The Boredom Always Ends

By: Michael Ashton | Tue, May 27, 2014
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After fairly boring trading through the first half of the month, the equity market has shot to new highs over the last few sessions. Could it be mere boredom on the part of investors, who are seeking more excitement?

Stocks have been expensive for a while, with Shiller P/Es near 25, yet the battle cry among bulls has been "but look, the trailing P/E is still low." Although the trailing P/E recently has incorporated earnings that represented unusually high margins (see chart, source Bloomberg), the "see no evil" crowd brushed that complaint aside. But now, the trailing P/E ratio of the S&P 500 is at 17.6, and at 18.7 before the write-off of "extraordinary items" (which, while extraordinary for any given company in a given year, are not extraordinary for the index of a whole, which always has some of these write-offs).

Margins Chart

So it isn't as if the equity market is now rising because earnings have been rising and prices are just catching up. The trailing P/E is now at a level slightly higher than it was prior to the 2007 top, and on par with the levels of the Go-Go Sixties prior to the malaise of the 1970s (see chart, source Bloomberg). Let us not forget that earnings quality isn't what it once was, either. And again: I am not a fan of a 1-year trailing P/E; I am merely pointing out that even this bullish argument is going away.


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To be sure, trailing P/Es aren't at the pre-crash levels of 1987 or 1999 - but, again, let us recall that margins are at cyclical highs, so that if we look at the S&P price/sales ratio, we again get a disturbing view that has equity valuations higher than at any time other than the 1999 bubble run-up. (See chart, source Bloomberg - note that Bloomberg history for this series only goes back to 1990.)

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Now, some observers will draw exaggerated offense to the notion that stocks might be priced for somewhat poor forward returns, and insist that the recent rally in bonds means that the ratio of the "Earnings yield" to bond yields is merely being maintained. Aside from the fact that this "Fed model" is explanatory rather than predictive (that is, it helps explain why prices are high, while not suggesting they will remain high...and indeed, rather suggesting the opposite as future returns are inversely correlated with the P/E of the starting point of the holding period), we also can't give credit for the equity rally to the bond market rally this year from 3% 10-year yields to 2.50% yields without simultaneously asking why investors didn't sell stocks when yields rose from 1.70% to 3% last year.

Admittedly, I was probably saying roughly the same thing at this point last year. Sour grapes? No, it just concerns the question of investing rules versus trading rules. In other words: I'm not telling you how to vote; I'm telling you how to weigh. Nothing has changed valuation-wise since last year, other than the fact that the market as a whole is growing more expensive.

On the "good news" front, corporate credit growth has been re-accelerating again. This is somewhat of a sine qua non for faster economic growth. We had seen decent credit growth in 2011 and into 2012, but when QE3 kicked off loan activity had ebbed. But now quarterly growth in commercial credit is nearing a 10% annual rate (see chart, source Board of Governors), something that hasn't happened since the beginning of 2008 - other than for a brief spike around the crisis itself.

commbkquart

While this is good news, it is not unmitigated good news considering that the Federal Reserve as yet has no viable plan for exiting QE before all of those horses leave the barn. One of the biggest concerns, in terms of a risk of unpleasant surprise, is that few seem to be giving the inflation risk much thought, either in markets where 10-year inflation swaps float in the middle of the 2.40%-2.60% range they have occupied for the last twelve months, or in policymaker circles. This is on my mind today because I was reading an article published on the BLS website entitled "One hundred years of price change: the Consumer Price Index and the American inflation experience" and ran across this passage:

"Why the return of inflation when it seemed to be guarded against and feared? One possibility is a change in the perspective of policymakers. Some have argued that inflation was tempered in the 1950s by a Federal Reserve that, believing that inflation would reduce unemployment in the short term but increase it in the long term, was willing to contract the economy to prevent inflation from growing. By the 1960s, however, the notion of the Phillips curve, a straightforward tradeoff between inflation and unemployment, ruled the day. Citing the curve, policymakers believed that unemployment could be permanently reduced by accepting higher inflation. This view led to expansionary monetary and fiscal policies that in turn led to booming growth, but also inflationary pressures. However much policymakers professed to fear inflation, the policies they pursued seemed to reflect other priorities. The federal government ran deficits throughout the 1960s, with steadily increasing deficits starting in 1966.

Aside from the dates, it strikes me that this paragraph could have been written today. The Phillips Curve, now "augmented," is still a key tool in the Fed economist's toolkit even as responsible control of the money supply is deemed passé. As for accepting higher inflation the FOMC changed its inflation target a couple of years ago to be 2% on the PCE, which was implicitly a bump higher from the previous 2% CPI target since PCE is normally 0.3% or so below CPI, and various officials have mooted the idea of letting price increases exceed that rate "for a time" since expectations are well-grounded. And then, of course, you have economists like Krugman arguing for a higher inflation target. Not that we ought to pay any attention to Krugman, but somebody invited him to speak at that conference and that suggests he still has credibility somewhere.

I must say that I don't believe in an end to history, in which a permanent and pleasant equilibrium exists in capital markets and economies, which both can continue to expand at a reasonable pace with low and fairly stable inflation and interest rates and generous profit margins. If I did believe in such a thing, then I might think that we had arrived; and then perhaps I would see equity multiples and bond yields as reasonable and sustainable. But I do not, because I have already lived through three periods where the VIX was in the 10-12 range: in the 1990s, in 2005-2007, and in 2013-2014. The first two periods produced very exciting finishes. The boredom always ends, and usually abruptly.

 


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Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
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Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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