November 17, 2003
Recipe for Trouble
The holidays are fast approaching. That means one thing, of course. Baked goods. With the exception of those peanut butter cookies with the Hershey's kisses that can be lifted out on their own, baked goods are pretty much all or nothing – accept every ingredient, or walk away. This is why fruit cakes have a bad reputation. There's usually something not to like.
The financial markets are more flexible. You can buy the fruit cake and hedge away the fruit, so to speak. You can buy the cookie and leverage up the chocolate chips. Still, the ability to select some ingredients and hedge away others – and do it well – is not universal. Many investors simply take the piece of cake that's offered to them and swallow it whole.
Those investors had better understand what's baked in the cake.
At present, three main ingredients come to mind: 1) unusually high valuations, 2) unsustainably low short-term interest rates, and 3) a mammoth current account deficit.
Long-term total returns of 4-8% on stocks might just be a tad optimistic
First, valuations. The S&P 500 Index currently trades at 20 times prior peak earnings. Except for the 2000 bubble peak, prior market cycles have only reached this level at the 1929, 1972 and 1987 market extremes. We know that measured from peak-to-peak, S&P 500 earnings have never grown significantly faster than 6% annually (even during the 1990's). We also know that the impact of favorable productivity improvement on long-term growth is measured in tenths of one percent (see last week's update for more on this). As a result, we can form very good estimates of the long-term returns priced into stocks here.
If the price-to-peak earnings multiple is held constant over the long run, stocks by definition must grow at the same rate as peak-earnings, or about 6% annually. Add in a 1.7% dividend yield, and stocks would deliver a long-term total return of about 7.7% from current levels if valuations were to remain at current levels indefinitely. This is the relevant estimate of long-term returns for investors who believe (contrary to all finance theory) that present interest rate and inflation levels justify current stock valuations. Even then, this estimate assumes that current valuations will be sustained indefinitely.
In my view, such optimism, if you can call 7.7% long-term returns optimism, is misplaced, because it ignores the concept of peak-to-trough. Specifically, once stocks have reached extremely high levels of valuation, there has always been some point, anywhere from 4-17 years later, when stocks subsequently reached moderate or low levels of valuation. Between those two valuation points, stock returns have been abysmal.
For example, suppose that a full decade from today, stocks do nothing but touch their historical average of 14 times peak earnings. Do the math. If earnings grow at a rate of 6% annually (and again, there is no historical exception demonstrating faster growth over long-periods of time), the annual capital gain on stocks over the coming decade would be [(14/20)^(1/10) x (1.06) – 1 = ] 2.3% annually. Add in a dividend yield of about 1.7% and the total return on stocks would be about 4% annually over the next 10 years. Given that most historical bear market lows have occurred at less than 9 times prior peak earnings (the modest 1990 low reached 11 times peak earnings), a 4% total return expectation might just be a tad optimistic.
In short, at current valuations, unsatisfactory long-term returns are baked in the cake. This doesn't speak to short-term returns, which are driven largely by investor's preferences to take risk (what we attempt to measure through market action). But investors taking market risk here should understand that they are taking risk on the basis of speculative merit, not investment merit.
Shorty gets a lift
The second unpleasant ingredient baked into the cake here is an inevitable increase in short-term interest rates from current levels.
Investors have a lot of beliefs about interest rate behavior. One is that an increase in long-term interest rates is a signal of coming economic strength. As it happens, long-term yields invariably fall in the months preceding an economic expansion, and typically remain well behaved as the economy enters a new recovery. Similarly, inflation rates typically decline during the early phase of an economic recovery. There is, however, one remarkably strong tendency in the data, and that is for real short-term interest rates to surge relatively early in an economic expansion.
On this front, the current recovery has been markedly different. Inflation rates have behaved normally, with the recent pickup in producer inflation being typical for a recovery that is now two years old, but real interest rates have remained negative at the short end of the yield curve. Much of this reflects foreign purchases of U.S. Treasuries, particularly by Japan and China, in attempt to support the value of the U.S. dollar and keep their own currencies from appreciating. With growing pressure on these countries to abandon this policy, the coming upward adjustment in short-term interest rates could be very abrupt.
As I note in Freight Trains and Steep Curves, the U.S. financial system has become disturbingly dependent on continued low short-term yields. Both corporate and mortgage debt are largely tied to low short-term yields. An upward spike would create pressure on both credit risks and the housing market. Look, if Ford bonds can be downgraded to BBB- despite auto sales that have never been higher, the outlook for corporate defaults is hardly sunny.
Moreover, the resilient behavior of Treasury bonds after last summer's slide is also the result of the unusually steep yield curve that encourages “carry” trades (borrow at low short-term yields, invest at high long-term yields). Upward pressure on short-term yields would create significant pressure to unwind these trades. Though my inclination is to believe that higher short-term yields would create enough economic difficulty to keep long-term yields restrained, there could be enough pressure on Treasury bonds from an unwinding of these carry trades to drive long-term yields higher anyway. In any event, numerous economic and financial risks are tied to the level of short-term interest rates. Unfortunately, an increase in short-term interest rates is also baked in the cake.
The virtuous trade cycle falls away
Finally, I've written enough about the gaping U.S. current account deficit that its mere mention should serve as a reminder of its consequences: an uninspiring outlook for U.S. domestic investment, a probable slowing of import growth (and with it, measured U.S. productivity growth), and upward pressure on inflation when the deficit narrows - a mirror image of the downward pressure on inflation we enjoyed while the deficit was expanding.
In short, some features of the current economic and financial environment might be affected by various developments and policies. Other features are simply baked into the cake. For buy-and-hold investors intent on choking down whatever is placed on the plate in front of them, this is just unfortunate. There are important problems and challenges in the current environment. Our willingness to take a certain amount of market risk based on speculative merit should not encourage investors to ignore these realities.
As of last week, the Market Climate for stocks remained characterized by unusually unfavorable valuations but still moderately favorable market action. This indicates that although stocks appear priced to deliver very disappointing long-term returns, investors still seem willing to accept market risk, at least at present.
For our part, we increased our hedging a bit last week. In the Strategic Growth Fund, slightly more than 55% of our stock holdings are now hedged against the impact of market fluctuations. Those stocks are held based on their own characteristics of value and market action, so we are very willing to hold them even in negative conditions, provided we can remove the impact of market fluctuations if necessary. For now, we're comfortable accepting at least some of those fluctuations. If and when we observe deteriorations in market action (even fairly subtle ones) suggesting that investors have become skittish about market risk, we would expect to shift to a fully-hedged investment position.
In short, we own a diversified portfolio of individual stocks that we believe have merit based on their own valuations. We're also accepting a moderate exposure to market fluctuations, but are well aware that this is based on speculative merit alone.
In bonds, the Market Climate for bonds shifted importantly last week. As a result of last week's advance in bond prices, combined with deteriorations such as a jump in producer price inflation, the Market Climate for bonds is now characterized by unfavorable valuations, but still tenuously favorable market action on our measures. As a result, we sold a substantial portion of our long-term Treasury holdings late Friday afternoon. At present, the Strategic Total Return Fund has a portfolio duration of about 4.5 years, meaning that a 1% (100 basis point) shift in interest rates would be expected to affect the Fund by approximately 4.5%.
As usual, shifts in our investment positions should not be construed as forecasts of market direction. Our approach is straightforward – we take risks in proportion to the average return per unit of risk associated with present, observable conditions. Specifically, we are not making any sort of a “bearish call” on bonds here. Very simply, the yield on bonds has declined at the same time that the probable risk has increased. This reduces the ratio of expected return to risk, and we have reduced our position in response. No forecast is embodied in this, except the obvious fact that a lower yield to maturity is a certain forecast of lower long-term returns from bonds.
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