Market Thoughts and the Long-Term Outlook for Inflation
July 28, 2010
A whole 1 point decline in the S&P 500 and for the bears it was like winning in extra innings after a three-week losing streak (and in contrast to the rally days, volume on the NYSE expanded 10% yesterday). We received all sorts of emails yesterday that Barton Biggs had reloaded the gun and moved from 50% to a 75% weighting in equities. Maybe that was the kiss of death. Maybe we have again stalled out around the 200-day moving average. Or maybe the market is simply the most overbought it has been in nearly three months, according to some oscillators.
Perhaps, like Barton, everyone has gone long the market again and we recall a survey that we saw over the weekend that PM’s are now 68% weighted in equities in their balanced funds. We can also see from the CFTC data that the net speculative position (futures and options) at the Merc has swung from a net short position of 40,000 contracts in mid-June to a net long position of 3,300 contracts currently. That sort of move will certainly move the needle. Ditto for the 1.2% decline in NYSE short interest over the past month. In the past two weeks, Market Vane bullish sentiment on equities has moved up 5 points. It’s all good. Meanwhile, consumer confidence has rolled back to a five-month low (what does Main Street know, anyway?).
Earnings on the surface seem to be doing just fine but at the same time, we can see that the economy slowed visibly as Q2 came to a close and the July data are telling us to expect a slightly different tone to Q3 guidance. There was a nifty article on Market News yesterday showing how 82% of the corporate universe beating EPS estimates is standard fare and that only 68% are doing so in terms of revenues (a figure lower than we saw in the second quarter of 2008 when the economy was knee-deep in recession). Sales are up the grand total of 9% YoY and this being compounded off a -14% trend this time last year – so margins continue to stretch out to the limits and one has to wonder how long that is going to last. Who knows? Maybe profits end up going to 100% of national income and labour’s share totally vanishes.
I was asked yesterday in an interview how I respond to criticism for missing the surge in the equity market. Well, for one thing, those that were long in 2009 got their clients killed in 2008 and it’s still not even a wash. Second, I was recommending credit and commodities last year, not cash, and these strategies played out well. There are always ways to make money without having to go whole hog into the stock market (if you think I’m bearish, there are others who make me look like Jim Carrey – have a read of “Doomsday Shelters Making a Comeback” on page 3A of the USA Today).
More to the point – we can get 80% rallies in a secular bear phase, and to be totally honest, I have never billed myself as a market timer. There are others here at GS+A that do that much better than me. The Nikkei has enjoyed 260,000 rally points in the past twenty years and the market is still down 70%. If you partake of these bear market rallies, know when to get out – or at least sell call options and collect the premium. It is amazing how people are still stuck in this belief that the 80% rally off the lows is still somehow a prevailing market condition – the S&P 500 peaked on April 26th and even with the recovery of the past few weeks, the S&P 500 at 1113, with all due respect, is no higher now than it was on November 16th of last year.
Through all the zigs and zags, this market has done diddly squat now for over eight months. You were better off clipping coupons, even at these low bond yield levels. And as for that 80% rally from March/09 to April/10, we wonder aloud how many are going to remember it once we retest the lows – the market rallied 50% in the opening months of 1930, as an example. Do you ever hear anyone today talking about the great rally of 1930? Does anyone today ever have much to say about 1930, or if they do, is it a fond memory? Well, the market rallied 50% at one point that year. There’s not much left to say on this one.
For the time being, it probably pays to treat the market as a 1040-1220 decision box as far as the S&P 500 is concerned. Even after the 9% rally of the past two weeks, it is still at the halfway-point of this well-defined range of the past ten months. What is amazing is how Main Street and Wall Street have diverged in recent weeks. The market has rebounded nicely and all we see now is optimistic prognostications about the outlook because of an earnings season that seemed to contain most of its growth in April which was three months ago – meanwhile, what did we see in the July consumer confidence report? That 9% of American households rate business conditions as being “good”.
Are you kidding me? That’s all we get with a 0% funds rate, a near 10% deficit/GDP ratio and a $2.3 trillion Fed balance sheet? By way of comparison, back when Lehman failed in September 2008, 13% believed business conditions were “good”, and when Bear Stearns failed in March of that year, the ranking was at 16%. In the wake of the 9-11 tragedy, it was 19%.
Meanwhile, 44% give the business background a “bad” rating, so the ratio of growth bears to growth bulls in the survey is nearly five-to-one; we doubt you will ever see that sort of ratio among surveyed economists or strategists. Now maybe these people polled by the Conference Board don’t know the first thing about the economy, but last we saw, it is consumers that command a 71% share of GDP so their opinions will count if they translate into (in)action.
Those that do not see how abnormal this so-called recovery has been, consider that in expansions, consumer confidence averages 102; in recessions, it averages 71; and we are at 50.4 as of July. So basically, the level of consumer confidence is 20 points below what the average level is during a recession and yet virtually everyone dismisses double-dip risks out of hand. Maybe there is no double-dip because we never really fully emerged from the recession that we know officially began in December 2007 – that was certainly the message out of yesterday’s confidence report.
THOUGHTS ON THE LONG-TERM OUTLOOK FOR INFLATION
Let me start out by saying that I do not believe that bonds are any “better" an investment than stocks, at least in principle. They both have their advantages.
For bonds, the advantages are that they provide an income stream – the principal and the interest payments are guaranteed in the case of most government securities; and in the case of the corporate sector, it inevitably comes down to the quality of the credit and the longevity of the company in question. In addition, the yield at the time of purchase is almost always at some significant positive spread over CPI inflation.
Stocks represent ownership in corporations that have assets and strive to make a profit, often paying out a portion of the profit in the form of dividends and retaining earnings to grow the business and increase the dividends in the future.
But the primary purpose of this comment is to suggest what things may look like when the Great Bull Market in Bonds, which began in 1981 with 30-year Treasury Bonds yielding 15.25%, finally comes to its glorious end.
For starters, I think it is safe to say that the bull market in bonds will end reasonably close to the point in time that inflation (or deflation) bottoms. This is because we have determined that by far the major economic factor that correlates consistently with the direction of market-determined interest rates, at least for long term Treasury Bonds, is CPI Inflation (headline and core).
The bond market, like politics, is an emotional issue and not well-liked in general by Wall Street because it has a negative correlation to the stock market most of the time. For a growth bull, the bond is the "enemy". The economic environment that most favours the long end of the bond market tends to be low or no growth and bonds have traditionally been an asset allocation decision that is bearish on the stock market.
As a result, fear mongering often takes the place of thoughtful and objective analysis when it comes to bond market commentary. One way or another, the long end of the bond market has continually been characterized as high risk for the last 30 years that it has been outperforming the S&P 500. That’s a little unfair – after all, it is the benchmark risk free asset for funding actuarial liability when taken to the extreme of a 0% Coupon Treasury Strip.
Let’s move on and make a sensible and objective effort at making a long-term forecast for core CPI Inflation. Based on our analysis, we could well see core inflation receding from around 1% now to near 0% in the next 12-to-24 months, which would imply an ultimate bottom in the long bond yield of 2.5% and 2% for the 10-year T-note. We should add that as long as the Fed funds rate remains at zero, reverting to a normal shaped Treasury curve would generate similar results for the long bond and 10-year note at the point at which the inevitable "bull flattener" reaches its climax. As we saw in Japan, this will take time, but yields at these projected levels will very likely come to fruition in coming years.
So what will be the cause of the next secular uptrend in inflation or hyperinflationary shock? It pays to look back at history. Prior to the inflation of the 1970s-early 1980s, periods of very high inflation were primarily associated with war. Increased credit demands to fund the war effort combined with the drop in productivity that goes along with blowing everything up is an inflationary stew.
Wars were typically followed by brief periods of deflation followed by stable prices until the next war. In the 1970s several factors other than war led to the brief bouts of hyperinflation and they are much debated. What is perhaps most important to recognize is that whether it is war, OPEC or rampaging Baby Boomers, history supports the notion that high inflation, at least at the core CPI level, tends to occur in brief bouts.
A quick look at the core CPI chart shows that for all but a brief period since WWII, inflation has been well below 5%. But it was the period from 1970 to 1980 that contained all readings above 5%. Coincidentally, this was the period in which the Baby Boomers were buying their first refrigerators to go along with a bungalow as they formed their households.
By 1983, core CPI was back down to 5% and never looked back, but the psychological damage was already done. Inflationary expectations were indelibly etched into the mindset of the Baby Boom cohort. So everyone positioned themselves for inflation by leveraging up their asset purchases. Inflationary expectations were the rationale for overconsumption and depleted savings rates.
What resulted was an interesting dichotomy. Asset prices inflated during the 1980s, 1990s and into the 2000s. Although the secular bull market in equities ran out of steam early in the last decade, most other asset prices (particularly residential real estate) went parabolic into the peak of the secular credit cycle in 2007.
Core CPI on the other hand, has been continually slowing since the peak of 13.6% in 1980 and even at the peak in the ratio of household debt to disposable income in 2007, was running no higher than 3%. Unlike geopolitical disruption or demographic shocks, asset bubbles and the credit cycle tend to have an important secular behavioral impact on society and therefore, the economy.
The credit collapse of the 1930s around the globe dramatically altered social norms related to consumption, speculation and saving. Those who were adults with families in the 1930s shunned debt and believed in “pay as you go” for the rest of their lives. By way of comparison, the inflationary shock of the 1970s enticed the Baby Boomers into a spending and speculative binge. Rather than save, they executed a failed strategy of speculating their way to a dignified retirement.
Now the clock has run out and household behavior is poised for a dramatic change. If the 55 year-old Boomer resolves to work longer and harder, cut the budget to save more and liquidate debt, can we really expect the politics to maintain the status quo? This type of behavior from the developed world will exert enormous deflationary pressure. In addition, the huge amount of debt and entitlement expansion that has occurred at the government level, particularly in response to the financial crisis, will be an enormous drain on economic growth as taxes are raised to service the debt and budgets are dramatically cut.
For this reason, it is appropriate to consider the possibility that the next secular uptrend in inflation must await the rebuilding of the household and government balance sheets to levels that launched the last uptrend. That, by the way was about 30% debt to disposable income in 1950, 60% in 1970, and realistically, it could take a generation to get back to that range from current levels of around 125%.
The outlook is not entirely dependent on the behavior of the developed world’s consumers and governments, however, if we are really trying to envision the next 20 years, the emerging market consumers (in places like China and India) have extremely low debt levels and high savings rates. Changes in emerging market consumer behavior should be, on balance, a source of counteracting inflationary pressure. Then again, the forces that most contributed to disinflation in the last three decades were globalization and technological innovation that lead to dramatic improvement in productivity and lower unit costs.
There is no reason to doubt that these forces will continue to be moderately supportive in the near future, even if higher marginal tax rates and reduced labour mobility (due to the fact that one-in-four Americans with a mortgage have negative net equity in their home and are thus "stationary") end up constraining the noninflationary growth potential in the United States (and Europe).
While the disinflation from 1980 to 2007 was mostly supply-side related, the deflation pressure now is coming from the demand side – a deficiency of aggregate demand caused principally by the contraction in credit (40% of the private market for securitized consumer and mortgage loans has vanished over the course of the past two years).
So, putting it all together, it is reasonable to conclude that prices are most likely to be stable for a generation. By stable, I mean flat and perhaps oscillating around plus or minus 2% (look at Japan, where there has been no such downward price spiral – the CPI sits right where it was 18 years ago). Because the economy is still gripped with overcapacity in several sectors, real estate and labour in particular, we may be headed towards an outright deflationary backdrop over the near- to intermediate-term, but a deflationary spiral seems overly pessimistic considering all the good things in the mix, including a reflationary policy backdrop which certainly helped establish a price floor in Japan in recent years.
That said, a “V” shaped recovery has always been off the table from our perspective because we still have so far to go in the secular credit collapse, so all the balance sheet expansion that the Fed has done and will do in the future should continue to offer up little more than an antidote. In turn, a reversal of CPI or core CPI trend to the upside for the next couple of years seems like a low- probability event, particularly given the demographic and retirement pressures that increasingly favor savings over spending in the broad consumer sector.
And what about the end of the Great Bull Market in Bonds? It could come pretty soon. You heard right. Long-term Treasury Bond yields could reach a secular bottom in the next couple of years. And what will it look like?
Well, rates will likely be much lower than anyone expects and, as typically occurs at secular market peaks, the public will probably swear by long bonds at the primary lows in yields. After all, what other safe investment has delivered inflation plus 2% or much better, guaranteed, in the past 30 years? But in order for the public to adore 2.5% yielding long Treasury Bonds, it will first have to believe in stable or modestly deflating core CPI as a long-term forecast. At last count, households still have a near-3% long-run inflation expectation according to the most recent University of Michigan survey.
The public will also need to be fed up with risk and, judging by the performance of stocks and real estate in recent years, who could blame them? And for the Baby Boomer at 55 or 60, “Gambler’s Ruin” isn’t an option. We can see that they are already voting with their feet as the mutual fund flows clearly indicate – increasingly towards income and away from capital appreciation strategies.
Finally, the public will probably need to be afraid to be out (of the bond market, that is). That will most likely be due to a “flight to quality” as we continue suffer the secular bear market in stocks and real estate and suffer the economic setbacks of renewed recession sooner than many pundits think.
One last thought on stocks: Like I said before, bonds are not better than equities. They are different. Every asset class has its time to be the leader. It goes without saying that the best time to allocate to equities is at the point of maximum pessimism and when the market is trading very inexpensively as it was at previous post-war secular bear market bottoms.
We know that historically, that “moment” has coincided with valuations below 10x on trailing “reported” earnings and dividend yields above 5% as measured by the S&P 500 Index. Note that while many a pundit cites the consensus as being $96 EPS for “operating” earnings for 2011, it is closer to $76 on a true “reported” basis (so apply a 10x or even a 12x multiple on that estimate!).
We also know that the conventional wisdom is oh, so wrongly linear at inflection points, so not only is the market cheap at these secular lows, but the future is much brighter than generally perceived. Pulling the trigger at that magic moment when bonds have peaked (yields have bottomed) and stocks can’t hurt you anymore, with dividend yields secure at twice the Treasury rate, would be nice. But you never know for sure at the right time, or you think you know for sure but are too early.
For now, we are not even close. Sentiment toward long bonds and inflation are still extreme and recent survey data show the typical balanced institutional portfolio manager with a 68% allocation towards equities. As for bonds, the yield on 30 year Treasury was recently core CPI plus 3%; 4% for a BBB corporate bond; and a 6% real yield in the BB space. The S&P 500, meanwhile, sports a P/E multiple of close to 15x and the dividend yield is barely over 2%.
In this light, it would seem highly appropriate to maintain a SIRP – Safety & Income at a Reasonable Price – strategy for the near- and intermediate-term, while keeping a close eye on the exit plan from this recommendation, though that could still be a few years down the road.
To continue reading, go here. (Free site registration required.)
(c) Gluskin Sheff