At heart, I'm a value investor. Buying companies with a "margin of safety" is the best way to generate superior long-term returns. However, I always maintain a very close eye on the macroeconomic backdrop. There's a reason for this: if you look at markets historically, the "big picture" stuff can often undermine valuation. What once looked "cheap" can suddenly look very expensive.
We can find a recent example of this phenomenon with copper producers. In January 2012, Southern Copper (NYSE:SCCO) sold at a P/E ratio of about 11x. It looked cheap, but only if you completely ignored the macro backdrop. The Chinese Asset Bubble had led to skyrocketing copper demand, causing copper prices to quadruple from levels a decade prior. I wrote about this situation in late '11 in an article, "Copper Producers Could Still Have a Long Way to Fall." There, I argued that China's demand surge was unsustainable and that, in spite of a 20% drop in 2011, copper prices had the potential to fall much further, which could destroy earnings for the miners.
Since that time, SCCO is down about 10% during a time period when the S&P 500 index (NYSEARCA:SPY) is up about 50%. The "value" case for SCCO was predicated upon the key assumption that copper prices and earnings would hold up and continue to grow. That did not happen, as SCCO's earnings have declined 30% over the past two years due to waning Chinese demand growth and falling prices. That 11x P/E ratio that looked "cheap" in early 2012 now seems quite high in hindsight. SCCO would've needed to sell at a 7.5x P/E ratio in Jan '12 to have generated the same return as the S&P index.
Of course, this is just a minor example. The most dramatic case for how the "macro" can undermine the "micro" came with the famous Crash of 1929. From a historical basis, the US stock market was not that terribly expensive in 1929. The P/E ratio of the S&P 500 was around 17x for most of the year; slightly above the historic norm, but hardly in stratosphere. The late 20's market, however, was fueled by easy monetary policies by the US Federal Reserve Bank, which created a massive and unsustainable earnings boom. The boom eventually turned to bust and earnings for the S&P 500 contracted rapidly. By 1932, S&P 500 earnings had fallen 75% from their 1929 peaks.
Looking at the Crash of 1929 within the context of historical P/E ratios, it's no more than a minor blip. In fact, the overheated 1929 market doesn't look much different than the overheated 1959 market. Yet, the '29 market fell 90% before bottoming out in 1932, while the 1959 market (with a similarly high P/E) fell a mere 10% before hitting bottom. The difference was that the '29 market was fueled by loose money and surging debt. The Federal government then responded to the '29 crisis, with a series of flawed policies, including the Smoot-Hawley tariff and one of the largest tax increases in American history.
All of this is to say that the macro environment matters. The decisions of policymakers and central bankers can have a huge impact on markets. In an increasingly globalized economy, it's not only the decisions of American policymakers, but also the decisions of global policymakers and central bankers that can impact your portfolio.
If the markets have seemed much more volatile over the past 17 years, it's not a coincidence. Monetary policies of the US Federal Reserve Bank, as well as actions by foreign governments, have had an outsized influence on bond and stock markets. These activities have been creating greater risks in the markets. In this article, I want to examine the connection between foreign government buying of US bonds, the Federal Reserve's policies, and the behavior of both the US bond and stock markets.
The US Housing Bubble
Before shifting into the current market environment, I want to start by examining the "Housing Bubble" era, which runs from 1997 to 2005. It's important to understand that era to get a better sense of the current one. I've written about the US housing bubble several times and my view is that it had several causes. However, by far, the biggest two drivers of the bubble were:
(1) Loose monetary policies promoted by the US Federal Reserve Bank beginning as early as 1997 and lasting till at least 2005; and
(2) China's decision to prevent the Yuan from appreciating starting around 1997.
The second one might seem odd, but the housing bubble, bust, and subsequent financial crisis all seem to have dates closely aligned with China's (NYSEARCA:FXI) major currency policy shifts. Is that completely a coincidence? My view is that it's not. Rather, China's USD peg, which was primarily used as a vehicle to artificially undervalue their currency from about 1997 onwards, resulted in a US bond buying binge that allowed the US Federal Reserve to aggressively pursue loose monetary policies in the early 00's.
China's Bond-Buying Binge
From 1981 to 1994, the Chinese Renminbi (NYSEARCA:CNY) popularly known as the Yuan, declined versus the US Dollar, falling all the way from 1.55 Yuan per USD in '81, down to 8.72 Yuan per USD in '94. Somewhere around that point, China's export boom started to push the Yuan higher to 8.3 Yuan per USD by '97. Once the Yuan started to reverse, that's when Chinese authorities began to drag their feet a bit. Rather than allowing the currency to naturally appreciate, the peg became stubbornly fixed from around 1997 to around mid-2005, shifting only from 8.32 to 8.28 in that entire eight year span, in spite of phenomenal Chinese export growth. In 2005, China finally revalued the Yuan, allowing it to trade more freely.
The decision by Chinese policymakers to keep the Yuan undervalued had major ramifications across the globe. In the US, it impacted interest rates since China needed to buy a rapidly growing quantity of US Treasury securities. Foreign holdings of US Treasury securities increased from 10.6% of US NGDP in 2000 all the way to 32.9% of NGDP by around 2012.
China was the main driver of this "foreign government stimulus." It increased its US Treasury holdings 69.4% YOY by June 2003, 50.9% in July '05, and 70.9% in July '09. From March 2000 (when the data series begins) to December 2010, China increased its total holdings of US Treasury securities from $59.4 billion to $1.16 trillion; an 1850% rise!
China's massive buys of US treasuries impacted the market significantly. The yields on US 10-year Treasury bonds (NYSEARCA:IEF) have fallen after every major surge in Chinese buying.
From November 2000 to 2001, the US 10-year Treasury yield fell from 5.8% to 4.6% after China increased its holdings by 32.3%. More dramatically, from June 2002 to 2003, the yield on the US 10-year treasury fell from 4.9% down to 3.3% after China increased its holdings by nearly 70% over the year!
Even from July '04 to '05, after the Federal Reserve had been tightening policy for over a year, the 10-year yield fell from 4.5% to 4.1% after another major surge in Chinese buying. Conversely, Treasury yields held steady in May 2009 to May 2010 after China significantly reduced its buying activities. From a glance at these stats, it would appear that China's forays into the US bond market had a significant impact on interest rates.
Don't Forget About Japan
While China was the 800-pound gorilla in the US Treasury market from 2000 - 2010, it's worth noting that Japan (NYSEARCA:EWJ) was frequently active, as well, increasing its holdings by 62.2% YOY in April 2004. It has also picked up its pace of buying since the financial crisis.
Even with China dramatically increasing its share of US treasury holdings, Japan's share still managed to rise significantly from 2001 to 2004. After that, Japan's share decreased again till the financial crisis. Since the crisis, Japan has increased its holdings as from 3.9% to 7.0% of US NGDP. While China is still the largest foreign holder, it's possible that Japan could pass it within the next two years.
China's buying spree seems to very much coincide with the timing of the US housing bubble. US housing prices started to rapidly push upwards around 1997 and 1998. Following the Tech Bubble collapse in 2000, the housing market cooled temporarily, and the Federal Reserve aggressively eased rates. Housing prices did not take very long to rebound and shot up even more rapidly than they had before. Meanwhile, the Fed continued to ease all the way into mid 2003, when Case-Shiller showed 13.7% year-over-year growth in the 10-City housing price index. By late 2004, the US housing market was seeing 20% YOY growth in prices.
Further examining the housing bubble, we can see that bank credit briefly dipped after the collapse of the tech bubble, before rapidly surging again. The Fed continued to lower rates regardless of this rapid increase in credit.
US Disinflation and the Subsequent Federal Reserve Stimulus
The Chinese and Japanese governments both provided significant back-door stimulus to the United States, by beating down Treasury yields during the 00's. Since 2011, China's exposure to US Treasury bonds (at least as a % of US NGDP) has actually dropped. The US Federal Reserve has replaced China as stimulator-in-chief. The result is that bond yields have continued to fall, even in spite of a lack of major activity from China.
The US Federal Reserve's ownership of Treasury securities fell significantly in '07 and '08, before skyrocketing from 2009 onwards. The first quantitative easing program [now known as "QE1"] was launched in late 2008 and focused on mortgage related securities. The second phase of QE1 began in March 2009 and focused on US Treasury bonds (NYSEARCA:TLT). In the chart below, the blue lines represent the beginning of the Fed's QE programs, while the orange lines represent the end-points.
What's even more fascinating is the connection between the US Federal Reserve's bond portfolio activity and the S&P 500. After the Fed initiated a major sell-off of treasuries in 2007 and 2008, the US stock market collapsed. The Fed reversed course in March 2009, and as chance would have it, the US stock markets bottomed that same month. Since then, the S&P 500 has tracked Fed moves very closely, with only a few minor deviations.
We can see a similar trend with the Russell 2000 index (NYSEARCA:IWM).
The other interesting correlation is margin debt vs. the S&P 500. With every spike in margin debt, the S&P 500 has surged. NYSE margin debt is now at similar levels (as a % of NGDP) as it was in 2000 and 2007. It's likely that the Federal Reserve's activities have been largely responsible for this recent surge in margin debt.
Before jumping into conclusions, there are two more charts that I can really only throw into the "miscellany" category. The first is on Belgian buying of US treasuries and the second is on the price of gold.
This is perhaps one of the oddest stats I found digging through Treasury data. Belgian holdings of US Treasury securities have skyrocketed since 2011, rising from about 0.2% of US NGDP in early '11 to 2.0% currently. Belgium is now the third largest foreign holder of US treasuries. It's not completely clear what's behind this move, but there is speculation that either China or Russia could be using Belgium as a go-between to disguise their own moves.
My final chart shows gold prices (NYSEARCA:GLD) over the past 46 years, with annotations highlighting certain events, including the US leaving the gold standard, the Japanese Asset Bubble, the Plaza Accord, and China's currency moves. While the connection between these events and gold prices is not quite as obvious as it was with copper prices, it is nevertheless an interesting exploration.
At the very least, it's clear that almost all the major spikes in the gold price chart are related to inflation somewhere. The US "high inflationary" period which ran from about 1978 to 1981 coincides with a major surge in gold. We can also see two spikes that occur during the Japanese Asset Bubble. Gold prices mostly fell from 1988 to 2000, which coincides largely with the Japanese disinflationary era (and low inflation in the US). Gold hit its top in 2011, which was also about the time that China's inflation and stock markets topped out.
Government and central bank policies heavily influence both bond and stock markets across the globe. China's attempt to prevent the Yuan from appreciating led to significant US bond buying, which then reduced US interest rates, and may have partly helped to fuel the US housing bubble.
Since the financial crisis, and especially after 2010, the Federal Reserve has moved in as the major buyer of US Treasury bonds, and has continued to push US interest rates downward. Fed bond buying and selling appears to be highly correlated with the S&P 500 and other major US stock indices, suggesting that Fed activity may be one of the largest drivers of the market.
The market crash of 2008 took place after the Federal Reserve dumped off a massive amount of Treasury securities and the 2009 stock market bottom coincided with a surge in Fed buying. Since then, almost every major spurt in the US markets has occurred after Federal Reserve stimulus, and the withdrawal of said stimulus has almost always led to a market correction or at least a more subdued market.
The biggest takeaway from all this data: there are substantial risks lurking out there. With the market looking as if it's almost completely fueled by Fed stimulus, any withdrawal of that stimulus could be problematic.
While I've found an increasing number of attractively priced stocks over the past few months, I nevertheless advocate some caution due to the macro environment. For the average investor, buying underpriced, dividend-paying stocks is the best strategy. I've been a fan of BP (NYSE:BP) for awhile and it's been our largest holding for the past year. There are other opportunities out there, such as well-diversified REITs like Realty Income (NYSE:O).
Holding a bit more cash than normal can help reduce the risk of your portfolio. While cash will earn a 0% return, the benefit is that it can provide you with a cushion in case there's a significant market correction. A cash position in the 10% - 30% range is reasonable; avoid extremes such as "100% cash" however. The goal should be to find a handful of reasonably-priced, high-quality stocks and if the prices begin to fall, you can begin to deploy some of your excess cash to buy more shares at better prices.
For more sophisticated investors, hedging strategies can be very beneficial. The restaurant sector may be particularly vulnerable in a downturn and many companies in the sector sell at exceeding high multiples, in spite of modest growth. For this reason, we've embarked upon a "restaurant basket" shorting strategy.
Overall, this is a very complex market. There are some reasonably priced stocks out there that should form the core of your portfolio holdings. At the same time, there are very high macro risks that many investors are ignoring. It's prudent to take some steps to protect yourself in case those risks eventually transform into a big market correction. While I'd never recommend completely pulling out of the market, I do recommend adopting a defensive and conservative posture given the macro risks.
Disclosure: I am long BP, O. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I own long-dated put options on FXI as a hedge.