March 2018

March has followed the pattern of the previous two months, with heightened equity market volatility creating worry for anxious investors. Despite that worry, the bond market has been a bastion of calmness with the 30-year bond trading in a relatively benign range of 3.22% to 3.00%. Given the continued strength of the U.S. economy, we had expected the bond to come under price pressure pushing the yield closer to 3.5%. That price action has been befuddling, especially given the steadily deteriorating budget deficit. On April ninth, the Congressional Budget Office announced that the deficit would likely hit $1 trillion dollars in 2020, two years sooner than earlier forecast. Investors didn’t blink an eye, which really is no surprise given the complacency that has swept over the public with regard to the U.S.’s profligate spending. The reaction was much the same last month when Republicans pushed through the $1.3 trillion spending bill.

American’s seem to have come to the conclusion that the Fed has and will continue to ensure prosperity for all and the idea of fiscal responsibility has become nothing more than an old fashioned notion. However, we got a glimpse of the future last month when the Treasury Department flooded the market with Treasury Bills. With the risk of a government shutdown earlier this year, Treasury reduced bill issuance in an attempt to stay under the borrowing cap. Because of the prospect of a shortage of T-bills, the yield to maturity in the secondary market plunged below the low end of the Fed Funds range. As a result, the Federal Reserve’s reverse repo program, which is available to select institutional clients and a de facto loan to the U.S. Government, skyrocketed to nearly $500 billion dollars. When a shutdown was averted and the debt cap lifted, Treasury issued nearly $300 billion in additional T-Bills, a 38% increase over the amount issued in February. As a result, T-Bill yields rose sharply and traded above the upper bonds of the Fed Fund range as investors sought to digest the additional supply.

With the increase behind us, T-Bills maturing in early June have fallen in yield by 15 basis points despite the rate hike in March and the expectation of another rate hike in June. The open interest in the reverse repo program also plunged from $500 billion at the peak to $4 Billion at the time of this writing, a nearly 100% plunge in open interest! The message here is that large moves in supply and demand will move the market, despite the Fed’s manipulation. It just so happened that with the freeze in the Bill market there was an alternative investment. We wonder who’s going to be the alternative source of buying when the Treasury is issuing a trillion dollars of additional debt year after year.

There are those who believe that should interest rates rise meaningfully in the face of supply, the Federal Reserve would restart their bond buying program to absorb the additional supply. While that may be sustainable in the near term, it’s a deeply flawed solution longer term for a number of reasons. First one trillion dollars is approximately 5% of GDP and as interest rates rise the compounding effect is going to cause the debt load to rise at an unsustainable pace. Secondly, as rates rise, the value of their existing portfolio is going to fall in value and that is likely to come under congressional scrutiny. Under the current spending regime both of those outcomes have a material probability of coming to pass. The fiscal irresponsibility of the U.S. Government resembles an individual getting caught up in the vicious circle of credit card debt. The debt is sustainable in the beginning but as spending exceeds income, it ultimately overwhelms the borrower.

In the history of money there have been numerous instances of countries pursing such a policy and in the vast majority of cases, the country was forced to either default on their debt, devalue their currency, or both. One has to wonder what will be the outcome for the U.S. dollar. It currently enjoys the status of being the world’s reserve currency and it’s bonds the store of wealth for many nations. That is unlikely to change overnight, but there’s a very good chance that it will erode. The big question is to what extent?

January 2018

The Federal Reserve, in managing the U.S. economy, is tasked with the dual mandate of ensuring full employment and stable inflation. The mandate is somewhat contradictory in that at full employment the tight labor force is likely to force wages higher which, in turn, risks pushing the overall level of inflation higher. That is, of course, if the numbers accurately reflect the actual rate of inflation, which we regularly argue is not the case. By focusing on an underreported rate of inflation the Fed has fallen dramatically behind in adjusting interest rates and now finds itself facing an overheating economy. Evidence is abundant in fourth quarter earnings reports, with strong revenue growth, rising cost of goods sold, and rising labor costs. In short, business is good but the cost of doing business is rising and output is at risk of being constrained by a shortage of goods and labor.

Prior to the most recent expansion, conventional wisdom held that the economy was operating at full capacity when the unemployment rate reached the theoretical level at which a further decline would cause a rise in inflation. The measure known as the Non-Accelerating Rate of Unemployment or NAIRU, was a completely subjective measure, but was considered to exist at approximately 5.2%. Economists would debate the precise level of NAIRU while bond traders sold bonds when unemployment approached the feared 5.2%. It was understood that the Federal Reserve would raise rates in advance of achieving full employment, so as to not let the inflation “genie” out of the bottle. Of course, that was thirty years ago and the inflation nightmare of the 1970’s was still fresh in the minds of most Americans. Fast forward to the current situation and the concept of NAIRU has all but disappeared. So much so that as we start the New Year and financial firms put forth their 2018 economic forecasts, some have called for the unemployment rate to fall below 3%. Applying the logic of NAIRU, if 5.2% unemployment is a sign of a strong economy, isn’t 3% a sign of an overheating economy? Despite that, the Fed continues to keep interest rates low, and notwithstanding the recent market volatility, the appetite for stocks remains strong. Indeed, the S&P 500 generated a positive return in every month last year; the first time that’s ever happened. Moreover, with the recently passed tax reform, corporations are likely to repatriate the vast sums of cash that they hold overseas. The hope of the President is that they’ll use those sums to fund research, development and expansion. The worry, instead, is that they will use the repatriated cash to buy back shares of their stock. We suspect that corporations will do a little bit of both. With every sector of the economy running at peak performance and the tax cuts putting more money in the pockets of consumers and corporations, and the stock buyback machine continuing to operate at full speed ahead, what could go wrong?

Investors have contemplated that question in the last several trading sessions and the answer seems to be concern that the Fed will finally begin to move more aggressively in raising rates. To be sure, the risk always exists that a mild selloff could develop into something more significant creating a material pull back in stock prices, greater than the 9% drawdown we’ve seen this month. But that’s seems unlikely to happen for two reasons. First, the Fed is not going to suddenly become hawkish. Despite the economy running at full capacity, there are some members of the FOMC that are still arguing against normalizing interest rates. Secondly, since 2009 the Pavlovian response to any market weakness has been to “buy the dip.” That goes for individual investors and corporate buybacks. But that’s not to say that stocks are cheap. We’d argue otherwise and that the selling is justified by the valuation. But anecdotally, the first quarter has started on a healthy note and there’s a very strong likelihood that first quarter earnings will surprise to the upside which is likely to embolden the bulls.

Then where is the risk? If the Fed is supportive of stock prices and there is a seemingly insatiable demand from investors, what could hurt the market? The answer is the hidden in plain sight, and it’s the climbing debt load. Every year during his eight years in office President Obama ran an enormous budget deficit. It became an issue for about a political “minute” when the now-defunct “Tea Party” Congressmen tried to fight it, but it’s since decidedly become a non-issue. So much so that the $1.5 trillion price tag for the Trump tax cut was merely a minor issue in negotiations. Currently the value of outstanding U.S. government debt stands at $20 trillion, that’s more than double the size of the debt when Obama took office. And with some forecasting $1 trillion annual deficits in the coming years, the bond market could be headed toward a point of saturation. The biggest question of all will be how the Fed will respond if the saturation point comes at the same time that inflation becomes a problem. The bigger question is how close are we to that point?

November 2017

In 2004, an acquaintance left his job as a banking clerk to become a real estate sales agent. Almost overnight his income doubled as the homes he represented sold briskly. The market was so hot that he was working seven days a week and his income soared well over $200,000. However, in 2006 sales began to slow and buyers were grumbling that home prices had grown out of reach. Builders continued to build new homes, albeit at a diminished pace, and realtors aggressively argued that all was well in the market. The neophyte real estate broker, in an effort to sustain his business added a “click-through” to his website entitled the “anti-bubble argument.” When clicked, a series of charts popped up comparing home prices to a number of measures, concluding that not only was real estate not in a bubble, but the opposite was true. To not buy would be to miss out on the next leg of another profitable run in home prices. His logic was that if he could convince his clients that U.S. home prices were going higher, he’d be able to ensure that his recent uptick in income would continue. Of course, that wasn’t to be and he is now blissfully, though less profitably, operating a boutique organic vegetable farm. I was reminded of his anti-bubble argument as I listened to the parade of investors and traders on the financial news program one recent morning. One after another, the experts agreed that stock prices are expensive and the risk level elevated, but each suggested looking past valuation so as to not miss the next leg up in prices. They are engaging in the same attempt at deception as the real estate agent. The profitability of their employers depends on investors remaining invested in their funds. When pressed on the matter of valuation, the usual retort is to say that they mitigate the downside by focusing on high growth stocks or defensive stocks, or some combination of both. We see many similarities between the current stock market and the 2006 Real Estate market. It impossible to know for how much longer the stock rally will last, but by nearly every measure, stock prices are expensive.

We’ve written on several occasions about our frustration with government reported data and the release of the October consumer price index (CPI) is another stark reminder of why. The Bureau of Labor Statistics reported that headline CPI rose 2.0% year-over-year, decelerating from the 2.2% pace recorded the previous month. Often we’ve said that the muted CPI seems directly at odds with the rising cost of living of the average American. Digging into the details of the report offers a glance as to why and we reference several components to illustrate the point. The first is shelter, which constitutes 33% of the index. The economic profession looks to the Case Shiller national index as the definitive measure of home price inflation and the last reading was a 6.07% rise in home prices year-over-year. That’s far higher than the 3.2% change measured in CPI. Adjusting for the actual change in home prices would add approximately 0.71% to the top line inflation measure. The next items we question are medical care and health insurance, rising 1.9 and 0.2%, respectively. Unlike home prices, there is no definitive data to substitute for these items, but one can attest that when co-pay and co-insurance are factored in the cost of a visit to the doctor, and the staggering annual increase in insurance premiums, health insurance costs are rising far faster than the ridiculous rates suggested by the BLS. Finally, according to the BLS the cost of telephone and internet services fell -7.1% and -1.0% year-over-year, respectively. Regarding those two items, the BLS has said the move to unlimited data earlier this year would result in a falling adjusted price when the additional service is considered. In essence, they’re saying that you’re getting more for your money so that’s deflationary. I can tell you that neither the cost of our phone nor the cost our internet access has fallen. Ever! To solve for the inaccuracies presented by the BLS, we made a number of subjective statistical adjustments that are in no way definitive, but nevertheless, we believe are more reflective of price changes. Based on those adjustments we believe the year over year change in the cost of living is closer to 3.25% rather than the 2.0% report by the BLS. By that measure, the real return on the 10-year Treasury note would be -0.85%.

September 2017

Signs of excess abound in the capital markets as the ongoing emergency monetary policy supports frothiness and exuberance at every turn.  Last month, billionaire Warren Buffett commented that he wouldn’t be surprised if the Dow Jones Industrial Index, currently valued at 22,600, climbed to 1,000,000 in the next one hundred years.  In making that audacious prediction, Mr. Buffett seemed to be showing unbridled confidence in the stock market.  However, solving for the average return, a mere 4% compounded annually would take the index to 1,000,000 in 2117.  Since 1928, the average annual return for the index was has been approximately 11.4%, or nearly three times that expected by Buffet.  To measure the variation around that average return, statisticians look to the standard deviation, which for the same period was approximately 19.7%.  Sparing the reader the calculations and explanations, that standard deviation implies that an investor can expect, with near certainty, that the return of the Dow Jones average will be between and -47% and 70%.  That’s an enormous range, but reflective of what has been witnessed since 1928.  The worst year was -43% in 1931 and the best year was 52% in 1954.

At this point the reader may be wondering why an investment firm specializing in fixed income cares about the risk/return profile of stocks.  The short answer is that stock prices are one of the macro factors that impact interest rates.  What prompted our thinking was the collapse of implied volatility imbedded in S&P500 option prices, often referred to as the VIX, or as the media likes to call it, the fear index.  On September 21^st, the day after the FOMC meeting, the implied volatility on S&P 500 options touched 6%, one of the lowest levels ever witnessed.  To put that into context, let’s assumes that for the next for the next 100 years the average expected return of the S&P 500 will be 11.4% as it was for the last 100.  If so, that 6% implied volatility is indirectly saying that you can expect the stock market to generate between -7% and 29% with near certainty.  Of course, the options we’re talking about expire in two weeks, not 100 years.  But the concept is the same and illustrates the ridiculous degree of complacency that’s crept into the capital markets.

The irony is that the media had been abuzz in September with continued nuclear saber-rattling out of North Korea, the catastrophic results of two category 5 hurricanes, the worst earthquake in Mexico in over 30 years, and hawkish language from the Federal Reserve.  To further drive home the irrationality of the capital markets on that same September day that implied volatility bottomed, pundits were pointing to the yield differential between the 5-year and 30-year Treasury notes as indicating that a recession is looming.  If a recession is looming, stock prices should be a whole lot lower, and implied option volatility a whole lot higher.  Recall that in a recession profits recede from their previous high and the price/earnings ratio of those earnings contracts, taking stock prices lower.

We do not share the view that the U.S. is at risk of recession, but we are of the opinion that stock prices are overvalued, especially if interest rates rise, which seems likely, albeit at a very slow pace.  With that opinion and the exceptionally low cost of option protection, now may be a good time to hedge one’s equity portfolio.

July 2017

The equity market remained a bastion of tranquility in July as the S&P 500 rallied 1.9% and the volatility index (VIX) touched an all-time low of 8.84 late in the month. A telling example of the complacency was on display in a Bloomberg TV interview. The analyst being interviewed was asked how she could offer a buy recommendation on a stock with such a lofty Price/Earnings ratio. The analyst responded that yes, the stock price is expensive from a P/E perspective, but not as expensive as other stocks in the industry. We worry that when analyst’s start justifying buy recommendations on expensive stocks based on relative value, the market is at risk.

Similarly, bonds posted a benign month, with 2-year interest rates a few basis points higher and ten-year notes a few basis points lower. All eyes were on the Federal Reserve mid-month in anticipation that Chair Yellen would further flesh out the start date of balance sheet reduction. But rather than offer details, she stressed that the Fed would move slowly in normalizing policy. Despite that, we expect that the start date is likely to be detailed at the September meeting and will commence in October.
In the foreign exchange market, the action was anything but benign. The Euro staged an impressive rally, rising 3.36% in price, finishing the month at 1.1811. Recall that at the start of this year the cost to buy one Euro stood at $1.04 and the vast consensus was that the cost would ultimately fall below $1.00. The logic had been that with negative interest rates in Europe, investors and savers would sell the Euro and buy U.S. Dollars to earn the interest rate differential. As we’ve written previously, that logic is flawed due to cross-currency interest rate arbitrage. Nonetheless, there seemed to be more than enough of those Europeans in search of yield to push the value of the Euro down to near parity. In hindsight, that had become a very crowded trade and with European economic prospects brightening, the Euro shorts needed to cover. As we mentioned in last month’s update, ECB Chief Mario Draghi briefly floated the idea of trimming the emergency quantitative easing in which the central bank has been engaging.

At the time of this writing, we are about half way through Q2 corporate earnings, and they have been broadly positive, which has further served to support stock prices higher. The problem is that stock prices have reached nosebleed levels as measured by the Price/Earnings ratio. The current 2017 estimated P/E for the S&P 500 stands at approximately 19 times earnings. While elevated by historical standards, the divergence of the 500 stocks in the index brings to mind the adage that one can drown in a lake that on average is only two feet deep. That is to say that the average P/E masks the wide valuation divergence among stocks in the index. For example Intel, Ford, and General Motors, to name a few, trade well below that average, while so-called large cap value stocks like Procter and Gamble, Colgate, MMM, and John Deere all trade well above it. We sarcastically refer to the large caps as value stocks because at current prices we see no value at all. Each of the four stocks has suffered a decline in revenue over the last four years. A quick and dirty measure of value is the Profit/Earinngs ratio divided by the Growth rate (PEG) ratio. As a rule of thumb, a PEG ratio of one offers fair valuation for slow growing corporations and the ratio rises for faster growing companies. Logically investors are more willing to pay a higher price for a faster growth. Why, then, do we have slow growth companies trading at a PEG ratio of four. We believe that the answer is index fund buying. Since those companies represent large weightings in the S&P 500, they represent a bigger share of the index and hence a bigger resultant purchase when an investor buy an S&P index fund. When demand for index funds explodes as it has in recent years, demand for those shares correspondingly explodes. In essence, the index fund managers become price insensitive buyers. In that sense, who cares how expense the underlying stocks are; they need to be purchased. Price insensitive buying rarely ends well!