One of the more intriguing things I have observed in the stock market in the past quarter is that the S&P 500 (SPY) rose in the face of a negative GDP print. In fact, the market rose from a low of 1310 at the end of month close in May 2012 leading up to the Q4 GNP economic report. Very aggressive market pricing actions currently abound, and it doesn't take Einstein to realize that something is askew.
- Junk bonds pricing at 5%-6% when historically they have traded at risk adjusted returns are at least 8% to 10%
- Dell stock price drops to $9 after 5 years of steady to declining growth, gets a buy-out bid that rational analysis says is very risky, only to have two more bidders place even higher bids
- Companies with very low investment grade quality are currently racing to issuing bonds with 2057, 2061, 2073 maturity dates - and someone is buying.
- And so on…
Warren Buffett is fond of saying, "in the long run, stocks always out-perform…. ", and he has used this statement in rationalizing his recent purchase of Heinz (HNZ). He also was one who correctly pointed out in the 1990s when the market was reaching for the stars, that it was time to get out. If you did the math in the 90s, company valuations in many cases were analogous to asking a 5 year old to lift 500 pounds over their head. Today he says the market is completely different on a valuation basis. As did Alan Greenspan last week when he said "irrational exuberance" was the last way he would describe the current market.
How can a stock market show continuous new highs in the face of slow to no real economic growth be rational now but not in the 1990s? How can increasingly higher prices for poor quality credit issues and struggling companies create a bid up in prices be rational now, but not in 2007?
All of this makes sense only in a world where "the emperor is allowed to wear no clothes," until he is not.
Today's Challenged Investment Market
Today's investment climate is very unique when I compare it to any investment point I have faced in my lifetime.
The Federal Reserve is strangling the short and intermediate end of the yield curve with Treasury purchases (QE) that have "drained the swamp" when it comes to finding a return for invested funds. They are also price controlling interest rates so the government pays zero or very low interest rates on the excessive debt it has accumulated and plans to continue accumulating in the upcoming years. The current Fed argument for such low rates is that if they did allow rates to increase right now, the stock market would tank…
The Fed policy statement on March 21st gave the following direction: The Fed intends to maintain a zero-rate interest rate policy and extend QE until the economy meets an employment target (i.e., real growth). If inflation becomes a problem, QE will stop first, after which rates will be allowed to rise if inflation remains a problem (defined as above 2.5%). The only potential scenario where the Fed will raise rates if real economic growth continues to be slow is if a market "bubble" materializes. However, the policy committee views monetary policy as a "blunt" instrument in this case, and prefers not to take this course of action.
The current Fed policy by design is intended to cause inflation, the real question is "will it?"
Directly in the face of a policy which is designed to be inflationary, bond buyers are doubling down and buying more.
Conclusion, the bond markets are either being controlled by an emperor without clothes, or the buyers believe he doesn't have any.
Real Economic Growth Requires Top-line Increases, Not Just Share-Repurchases
So what about stocks?
Over the last five years since zero-interest rate policies went into effect, large cap companies have done an excellent job of increasing share prices through share re-purchases. However, what I currently see is a large number of stocks increasing in value based on bottom line earnings measured over a smaller and smaller shareholder base, not from revenue growth.
This activity is a perverse impact of the Fed's "extended period of time low interest rate policy." Just buy back enough company shares with either company cash flow, or better yet, just borrow money for the next 50 -60 years at 5% or less and it will be accretive to share value immediately.
A sample of high profile companies that fit this description are: IBM (IBM), Time Warner (TWX), Hewlett Packard (HPQ), and Lockheed Martin (LMT), just to name a few. The average decrease in shares outstanding over the time period in these companies is 25%. Top-line growth over the past five years at these companies, however, has been flat to negative.
Just recently, Bank of America (BAC) was granted a pass by its regulators to initiate a $5B buy-back in the coming year. I applaud the financial engineering and believe it has/will increase share price. However, what the company management is saying to me by this action is -- "I have no place, or I refuse, to lend this money in the current rate environment." If a bank as big as Bank of America is turning away capital that it could be putting to work, it is a virtual lock the economy will continue to struggle with low real growth.
So maybe the emperor is hanging out in the stock market as well…
Determining which Market - Stocks or Bonds is the Least Irrational Today
All of the irrational pricing will get resolved through time based on some concoction of Fed policy, Fiscal policy and hopefully private market activity. When the emperor has to put the clothes back on, there will be clear relative winners and losers depending on why he has to grab a robe.
To look at who is most likely to win, you need to have a framework to understand how major changes in the real economy and changes in Federal Reserve policy affect the return you can get from an investment in the stock market versus the bond market over a longer time frame than quarter to quarter.
I was born in 1962. I track the market and many of the major statistics since my birth in order to understand how events today relate to what I have experienced in the past. When I analyze the S& P500 data over this period of time, I get the following broad brush view:
What this table shows is that from the time I was born until now, if I had made an investment in the S&P 500 at the end every month, and held each investment for 10 years exactly, the S&P 500 would have earned me 8.68% including dividends. Why did I use 10 years? So I could compare the return to the alternative of just buying a new issue 10 year Treasury note at the end of every month and holding it to maturity. If I had just used the buy and hold Treasury strategy, my return at the present time would have been 7.35%.
But there is a risk in using this average data. It assumes I make an equal dollar S&P 500 investment at the end of every calendar month 494 months in a row -- which is slightly more than 41 years (all data is closing price, last trading day of the month). This justifies Warren Buffet's argument in my mind that in the long run equities outperform bonds. However…
Since the year 2000, bonds were the hands down winner over stocks. If you traded out of the S&P 500 into a 10 year T-Note in August 2000 when the S&P500 closed month end at 1549, you would have gotten a yield to maturity of 5.83%. It was a great relative buy. In ten years you cashed out having 1.76 times your initial investment. Meanwhile the S&P investment was under-water at a -2.5% CAGR plus dividends.
But this is a past event, and lightning usually does not strike twice in a lifetime. We have reached the same stock market valuation level as 2000, but under different circumstances. What I want to know is, in what scenario does the seemingly growing irrational behavior in the stock market seem more rational, and in what scenario does the crazy price action in the bond market begin to make sense?
To review the likely outcome for the present situation, I have created the data table below. The table shows how the S&P500 CAGR returns on my 10 year holding period portfolio changed over time in relation to real GDP, interest rates (30 Year), and inflation.
Here is a summary of the data:
- If Real GDP averages 2.8% annually or less: In this case, the S&P500 CAGR averages only 1.09%. Low real growth in the economy is very detrimental to stock market returns -- common sense to most investors, but this is a method which quantifies the impact.
- If the 30 Year T-Bond trends higher over the period: Interest rates can rise and the stock market can on average perform better than a pure low growth scenario, but only if it is combined with inflation. In general, the market returns are still well below average at 3.88% CAGR.
- Both Real GDP is low, and the 30 Year T-Bond rates rise: In the data analyzed, when rates rose and growth was low, CAGR was 2.95%. There were very few times that this actually occurred.
- If inflation trends up over the investment period: When inflation was a problem during the past 50 years, CAGR averaged 4.61%. However, the impact is not as bad as what commonly might be expected probably because many companies in the S&P are natural hedges against inflation.
- If inflation trends up and the 30 year T-Bond rises: If the Fed or the market leans into inflation by raising rates, the average CAGR of the S&P falls to 2.15%.
- If Real GDP is low, Inflation Rises and the 30 year rate rises: This scenario has very rarely happened over the past 50 years for an extended 10 year period of time. When it has, the CAGR averaged 2.39%.
There is only one clear win/win scenario for the market, and it is summarized in the following table, which is the inverse of the above data:
Not unexpectedly, if the market shows strong real growth and/or interest rates fall, S&P500 returns are above average. If you can combine high real growth and falling interest rates, a la the 1980s, you have an equity paradise of 10.8% CAGR for a ten year holding period.
Relative Winners and Losers
Unfortunately, equity paradise produced by high real growth enhanced by steadily falling long-term bond yields is not possible in a zero interest rate world.
The reality is that the entire market has to correct over time before paradise is reached again. There are two near-term outcomes in the zero-rate market that could definitely materialize, producing relative winners and losers. One is a "Zombie" market, and the second is "Return to Inflation" market.
- Zombie market - Current irrational bond bets clearly win in this scenario, however, poor credit quality will probably become a major issue. The worst case scenario for the S&P 500 is if the real economy grows very slowly, inflation stays generally low, or possibly is deflationary, and the 30 year bonds stays around the same level it is today. In this world, the expected CAGR for the S&P will average 1.09% plus dividends. This might beat the current 2% 10 year Treasury, but it is a definite "dog." A pure deflation scenario would cause negative stock market returns.
- Return to Inflation market - S&P Equity bets clearly are a relative win in this scenario, while bonds are re-priced and lose relative value in the near-term. S&P500 CAGR actually levitates as inflation rises. Although a monetary illusion, the stock market is a hedge. On the contrary, being in a perpetual bond index fund linked to Treasuries or Corporate Bonds would be a big relative loser -- the opposite of 2000-2012.
My conclusion about current market pricing of bonds and equities is that participants are simply taking the excess cash being flooded into the market and hedging bets on these two scenarios. The outcome is to be determined.
Portfolio Implications and Strategy
Eventually the emperor will put his clothes back on. When it happens and the market corrects, you better be properly seated.
My view is that the past decade and the near disastrous brush with deflation is not a place any Fed chairman in the next 50 years wants to re-visit. Additionally, true equity paradise for the emperor is when growth is combined with relatively high interest rates that can fluctuate more freely so risk taking can be rewarded and/or punished by market forces, not a committee. This reversion to higher growth, higher rates will require higher inflation to transition the markets. But achieving the reversion requires private market bank participation through lending which translates to money supply growth, not singularly from Fed balance sheet expansion.
Currently the jury is out on which market bet is going to win, but risk-reward indicates hedging for the zombie market outcome, and positioning for inflation based growth is a better 10 year strategy today.
For this case, my current recommended portfolio strategy is:
- Bleed off any high duration credit exposure, especially perpetual bond mutual funds and ETFs. The bonds in these funds are continually rolled over, and you are essentially throwing good money into an asset that is almost certain to have a negative return for the inter-mediate future. The only reason to hold perpetual high duration credit just for higher yield today is if you think we are going into an extended Japan style deflationary period.
- Avoid the current long duration debt "sellers" market. There is a large supply of new very long duration, low interest rate Preferred and Exchange Traded Debt issues. This includes big banks extending non-cumulative, long dated preferred stock. If you can withstand this credit and duration risk, buy the company equity. Why be a shareholder with no upside, but take the downside risk?
- Control the duration in your stock and bond portfolio by whatever means available. This means you need higher dividend payers in your stock investments and fixed maturity dates on your bond portfolio.
- Junk bonds, at 5-6%, should be avoided until sanity prevails. In this market you lose in either of the likely scenarios. First, in the "zombie scenario" credit quality suffers and the current pricing is not sufficient to cover the risk. In the second scenario, rates run-up and you are left with a low quality credit that you cannot trade out of until it matures.
- Continue to accumulate hard assets as an inflation hedge. I prefer shorter duration assets in this category. Energy stocks (BP), (RDS.A), Royalty trusts (PER) (SDR) and Energy Pipeline (ETP), Storage (PNG) and E&P (DLMP) MLPs are my current recommendations in this area. If you only trade indexes in your portfolio, then choose ones that have higher current yields so the pay-out can be rolled over through time such as (AMJ) or (AMLP).
- Find equities or quasi-equity investments in companies that have underperformed the market, and have balance sheets and business models that could be leveraged in a potentially inflationary environment to provide higher share value, similar to Buffet's Heinz purchase. Companies in the short-term that have the balance sheet strength and can "shrink to prosperity" are near-term buys. If more leveraged buy-outs are announced, scan the bond market for potential shorter duration, higher yielding bond positions in relatively strong companies.