I’m not a downer all the time. I try to go where the data leads, in a risk-averse manner. If it keeps pointing in the same direction, so be it.
When I first began writing on this website in August 2010, I argued against the prevailing gloom. Recovery Summer as predicted by the advocates of Keynesian stimulus had been a bust, the Fed had already begun what was later codified as QE 2 (but there was no cheerleading), some economists were calling for a double-dip recession to have begun, and ECRI was publicly saying that it would let us know in a couple of months if this was a mid-cycle slowdown or a prelude to a new recession. (In November 2010 ECRI decided there would be no recession soon and instead called for renewed expansion; they also vigorously criticized QE 2 as being dangerously stimulative.)
I thought the odds favored “risk on”, and said so on multiple blogs.
Luckily, I was long silver at $20 an ounce, gold, multinational stocks, emerging market bonds and currencies, AAPL, etc.
But the U.S. hit on Bin Laden and immediate collapse of the silver price overnight from near $50 to the low $40s was a sign to me that all that weak dollar stuff was done for. The U.S. was back, I felt. I spent the next week exiting numerous weak dollar-related positions, leaving little but gold and cash, and soon began accumulating Treasury bonds. This was duly noted in such posts as Changing on a Paradigm, Goldman Wrong on Rates, Zero Hedge Wrong on Oil As Deflationary Side of Biflation Begins Its Ascendancy, Yotai Gap to Provide Fuel to the Treasury Bond Bull?, and Only You Can Prevent Your Own Investments From Burning Up. Weeks and even a month or two went by, and there was no evidence that my thesis was correct. Out of the blue, the collapse I anticipated of both stocks and interest rates occurred, and gold melted upward in price (July/August). As the dust settled in September, I changed tone and, uncertain both about stocks and inflation hedges, wrote Gold on Hold; The New Play May Be in Munis.
From the first week in May 2011 until the close of business this past Friday, the SPY (ETF for the S&P 500 index) has given a total return of about 5%. How did the boring stuff do? Well, a muni bond ETF with the symbol MUB has returned about 20%, much of it tax-free. The “leveraged” closed-end fund with the symbol NIO has had a total return of 30%+, much of it tax-free.
But those are pikers compared to the Treasury bond I’ve written about in numerous blogs. TLT, which is the well-known ETF that passively owns 20-30 year duration Treasury bonds, has had a total return of roughly 43%, almost as much as AAPL. My favored T-bond, the zero 30-year bond, traded at a price of about 25 on May 2 last year. That same bond, maturing in 2041, would now be worth about 44.
This implies about a 75% gain. This beats AAPL, up about 60% since May 2, 2011. It beats almost any asset I know.
All from a debt instrument issued by the world’s largest debtor. What is the pot of gold at the end of this super-performing asset? Sorry, there is no gold. There is no change-the-world invention. There is no growth-plus-inflation story that McDonald’s and Disney offer investors. The bond is simply scheduled to reach a price of 100 in 2041. It’s trading in the 40′s already. This is the hottest ticket going in investments for the past 18 months, believe it or not. And it just might continue to be the the least bad choice around into next year, interim counter-trend moves notwithstanding.
This is the quietest massive bull market in history. Yet, all the media attention goes to stocks, which have gone nowhere for a year and a half, for five years, and for over a dozen years. My sense is that this downtrend in rates and upturn in bond prices is supporting the prices of stocks, commodities and other “risk assets”. Meaning, the huge rise in bond prices has “allowed” overpriced stocks to hold their prices rather than drop.
Profits of U.S. corporations may have entered into their own recession now.
The number of multinational companies that are showing almost no year-on-year sales growth is growing. They can only cut expenses so far to keep profits up. Worse, Political Calculations has added to its ongoing recession call with a post yesterday titled Dividends: U.S. Deeper in Recessionary Territory. It’ shows that a large number of public companies are now reducing or eliminating dividends, at a rate that on a 10-year time frame has only been seen during the Great Recession. It’s fair to expect that many of the companies cutting dividends are U.S.-based, so that it is difficult to point to the rest of the world as the source of all recessionary forces.
In the meantime, industrial production in the U.S. has been weak and often negative on a monthly basis, a trend which is confirmed by railcar year-on-year trends (down 6%, see pp.2-5), real disposable income is not good at all, the prices of sensitive raw materials such as “Dr. Copper” as well as oil are in downtrends, and there is a significant correlation between the direction of the U.S. economy and that of Europe as a whole.
An economic researcher, Marcelle Chauvet, estimates that the chance that the U.S. was in a recession as of this past August had risen from zero this winter to 15%. Worse, her “business cycle indicator” turned negative for the first time since the ‘Great Recession’. It had not been negative except for the immediate aftermath of Hurricane Katrina since the recovery from the 2001 recession. That 15% reading has rarely been seen outside of actual or imminent recessions.
None of the above would matter for the markets if sentiment were gloomy as reflected in sentiments of newsletter writers, who are optimistic, or the VIX (“fear index”). It is not gloomy and, as discussed before, stocks are not cheap, even though the major averages have mostly gone nowhere for so long.
Evidence of over-bullish sentiment abounds. In a recent Barron’s Big Money poll, the favored investment class was A) stocks and B) U.S. stocks within that asset class. This, after U.S. stocks have been the best stock market performer for some time already. This looks like what is called staying with the trend or chasing performance, and I don’t trust it at this point.
Numerous headlines attest to frothy and even record loose conditions in the bond market. From HighYieldBond.com, Sept. 20:
Intelsat Jackson late yesterday made history as the lowest triple-C print on record as it placed a $640 million issue of 6.625% notes due 2022, at par, the middle of talk. The CCC+/Caa2 paper is essentially steady since freed to trade, with quotes at 99.75/100, according to sources.
Bookrunners were Morgan Stanley, Credit Suisse, Barclays, Bank of America, Goldman Sachs, J.P. Morgan, and Deutsche Bank. Proceeds fund a tender offer for $603.2 million of 11.25% notes due 2016, which are vintage-2006 bonds backing the merger of Intelsat and PanAmSat.
That’s pretty amazing, given that a CCC rating has a high likelihood of insolvency soon. Gone are the days of 2009, when high-yield bonds went begging at record spreads of above Treasurys, which themselves had notably higher yields than now. Oh, what a few years of a bull market can do…
That was September. Matters may have gotten even more bizarre.
Barron’s reports that:
Investor Protections for Lowest-Rated Junk Bonds Got Worse in October
New corporate bonds are increasingly junk-rated, junk bonds are continuing to get junkier, and the junkiest among them continue to offer increasingly bad protections known as covenants for the investors who buy them.
Amid heavy October junk-bond issuance, covenant quality remained close to historical lows, Moody’s says Friday.
“October’s distinguishing feature is the poor covenant protection in the lowest-rated credits,” says Alexander Dill, head of covenant research at Moody’s. “For Caa-rated bonds, the historical relationship between ratings and covenant quality broke down in October after holding [in September].”
Of the bonds with Caa ratings, the lowest on the Moody’s scale, 31% are in the rating agency’s weakest covenant quality category, compared with 3.5% historically and 7.7% in September. The low average covenant quality scores were due largely to significant liens and structural subordination risk. Usually lower-rated bonds have stronger covenant packages than higher-rated bonds because investors expect weaker credits to offer more protection.
Barrons also reports that:
2012 Global Junk Bond Issuance Reaches Record $341.6 Bln
After a robust October, global high yield corporate debt issuance now totals $341.6 billion in 2012 year-to-date, surpassing the all-time annual record $322.9 billion set in 2010, per Thomson Reuters figures released Friday. This comes as investors worldwide have been scouring asset classes looking for anything resembling yield, and often settling for junk bonds, even though junk-bond yields have repeatedly set new historic lows this year.
Will it really be different this time?
Too many investors are chasing yield and chasing performance, just as occurred at or near the end of the prior boom. But many bull market leaders such as Apple and Dollar Tree, both of which are among the very few individual stocks I have championed on EconBlogReview going back to 2009 (DLTR) and 2010 (AAPL), have quickly dropped over 20%.
Almost everywhere I look amongst public companies, I see declining earnings estimates for 2012 and/or 2013. In the very long run, well-run, well-financed corporations “ought” to have a better “total return” than most other investments. In the real world, though, where prices are remarked over thirty hours a week, the best argument I can find for stocks is that they are less bad than cash, bonds or tangibles. That might be a persuasive argument if shares were truly cheap. Unfortunately, except for the bizarre overvaluation of stocks in the fin-de-millenium nonsense of 1998-2001 period, a sensible economist calculates that stock prices right now are roughly as far above the actual replacement value of their assets as has ever been seen, going back to 1900. From Andrew Smithers (click through to see chart):
With the publication of the Flow of Funds data up to 30th June, 2012 (on 21st September, 2012) we have updated our calculations for q and CAPE. Over the past year net worth has risen by 9%, with the most significant rise being in the value ascribed to real estate (+9%). Interest-bearing assets have fallen slightly, while interest-bearing liabilities have risen by 6%.
Both q and CAPE include data for the year ending 30th June, 2012. At that date the S&P 500 was at 1362 and US non-financials were overvalued by 43% according to q and quoted shares, including financials, were overvalued by 48% according to CAPE. (It should be noted that we use geometric rather than arithmetic means in our calculations.)
As at 21st September, 2012, with the S&P 500 at 1460, the overvaluation by the relevant measures was 53% for non-financials and 59% for quoted shares.
Although the overvaluation of the stock market is well short of the extremes reached at the year ends of 1929 and 1999, it has reached the other previous peaks of 1906, 1936 and 1968.
Message: be wary of reliance on trailing earnings. Even more important, “forward” P/E’s do not exist. The earnings have not occurred. Ownership of shares in listed companies guarantees nothing. The stock market may close. You put in a dollar, you get back two cents over the next year. This is exciting? This is safe? This is the foundation of deferred compensation promises to retirees? Don’t people know that a number of times since World War II ended, dividends on the DJIA have hit and far exceeded 6%? The yield on the Dow’s ETF (DIA) is 2.46%. If dividends grow 5% a year, they will double in 14 years. The yield on the Dow would then be 5% if the price stayed the same. Why can’t the Dow go nowhere until 2026, even with no depression? If that might be the case, a 3% tax-free bond would turn $100 dollars now into $130 then, free of tax. This would roughly equal the after-tax return on the Dow, but typically dividends do not advance at triple the rate of the 10-year Treasury as I have hypothesized. If dividends advance at 3.5% per year, double the 10-year bond rate, you would simply be better off in munis or, perhaps, a zero-coupon long-term Treasury bond.
Here’s an example of how risky stocks are, even the “blue chips”.
Disney (DIS) had a minimally weak quarter, reported Thursday after the close. The stock dropped 6% the next day. Anyone who bought the stock at the closing price the day before is sitting on a loss equal to 4 or 5 year’s worth of DIS dividends. The current 2% yield on the SPY can be readily erased in one hour, much less one day.
Over many years, what has generally occurred is that stock markets bottom when profit margins are very low (they are very high now) wh;en there are lots of forgotten assets that were once thought to be good but now are just hanging around unused (there are almost none now); when the idea of FaceBook being worth nearly a full one percent of the entire gross domestic product of the United States would evoke scorn, not a (brief) frenzy to buy; and when one single maker of computing devices could not possibly justify an entire hedge fund devoted to it alone. Major market bottoms typically have numerous companies selling below the value of their assets (as economic activity is depressed, not unnaturally and continuously stimulated), and even recessions don’t do a lot of damage to the averages (this was the case in the 1948 and 1982 recessions)- because investors had become overly gloomy and stock prices reflected that gloom.
These points relate back to the theme of this post. Investors are acting as they did at other major peaks in the stock market and of the economic cycle. Instead of flying tech stocks, commodities and shares of their producers, and homebuilders circa 2005, it is now junk bonds, the junkier the better. A friend told me yesterday he just read that hotel properties on Miami Beach are soaring in price again. Amazing- Miami Beach has been discovered! The connection is obvious– the junk bonds are financing takeovers of trophy properties to “protect” against “inflation”. All this is occurring as many European economies, and perhaps that of the U.S., are accelerating to the downside, which tilt the risks to “deflation”. This is precisely what was happening in 2007 and 2008. Deja vu all over again.
Is Europe 2012 going to blow up the world economy as the US in 2008 did? I hope not, but hope is not a strategy.
Governments have attempted to solve problems that were caused in large part by too many bad loans by issuing more debt. Markets have reacted by allowing the strongest governments to borrow at zero or near-zero interest rates. In turn, equity and junk bond markets have unsurprisingly reacted by assuming that cash is trash and serious recessions have been banned, leading to the speculations described herein. Governments have kicked numerous “cans” down numerous “roads”, but the United States, the U.K. and Germany are nothing more than political entities created and inhabited by the same people and companies that in their individual roles were the actors in the run-up to the Great Recession, making and taking dangerous loans. So how are matters getting better by that strategy?
So long as they (we) have faith in the monetary system, then it makes sense that another economic downturn in the U.S., even if ultimately seen as mild, is likely to involve a period of yet lower interest rates on Treasury bonds and on other AAA debt instruments, and probably a fresh bear market in stocks. The average bear market produces a peak-to-trough drop of about 30% in stock prices. CNBC might just need its Dow 10,000 hats again, strange to say.
Regardless of the innovation of continuous money-printing, aka QE 3, it is of course impossible to know the future regarding prices of this-es and thats. So I’m not predicting one outcome or another. I’m certainly not advocating any strategy involving buying puts on the market or selling naked calls, or insisting that interest rates are about to plummet. Rather, the goal is to inform readers that in conjunction with record low short-term rates in the United States, implemented as an emergency post-crash measure, various extremely risky investment behaviors have occurred. Zero interest rates do not immunize against recession.
Thus I am following a cautious investment path that avoids as much as possible the areas that have great froth, and periodically it’s likely that I will go long Treasurys again on back-ups in interest rates.