A Few Weeks Later: Did the Debt Downgrade Matter?

Well, we've had a bit more time to analyze the situation since the S&P downgrade of the U.S.'s credit rating.  Did it impact interest rates? Yes, but not how it was expected.

Ten year treasury rates have dropped off a cliff and are now well below the year on year change in CPI (3.6%).

Granted, this isn't the best measure of "real" interest rates, but it does give some sense of where we are now. This has actually gotten more extreme in August where we would be in near historic territory, except for the few blips in the 1970s where there were peculiar alignments of inflation rates and interest rates for brief periods.  It's clear that we have not seen any increase in real rates and don't seem to be near it either. 

Once again, all of the devastation has been in the equity markets.  As I said earlier this month, we would have a brief period of stabilization before a resumption of the fall.  We followed that traditional pattern and appear to be on another down leg.

At this point, it seems quite likely that we will see more difficult days ahead, but not because of a debt-induced panic.  Rather the issue is that growth prospects have utterly and decisively collapsed at this point.  The Philly Fed Index this last week was an utter disaster.  At over -30 (or under depending on how you look at it), it is at a level that has never failed to be associated with recession.  Once again, the threat is deflation and stagnation. 

Strength of Treasury Auctions

This table is from Haver Analytics. When you look at the bid to cover ratios (value of bids/value of accepted bids), yes the recent auction was disappointing relative to auctions this year. However, when compared to actions in normal times, such as 2006, it's still stronger than at that point. I don't remember anyone in 2006 saying that the U.S. government was on the brink of default. 

The same certainly goes for shorter term bills and notes, where we have actually seen record high bid to cover ratios for some issues. Some of these levels are about 2x what they were in 2006. Generally, the shorter term you go right now, the higher the bid to cover ratios are. Bid to cover ratios have generally been a little bit stronger (and I do mean a little bit) on the short end of the curve than on the long end, probably due to there being a greater preference for more liquid assets. 

Now, what we are seeing in recent action is that bid to cover ratios for short term instruments are running around 4-5x compared to long term running around 2.3x to 2.7x. The reason for this disparity is that long term treasuries are simply a very risky proposition at these interest rates. The odds of significant principal loss are high whereas you don't run that risk with the short term bills. You don't earn any interest on them either, but it's still reflective of individuals and institutions being more concerned about capital preservation than appreciation. 

There was a bit of concern on Wednesday about a "disastrous" 30-year treasury bond auction. In truth, by the metrics that are typically used, it really wasn't that bad.

El-Erian Says Quantitative Easing Will Cause Inflation

http://www.bloomberg.com/news/2010-10-25/pimco-s-el-erian-says-fed-treasury-purchases-may-disappoint.html

I say "Good". Inflation is necessary to unwind some of the excesses of the credit bubble over the past decade. Debt is denominated in nominal dollars and can be eroded via inflation. Particularly, inflation would help unwind the negative equity situation that many homeowners find themselves in.

Now, of course the flip-side is that this means higher interest rates and the plethora of issues that come with that. However, I think we have proven since mid-2008 that low inflation and low interest rates are not enough particularly in an environment of high consumer debt loads. The issue is if we get the sort of inflation we had in mid-2008 when commodity prices surged and had the effect of rapidly reducing real incomes. That makes servicing debt actually more difficult. To be honest, given the behavior of commodities markets so far, I am concerned about this prospect. It does seem that the excess liquidity likes to slosh in there at the moment (See the commodity charts below).

Is the market cheap or expensive right now?

I'm not going to cop out and say it depends (though what methodology you use matters). I'm just going to come right out and say that it looks slightly undervalued overall.

This headline "S&P 500 Profits Cut First Time in Year by Analysts" should give some pause because I don't like it when earnings upgrades give way to downgrades while the market is struggling to make gains. That generally signals some warning signs. However, there is a fair amount of cushion regarding earnings estimates. The article states that S&P 500 earnings estimates were cut from $96 to $95 for the S&P 500. That's based on a "share" of the S&P 500 if you view the index level as a price. So then, the basic calculation is made with the S&P 500 trading at 1165 and earnings at $95 the S&P 500's PE ratio is a whopping 12.26x. Not exactly a historic high. As such, estimates could be cut a great deal and the market still would be in decent condition from a valuation perspective.

An annoying post from Mish's Global Economic Trend Analysis references the 1970s where, as market historians know, the stock market failed to advance throughout the decade. The S&P 500's PE ratio entered the decade at around 16x and left at under 7x, representing severe multiple contraction. However, if you look at long term interest rates, as we have in previous posts comparing the relative attractiveness of bonds to stocks, this makes sense. 10-year treasury rates rose from around 7% to as much as 12.75% by March of 1980 (the same month cited in that post) and then up to a high of over 15% by 1981. If you look at the comparative earnings yields and interest rates, you have stocks at 6% or so at the start of the decade with 7% on treasuries. In 1980 you have stocks at 14% (approximately) and bonds at nearly 13%. I rounded a fair amount here because I am feeling lazy, but the post I'm responding to was even lazier.

Currently, by the same comparison, stocks at a forward earnings yield of 8.15% (not the same comparison, but let's use it for now) and the ten year treasury is at 2.39%. Depending on your metric, you might use the ten year trailing PE ratio, which puts us at 21x earnings, or the one year trailing which seems to be more like 15x (depending on what is included in trailing earnings). In any case, unless interest rates start rising a great deal, which is highly unlikely, the outlook for stocks is fairly constructive at the moment.

Edit: I just remembered that we had an earlier discussion about whether or not the spread between earnings yield and interest rates is a good predictor of future returns. Generally it isn't, but the relevant comparison is whether or not it is useful for selecting between stocks and bonds which offers the best return and on that count it performs reasonably well.

Another View on Interest Rates and PE Ratios

In the interest of fairness, here is a view saying that comparing interest rates and PE ratios is a useless exercise: http://www.marketwatch.com/story/are-stocks-really-undervalued-2010-09-03?dist=beforebell

I have several issues with the way the study was conducted as it seems a painfully simply regression analysis for a firm that specializes in it. What I found in my own research was that periods of a big positive spread between earnings yield and interest rates correlated very highly with periods before a major bull market and the inverse was also true. There was one period where this relationship broke down badly which was the 1990s, but that was the only one I could find.

I will do my own regression along the lines of the way they designed it and try to figure out how they came up with what they did because my knowledge of the data does not seem to support the notion here. Now, they used real rates of return against nominal comparisons of PE ratios and interest rates, whereas I kept everything in nominal terms.

Dynamic Asset Allocation Model: August Update

I had hoped to do these on a more regular schedule, but life has not been particularly permitting on that front. In any case, the August Dynamic Asset Allocation Model suggests an 80% weighting for equities going forward. Of course, this is the same as it has been since pretty much the end of 2008 with a few small twinges back and forth here and there.

However, August did see some interesting movement in a couple of the indicators. The yield curve measure moved down as ten year rates have continued to come in. Corporate spreads also narrowed in August, suggesting looser credit conditions for corporations, which is bearish for the model due to the contrarian intention of the indicator. The overall model remains very bullish because the earnings yield metric is at levels similar to the early 1950s as well as the bottom in 1974, which is immensely bullish for stocks.

Still, this model was based on historical patterns and a deflationary environment would ruin some well established historical relationships on which investors have relied. Principally, in our discussions of PE ratios we talked about how PE ratios work because there is the implicit assumption that earnings in the future will be higher. In a deflationary environment this isn't the case. As such, keep your eyes peeled. I still think that stocks are quite cheap on a historical basis relative to alternative investments, but it isn't as unqualified as the indicators in the model would suggest. 

Brief Thoughts on Fed Action Today

I had a couple brief, and these will actually be brief, thoughts on the Fed's action today.

I don't think the announcement that they will be reinvesting maturing MBSs in Treasuries is actually that substantive as it basically means that the Fed simply is forgoing an otherwise scheduled balance sheet contraction that would have slowly removed liquidity from the system. While that's good, it isn't overly stimulative compared to our current situation except to say that it means we won't have dramatically tightening monetary policy in the near future.

More important than the actual announcement is that the Fed recognizes that economic data has softened notably since May and that the specter we face now is deflation rather than inflation. They didn't explicitly state that deflation is a concern in the FOMC statement today, but implicitly that was there. The key here is that we had to see that the Fed was willing to do more and I was somewhat satisfied that they did. This is good for stocks on two fronts and bad on one. The positives are that the Fed will remain stimulative, helping economic growth and, by extension, earnings. The other is that by buying long term treasuries, interest rates will be depressed, helping stocks appear more attractive as an investment. The bad news is that economic data is weak enough to warrant these actions, which is bad for the earnings outlook, though we haven't heard much from companies indicating that they expect to be taking down estimates. We shall see...

EDIT 8-12-2010: The market certainly seemed to hone in on the third point I broached which is that we only got to this point due to weak economic data and the specter of deflation. I suspect over the next couple weeks that this will be the main focus of the market and every sign of deflation will be greeted with severe trepidation.

What do current bond yields and war bonds from WWII have in common?

They pretty much share the same interest rate. That's right. I calculated the effective compounded interest rate of war bonds sold during WWII to be 2.91% for a ten year instrument while current ten-year notes are trading at 2.98%. So, current market forces have pushed interest rates on government bonds so low that they're, well, downright patriotic allowing the government to borrow money so cheaply.

It makes me think of this WWII-era commercial for war bonds:



By the way, calculation was based on the following information. You could buy a bond that matured in ten years at $25 for $18.75. So, the calculation is ((25/18.75)^(1/10)) which is the good old fashioned compounded annual growth rate formula for those who are interested in such things.

What does a 2.95% yield on the 10-year mean?

Back before the world blew up in 2008, if ten-year treasury rates were much below 4%, I would say that you were either in a recession or a financial panic. Below 3%, I would have said that things must be pretty nasty right now. Well, I would say that the confluence of bad news out of Europe, China, and our own markets does indicate that conditions are fairly rough, but I think the more important signal is that there is absolutely not a chance of a major inflation outbreak. Indeed, 2.95% on the ten year indicates that we are either at 0% inflation or even have a mild case of deflation about to set in.

In either case, this is highly unusual and bears watching. My own suspicion is that investors are ridiculously risk averse, but the extent of the rally in bonds now has taken on a different life. It's hard to say for certain what such low yields portend.

Strategy Sessions- Part 1: Overview of Asset Allocation Versus Individual Securities

Steve brought up an interesting fundamental debate that investors have to resolve in their own heads: Should I be a stock picker or should I focus on asset allocation?

To put my own chips on the table here, I do both. Yes, it's a cop-out, but at the same time there is some value in it. Spreading your bets around not only different securities, not only around different asset classes, but even among different strategies does reduce the possibility of catastrophic loss and that is one of the chief objectives that any individual must bear in mind when making investments. Part of the reason I pick individual securities is that it simply keeps me interested in the market. The other reason is that I firmly believe that, with a good research methodology based on the fundamental value of companies, you can beat the market. However, I made my peace with the idea that I will not always beat the market and a lot of people do not come to terms with that.

As to the issues regarding picking individual securities, you must have a stomach of steel to handle the volatility. I own upwards of 18 different stocks at any one time so a large move in any one of them does not usually phase me. However, this sort of environment is not appropriate for many people for any number of reasons. Quite frankly, there is nothing wrong with being uncomfortable with high levels of volatility. It's a natural human reaction. If you do not feel able to keep up with the pace of the market, I would recommend broader strategies that focus more on asset allocation. Quite frankly, there is a damn good chance you will actually do better than being a trader or a stock picker. There's a great deal of evidence from economists and financial historians to support that idea.

To that end, I have devised a dynamic asset allocation tool designed to allocate into appropriate levels of stocks and bonds based on credit market indicators. The basic theory is that credit markets give indications of when you should get in and out of the market. I have always believed, with substantial empirical research from countless economists to support this belief, that interest rates are vital market signals and that relationships between different interest rates and those interest rates versus equity prices can be valuable investing tools. The model I have worked on will need revision as time goes on, but I think the general premise is solid.

In a few future posts related to this broader subject I will:
1. Discuss the dynamic asset allocation model introduced here
2. Outline some reasons why some individual stock holdings may be more subject to volatility than others
3. Introduce some methods for reducing volatility while still leaving open possibilities for gains
4. Whatever else I might think of

I'm doing this somewhat backwards because I am actually somewhat giddy to share the dynamic asset allocation model.