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. 

More On the US P/E

Debate over the “Shiller CAPE” normalized P/E ratio, popularized by Nobel Prize winning economist Professor Robert Shiller, has been particularly pointed this year.  As we’ve discussed in the past, this measure takes the average of 10-year trailing earnings for the “E” in the P/E ratio in order to smooth out and eliminate the volatility present in typical expressions of simple trailing 12-month S&P 500 earnings.  Supporters of the widely followed valuation measure correctly point out that future 10-year total index returns have a statistically significant relationship to CAPE valuation levels.  Detractors have leveled a number of charges varying from complaints that 10-year trailing earnings unfairly capture the massive, and in their view highly unusual earnings cliff dive that occurred in ‘08/’09 (but ignoring the fact that earnings were overly inflated ahead of the crisis), to the fact that the supposedly mean reverting ratio has remained above mean for the vast majority of the past two decades undermining the credibility of the indicator.  

A particularly interesting argument against Shiller’s version of the normalized P/E came from a blog by the name of Philosophical Economics back in December.  The blogger pointed out that changes to the treatment of “goodwill impairment” when calculating GAAP earnings had created real problems in terms of the consistency of Shiller’s earnings data over time.  The blogger demonstrated this issue by comparing GAAP earnings since the early 2000s (when the rules changed) with Bloomberg’s S&P 500 earnings calculation of scrubbed non-GAAP earnings from continuing ops and showing that the deviations between the two series since the early 2000s had increased dramatically since the shift.  We thought this was a particularly compelling argument and therefore used the alternate Bloomberg earnings data series in the same manner as the above blogger to reconstruct a historical normalized P/E ratio to create a more consistent measure.  

First, we’ll take care of a few housekeeping items.  Since the Bloomberg pro-forma data only goes back to 1952, and considering that deviations between pro-forma and GAAP are much, much small prior to the goodwill changes, we took a bit of “artistic license” and added Shiller’s publicly available data for the period from 1925 to 1952 so we could get a longer term view incorporating the bubble of the late 1920s and the subsequent depression years.  Now that that’s out of the way, here is the chart:

Now that we’ve addressed inconsistency due to GAAP changes, what do we learn from the current normalized P/E levels using the alternate “pro forma” data?  We see that the real (inflation-adjusted) P/E ratio currently sits at 22x versus the 25x level of the traditional Shiller P/E.  This compares to a long-term average of approximately 17x and a long-term median of 16.5x.  While not as overvalued as the traditional Shiller P/E, we see a market that’s still decently above historical levels.  How does this translate into a prediction for future returns?  The 10-year future annualized return forecast comes in at 3.54% for inflation-adjusted total returns (i.e. with dividends), 6.38% for non-inflation-adjusted total returns, and 4.47% for non-inflation-adjusted returns without dividends.  This compares to historical averages of 5.71%, 8.85%, and 6.63% respectively.  These numbers, therefore, look better going forward than those produced by Professor Shiller’s calculation.  Still, we’d say at current levels, even with the GAAP adjustments, there’s a good chance that market returns over the next 10-years will be substandard relative to historical averages.  

Regarding the criticism by some that the ratio has remained above median for a good part of the past 15 years, we see looking over the future returns streams that the above average P/Es resulted in sub-average returns.  The massive spike associated with the late 90’s tech bubble?  That spike resulted in outright negative 10-year annualized nominal and real returns.  How about those elevated P/E ratios observed in the period from roughly 2003 to 2007?  So far, the 10-year annualized returns that have been realized from 2003 and 2004 onward have been roughly in-line with the sub-par results P/E ratios would have predicted.  Take September/October 2003, for instance, when the normalized P/E was trading at approximately 22x, the current observed level: 10-year future total real returns were 4.5% per annum, over a percent lower than historical averages and nominal total returns were 6.9%, approximately 2% lower per annum than historical average.  The pattern has continued.  And, don’t forget that there was one heckuva wild, dangerous ride during that 10-year period, with the S&P 500 falling over 60% peak to trough at one point during the financial crisis.  

There are some other interesting historical observations worth pointing out, in our opinion.  Look at the Great Depression period and the secular bear market associated with that era.  Leading into the ’29 crash, valuations were extremely elevated.  At the beginning of the Depression, valuations dipped into the single-digits at a velocity similar to the velocity of valuation compression we’ve observed at various points over the past 14 years.  Over the five-year period from 1932 to 1937, however, markets recovered materially and valuations actually pushed back above 20x to a level almost exactly where we currently reside.  Sure enough, a relapse sent markets and valuations tumbling from overstretched highs back towards cycle lows.  

Of note, the next single-digit valuation low in 1942 proved, though, to be one of the better buy-points of all time.  Buying at the valuation low in 1942 would have produced double-digit annualized returns over the next 25 years.  Further showing how important starting valuation is, buying the market at the height of the Depression in 1932 when valuations hit a modern low produced double digit total returns over the ensuing 33 years until the next valuation peak was reached in 1965.  Similar observations and outcomes arise out of the valuation lows of the 1970s and early 1980s.

What’s the point of all this?  Set expectations appropriately for US returns and make sure you’re keeping your eye open for opportunities elsewhere.  They do exist.  Again, at current valuations, we’re hard-pressed to believe that US returns will be able to approach or exceed long-term historical averages over the next decade.  On the flip side, many other markets overseas hold much more attractive valuations in the low to mid teens.  In fairness, just because US valuations are elevated doesn’t mean that total market Armageddon is around the corner.  There are a lot of breathless, hyperbolic bears out there right now.  But, thinking that a decade of 80’s and 90’s like equity returns are in our future isn’t a very prudent way to approach US markets under current circumstances.

Scattershot Summer Thoughts:

EAFE: Waiting for Godot

As we’ve discussed in the past, since the beginnings of the 2007 to 2009 financial crisis, the MSCI EAFE, an index comprised of developed market companies from Europe to Australia to the rest of Asia, has significantly trailed the performance of US markets.  Of course, the sovereign debt crises spreading across southern Europe from 2010 to 2012 hurt European equity markets and held back performance.  And, Japan has been a multi-year economic mess, though Abe’s moves since late 2012 have ignited strong recent upward moves in Japanese equities.  Looking over the first six or so months of 2014 though presents a similar relative performance picture despite the fact that attitudes towards international equities, and Europe in particular, seem to have perked up considerably.  Through yesterday (7/10), the EAFE total return is 3.79% vs. 7.44% for the S&P 500. 

Long-term relative performance analysis shows that the back and forth battle between US and International stocks has been cyclical in nature, with long periods of EAFE outperformance followed by long-periods of US outperformance.  In the past, major turns in relative performance have occurred when the relative strength ratio between the EAFE and S&P 500 has reached extreme levels, generally either +1 or -1 standard deviations from the average.  We’ve passed that threshold recently, with the EAFE performance relative to the S&P 500 falling below -1 standard deviation from the average in recent weeks for the first time since late 2001 and early 2002.  Here’s a chart of long-term relative strength.

The last time the EAFE crossed this threshold to the downside, the EAFE index outperformed the S&P 500 significantly over subsequent years.  From 12/31/2001 to 12/31/2007, the period roughly corresponding with the minor uptrend in the chart coming after the last threshold breach, the EAFE was up 132% (total) vs. 42% (total) for the S&P 500.  Interestingly, even with all of the economic and political troubles outside the US over the past 13 years, the EAFE has matched S&P 500 performance on a simple basis and actually outperformed the US when taking dividends into account.

Investors like us have been waiting for our international developed brethren to re-take the performance mantle from the US for a few years now.  The above suggests that the winds may shift in coming quarters and that the EAFE may soon become a strong relative performer.

Emerging Markets Emerging?

Speaking of relative performance and downtrends, there’s no denying Emerging Market equities have been performance dogs when compared to the US and even developed Europe and Asia over the past several years, defying all sorts of conventional wisdom coming out of the Great Recession.

Year-to-date, the MSCI Emerging Markets Index has shown some vigor, matching the performance of the S&P 500 for the first time in what feels like ages.  Is this the beginning of another long period of outperformance or another short-term reversal?  The evidence seems mixed at this point.

Like the EAFE/S&P 500 comparison above, Emerging Markets performance relative to US stocks has been just as cyclical.  The recent underperformance comes after a long period of outperformance following extremes similar to extremes observed above in the EAFE chart.  Even with underperformance over the past 3 or 4 years, relative strength is stuck in the middle of the 2 ½ decade range as seen below:

Using relative valuation, Emerging Markets are clearly undervalued on a long-term basis, with various CAPE P/E ratios hovering in the low-teens versus the low-20s for US equities.  At some point, those wide valuation differentials will converge.  When though?  We also look at the 200-day moving average for the relative strength ratio between the S&P 500 ETF, the SPY, and its Emerging Market counterpart, the EEM.

At this point, the downtrend remains in place as shown below:

At IronHorse, we’re seeing more and more emerging-market stocks pop-up as targets for consideration; we’ve even added a small amount of single-stock emerging markets exposure in recent months.  We’ll become more comfortable, however, with large amounts of emerging markets exposure when the above trend starts moving the other way.

Sentiment:  The Song Remains the Same

The past few years, we haven’t ceased to be amazed by the quickness with which broader market sentiment deteriorates at the first hint of correction.  This is a very good thing in our estimation.  Take recent market action.  Granted, the S&P 500 and global markets have pulled back in recent sessions.  Nonetheless, the S&P 500 is still slightly up for the month of July at this writing and the MSCI World is down less than 1% for the month.

What’s happened to various sentiment indicators?  Fear has jumped.  It’s not extreme, but the jumps higher for fear gauges seem disproportional relative to the magnitude of actual equity market moves, a condition that’s persisted for much of this equity market cycle.  For example, the put/call ratio has jumped from a roughly neutral level to approximately 0.6 standard deviations above the long-term average.  The 10-day average for the ISES option indicator has fallen from an extended level over 1 standard deviation above the norm to a neutral level over the past two weeks.  Meanwhile, individual investor sentiment as represented by the AAII bull/bear/neutral survey remains below long-term averages.

As we mentioned a few weeks ago, there seem to be several pockets of serious complacency out there, but nothing that warrants deep pessimism.  Corrections, minor or not-so-minor, are healthy recalibration agents for up markets.  Investors broadly seem to still think, though, that every little hiccup is the beginning of the end of days.  Until this behavior changes significantly, we’ll remain encouraged.

Inflation: Little Sound, Little Fury

This week, the back and forth continued among various Fed officials, Fed watchers, and market gurus about the future path of inflation, and hence Fed rates.  Some of this back and forth has contributed to some of the recent market hiccups.  James Bullard, St. Louis Fed President, suggested this week that the Fed Funds rate could increase sooner than the markets expect. 

Of course, there remain a number of pundits and analysts out there sounding the inflation warning signals, as they’ve been doing for five years now.  To this, we say, “Where’s the Beef?”  Looking at 5-year and 10-year TIPS/Treasury spreads, a way to gauge the broader market’s expectations for future inflation, inflation expectations remain well grounded at this point and have barely budged in recent months, even with improving labor market numbers and other indications that economic growth has regained its footing.  The following charts provide a visual representation of this benign pattern:

 

Furthermore, it seems to us that the biggest driver of sustained inflation problems in the past (take the mid to late 1970s for instance) has been strong increases in unit labor costs.  At this point, there’s no sustainable evidence that unit labor costs are increasing materially in the US.

Look at the below chart showing year over year unit labor cost moves.  As you can see, the green line, the 24-month moving average for year-over-year unit labor costs, began increasing in 1967 and didn’t stop until Volcker broke inflation’s back over a decade later.  Of course during this time period, Americans experienced the infamous double-digit inflation that affects attitudes to this day.  What’s happening now?  Actually not much.  There’s always statistical noise in this series.  Focus on the 24-month moving average which remains in a downtrend.  Wage data in the recent strong employment reports remains unremarkable.  We’ll begin to worry about long-term inflation trends when labor costs begin to uptick in a meaningful and sustained way.  

The VIX and Company Risk

Keeping with a few recent posts dealing with volatility and the market’s overall opinion on market stress, we thought it might be interesting to examine the connection between equity market volatility and market participants’ ideas on corporate risk.  

The VIX, an index that quantifies the market’s views on forward 30-day volatility, has historically been very closely related statistically to past/recent realized market volatility.  In other words, the levels of recent market volatility heavily color the market’s view of volatility in the near future.  This makes sense.  There’s a strong amount of “recency bias” among investors.  Taking the view on market volatility one step further, though, shows that percentage changes in the VIX are significantly correlated to percentage movements in Markit’s 5-year Investment Grade Generic CDX Index, which measures credit default swap prices for 125 investment grade companies across all sectors.  Higher levels in the CDX index show that the cost to insure against bond defaults in these companies is rising, meaning that the market’s view on corporate risk is increasing.  Lower levels in the index show that the market is less worried about corporate risk.  The VIX/CDX relationship is interesting, and shows the direct connection between individual company risk (or perceived risk) and overall market jitters.  

Here is a chart going back to the beginning of 2006.  Values for the VIX and CDX indices have been normalized for comparability.

Sharp rises (declines) in the VIX have been accompanied by sharp rises (declines) in the CDX index over the past decade.  In percentage terms, the moves from peak to trough have been almost completely in sync.  Accordingly, the weekly correlation for the percentage co-movements in these indices is approximately 0.65.  

We’ve obviously gotten geeky here.  What does the above chart convey in our view?

• As one would expect, stock market volatility is related to underlying corporate risk.
• Just as the realized volatility and the overall VIX index have hit multi-year lows, the market’s view on corporate risk is falling to the lowest levels since 2007.
• In 2007, the VIX and the CDX index began creeping higher nearly a year before global equity markets began experiencing significant convulsions.  
• While there are no guarantees, we’ll surmise there will be a similar deterioration in market attitudes towards risk decently ahead of the next market snafu.  
• We’ve seen this play out with deterioration in leading economic indicator indices over time.  Significant downward moves in the leading economic indicators have occurred well ahead of major market calamities.  Of note, the beginning of the move upward in the VIX and CDX indices in early 2007 coincided almost perfectly with signals from leading economic indicators that recession probabilities had increased significantly.  This makes intuitive sense that perceptions of corporate risk, and hence volatility, would increase with increased recession probabilities.  Because…What happens during recessions?  Earnings collapse and earnings volatility significantly increases.  In other words, corporate “risk” jumps through the roof.
• Therefore, while corrections, sometimes very uncomfortable, come and go, we maintain our view that a major market calamity isn’t on the immediate horizon.  As with some of the other early warning indicators we’ve discussed such as financial market stress, until we see indicators like the CDX index begin to creep higher on a sustained basis in sympathy with recession warnings, we’ll stay involved in markets.  As seen above, the CDX index is still trending down.  And, despite a noisy and discouraging Q1 GDP print in the US, leading indicators here and abroad haven’t budged to the downside whatsoever.  The probability for recession over the next 8 to 12 months remains very low.  We’ll stay vigilant though!

Complacency

A few weeks ago, we discussed the very low levels of stress showing up in the various Federal Reserve and Conference Board financial system indicators.  Digging deeper and looking at some of the individual indicators of risk-tolerance and volatility out there in various markets produces some very interesting observations.  

Since we spend our time investing in the global equity markets, we’ll take our first quick look at volatility in the S&P 500 and the MSCI EAFE equity indices.  The charts below show that market volatility is back at multi-year lows, hence explaining why the VIX in the US is trading at multi-year low levels.  We use the standard deviation for the trailing 20 days of index performance.  In the S&P 500, realized volatility has reached the lowest sustained levels observed since early 2011.  The EAFE has achieved a much more significant milestone.  20-day volatility in the MSCI EAFE hasn’t been at these levels since May 1996!   

What happened the last time volatility got this low?  The 2011 episode, of course, morphed into a massive correction and spike in volatility in August of 2011 as the European financial crisis and S&P US debt downgrade crisis took hold.  In 1996, the EAFE subsequently corrected just south of 10%, with the correction low achieved in early 1997.  The market correction lasted nearly a year.  In both of those cases, markets eventually resumed strong upward trajectories.  Prior to 2011, the last sustained round of low volatility at these levels occurred in April 2007, just before the global financial crisis began brewing.  We don’t want to make any alarming market calls, especially since many of the other indicators we follow show a much better backdrop than the environment confronting markets in April 2007.  Nonetheless, we would not be surprised to see this market take a corrective breather in the near-term.  

Our next look comes from the world of high-yield bonds.  We like to look at the spread between the Bloomberg High-Yield Index and 10-year US Treasury yields.  When this spread is trending down and compressing, it’s an indication that flows into the riskier end of the debt pool are strong and, hence, risk tolerance is higher.  This week, the spread has compressed to the lowest level observed in our data series, which goes back to 2002.  Yes, depending on the indicator, high yield spreads have now equaled or eclipsed the levels observed in early 2007 on the downside.  The global chase for yield has certainly been a formidable force.  Anecdotes in the business press continue to pour out about the reemergence of cov-lite loans and PIK bonds and the like.  

Does this mean the world is about to come to an end?  Not necessarily.  As you can see below, during the last cycle, spreads first reached super compressed levels in late 2004 and stayed benign for approximately three years before the wheels came off the debt (and equity) markets and spreads spiked to record levels.  As we mentioned above when discussing equity volatility, the general indicators we like to use present a better backdrop than observed in early to mid 2007, when indicators were clearly showing recession probabilities were high and that long-term momentum was waning in various areas across the investment universe.  But, we’ll say again, we wouldn’t be surprised if there’s some sort of corrective activity in these markets to keep participants on their toes in the near future.

We’ve said on several occasions over the past year and a half that the overall intermediate-term market backdrop remains favorable worldwide, especially in overseas markets.  There’s nothing at present that materially changes our intermediate-term view.  However, corrections are a part of life in equity markets and other markets and serve to reset investor expectations in a healthy way.  Indicators like the ones above show that a reset may be in order in coming weeks and months to recalibrate risk markets that have become very complacent.  Of course, we’ll keep an eye on the longer-term trends.  If anything changes underneath the surface worthy of changing the intermediate-term outlook, we’ll certainly shout it from the rooftops.

No Stress

With accommodative central bank policy feeding into low stock market volatility worldwide, tight corporate bond spreads, and other indications that financial market worries remain at low levels (such as report this week in the Wall St. Journal that home equity loans are becoming popular again), we thought it would be interesting to capture where current financial conditions stand in a single, clean indicator.  

As such, we used three financial system stress indices produced by various Federal Reserve branches in combination with the Conference Board’s Leading Credit Indicators Index to produce a single indicator showing that, indeed, we’re observing a period of accommodation and low financial stress that rivals the go-go financial system days of the mid-2000s.  

Quickly, how did we construct our index?  We took the 4-month moving averages for the St. Louis Fed Financial Stress, Kansas City Fed Financial Stress, Chicago Fed National Financial Condition, and Conference Board indices going back to 1994.  Then, we calculated the Z-scores (standard deviations away from average) for the 4-month moving averages in each of the indices.  Finally, we averaged those z-scores across the four indicators to produce the final indicator.  

How do organizations like the Federal Reserve Banks and Conference Board construct financial system indices?  The Conference Board, for instance, uses a variety of financial market indicators such as swap spreads, the TED spread, margin and debit balances, and national bank loan surveys to construct their index.  The Chicago Fed uses 105 different financial market indicators to construct an index, many relating to loan surveys and various interest rate and swap spreads as well.  

Here is a visual representation of the work:

As you can see financial system stress remained below average through the mid-1990s until the time of the Asian/Russian/LTCM financial crises drove financial system stress higher.  Stress remained elevated through the market turmoil and recession from 2000 to 2002.  Coming out of the early 2000s recession, financial stress declined markedly, reaching a bottom in 2005 at approximately the same time the real estate boom was nearing a peak and central bankers in the US started talking about the so-called “global savings glut.”  Stresses started to increase dramatically in mid-2007 as the markets glimpsed the first signs that the leveraged financial products markets associated with the housing boom were beginning to crack.  As the worst financial crisis since the Great Depression unfolded, we see a dramatic spike in system problems.  The highest level of stress in our indicator was reached in December 2008 near the very height of the Great Recession.  Coordinated global central bank actions pulled us back from the brink through 2009 and financial system conditions have continued to improve since then, except for a few spikes associated with the European turmoil during 2010 and 2011.  Interestingly, the lowest level ever recorded in this index occurred in February of this year.  The index isn’t far removed from those lows; financial conditions remain very accommodative.  

What are some takeaways from looking at this data?  

Over the past 20 years, the two big equity market downturns in the US and globally happened several months to a couple of years after these financial stress indices began showing bottlenecks in the system and spiked higher, well above zero.  Looking at the current market situation, while this isn’t a primary indicator we use to drive risk allocations, we think this meets up with other indicators that we use showing that the risk for a major market calamity are reasonably low at present, even though long-term valuations in the US are somewhat stretched.  For instance, leading economic indicators here and abroad show the risk of recession over the coming year remains very low.  And, general longer-term market technical indicators remain favorable.  Until we see indicators like this begin to grind noticeably higher and above the zero-line, we’ll remain sanguine about the intermediate-term path of equity market prices.  

That said, the contrarian gremlin in us notes the extreme low stress level in this index will have to unwind at some point.  Looking across markets and asset classes, it’s hard for us to see, for instance, how high-yield corporate debt spreads could get much tighter.  Granted, this index remained at extremely low levels for three or four years ahead of the Great Recession.  When benign conditions unraveled, however, the unprecedented long period of calm morphed into an unprecedented period of stress.  Just as risk and reward can be symmetrical when looking at equity markets, there’s a symmetry to indicators like this.  Big deviations to the downside tend to lead eventually to big deviations on the upside.  We’ll certainly keep an eye on this and other market indicators for signs that trends are changing.