at Columbia Business School, an investment must meet two simple criteria:

  • First, does it offer safety of principal? In other words, ‘is my initial investment protected somehow such that I’m likely to get it back even if my analysis is faulty?’
  • Second, will it provide an adequate return? In other words, ‘am I being adequately compensated for the risk I’m taking here?’

If you can honestly answer both of these questions with a confident ‘yes’ then you should have no worries.

If you answer either of these with a ‘no’ then you should probably have some sort of stop loss (like the primary trend) in place to make sure you don’t let a speculative position hurt you too badly if it goes against you.

Finally, if you don’t know where to begin in answering these questions then you’re clearly operating outside your own “circle of competence.”

In this case, you probably want to educate yourself a bit more so that you understand how to answer these questions and then focus your efforts going forward on investments that are within your own ability to analyze.

And why not start right where Buffett did with, “The Intelligent Investor“?

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Is It Time To Buy Stocks? Not If You’re A Long-Term Investor

The stock market is off to its worst start in history this year. Not only that, the losses over the past few weeks have come amid one of the most rapid declines over the past few decades. This has some coming to the conclusion this has to be buying opportunity.

I’ve seen plenty of headlines and articles lately featuring advisors suggesting investors ‘stay the course’ or even ‘buy into the depressed prices.’ But is this really good advice for the average investor?

There are a couple of questions to be answered here. First, how ‘depressed’ are prices? Are stocks actually cheap? I think most investors would be shocked to find out that, not only are stocks not yet cheap, they are, in fact, still very expensive.

Using Warren Buffett’s measure of total market cap-to-GDP, stocks are still well above their long-term average valuation even after the declines we have seen recently. In fact, the only time they were more expensive than today, even after the recent selloff, was during the height of the dotcom bubble in 1999-2000.

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Furthermore, “well above fair value,” carries a couple of unpleasant implications. First, it means returns going forward are going to be well below average. “The price you pay determines your rate of return.” Pay a high price and you are guaranteed a low rate of return.

The chart below shows the expected rate of return from current valuations compared to the yield on the 10-year treasury note. Right now investors are taking much greater risk for less return than can be gained from the “risk-free” rate. This makes it hard to justify stocks as an, “investment,” currently.

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Second, paying well above average valuations means you expose yourself to above average risks. If stocks fell back to their long-term average valuation based on this measure, it would mean about a 40% decline from current levels. For valuations to actually become ‘depressed,’ it would take an even greater decline. And the history of valuations and drawdowns validates this risk.

So simply based upon valuations it’s not a great time to buy stocks. However, Warren Buffett has also famously advised investors to, ‘be greedy when others are fearful.’ Have investors become unduly fearful which would mean it’s time to get greedy?

In the short-term, one could argue we are seeing a certain amount of fear in the markets. CNN’s fear and greed model recently got pretty low. DSI, another sentiment indicator, also shows investors have become pretty bearish recently.

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It’s very important to note, however, that these are very short-term indicators. For this reason, they are probably only appropriate for short-term traders. On a long-term time horizon, we are only just now coming off of one of the extended periods of bullish euphoria in history for the stock market. Is a bit of short-term fear enough to form a long-term bottom?Screen Shot 2016-01-21 at 9.28.20 AMChart via Yardeni

One way to look at longer-term investor sentiment is to observe the total amount of leveraged speculation in the markets relative to the overall economy (as measured by margin debt-to-GDP). When leveraged speculation is very high, investors can reliably be considered greedy and vice versa.

Currently, the amount of leveraged speculation relative to the economy is about as high as it was just prior to the dotcom bust and the financial crisis. In other words, very rarely have investors ever been more greedy than they are today, which should remind you of the other half of Buffett’s advice: ‘be fearful when others are greedy.’

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All in all, it’s difficult to make the case it’s time to buy stocks today for anyone other than a very short-term trader. They remain very highly valued and investors have not become fearful yet on a long-term time frame by any stretch of the imagination.

These are two of the reasons I have been recommending investors consider reducing risk in their portfolios over the past year or so. If you’re a long-term investor, it’s still not a great time to buy. Considering the poor returns and elevated risks stocks pose currently, you may want to do just the opposite in order to match your risk tolerance and time frame to this reality.

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Owning Stocks Today Is Risking Dollars To Make Pennies

The Fed released its latest Z.1 report today and, though it’s not the timeliest of data, there are a few interesting data points to go over. First, the “Buffett Yardstick,” market cap-to-GDP, shows some erosion from very elevated levels as stock prices fell during Q3.

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The selloff in stocks also precipitated a fall in the amount of total financial assets households have allocated to the stock market. This was also recently sitting at levels very rarely seen over the past sixty years or so.

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Both of these measures have high negative correlations to future 10-year returns in the stock market. In other words, the higher they are the lower your future returns. This is just another demonstration of, “the price you pay determines your rate of return.” Pay a high price for equities (or any asset, for that matter) today and you essentially guarantee yourself a low return.

As of the end of Q3, a composite forecast of both of the above measures along with a simple regression model suggests forward 10-year returns should be somewhere in the neighborhood of 0.72% per year. While this is nothing to get excited about, it is the first positive return expectation for this model in two years.

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Ben Graham famously wrote:

An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.

In terms of an adequate return, I’ve argued that stocks should at least offer better prospective returns than those offered by risk-free treasuries. As I explored in my “How to time the market like Warren Buffett” post, simply comparing the forecast for equities to the 10-year treasury rate is a simple way to determine whether stocks make sense from an investment standpoint.

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Though the prospective return for stocks has turned positive it is still below the risk-free rate. Historically, this has been a rare occurrence. Only during the dotcom mania and at the height of the real estate bubble did we see a sustained periods of stocks offering less return than 10-year treasury yields. Clearly, those were not good times to take the added risk of owning stocks.

But I believe it makes sense to add a trend-following component to this fundamental analysis to improve its timing. Stocks can stay overvalued for long periods of time. Following the Warren Buffett model helps you avoid major bear markets but it also gets you out of the market far too early at times.

The end of Q3 saw the S&P 500 close below its 10-month moving average, a measure that is highly effective at determining the overall trend. The 10-month rate-of-change also turned negative suggesting the long-term uptrend has officially reversed course.

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All told then, at the end of Q3 the broad stock market was extremely overvalued (the “Buffett Yardstick” was only higher during the dotcom mania), extremely euphoric (households have rarely had a greater allocation than they do now), and the trend had reversed to the downside. This is why I called it, “the worst possible environment for stock market investors.”

Now, as I suggested at the open of this piece, this data is delayed quite a bit. Since the end of Q3, the S&P 500 has rallied nearly back to its all-time high set in May. It’s also regained its 10-month moving average as of the end of last month. However, it is doing battle with that very level today as I write. It will be very interesting to see if it can continue to hold its head up from here even as earnings continue to decline and bond market risk appetites rapidly wane.

I also find it noteworthy that this trend-following component is really inspired by Paul Tudor Jones, who has famously expounded on the value of the 200-day moving average (roughly equivalent to the 10-month moving average). His second tenet of successful investing, however, concerns the risk/reward ratio. PTJ only pursues a trade that offers a 5-to-1 reward-to-risk ratio.

In this light, the broad stock market today offers less than a 1% annual return over the next decade along with a large double-digit potential drawdown. It would take another major bear market, similar to the last two, for stocks to simply fall to their median valuations over the past several decades. This potential downside is also confirmed by the record level of margin debt in the market.

So owning the broad stock market today is essentially risking dollars to make pennies. And that’s a reward-to-risk ratio that should make both investors, like Warren Buffett, and traders, like Paul Tudor Jones, stay far away.

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Like Clockwork They’re Bashing Buffett Again

Once again, it’s becoming popular for the media to bash Warren Buffett’s lackluster performance.

If you’ve not been hiding under a rock for the past few months, though, you’re well aware of the fact that there are just a handful of stocks responsible for the gains in the major indexes this year. Outside of these few, the vast majority of stocks have actually declined in 2015.

Certainly, Warren is not the sort of investor to buy the FANGs. Facebook, Amazon, Netflix and Google trade at an average p/e of 360 making them entirely off-limits to any self-respecting value investor.

This is no revelation. What is interesting, however, is every time the media sees fit to bash Buffett in this way, he ends up getting the last laugh.

They bashed him during the financial crisis for being too bullish. The big, bullish bets he put on back in 2008 and 2009, though, have paid off incredibly well since then.

And, in a more similar fashion to today’s bashing, the media tarred and feathered Warren back in 1999 for being, “out of touch,” in sitting out the dotcom boom. In a cover story, Barron’s wrote:

To be blunt, Buffett, who turns 70 in 2000, is viewed by an increasing number of investors as too conservative, even passe. Buffett, Berkshire’s chairman and chief executive, may be the world’s greatest investor, but he hasn’t anticipated or capitalized on the boom in technology stocks in the past few years.

This ran in December, 1999, just a few months before the boom famously turned to bust. Once again, Warren hasn’t, “anticipated or capitalized on the boom in technology stocks,” and his performance has suffered as a result.

But, after successfully practicing his own brand of investing for over half a century, do you think he’s worried about his short-term underperformance? Or worried about them teasing him about it?

I’d actually be surprised if he didn’t see this sort of criticism in the media as a contrary indicator and marvel at its cyclical regularity.

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