Fed Model Update

Periodically, we update our version of the so-called “Fed Model” to provide a picture of how current US stock market valuation compares to Treasury yields from a historical perspective.  Traditionally, the Fed Model takes the trailing twelve month P/E ratio for the S&P 500, inverts it to get what’s known as the “earnings yield” then takes the ratio of the earnings yield to the yield for the 10-year US Treasury bond.  Theoretically, the higher the ratio, the more undervalued the market is and vice versa.  There have been many justifiable criticisms of the traditional Fed Model, many due to the fact that the traditional Fed Model has been an imperfect predictor of future stock market out and under performance.  We think some of this has to do with the traditional volatility of the trailing twelve month P/E ratio, which can jiggle violently during times of major movements in price and underlying earnings, especially when earnings completely fall out of bed.

To combat this issue, we substitute Shiller’s 10-year CAPE P/E for the trailing twelve month ratio as the “E” in the longer-term version is much more stable.  The longer term chart for this indicator follows:

As you can see, using +/- 1 standard deviation bands as a guide, the model has performed reasonably well in signaling severe under and over valuation turning points, especially on the undervaluation side.  A move above the range in early 1962 (undervaluation) presaged a strong move higher in markets for the next several years.  Similarly, the move above the standard deviation range during the market lows of 1974 proved to be a decent point for what would become a bull market rally lasting until 2000, which is where extreme overvaluation levels were reached (though in fairness it took until 1982 for the bull market to begin in earnest).  The model again signaled extreme undervaluation levels in the wake of the financial crisis in late 2008.  Since that time, the model has remained in severe undervaluation territory, primarily due to the fact that 10-year Treasury yields remain so low.  During that time, US markets have tripled off the lows on a nominal return basis and performed even better when dividends are taken into account.  

As of now, owing to the continued low bond yields, the model remains in undervalued territory, despite the fact that long-term CAPE P/E ratio is reaching very extended levels.  Many observers would argue that the model is “broken” due to the outsized influence of extraordinary Federal Reserve policy on long-term interest rates.  Over the past several years, however, markets have continued to move higher validating the signal, even though it’s been “distorted.”  

The signal could move out of undervalued territory one of several ways.  A strong spike in Treasury yields would of course push the ratio down all things being equal.  Or, for better or worse, the market could take off to the upside recreating the extreme CAPE valuation bubble scenario observed in 1999 and 2000.  Or, certainly, one could get a strong combination of the two.  

So what happens going forward?  Is this a broken, or meaningless indicator?  Perhaps, using a revised version of the Fed Model could help provide some additional perspective.  Instead of using 10-year Treasuries, we’ve also recreated the Fed Model using long-term investment grade bond yields.  Here is the Fed Model with that adjustment:

This version doesn’t show the same extreme in undervaluation as our “traditional” model, but it’s still near the top of the range observed over the past few decades.  

All things considered, these Fed models add to other pieces of evidence that suggest it may be a mistake to write off the bull market in US stocks just yet.  While US markets are certainly overvalued using the long-term CAPE PEs as a guide, long-term momentum remains comfortably intact, and forward-looking economic models continue to show very low probability for a US recession in coming months.  As we’ve discussed in the past, the most devastating bear markets over the past century have occurred when markets face a devastating combination of extreme overvaluation, deteriorating intermediate to long-term momentum, and a strong deterioration in forward-looking economic indices, such as the Conference Board leading indicators, showing high probabilities of future recession and earnings dislocation.  Right now, two out of three of our indicators are in green territory.  The Fed Models aren’t necessarily the so-called “end all and be all.” But, they’re matching with other indicators, which makes the models hard to ignore, especially since they’ve performed reasonably well as action triggers across several distinct economic periods during the past 50 years.   

Oil Price Decline: Secondary Effects

The financial world has focused much attention on oil markets in recent weeks, and rightfully so.  Brent crude and WTI prices have fallen nearly 50% since summer.  This afternoon, WTI has closed below $58 per barrel for the first time since May 2009.  Obviously, this has enormous impacts on oil industry equities, not to mention the biggest oil-producing countries around the world, at least in the intermediate term.  Levered oil service and extraction plays have seen 50% plus declines in stock prices.  Russia, Venezuela, and a host of other countries have begun to experience severe macroeconomic and market stress due to the price declines.  Meanwhile, the effects on the rapidly expanding shale play in the US and Canada haven’t become fully apparent yet.  It’s safe to say, though, that these price declines will start to severely impact future capital spending in the US and Canadian oil spaces.

Just as importantly, the move in oil is beginning to impact other markets and expectations.  Very quickly, we’ll point out a few instances where the impact of oil’s decline is filtering through global markets.

First, let’s take a look at US high-yield bond markets.  As we pointed out earlier this year, high-yield spreads had narrowed to levels unseen since the pre-2007 crisis days reflecting the general high optimism in global markets and investors search for yield.  Now we’re coming to find out that a solid portion of high-yield issuance in the US was related to the emerging oil boom here.  With oil prices cratering, heavily levered oil-related companies are finding their margin for error in terms of debt service rapidly eroding.  This is beginning to influence overall yields and yield spreads relative to Treasuries.  As you can see below, since oil started declining this past summer, yield spreads relative to Treasuries have jumped approximately 200 basis points.  The absolute yield as represented by the Bloomberg High Yield has jumped by nearly 150 basis points over that time period.  While the spread relative to Treasuries is certainly nowhere near the levels associated with crisis (look at the spike in ‘08/’09), there’s been a quick resetting of expectations in the high yield market in line with oil’s declines.

Next, let’s take a look at market inflation expectations globally (below).  Global central banks now have quite a dilemma on their hands, especially the Federal Reserve and the European Central Bank.  Not too dissimilar to the oil spike in ‘07/’08 sowing confusion among central bankers as to the true path of inflation, central bankers now have some tough decisions to make on future policy as expectations for inflation in the US and Europe have dropped dramatically in line with the collapse in oil.  In the US, for instance, QE3 has been effectively wrapped up, economic data has looked strong, and Federal Reserve officials are talking potential rate hikes by mid-2015.  Meanwhile, 10-Year US Treasury yields are hurtling back towards the 2% level and inflation expectations 5 and 10 years forward are falling back to levels last seen during the crisis.  In Europe, persistent economic weakness has pressured price levels for the past few years; even without the new oil price variable, it’s clear that Europe is treading very close to outright deflation, a strongly negative situation from an economic perspective.  Now with oil falling, inflation expectations have accelerated to the downside, perhaps adding to the urgency of the situation.  Accordingly, Mario Draghi and his colleagues at the ECB are mulling much more forceful action, German reluctance be damned.  How do central bankers incorporate oil’s price influence on overall inflation/deflation?  Remember, in the US pre-crisis, the Fed erred by letting commodity price inflation hold them back from acting more forcefully sooner to counter the growing economic problems.  In this case, does a depressed oil price and headline inflation number keep the Fed from acting quickly enough to address a rapidly improving labor market?  Draghi’s situation is a bit more clear cut—core inflation is on a harrowing downward trajectory too--but these new variables certainly make discussions among numerous stakeholders much more difficult.  

Europe 5-Year, 5-Year EUR Inflation Swap Rate (Future Inflation Expectation)

Source: Bloomberg

Again, we see a situation where action in one market begins exerting significant influence on situations elsewhere, and more rapidly than investors and policymakers are prepared to react.  Oil’s price declines are good for many of the world’s consumers, of course, but they create numerous complications for investors and policymakers across asset classes in many of the developed countries.

What Happens After Big Upside Reversals?

The past month has presented a seemingly extraordinary situation in the markets with the S&P 500 at one point falling nearly 10%, then recovering to significant new highs within weeks.  Some observers view the move as unsustainable and a sign that significant trouble still lurks ahead for markets.  We thought it would be interesting to see how the S&P 500 has actually performed historically in the wake of sharp v-shaped reversals like the one we just witnessed.

First, we needed to come up with a precise definition of what constitutes a sharp upside reversal.  Please bear with us here.  To start, we calculated the mean difference between the S&P 500’s daily closing price and the daily 50-day trailing moving average since 1955.  We then calculated the standard deviation statistic for that mean difference.  For the uninitiated, standard deviation gives us a sense statistically of how significant a move has occurred below or above a mean.  For instance, under a normal “bell curve” approximately 66% of outcomes should be with + or – 1 standard deviation of the mean and approximately 95% should be within + or – 2 standard deviations of the mean. In this case, we looked for all trading days since 1955 in which the number of standard deviations from the mean (also known as a “z-score”) in terms of distance from the 50-day moving average was 2 or more z-score points above the z-score from 25 days prior (basically 5 trading weeks).  In other words, if the S&P 500 closed 2 standard deviations below the 50-day moving average five weeks ago, and closed 1 standard deviation above the 50-day moving average today, that would count as a reversal (the z-score difference would be 3 in this example).  

As others have observed, this turns out to be a somewhat rare occurrence.  Overall, there were 14,993 trading days in our sample.  703 days, or 4.7%, met the criteria set out above for a significant upside reversal close.  Keep in mind though that these days tend to cluster in bunches, so there can be long periods of time between market periods exhibiting this type of behavior.  

How does the market perform, on average, in the wake of these upside reversals?  Quite well actually.  It appears that the good performance carries on.  We looked at performance 90 trading days, 270 trading days, and 540 trading days from a reversal trigger day.  The data is below.  

As you can see, for each of the three time intervals, short-term to long-term, the average performance following reversal trigger days was higher than normal.  The difference in average performance is statistically significant for all three time-intervals at the 99% level.  And, for the 90 and 270-day time intervals, the percentage of negative outcomes after reversals was solidly lower than for the overall data set.  At the 540-day interval, the percentage of negative outcomes was slightly higher.  

Does this mean the market is guaranteed to jump 10% to 20% over the next year or so now that we’ve observed a sharp upside reversal period?  Of course not.  As one would expect, there were plenty of negative results to be found in these data sets, with the ‘73/’74, ‘00/’02 and ‘07/’09 mega bear periods providing some particularly gory outcomes.  Nonetheless, the outcomes show that volatile reversals of the sort we just observed in recent weeks more often lead to periods of significantly better than normal performance moving forward instead of major pain, especially when the reversals happen in the middle of a benign economic and market performance period.  If we see reversal events like this crop up in conjunction with deterioration in the overall fundamental market and economic backdrop, we’ll begin to raise our eyebrows, though.

What’s Working Globally: Sector Relative Strength Overview

A few weeks ago, we discussed the fact that EAFE markets had reached record relative strength lows vs. US markets.  This week, taking the relative strength work in a different direction, we look at which sectors in the MSCI World index have been outperforming and which have been lagging, perhaps giving us a little extra insight into overall market direction.

First, here are the relative strength charts for each sector index relative to the overall MSCI World index.  Upward sloping lines show relative outperformance; downward sloping lines show relative underperformance.  We’ve added a 30-week moving average for the ratio to help with the trend visual.

From the above we see the following sectors currently displaying relative strength ratios above the 30-week moving average:

• Consumer Discretionary (But barely—the trend has been down this year)
• Consumer Staples
• Information Technology
• Health Care
• Utilities
• Telecom Services

The following ratios have fallen below the 30-week moving average:

• Materials
• Financials
• Energy
• Industrials

It should be noted that the Consumer Discretionary sector has struggled on a relative basis for most of the year following a long period of outperformance off the 2009 lows and has barely moved back above the trendline.  We’d continue to classify this sector as residing in a “danger zone” even though it’s acted better recently.  

What are some other off-the-cuff observations?

• Move Consumer Discretionary into the “weaker” camp as discussed above and we get an overall picture of economically sensitive sectors lagging while the traditionally “defensive” sectors display relative strength.  The recent rally off the correction lows hasn’t meaningfully changed this dynamic.  Yes, relative strength in sectors like Industrials and Consumer Discretionary have outperformed in recent weeks, but remains well off the levels observed at the beginning of the year.  We know the US specifically is performing well economically.  The “defensive beating sensitive” dynamic in global indices, however, reflects the spotty economic situation observed this year in Europe and Asia.  Subdued demand from mainland China hasn’t helped (see Materials and Energy below, for instance).
• From approximately 2000 to 2008, the relative strength ratios for the Energy and Materials sectors nearly tripled.  After nearly a decade of outstanding relative outperformance, Energy and Materials names have been really tough relative investments over the past several years, as one might expect after a strong run.  The recent significant price declines in oil and other commodity markets have accelerated the underperformance trends. Looking at the charts, relative strength support levels have been broken and there seems to be little reason at this point why this situation should change meaningfully anytime soon. The Energy sector looks particularly vulnerable.
• Ditto for global Financial stocks. Overall, Financial companies haven’t been able to get out of their own way since the beginning of 2010.  Global economic weakness, scandals (Forex-rigging fines provide the latest examples), and other factors have kept them stuck in the mud.  If and when these companies regain their footing from a regulatory, management, and economic standpoint, there’s significant room for upside here though.  
• Telecom Services have been a performance wasteland since the heady days at the end of the tech/telecom boom of the late 1990s, despite the fact the globe has witnessed an amazing transformation and expansion in global telecom and data networks.  Overcapacity and debt hangovers following the late 90s party have morphed into other issues, such as heavy investment requirements for new networks and low returns on that invested capital, competition, and saturation.  Against this backdrop, it’s easy to understand global telecoms’ reticence to embrace “net neutrality.”  Fundamentally, it’s hard at this point to see why this sector can break out to the upside on a relative performance basis.  Like financials, though, if these companies can get it together, there’s plenty of room to run.
• In contrast, the broader Information Technology sector is starting to show some solid relative strength after a 10-year period of market-matching performance.  While many investors have spent considerable energy following Apple, some of the old-school large-cap tech names like Microsoft and Intel, which have considerable influence over overall sector performance, have quietly demonstrated strong performance this year after trading sideways for much of the past decade.
• Health Care refuses to slow down.  Over the past two decades, Health Care has been the biggest outperformer in the MSCI World.  Demographic change, ever-rising health care costs and spending, and initiatives like the ACA have propelled health care higher at various stages in the cycle.  As seen with sectors like Energy, IT, and Telecom at various points in time, strong spikes higher in relative strength have often been followed by hangovers.  Health Care isn’t showing any cracks right now.  This sector will be interesting to watch in coming years, though, as governments and consumers look to put a lid on health-care costs.
• Here’s a final interesting tidbit.  Since 1995, the global Consumer Staples index has outperformed the Consumer Discretionary index significantly (347% to 204%).  Considering the fact the world has seen hundreds of millions of people from emerging markets such as China enter global consumption channels, and that consumer debt in developed economies increased significantly over that time period, we find it somewhat surprising that performance has accrued to consumer “needs” over consumer “wants.” 

Investing Based on Emotion, Ideology, Frenzies, or Fads: Just Don’t Do It

A friendly reminder.  Making asset allocation decisions based upon emotion, ideology, political inclination, commercials you hear on CNBC, market fads and frenzies, and other similar justifications is a quick way to the House of Long-Term Investing Frustration.  Yet, time and time again investors fall prey to the quick sell.  We’ve mentioned the emerging market performance issues over the past five years.  Another recent source of frustration for many?  Gold.

A few months ago we pointed out that there had been a material trend shift over the past few years in the Gold price to S&P 500 relative strength ratio, and the Gold price to US Dollar Index ratio.  Since that time, the damage in precious metal prices, and commodities in general, has continued.  Three rounds of quantitative easing have come and gone since 2010.  The Bank of Japan embarked on an aggressive, ambitious new monetary reflation program in late 2012 that’s continued mostly unabated to this day.  Then, last night, they announced an even more aggressive roadmap.  What happens?  Gold prices fall to new multiyear lows today.

We’ve all seen the ads on TV, heard the frightful commercials on the radio, and listened to the gold bug pundits on the talk shows discussing how everything from the Federal Reserve’s programs in 2010, 2011, and 2012 to Obama’s reelection in 2012 was going to be the death knell for civilization as we know it.  Instead, gold markets have observed 30%+ price declines since the election of 2012 while equity and other risk markets have moved materially higher.  Prices have cruised through trend lines like the Germans through the French Maginot Line.

Here are some updates on the relative strength charts mentioned above:

Yes, Gold had a phenomenal move during the years leading up to and through the financial crisis, relative to equity markets and the dollar in general.  However, and unfortunately, the mass of individual investors and those catering to them didn’t catch the bulk of that move.  Much capital was invested at or near the peaks of these relative strength charts.  There will certainly be “back and fill” moves going forward, but these moves have tended to carry on for years.  We continue to believe that the gold price will struggle for a while longer.

What’s are some quick lessons?

Conventional wisdom is nearly always the big loser when it comes to investing.  There’s a broad range of research showing that individuals and institutions alike are strikingly terrible at timing the big moves among various risk assets.  The past 15 to 20 years have provided some particularly painful examples.  Looking at the relative strength charts above, notice that the peak of the S&P/Gold relative strength chart and the nadir of the Gold/Dollar chart, coincided with the peak of the tech stock boom and broader secular bull market in 1999/2000.  Back then, stocks were promoted as far as the eye could see (remember the online brokerage commercial where the teenager takes off in a helicopter) while gold was a complete afterthought.  Within months, the trends highlighted above changed dramatically.  The subsequent 10 years ushered in a brutally frustrating secular bear market in stocks and resurgence in gold and commodity prices.  Likewise, as we’ve pointed out numerous times, a similar phenomenon occurred with Emerging Market equities.  Almost entirely shunned at the turn of the century, emerging market stocks outperformed significantly from 1999 to 2010.  At approximately the same time the pundits and analysts were telling us that gold was ready to rocket to $3000 or even $8000/oz, investors were bombarded with reports that emerging market equities, particularly the so-called BRICs were ready to trounce the developed markets for years to come.  Instead, over the past five years, even diseased European markets have outperformed broader emerging markets by a solid margin.

Piggybacking on the conventional wisdom talk, we can draw an ultimate lesson: value and reversion to the mean usually win out in the long run.  

Admittedly, for many, it can be difficult to identify areas of the broader marketplace showing value.  Not everyone has access to valuation databases and nifty charts, nor do many people have the time to engage in this type of analysis.  Access to investing platforms is easy, though, especially when there are thousands upon thousands of specialized ETFs and mutual funds to choose from.  Somewhat counter intuitively, this can be dangerous to one’s financial health.  Innate behavioral biases virtually assure that emotional investors are going to get drawn to the “shiny light” products.  Unfortunately, the opportunistic carnival barkers don’t usually show up until much of the move in the “shiny object” has already occurred and valuations are out of sorts.  With numerous products to choose from, inexperienced investors, and even experienced ones, now have ample opportunity to follow the herd and end up in performance killing corners of the universe.

What’s the simple solution?  For most, diversification with mechanical, emotionless rebalancing at specified time intervals back to target portfolio weights eliminates a good portion of the problem.  Of course, people need to make sure that the target weights themselves in a portfolio aren’t subject to political or economic biases.  Crafting a financial plan in 2010 and deciding that an appropriate target weight for metals was 75%, for instance, would’ve been an unfortunate expression of “diversification.”  

So, where are some potential value areas around the world now in equities?  We pointed out last week that valuations in overseas developed and emerging equity indices are now trading at the biggest discounts to the S&P 500 observed at any time over the past decade.  Relative strength charts for developed overseas markets show near-historic underperformance for EAFE equities relative to US stocks.  We’ll venture a guess that at some point in the coming months or years, markets will observe a dramatic reversal in relative performance between US and international equities.  It may be sooner, it may be later, but it will happen at some point in a fashion reminiscent of the turns in gold/equities and emerging markets/developed markets sentiment at various points over the past two decades.  Turns like these typically occur at points of maximum pessimism/optimism and, hence, are ignored by the vast majority of investors.  As is the ongoing nature of the game, we have little doubt that most investors will miss the next big turn in the world of relative returns.

Mind the (International) Gap

Over the past two weeks, the US-focused S&P 500 has been on a wild roller-coaster ride.  After falling nearly 10% from the late summer peak, the index has recouped over two-thirds of the losses and reestablished a position in the middle of the 1925 to 2000 trading range that’s prevailed since early summer.  

The MSCI EAFE, an index composed of stocks from Europe, Australia, and the developed Far East, presents a vastly different story.  During the current correction, the EAFE declined approximately 15% peak to trough and has only recovered about 4% during the recent bounce.  Similarly, the MSCI Emerging Markets index, which showed promise earlier in the year, fell over 12% peak to trough and has barely rallied back during the recent move higher in global equities off the lows.  

The large performance gap between US equities and international equities, both developed and emerging market, has been an issue for five years running.  From the end of 2009 through 10/23/14, the S&P 500 has nearly doubled, up 93%.  In contrast, the MSCI EAFE is up 33.7% and the Emerging Market index is up a paltry 13.54% total.  Wow, talk about turning conventional wisdom on its head!  Few talking heads in 2009 would have predicted that the US would so handily beat emerging markets over the ensuing five years. 

We’ve pointed out in the past how relative strength between the various indices tends to trend for long periods of time.  Let’s take a quick look at the long-term relative strength charts for the S&P 500 vs. the EAFE and the S&P 500 vs. the MSCI Emerging Markets Index.

Since the formation of the EAFE Index in the early-1970s, under and outperformance trends appear to run in 20-year cycles.  The EAFE, running on the back of a strong Japanese equity rally, significantly outperformed the S&P 500 from the early 1970s until the early 1990s.  Since then, except for a brief period of outperformance in the mid-2000s, the S&P 500 has maintained the upper hand.  With the recent relative underperformance of the EAFE, generally associated with the continued economic and market malaise in Europe, the EAFE/SPX relative strength index has now fallen to levels not observed since the early 1970s.  The post-financial crisis years have not been kind at all to developed international equity markets.

As seen above, the over and underperformance cycles for emerging market equities have run at shorter time intervals (approximately 10 years).  Emerging market equities had a strong run in the 1990s until crises in the back half of the decade, notably the Asian and Russian financial crises, seriously dented money flows into emerging markets.  During the decade up to and through the global financial crisis, we see significant outperformance reflecting the general “emerging market miracle” economic outperformance observed during that period.  Since then, the ratio has dropped like a stone and remains comfortably below the long-term moving average.  

If there’s a silver lining to the relative strength story, past moves through the +1 or -1 standard deviation bands have been precursors to future trend changes.  In this case, there may be some light at the end of the tunnel for EAFE stocks.  If past experience is any guide, however, emerging market stocks may have to experience more relative performance pain before they regain their footing.  

Adding long-term valuation to the analysis potentially adds another silver lining for international markets.  Currently the EAFE and the Emerging Market indices are trading a solid discounts to the S&P 500 when using 10-year, cyclically adjusted P/E ratios.  The S&P 500 is currently trading at 21.7x cyclically adjusted pro-forma earnings, nearly 1 standard deviation above the long-term median of 16.4x.  Alternately, the EAFE is trading at approximately 15.9x, below the long-term median, and the Emerging Market index is trading at 12.3x, the lowest levels since the financial crisis.  Moreover, the ratio of the S&P 500 P/E ratio to both the EAFE and Emerging Market P/E ratios is at the highest levels observed over the past decade.  The valuation divergence has become as significant as the performance divergence.

CAPE PE ratios in isolation have been solid predictors of future 10-year performance regardless of the overall qualitative economic and investing environments across regions.  Again, if valuation history is any guide, odds seem to favor a reversal in the relative performance trends in the coming years.  The valuation ratio charts for the three indices are presented below.

It’s been a rough stretch over the past half decade to be a international investor.  We’ve been waiting for quite a while to see some turn around in the relative performance situation for international stocks.  Until we see the relative performance ratios stabilize and move comfortably through the long-term moving averages, we’re not ready to call the end of the underperformance cycle.  Looking at overall valuation and relative valuation, however, gives us some encouragement that international markets are on the cusp of a performance shift.

Visualizing Recent Volatility:

After a three-year stretch of significantly lower than average volatility in global markets, the volatility spirits rediscovered their mojo in recent weeks.  Instead of jumping on a crowded bandwagon and examining and reexamining all of the reasons “why” global markets have entered correction territory, we thought it might be interesting to provide some visuals that show how quickly greed turned to fear in risk markets and show how the fear associated with the recent correction compares to past episodes.  As you will see below, and as we’ve pointed out in the past in various venues, though markets have displayed signs of complacency at various points during this uptrend, market participants have been very quick to jump to pessimistic extremes at the first signs of market distress, even though the overall corrections are minor in scope relative to past speed bumps.  

Let’s look through some of the charts.

First, let’s look at the truest representation of market volatility, realized volatility in the S&P 500 and MSCI EAFE in recent days and weeks.  We accomplish this by taking the 20-day standard deviation of daily market percentage moves.  Simply, higher standard deviation numbers mean dispersion or volatility in the daily performance numbers over the trailing 20-day period has increased.  We’ve included a chart of 20-day standard deviation that covers 1958 to the present.  You’ll see below that in recent months, volatility hovered around the lowest levels ever observed in the data series for both the EAFE and the S&P 500.  As bad as recent action has felt, however, the recent turmoil has barely taken actual volatility for the S&P 500 above its long-term average.  Interestingly, despite the fact that the MSCI EAFE has corrected far more than the US-specific S&P 500, EAFE realized volatility remains below the historical average.  Realized volatility for both indices hasn’t even scratched the surface of the volatility observed during the 2011 European debt crisis.  Overall, it’s felt like a wild ride in recent weeks, but only because our collective perceptions have been warped by the extended period of unusually low volatility.

The overall corrections have been contained thus far by historical (or even recent) standards, and realized volatility, as we’ve seen above, hasn’t really come close to touching levels observed during past corrections.   How’s psychology holding up?  Traders and investors wilted pretty quickly out there.  Let’s look at three different gauges that help measure investor psychology: the CBOE put/call ratio, the ISES Sentiment Chart, and the relationship between the VIX and VXX volatility measures.  

The CBOE put/call ratio spent the early part of this year near the lowest levels observed over the past decade (higher levels indicate more put activity relative to calls, hence more fear).  With the recent correction, the 10-day average for the put/call ratio quickly rebounded to levels nearly 2 standard deviations above the average going back to 1995.  

We see a more dramatic story in the ISES indicator, which also measures put activity relative to calls.  This indicator operates in reverse; lower levels indicate more fear in the markets.  Here, the 10-day average for the indicator has reached levels not observed since the depths of the financial crisis in 2008/2009.  As recently as early September, the ISES was approximately 1 standard deviation above the longer-term average.  Now, it’s reached levels approximately 2 standard deviations below the norm.  By this indicator, overall fear in the market is significantly disproportionate to the actual disruptions taking place in the broader markets and the magnitude of the change in market fear over such a short time frame is dramatic when considered against the overall market backdrop.  At this point, it appears that traders have been overemotional.   

Next, let’s look at the relationship of the VIX Index to the VXV Index.  The VIX measures 30-day implied volatility for at the money S&P 100 index options.  The VIX is probably the most widely followed “fear gauge” in the marketplace.  The VXV, a cousin of the VIX, measures 90-day implied volatility.  During normal periods, the longer term implied volatility as measured by the VXV is lower than shorter term implied volatility as measured by the VIX.  During periods of market fear, this relationship is upended with near term-implied volatility spiking past longer-term volatility.  We see below that the VIX:VXV relationship reached levels this week that haven’t been observed since the Europe-induced correction of 2011.  Despite the fact this correction (to this point) is roughly equal in terms of magnitude to the corrections experienced during the summer of 2013 and early summer 2012, this fear gauge, like the ISES above, is acting as if a much greater calamity has taken place.  

Are the recent gyrations the first shots across the bow in advance of much bigger market problems?  Granted, just because spikes in fear gauges have outpaced the actual disruptions in the markets doesn’t necessarily mean all is well, the contrarian stabilizers are ready to kick in, and that markets are going to resume their march ever higher.  For instance, we can look at the charts above and see that the fear gauges spiked to levels near current levels at the beginning of 2007 and remained at those levels, even though the worst parts of the market calamity and financial crisis didn’t arrive for another year to year and a half.  Yes, some of those extreme fear levels triggered some large upward counter-rallies throughout 2007 and 2008, but they turned out to be small drops in the bucket compared to the large downward moves taking place during that time period.

At this point, our work still suggests there’s no reason to believe that the current market correction is ready to morph into anything akin to the problems experienced globally in 2008/2009, or from 2000 to 2002.  While leading economic indicators in Europe and Japan are becoming problematic, similar to early/mid 2011, the US and other regions continue to show very little risk of imminent recession.  Yes, intermediate to longer-term market technical indicators have broken down again in Europe.  The upward story, however, remains intact to this point in the US and Japan.  Valuation is above average in the US on a longer-term basis using adjusted CAPE measures, but not at the levels observed in 2007.  As such, we believe the worst-case scenario at present is a correction similar to the ones experienced in 2010 and 2011.  Those corrections were certainly painful in the short-term but proved to be short-duration setbacks within the larger uptrend.  Against that risk scenario, we hold the view that investors have overreacted to this correction in a manner similar to overreactions observed in May-2012, Fall-2011, and spring-2010.

Of course, if the data changes, we reserve the right to change our minds.  We’ll be the first to shout from the rooftops if anything in the model changes suggesting that something much more momentous and dangerous is on tap for investors.

GDP Q2: Looking Under the Surface

It’s been a while since we looked at some of the numbers within the US GDP report and what they might say about the underlying trends in the American economy.  This morning, the US government released the final revision for Q2, and the numbers overall proved solid.  GDP came in at 4.6% on a Q/Q annualized basis, a vast improvement over the Q1 negative print.  Y/Y, real GDP came in at 2.6%, solid but not spectacular, continuing the pattern observed since 2010.  Average Y/Y real GDP since Q1:2010 has been about 2.2%.  This compares to an average Y/Y real GDP number of 1.6% from Q1:2002 through Q4:2009.  Thus, all in all, growth is mediocre, but it’s been mediocre for more than a decade.  The “New Normal” really isn’t particularly new at all.

Underneath the headline numbers, there are some interesting trends among the GDP aggregates, Consumption, Investment, Net Exports, and Government, as a percentage of GDP.

Consumption spending continues its pattern of growing in-line to slightly below overall GDP on a Y/Y basis.  As such, Consumption, which reached a high point of 69% of GDP in 2011 has retrenched a slight bit to 68.5% of GDP.  Nonetheless, Consumption still remains near the very high end of the historical range.

A bright spot in the report appears to be growth in Investment.  Real investment growth in Q2 was 7.7% Y/Y, the best showing since 2012 and comfortably above the historical median of 4.7%.  With the improvement, investment as a percentage of GDP continues to move closer to the middle of the long-term range and has reached levels not observed as a % of GDP since the pre-crisis days.

Defying conventional wisdom, total government expenditures continue to probe the low end of the historical range as a % of GDP.  Y/Y real growth in government expenditures came in at -0.7%, the 16^th straight negative year over year print, by far the longest negative streak in the history of the GDP series.  The last period with negative real Government expenditures was the 1993 to early ’94 period.  Prior to that, you have to go back to the early 1970s.  Y/Y nominal government expenditures growth was under +1% for the 14^th straight quarter.  Of note, prior to the current run, nominal government expenditures hadn’t fallen below 1% on a Y/Y basis since a brief negative run in the mid-1950s during the Eisenhower Administration.

Finally, net exports, which have been in negative territory as a percentage of GDP since the early 1980s, remain comfortably higher than levels observed in the years preceding the Great Recession, but near the lower end of the historical range.

Taking Investment + Net Exports as a proxy for “national savings,” we see that the picture has improved significantly since the Great Recession, but remains below historical levels.  It’s currently in-line with the levels observed in the mid-2000s, pre-crisis.

All in all, we continue to believe that consumption growth will underperform relative to the other aggregates, perhaps keeping some longer-term pressure on the consumer oriented segments of the US markets.  Conversely, we believe overall investment will continue moving higher as a % of GDP, as will government expenditures, mainly due to the renewed health of state and local government finances.

Market Tidbits

Dollar En Fuego

Several months ago, we pointed out that the US dollar index relative to gold had breached long-term moving averages to the downside.  After some sideways churning, sure enough, the dollar has resumed its march higher while gold moves back towards multi-year lows, keeping the ratio on the downward slope.  Since the end of 2009, Gold is essentially flat while the dollar index is approximately 15% higher.  Conventional wisdom has been completely turned on its head over the past four to five years.  Three rounds of QE, political turmoil in Washington, and a muddle through economy had many investors convinced a significant dollar collapse was on the way and gold would outpace equities.  The opposite happened, a not so atypical situation in markets.  What happens going forward?  Considering the intensity of the recent moves, we wouldn’t be surprised to see a short-term technical reversal.  Longer-term, there’s still plenty of space to the downside on the below chart, especially in light of the massive upward move in the ratio from 2003 to 2011.   

Source: Bloomberg and IronHorse Capital

Inflation Expectations: Tame

Meanwhile, as always, Fed watchers gnashed their teeth over the future Fed Funds rate trajectory and the Fed statement ahead of this week’s meeting.  After the meeting, the “dot chart” showing Fed members’ predictions on the future rate path showed that the median projection for 2015 has moved slightly higher, from 1.125% after the June meeting to 1.375% today, suggesting rate hikes earlier than projected in 2015.  Two Fed Presidents dissented.  Dallas Fed President Fisher remains preoccupied with heading off phantom inflationary pressures before they spiral out of hand.  Next month should represent the final month of QR.

We remain baffled by the rush for accelerated rate hikes in the US.  We pointed out early in the summer that inflation pressures are completely benign at this point and that contributors to inflationary episodes, such as labor costs, remain subdued.  This week, markets received word that year-over-year CPI came in at a paltry 1.7%.  Year-over-year CPI hasn’t exceeded 2.2% since early 2012.  Around the world, there’s a real risk of outright deflation in Europe and Japanese economic momentum has dropped off dramatically in recent months, perhaps putting some of the price stability gains at risk there as well.  

Market participants are voting.  Looking at the yield spreads between Treasury bonds and TIPS, we see that market expectations for future annualized inflation are rolling over again back into sub-2% territory over the next five years.  We remain of the view that it’s much easier to tame inflation after it appears than it is to reverse the insidious deflationary trends associated with sub-trend economic episodes.  The US remains far below potential.  The worries about “overheated” economic growth seem ridiculous.  If anything, the Fed, ECB and others may be too timid when it comes to pushing economic growth back towards long-term potential.

Source: Bloomberg and IronHorse Capital

Europe and Japan: The Feeling’s Gone

With recent updates to the OECD leading economic indicators for Europe and Japan, we see that the economic momentum that kept markets hopeful throughout 2013 and early-2014 has dropped off considerably.  In Japan’s case, Abe may have a big problem on his hands, with the smoothed Japan LEI moving back into negative territory for the first time since the ‘08/’09 global recession, suggesting that the probability for a Japanese recession is significantly elevated.  Japanese citizens may be getting the worst of all worlds: higher prices, and dim economic prospects.  Europe isn’t terribly far behind in terms of entering negative economic territory.  As discussed above, outright EU deflation could be in the cards; the ECB recently felt compelled to enhance monetary stimulus programs within legal bounds, though indicators this week show that some of the measures had disappointing results.

Source: OECD, Bloomberg and IronHorse Capital

Source: OECD, Bloomberg, and IronHorse Capital

US: P/E’s Creeping Higher:

The S&P 500 index has moved comfortably above the 2000 level again.  Long-term valuation ratios have moved in lock step.  As of today, the 10-year CAPE P/E, using adjusted, pro-forma earnings to satisfy those concerned about accounting changes over time, stand at approximately 22.3x, approximately 0.8 standard deviations above the norm.  Valuations in the US are roughly back to levels observed in ‘06/’07 and during the mid-1960s.  As we’ve mentioned in the past, we’re not suggesting that a big market maelstrom is imminent.  Instead, we want to point out that valuations near these levels have regularly produced sub-median real and nominal annualized market returns over the subsequent seven to ten years.  In other words, it might be a bad idea to count on double-digit US returns over the next several years when thinking through the kids’ college funds.  That doesn’t mean there isn’t opportunity elsewhere around the world, however.  Many individual countries/regions’ index multiples are trading in the low teens and single digits.  As such, we remain convinced that longer-term equity returns will come from overseas stock markets and that the US will be a long-term laggard.  In addition to the P/E chart below, we’ve included a handy-dandy rundown of markets from cheapest to most expensive across several valuation metrics produced on Mebane Faber’s World Beta website.  As you can see, the US is among the five most expensive in the world.  Eastern European emerging markets and peripheral European developed markets hold many of the “cheap” spots.  Much of the European malaise mentioned above has already been factored into equity market outlooks.

Source: Bloomberg and IronHorse Capital

Source: Mebane Faber World Beta Blog. mebfaber.com

The Sunk Cost Fallacy and The European Dilemma

It’s déjà vu all over again.  Three years on from the meat of the European sovereign debt crisis, and two years on from then-new ECB President Mario Draghi’s “whatever it takes” rescue program, which spurred across-the-board European asset price rallies, European economic data is showing strains again.  France remains stuck in neutral.  German GDP growth actually contracted last quarter.  Unemployment rates across the Eurozone, especially in the periphery countries, remain disturbingly high; Eurozone-wide unemployment remains at 11.5%, but localized numbers can appear much more harrowing.  Core and headline inflation remains dangerously close to stall speed.  The latest annual CPI numbers for Europe in July showed overall Europe-area inflation below 1%, with outright deflation (the naughtiest of naughty economic terms) still observed in Greece, Portugal, and Spain.  Italy is on the cusp.

A simple fact: potential Euro-area GDP remains upwards of 20% below potential and economic activity, unlike the US and others, is nowhere near pre-crisis levels.  The way things are going, economic activity won’t make up significant ground anytime soon.  As such, the blame game has begun ramping up again.  On one side, the hawkish types continue to bemoan the fact that structural economic reforms haven’t proceeded as quickly as liked in periphery countries and that further budget cuts and reform are necessary to secure economic prosperity.  On the other side, economists and policy-makers argue that current ECB measures are too timid and that aggressive monetary stimulus should be accompanied by aggressive fiscal stimulus to kick-start activity.  In their eyes, European austerity policy, though softened somewhat over time, is a “penny-wise, pound-foolish” endeavor.  Likewise, the Euro-currency-area structure can be equated, in their eyes, to the shackles of a gold system that undermined flexibility and exacerbated European economic problems during the Great Depression era.  

There’s merit in both of these arguments.  Without a doubt, closed, protected economies like Greece and Italy require much more work to achieve long-term competitiveness.  On the flip side, while no one in the US is claiming economic victory, aggressive Fed action in conjunct with other aggressive moves by US policy makers helped keep the US on a growth trajectory, however uneven.  Yes, policy-makers have made mistakes along the way in the US, but on balance our system found a path to a viable support structure.  We in the US complain about the state of economic affairs, but the general state of economic affairs here is much better than experienced in the bulk of Europe, or even a number of former high-flying emerging economies.  

While the issues at play on the European continent are far more detailed and complicated than could ever be examined in a simple blog post such as this, we tend to sympathize with those calling for a more aggressive European response and a move away from the shackles and restraints the Euro union place on the weakest nations.  Frankly, we’re curious why peripheral nations have chosen to remain in a structure that allows them nearly zero flexibility in terms of monetary/currency policy response.  Sure, economic growth has stabilized to a certain extent in the periphery during the years following the ECB’s 2011/2012 actions, but not enough to move the proverbial “needle” in any major way.  Overall, it’s arguable that monetary stimulus remains woefully inadequate in these countries in terms of providing proper air cover for the demand destruction associated with the massive strides many have made in collapsing primary budget deficits.  It’s not crazy to think that these countries could remain well below potential GDP for decades into the future.  Again, what keeps policymakers (and citizens) beholden to a quasi-depression track?

A version of the “sunk-cost fallacy” remains in play among policy-makers and citizens alike.  The sunk-cost fallacy is an economic problem under which individuals, organizations, or policy-makers make forward-looking decisions erroneously based upon the time, money, or other resources “sunk” into a project in the past.  Time, money, and effort expended in the past should never be a consideration, only the future “profitability” or “viability” of an effort.  What’s done is done.  If a project is going to be a proverbial money-loser going forward, it should be stopped no matter what’s been invested in the past.  

A version of the sunk-cost fallacy is playing out in the European sphere, in our estimation.  For years, we’ve heard politicians, economists, and individual citizens across Europe express their commitment to a monetary union solely on the basis of the immense amounts of political effort that have been expended over the past six decades.  This has been particularly true of politicians in the economically depressed countries.  The structure of the EU can’t be significantly questioned because “We’ve dedicated so much time and effort to the project and the notion of European solidarity.  If we change course, we sacrifice our significant past investment in a Pan-European identity.”  Yes, there have been reasonable qualitative and quantitative economic arguments put forth to defend the status quo, but more often than not, the pursuit of the status quo is justified solely by the simple notion expressed above.  

Just as in running a business, this can be a dangerous notion, and create much bigger problems down the road.  Dumping the rest of one’s life savings into a money-losing venture to justify the past investment, for instance, would lead to full financial devastation and the even bigger problems associated with being completely wiped-out financially.  Continuing this project in the periphery nations simply on the notion of a large historical investment in the European “project” without some serious soul-searching regarding future policy options could lead to devastating effects at the national level over the coming decade.  

Already, younger generations entering the workforces in these countries face bleak future prospects.  Despite progress made on budgets, debt-to-GDP ratios continue to rise because of stagnation.  The best and the brightest continue to emigrate to other nations.  Birth rates are down, exacerbating negative demographic trends.  Extremism has increased, evidenced in recent years by organizations like Golden Dawn in Greece, as marginally attached individuals seek outlets for their discontent.  If European growth at-large stalls out again meaningfully, and broader deflationary trends become a part of broader European economic life, there are few pathways for these countries to exit their depression-like conditions, especially if they remain in the currency union with its current slate of policy options and prescriptions.  These problems will become significantly magnified.  A blow-up of that pressure cooker down the road would make today’s dilemmas look like small potatoes.  

Does this mean that breaking off portions of the currency union is desirable or fait accompli?  Not necessarily.  But with economic growth stalling again, it’s time for the periphery nations to break the shackles of sunk-cost thinking and engage in some serious self-examination in terms of what type of economic growth is achievable within or without the binds of the union.  Band-aids and European solidarity proclamations are no longer acceptable or sufficient.  Likewise, it’s in German and ECB leaders’ interests in the long-run to meet the periphery countries further in the middle before centrifugal forces move beyond their control.  A broader Japan-esque “lost decade” experience with pockets of depression has dangerous implications on a fractured continent like Europe.  Old solutions and old ways of thinking based on past investments in the European project will ultimately lead to violent economic problems.  These countries must find sustainable economic growth.  If that means a controlled exit, so be it.  Exit and/or radical economic policy measures should be on the table.  

Fundamental Free Lunch: Update

Periodically, we like to update a back-test that uses a single fundamental factor, EV/EBITDA, to demonstrate how successfully a ultra-simple value portfolio can play out favorably over a number of years.  Now that we’ve crossed the halfway point for 2014, we thought this would be a good time to revisit this back-test and update it with year-to-date numbers.

As in past iterations of the back-test, we begin by ranking all the components of the S&P 500 at the end of each calendar year from 1992 (earliest data) to the present day by EV/EBITDA multiples, taking the 50 cheapest stocks in the S&P 500 and rebalancing on 12/31 each year.  Companies are equal-weighted.  Once a portfolio is set, there’s no trading over the course of the year.  Companies involved in M&A transactions over the course of any given year go out at the takeout price; we do not replace the acquired company with a new position.   Finally, in a new twist, for comparison purposes we use total returns for the S&P 500 benchmark (i.e. include dividends) but exclude dividends for the back-tested portfolio.  Since annual dividend yields for the S&P 500 are generally 2%+, this is a back of the envelope way to account for performance draining factors like slippage, commissions, and other fees.  All data comes via Bloomberg.

Why do we like to do this?  As you’ll see below, a super-simple portfolio using EV/EBITDA multiples for stock selection once per year without any other work produces outsized returns over the index over time.  It’s a powerful reminder that fundamentals work over the long run.  And, it’s a reminder that complexity can be the enemy as well over time.  As an aside, it’s incredibly interesting to go back over the past few decades and look at the names that pop up along the way, many of which no longer exist.

Here are the results through the end of trading today, 7/25/14.  

The back-tested portfolio outperforms the S&P 500 by over 4% annualized during the approximate 21.5-year period.  Because of the power of compounded returns, this is a very big deal.  $1000 invested in the model portfolio using the single valuation factor is worth $15,972 today versus $6,939 for an index tracker.

As we’ve pointed out in the past when conducting this exercise, there is a catch.

Pretend you are a portfolio manager launching this simple value based strategy on 12/31/1992 knowing that value works over the long run.  You invest the portfolio and look like a rock star the first two years.  Then, the value-manager killing late-1990s growthy stock bubble takes off leaving you in the dust for five straight years.  By the end of 1999, you’re losing by over 40% to the index with investors abandoning the portfolio (at the worst possible time, by the way) in droves to chase the newfangled internet stock dreams.  For the next 14½ years post-1999, the portfolio crushes the index, but you may not be there with a product to take advantage.

The moral: true value investing can be incredibly streaky and requires significant patience.  Over the first 21 years of the back-test, the model portfolio underperforms in eight. Though the long-term rewards are substantial, it is enormously difficult for investors, whether individuals or institutional, to stay the course, stick to plan, and take advantage.  Furthermore, it’s easy in hindsight to look at the names that pop up along the way and think that some of the moves were obvious in hindsight.  In real-time, many of the companies included in the portfolios were wounded and down on their luck at the time for rebalancing.  Apple, for instance, shows up in the early 2000s when few gave it much of a chance to do anything.  At the very least, the vast majority of the names included in the portfolio over time were far from being considered the sexist names in the investing universe.

Ultimately the value “free-lunch” continues because no matter how much the collective investor universe understands that value ultimately wins, very few are actually able to exhibit the patience, consistency, and discipline to take advantage.  A pesky thing called emotion intervenes over and over.  Investors can’t help chasing the shiny object, nor can they help ignoring the names that are trading cheaply but happen to carry some baggage.