In a previous article about the macroeconomy, I pointed out that bonds were about to enter a bear market, that inflation would start to appear and that deficits would soar. Well, all of that has happened and is going to worsen.
The 10-year bond yield is now touching 3%, which is a pivotal number (see chart below from Bloomberg).
As long term bond yields touch this number, we will see a pattern shift in the P/E ratio average of equities. P/E ratios tend to rise when bond yields go up, which will push up equities. This is true for bond yields below 3% as in that stage, investors feel that the economy is growing again as interest rates rise. But once the 3% threshold is reached, P/E ratios will drop. This is because average dividend yields are historically at 3-4%. When bond yields go above 3%, people will trade stocks for bonds as bonds will yield more. At a constant earnings rate, the stock prices will have to come down when bond yields rise. The average P/E ratio will be about 17 at 3% bond yields, dropping to 14 at 6% bond yields (see chart below from Morgan Stanley Research).
Now where do we stand today on the equity market P/E ratios? The S&P Composite is trading at a P/E of 24, which is historically very high (see chart below from Advisor Perspectives). We could see a 30% drop easily, to come back to the historic average.
When we look at the Buffett Indicator, tracking total market capitalization of equities to GDP, we see that stock markets have never been this overvalued since the dot-com crisis (see chart below from Gurufocus). So we have a long way to go down.
This week, we did have a little taste of what could happen. The VIX shot up on Monday, February 5th and stocks went down almost 10% (see chart below from Markets Insider).
On a longer term chart, this "major drop", is but a small blip. So we are just in the initial stage of a bear market (see chart below from Google Finance).
Another major warning sign I could find is that the interbank loans are deteriorating (see chart below from FRED). A plunge in interbank loans can be seen in January 2018.
All of this means that banks aren't lending to each other anymore as banks rely more and more on the easy money of the central banks. Libor rates are moving up, pointing to increasing credit risk (see chart below from FRED). These rates will continue to move up and stay above the Fed funds rate, because the latter is risk free. If the Federal Reserve doesn't stop increasing rates, it will be responsible for an equity market correction and possibly also a real estate market correction.
With rising Libor rates, bond yields will also keep going up and this leads me to the next major issue. As bond yields keep going up, the U.S. dollar will fall with it. You can see it like this: when investors move away from U.S. bonds, they will sell their dollars and put them back into other assets, mostly denominated in another currency. This brings me to my favourite chart below, which says that while U.S. bond yields rise, the U.S. dollar falls.
We are entering a decade of a declining U.S. dollar index and this is confirmed by rising deficits (see chart below from FRED). The red chart here seems to be plunging (higher deficits) and will bring the U.S. dollar down with it. Make no mistake, deficits are going to go up. The latest nail in the coffin comes from the 2-year budget deal, which was signed this week and will add another $400 billion to the debt within 2 years. The $80 billion in disaster relief is one time, but the $160 billion in spending will recur every year. So over 10 years that will add $1.6 trillion to the national debt, on top of the $1.5 trillion added by the tax cuts.
It is time to wake up and move your assets out of the U.S. dollar, the U.S. stock market and the U.S. bond market.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.