In the spring, I wrote why I believed the following twelve months would likely see rising equities and falling commodities. Insofar as that argument has yet to expire, this article can be considered an extension and elaboration of that theme into the beginning of 2015.
The single best predictor of cyclical performance a year in advance is the yield curve spread. Almost every spike in crude oil prices (OIL), the majority of stock market (SPY, DIA, QQQ) collapses, and every recession have been led by a spread being at or below the 1.0 level (represented as above the -1 level in the chart below). In mid-2012, the spread briefly squeezed down into the neighborhood of 1.3, but has since doubled.
Although there is no clear causal link between the yield curve and subsequent performance in oil, stocks, or GDP growth, this has been a fairly stable set of relationships, and it seems to be indicating bullishness in 2014.
STOCKS OR COMMODITIES?
The problem is not coming up with a positive forecast for the current business cycle, then. Rather, the question is, how should we be taking advantage of the cyclical bullishness? On an inflation-adjusted basis, stocks and commodities (DBC, GSC) have been inversely correlated with one another in modern times. The following is a quick summary of my attempt to make sense of the relationship between the two and how we can use that relationship to make some reasonable guesses about the future.
My argument is that we are in the midst of a secular bull market generated by expanding P/E multiples atop a long-term stationary trend in earnings. The earliest signal for a secular rise in P/E ratios under our Bretton Woods II system has been a sudden collapse in commodity prices, softness in energy, and a spike in precious metals (GLD, SLV).
In 2008, crude oil crashed relative to gold, and in 2011, precious metals experienced a blow-off top that marked the end of the commodity bull for the foreseeable future.
Under Bretton Woods II, precious metals (specifically, gold and silver) have behaved as "hyper-commodities," outperforming other commodities during booms and underperforming during commodity busts.
And, because commodity prices and P/E ratios have always been inversely correlated, we can take the crashes in commodities generally and in oil, gold, and silver specifically, to be both bullish for P/E ratios and bearish for commodities.
On the commodity side, that is rather circular logic, but it appears that, under our post-gold-standard system, a cyclical shock during a commodity boom is a different animal from a cyclical shock during a stock market boom. Our worst recessions under Bretton Woods II were in the mid-1970s, early 1980s, and after the most recent crisis.
In each instance, a similar set of symptoms manifested themselves:
1. The real economy experienced traumatic shocks in terms of GDP and unemployment, as well as severe, global financial crises.
2. The national psyche experienced a traumatic shock calling forth transformational, dark horse political figures who symbolized a break from the prevailing malaise (e.g., Carter following Nixon; Reagan following Carter; and Obama following Bush).
3. Commodity prices collapsed--especially precious metals--after inexplicably spiking.
4. Inflation fell dramatically.
5. Emerging economies (BIK) ultimately were hit harder than developed economies.
6. Stocks suffered initially, but recovered much faster, despite pessimism about the "death of equities" or the austerities of the "new normal."
Unfortunately, there are no established methods for predicting secular changes in stocks, bonds, and commodities, so until there are, this symptomatic approach to markets would appear to be the only way we have to make predictions above and beyond the cyclical horizon.
DOES FED POLICY MATTER?
Although debate continues to swirl around the impact of QE and low interest rates on stocks, I am extremely skeptical about the notion that monetary policy has a significant impact on asset prices or inflation. From what I can tell, most of the QE commentary is just guesswork and assumptions. Lay a graph of QE over stocks, bonds, commodities, inflation, or whatever, and see which one fits.
Whatever the case may be, I am not smart enough to figure out what impact QE is having or what effect tapering will have. From my perspective, asset prices and macro-economic indicators are behaving no differently than they have over the last forty years. That makes it hard for me to believe in the rhetoric that we are really in uncharted territory.
THE NEW NORMAL IS NOT THAT NEW
So, let me add a few developments that I have observed since I wrote the one-year outlook article back in April. These are lagging indicators that seem to confirm the secular theme I have been talking about this year and reduce the likelihood that tapering will kill this bull off.
First, we can begin by observing that the earnings yield (E/P) tends to correlate with interest rates, especially over cyclical time frames since the 1970s.
(Sources: Unless otherwise noted, data in all further charts courtesy of Shiller)
Second, earnings tend to correlate with interest rates (UST, IEF) over cyclical time frames. In the chart below, one can see that, since the early 1970s, earnings and bond yields have correlated with one another when divided by their 60-month moving averages.
Those have been fairly constant relationships over the last forty years, although the correlation between earnings and interest rates has softened recently.
What is really interesting is how stocks interact with both earnings and interest rates. I have found that during periods of secular P/E contraction (i.e., a secular rise in the earnings yield), stocks tend to correlate with earnings and interest rates at cyclical intervals. One could say that stock prices become very "rational" during these periods. But, during secular P/E expansions (i.e., a secular decline in the earnings yield), stock momentum tends to be inversely correlated with earnings and interest rates at cyclical intervals.
In the charts below, the S&P "outperforms" earnings and yields on a short-term basis during P/E expansions (such as in the 1980s and 1990s) and inversely correlates with them during those expansions.
Over the last two years, although interest rates were weak going into 2013 and earnings momentum declined, stocks accelerated, and there was all sorts of talk about interest rates and inflation failing to "confirm" the stock market rally or stocks being in a bubble. In fact, this seems to be typical behavior of a secular bull market in stocks (and a bear in commodities) under our monetary system.
I have also found that when short-term moves in bond yields (especially long-term yields) have correlated with the yield curve spread over the last forty years, P/E ratios seem to move higher. As long as ZIRP is maintained, it will be inevitable that long-term yields will highly correlate with the yield curve spread.
WILL THE NEXT 40 YEARS LOOK LIKE THE LAST 40?
Of course, there is nothing inevitable about any of these relationships. Most of them seem to be contingent on the monetary system. Although the relationships between the earnings yield and commodity prices appears to be fairly stable over the long run, as do broader relationships between stock yields, interest rates, GDP growth, and commodity, producer, and consumer prices, most of the relationships discussed just now have only been true since Nixon slammed the gold window down on the world's fingers.
Many of these relationships are quite different from what prevailed during the time before the Fed was established. For example, although earnings express a fair (and increasing) amount of cyclicality, they have been extremely stable over the last half-century. Changes in the secular disposition of the P/E ratio have come entirely from the 'P' side since the 1950s. But, prior to the Fed, stocks were highly correlated with earnings and less volatile. Most secular shifts in the P/E ratio prior to the 1920s originated from volatility in the denominator. These tremendous structural shifts in stock market performance vis-a-vis earnings can be seen in the following charts: the so-called "irrational exuberance" found in the stock market is a curiously modern phenomenon.
Moreover, both corporate profits relative to GDP (a proxy for national profit margins) and stocks relative to profits (P/E) appear to be in a long-term upward trajectory, especially over the last fifty years. These kinds of changes have coincided with sea changes in a broad set of economic relationships (the collapse in American real wages, the emergence of Baumol's cost disease, the breakdown in the Phillip's Curve, and so forth) and the unprecedented expansion of credit/debt and the financial sector. The links between these factors remain obscure and may prove to be coincidental, but it is nevertheless rather hard not to connect them to the rise of the Federal Reserve and the dollar hegemony.
Whether these changes can be attributed to the existence of a central bank or not, the important thing is that there appear to be both stable relationships over the very long-term (i.e., centuries) and the medium-term (i.e., decades), but a breakdown in the latter will almost inevitably occur. Even if, as some argue, the P/E ratio has arrived at something like "a permanently high" long-term average, it is also highly likely that there is a natural limit to where P/E ratios can go, and therefore, over the very long-term, we have to be skeptical about how likely it is that markets can continue to be pushed upwards by multiple expansions.
Similarly for profits. The long-term upward trend in profit margins cannot be maintained forever. People like Warren Buffett have drawn red lines for profit margins before (at 6%), only for margins to nearly double that, so I will refrain from speculating on where margins become unsustainable, except to say that we can be certain that there is a definite mathematical limit. A secular-level decline in margins would not necessarily be bearish. In fact, as I discussed a month or so ago, it could just as likely be bullish, but the long-term trajectory (beyond decadal vicissitudes), must give way to gravity at some point.
(Sources: St Louis Federal Reserve, Shiller, Measuringworth.com)
Having said all that, profits, especially nonfinancial profits, remain the most curious element of this market. It is difficult to draw a lot of conclusions from a slight, short-term deviation, but they remain stronger than where their historical relationships to the P/E ratio, interest rates, and financial profits suggest they "should" be at. In a typical P/E expansion, profits should probably be weaker than they are at present.
Ultimately, there is no way someone can guarantee a certain outcome about what will happen in 2014 or 2015 or whenever. My belief that stocks will likely be higher in January 2015 than they are today and precious metals lower rests on relationships and behavior that appear to be temporary, at least partly artificial, ultimately unsustainable, and yet surprisingly durable.
Quite frankly, there is no right way to predict markets, but until the relationships discussed above break down or the cyclical or secular signals reverse, I cannot see why one should try to swim against the current by being bearish on equities or bullish on commodities. I continue to be bullish about this market, but not blind to its imperfections.