- A static view tells us stocks are cheap. A dynamic view tells us hell is about to break loose.
- Vehicle loans have increased 57% since 2010. If interest rates increase, car sales and other credit related sales will falter and lead the economy into a recession.
- However, as always, there are ways to make money in any environment. Today we’ll discuss an actionable idea and introduce you to a profitable long term investing philosophy.
This market has lost all connections to economic reality.
The FED’s rate hike lowered treasury yields instead of pushing them higher. This is at odds with history as since 1954, the correlation between the federal funds rate and the yield on 10-year treasuries has been nearly perfectly correlated with a correlation ratio of 0.91, 1 being perfectly correlated.
Figure 1: 10-year Treasury yield dropped after the FED’s announcement. Source: Bloomberg.
Despite the short term deviation, know that treasury yields will follow the federal funds rate and as the FED clearly announced gradual rate increases, we all know what’s going to happen. Why don’t markets move accordingly? Well, short term traders, built-in expectations, and fund flows can skew market forces in the short term. In the long term, we’ll see higher interest rates which will affect all fixed income assets.
Stocks didn’t budge even though they were supposed to drop because actual stock yields are still much higher than the risk free rate.
Figure 2: S&P 500 in the last 30 days. Source: Bloomberg.
However, an interest rate increase of 0.25 percentage points should lead to a similar increase in the required return from stocks.
By adding 0.25 percentage points to the 2017 S&P 500 expected returns, using 2017 S&P 500 estimated earnings of $130, the S&P 500 should have dropped at least 100 points. The current forward expected earnings yield is 5.4%. If increased by 0.25 percentage points, the S&P 500 should be at 2,270 points. Any further increases in the federal funds rate by a quarter of a percentage point should push the S&P 500 down another 100 points.
Every time the FED increases interest rates and the S&P 500 doesn’t drop, it just postpones the inevitable and increases the downside for the S&P 500. One of the main theses for this bull market is that stocks have the best yields, which was correct. But now that yields and inflation are increasing, the required return from stocks should also increase. This isn’t happening yet, but it will, and I wouldn’t like to own the S&P 500 when that happens.
Figure 3: The FED model – stocks are cheap as long as their expected yield is higher than what treasuries offer. Source: Bloomberg.
As treasury yields increase alongside higher federal rates, stocks should drop. Stocks aren’t dropping because the majority of investors don’t understand what they’re doing. When stock indexes hit multiple year lows, everybody runs away from stocks faster than they would run from the plague. When stock indexes hit new highs in an eight year old bull market, mom and pop investors run into the market reassured by past performance with the notion that the markets can only go up. Despite the FED’s rate hike and the S&P 500 at all-time highs, U.S.-listed ETFs have seen inflows of $125 billion so far in 2017, and in the week of the FED hike alone, ending Thursday, March 16, an additional $19 billion flew into stocks.
“Stocks Can Only Go Up”
I’ve been around financial markets for almost two decades now, and every time unsophisticated investors pour money into stocks based on the premise that stocks can only go up, the story hasn’t ended well.
If you look at the stock market from a static perspective, yes, I agree, stocks are still cheap. The spread between treasury yields and stock yields in the figure above still gives stocks a significant advantage over bonds as stocks are expected to yield at least 5.5% through earnings in 2017.
If you look at financial markets from a dynamic perspective, then the picture immediately changes. First, earnings estimates are the worst variable you should rely on. Analysts aren’t that good at estimating earnings.
Figure 4: Actual earnings (brown line) compared to analysts’ estimates (green line). Source: Bloomberg.
Analysts are especially bad at estimating earnings when the environment changes, primarily because they also have a static perspective on what’s going on. Analysts overestimated earnings by 34% in 2001, and by 74% in 2008. A similar overestimation will happen again when the economics change. The issue is that with the FED finally raising interest rates, the economics have started to change.
The Economics Are Changing
Apart from influencing financial markets, interest rates have a strong effect on the most important short term economic driver, credit. Modern economies thrive on credit and go bust when credit tightens. Car loans are an excellent indicator of how the economy is doing and on the available credit the population has. In the last three decades, interest rates for consumer credit have been consistently declining. This has lead consumers to borrow more and more.
Figure 5: Motor vehicle loans and interest rates. Source: FRED.
Since 2010, vehicle loans have grown a staggering 57%. This is, of course, unsustainable, especially if consumers get confronted with higher interest rates. The inevitable outcome is a recession or more monetary and fiscal easing. If a healthy recession comes along, analysts will miss their estimates by a large margin and stocks will drop as the greedy investors that are running into this market start panicking and selling at whatever price they can get.
If we see more monetary easing, then it will be clear that developed economies can’t grow at moderate growth rates without extreme stimulus which will lead to currency depreciations and inflation.
It’s as simple as that, the above will eventually happen as not even the FED can go against the cyclical nature of the economy forever.
Actionable Ideas & Portfolio Positioning
If you’re a trader and oriented to short term gains by seizing market imbalances, the low risk bet would be to short credit. The first thing that should pop is high-yield or junk debt. Higher interest rates will lead to many bankruptcies as highly leveraged companies see their marginal profits squeezed by higher interest rates. As junk yields are at historical lows and the FED has announced more rate increases, this is an extremely low risk high return bet.
Figure 6: U.S. junk bond effective yield. Source: FRED.
There will be many other yield spikes like the ones that have happened in the last five years, especially since the junk yield shouldn’t go much lower.
If you’re an investor, you should position yourself in a way that you are happy with what you own. The way to do that is to look at the intrinsic value of the businesses you own and not so much at what the market is saying they are worth. This topic requires a special article, so tomorrow we’ll discuss the best long term approach to investing.