Bond Yields Fall As Fed Tapers Purchases--Markets Perplexed!

• Bond yields are falling despite the Fed’s decision to taper QE

• This is because QE has not affected the economy
• Falling bond yields are not bearish for stocks

Since the FOMC began to taper its bond purchases at the beginning of this year, the 10-year Treasury yield has declined by 40 basis points from 3.0% to 2.6%. This has caused puzzlement in the financial commentariat:

“The demand for Treasury bonds is all the more remarkable because the Federal Reserve is ending the Treasury-bond-buying program it has used to keep interest rates low. That normally would reduce Treasury demand and push yields higher. Instead, Treasury prices have risen and yields declined.” (WSJ, 05 May 14)

This amazing phenomenon does not come as news to readers of my blog. I have been calling attention to the tightening of monetary policy for the past two years. The fact that the Fed has given up on QE is a signal of even greater tightening, which is entirely consistent with falling bond yields. Today’s bond market is looking at a very subdued horizon:

• 6.0% money growth, the impact of which is further diminished by declining velocity;
• 1.2% inflation, which is 40% below the Fed’s target;
• 3.7% nominal growth, which is inadequate to sustain anything like 4% real growth--which was in fact zero (QtQ) in the first quarter;
• A complete absence of any discussion at the FOMC of taking concrete steps to accelerate money growth.

We are also told that falling bond yields are a bearish signal for stock prices:

“One sign of the current worry is the strength of U.S. Treasury-bond prices. In times of economic optimism, investors normally buy risky assets like stocks, not safe Treasury bonds.” (WSJ, 05 May 14)

It is true that the depressed economic outlook is bearish for the rate of corporate earnings growth, but this does not translate into a bearish outlook for equity prices. That is because, ceteris paribus, declining bond yields increase the relative premium being paid to stockholders. Damodaran at NYU calculates the equity risk premium at 5.1% as of May 1st. This compares with an all-time high of 7% during the Crash and an all-time low of 2% in 1998. The current level is considerably above the historical mean. Stocks offer a relatively attractive prospective return in a world of ultra-low interest rates.

The ERP is elevated because bond yields are very low, not because of the outlook for earnings growth. The threat to current stock multiples is not low earnings growth, but instead higher bond yields. Given the current subdued outlook for growth and inflation, I see little reason to expect higher bond yields anytime soon.

There is a widely-held view that bond prices have been artificially supported by QE, and that the end of QE should herald lower bond prices--that financial markets have been artificially supported by “massive monetary stimulus”. The empirical evidence suggests that bond prices were not inflated by the Fed, and that the withdrawal of QE will not result in lower bond (or stock) prices.

My view has been that, because QE has failed to increase money growth, inflation and nominal growth, it has not raised bond prices. This is because inflation expectations have declined during QE, which should not have occurred during a period of “massive money printing”. Pre-crash, 10-year inflation expectations were above 2.5%; today, they are 2.2%--despite a quadrupling of the Fed’s balance sheet. The tapering of QE is a signal that nothing more will be done to raise inflation expectations, hence the rise in bond prices. QE was nothing but a sideshow: a huge distraction from the Fed’s continuing failure to get control of money growth.

Implications Of Weak Growth For Financial Assets And Monetary Policy

My economic forecasting prowess has been vindicated by the awful first quarter GDP growth data, which show that the economy is on the brink of recession. I have been saying since October that the economy is at risk of both deflation and recession. I have based my pessimistic outlook on the decline in money growth and inflation over the past two years, and on the Fed’s perverse decision to further reduce monetary stimulus in the face of subpar growth and inflation.

What does this depressing growth scenario mean for financial assets? It is bullish for both stocks and bonds, and bearish for inflation hedges like precious metals.

Implications for Bonds: Bullish

Low growth is bullish for bonds because it removes the risk of accelerating growth,  delays further the possibility of higher short-term interest rates, and anchors inflation expectations at their current low level. The big bond selloff has already occurred, during 2013, when the 10-year yield doubled from 1.5% to 3%. This year, bond yields have fallen back to 2.65%. I don’t like bonds because they yield nothing, but I don’t see the  “inevitable bursting of the bond bubble” happening any time soon.

Implications for Stocks: Bullish

Low bond yields are bullish for equities. Stated differently, high bond PE ratios support high stock PE ratios. (Today, the bond PE is 38x and the stock PE is 19x.) This relationship is captured by the equity risk premium, which compares the demanded return premium for stocks over bonds. On Friday, Aswath Damodaran at NYU will publish his calculation of the ERP for the first of the month. For April 1st, he calculated the ERP at 5.15%, which is on the high end of the range since 1961 (the range is roughly 2% to 6.5%). This means that you are being paid a historically high premium for owning equities.

The ERP is elevated despite high PE multiples because bond yields are so low. Skeptics say that the ERP depends upon strong earnings growth and abnormally low interest rates. The are wrong about earnings growth: the ERP does not reflect or depend upon strong forward earnings growth. They are right about interest rates, but rates are abnormally low because inflation is at a 50-year low. The 1Q14 growth data suggest that rates will remain abnormally low for some time.

Implications for Metals: Bearish

Precious metal prices should move in accordance with inflation expectations, and indeed both inflation expectations and metals prices have been declining since 2012. The current growth and inflation outlook suggests that metals prices will continue to decline until the Fed can get a grip on money growth.

Implications For Monetary Policy: Nothing

The 1Q14 growth numbers represent a victory for the doves and a defeat for the hawks. Once again, the hawks have been shown to have a complete misunderstanding of the Fed’s current monetary stance, which is contractionary, not stimulative. Once again, the doves have been proven correct: tapering at this point in the cycle is insane. This might give Yellen the ammunition she needs to reverse the decline in money growth, but history suggests that she, like Bernanke, will fail. For the Fed to do a complete 360 will require negative growth and higher unemployment, both of which are likely. Then we might see a policy rethink.

Knocking Down Jim Cramer's Bear Case

Jim Cramer just published “The Bear Case in 10 Easy Lessons”, which lays out the arguments for lower stock prices.  He throws these “lessons” out not as an argument but as discussion items, a sort of straw man. Here is his case and my observations:

1. Something is very wrong with the market when we get strong news out of the economy and interest rates plummet. That's a fear of an unknown unknown. What's the point of buying when there is something lurking?

Interest rates are falling because inflation is falling while the Fed is tapering. Low bond yields support low earnings yields (high PE ratios).

2. When interest rates plummet, the banks plummet, particularly now that the short rates aren't going higher. Banks are the linchpin of all big rallies, and we have lost them.

There is no doubt that banks are hurt by a low and flat yield curve which makes retail deposits expensive and compresses margins. Bank earnings are under pressure. But the current ERP is a result of low interest rates, and doesn’t depend on robust earnings by banks or corporates. And also, low interest rates may hurt banks but they help corporates.

3. There is no price where the insiders won't sell these extended techs with no dividends or earnings.

Tech goes its own way and is always hard to value using conventional tools. The valuation of blue chips is not so hard, and is poorly correlated with tech. If a tech selloff pushes down blue chips, buy them.

4. We have had a big run from the bottom, almost a triple, so it has to be out of gas and extended. It was just high-multiple stocks. Now it is every stock.

Distance from the bottom is not a useful index of valuation. Stocks were severely undervalued in 2009, when earnings were cyclically depressed. The fact that they are higher today contains no information about value.

5. We've seen this movie before in 2000. In fact, it was this week to the week that we were really beginning to thrash with the really awful dot-coms crashing daily and the insiders still selling no matter what the case.

The 2000 movie was of a classic equity valuation bubble, when the broad market equity risk premium was at an all-time low. That is not the case today; the ERP is at the high side of its normal range suggesting value.

6. Japan's a disaster.

Japan has been a disaster since 1991 and it has never had any impact on the US equity market. As a result of Shinzo Abe’s reflationary policies, Japan is finally beginning to recover, and now has higher inflation than the US.

7. China's a disaster.

China is not anything like a disaster. China remains the best performing economy in the world, although it slowing a bit as the PBoC reins in credit growth (which is a good thing). China prints its own money and has $3.5 trillion in external reserves.

8. The world's being kept afloat by central bank fiddling.

Global inflation is lower than it has been in 50 years. Global money growth is in the single-digits (almost zero in Europe). The IMF is warning about deflation. The world is kept afloat despite central bank incompetence.

9. The initial public offering flow doesn't stop.

IPO volume is suggestive of frothy sentiment and is a warning light. However, other measures suggest that we are not in an equity bubble comparable to prior episodes such as 1999. If equity prices fall from their current levels, market valuations will become more compelling.

10. Earnings will be terrible.

Future top-line and bottom-line growth are limited by anemic nominal GDP growth and by potential capacity constraints. However, from a valuation perspective, weak earnings growth is fully offset by low bond yields (i.e., a low discount rate for future cashflows). The current price-earnings ratio for 10-year governments is 38x with zero potential earnings growth, while the S&P ratio is half of that at 18x with potential (albeit weak) earnings growth.

Implications Of Deflation Risk For The Equity Market

• Deflation poses a risk to current stock market valuation.
• Inflation is falling and the risk of a deflationary episode is growing.
• Deflation is a monetary phenomenon caused by inadequate money growth.
• The Fed appears to be unable or unwilling  to raise the rate of inflation to its targeted level.

In a recent post I argued that the stock market is not overvalued, and that the equity risk premium is historically high, or at least within a normal range (depending on your calculations).  I cited a study by Duarte and Rosa at the NY Fed which found that:

“The ERP is high at all foreseeable horizons because Treasury yields are unusually low at all maturities.  In other words, the term structure of equity premia is high and flat because the term structure of interest rates is low and flat.”

In other words, the market is not overvalued in the context of bond yields. I further argued that I don’t expect bond yields to rise because of the subdued inflation outlook. Today I will discuss the other side of the inflation equation: deflation risk.

Research suggests that the stock market sweet-spot for inflation is between 1% and 6%. The market reacts negatively (i.e., it demands a higher risk premium) to inflation levels that are above or below this range. The stock market doesn’t like high inflation because it raises the discount rate for future cash flows, and it  doesn’t like low inflation/deflation because it reduces corporate earnings and magnifies debt.  You will recall that the market performed badly during the 1929-33 deflation, the very low inflation in 2002, and the deflation of 2009.

Deflation poses a risk to today’s market outlook. Consumer price inflation has fallen to low levels, producer price inflation has been bouncing around zero, commodity prices have been falling for three years, while the price of oil has been flat.

As we know from Friedman and Bernanke, deflation is a monetary phenomenon. Today’s low inflation is a result of low velocity-adjusted money growth (M x V). Strong growth in the monetary base (QE) has not translated into money growth, and the current moderate money growth has not translated into equivalent  nominal growth (P x T) due to falling velocity. Hence, we have  subpar nominal growth and deflationary pressures.

It is at this deflationary brink that the FOMC has chosen to taper monetary stimulus. The rationale for tapering in the face of below-target inflation is that the current sub-target level is temporary and inflation will rise (as monetary stimulus falls). Not every member of the FOMC buys this logic, according to the minutes of the latest meeting:“A couple of participants expressed concern that inflation might not return to 2 percent in the next few years.” What these two dissidents got was a meaningless promise: “members agreed that inflation developments should be monitored carefully.” In other words: ignore the numbers, the taper will continue.

When Ben Bernanke gave his famous helicopter speech in 2002, he listed five reasons why “the chance of significant deflation in the United States in the foreseeable future is extremely small”. These reasons were:

1. The stability of the US economy.

2. The strength of the financial system.

3. Stable inflation.

4. Anchored inflation expectations at a non-deflationary 3%.

5. The willingness and ability of the Fed to take whatever means necessary to prevent significant deflation.

Let’s look at these five factors in today’s context:

1. Economic stability: Check; the economy is stable.

2. Strong financial system: Check; we are not having a financial crisis.

3. Stable inflation: No; inflation has been falling since 2011.

4. Anchored inflation expectations at a noninflationary 3%: No;  inflation expectations have been falling since 2010 and are now below 2%.

5. The ability and willingness of the Fed to meet its inflation target: No, current inflation is running at half of target, and the Fed is withdrawing stimulus.

So today’s economy currently meets three of Bernanke’s five deflation risk criteria. Hence the recent concerns being expressed by the two dovish committee members. In his speech, Bernanke listed steps that the Fed could take to counteract deflationary pressures:  

1. Cap the entire yield curve;

2. Offer zero interest loans to banks;

3. Buy foreign government debt;

4. Monetize Treasury purchases of private assets.

Twelve years later, despite the clear risk of deflation, all of these tools remain unused--not even during the 2008 deflation.

Conclusion:

Current market valuations are merited as long as inflation remains within the moderate range (1-6%). Given that current inflation is at the bottom of that range, and that the Fed is reducing monetary stimulus, the principal risk to today’s  market valuation appears to be lower inflation or outright deflation.

Bond Yields And The Equity Risk Premium

Summary

• High PE ratios do not signal an overvalued equity market.

• Multiples are high because bond yields are low.
• Bond yields are not artificially depressed by the Fed’s bond-buying.
• Bond yields are likely to remain low, given the inflation outlook.

Duarte and Rosa at the NY Fed say that the equity risk premium is elevated at all horizons because the term structure of interest rates is depressed at all horizons. They say that the only thing that could reduce the ERP would be higher bond yields, and that earnings and dividend growth rates only play a minor role. That means that an equity investor cannot have an informed opinion about the stock market without also having an informed opinion about the bond market.

Stock market bears say that bond yields have been artificially depressed by the Fed's purchase of $3T of Treasury bonds, which represents a material proportion of the total float (about the same as the PBoC's portion). But I don't believe that QE is the reason why yields have fallen. If QE had been effective and had stimulated money growth, it would have raised bond yields. The idea that printing money depresses inflation expectations and bond yields is upside-down.

Bond yields are low because QE has failed. QE has had no impact on money growth or inflation or inflation expectations. Money growth since the crash has been anemic (~6%) and inflation and inflation expectations have trended steadily downward. We have gone from a disinflationary economy to a borderline deflationary economy. This is not good for workers (or earnings growth), but it justifies high PE ratios.

Inflation has not been this low since before the Vietnam war, and inflation expectations are very near their all-time low. Bond yields are at Eisenhower levels because inflation and inflation expectations are at Eisenhower levels. When you couple this with the FOMC's decision to reduce monetary stimulus in the face of declining inflation and inflation expectations, it's hard to build a case for higher bond yields. Since bond yields are unlikely to rise, then the outlook for stock prices remains bullish.

Decoding The NY Fed’s Latest Paper On The Equity Risk Premium

I read academic research papers so that you don’t have to. The NY Fed has recently released a working paper on the ERP. This paper follows a previous paper published last year, which reached similar conclusions. Both papers conclude that the ERP was at an historically high level in 2013. Further, the authors conclude that the ERP is a valid tool for estimating equity market value, and that ERP tools are superior to PE-related tools such as Robert Shiller's CAPE.

You really can’t value stocks through the cycle without reference to bond yields. Otherwise, we would just be looking at PE ratios and be thinking that stocks were expensive when rates were low (2002, 2009, 2012, 2013, 2014). Bottom line: ignore the PE and ignore the cyclically-adjusted PE (the CAPE). Only look at the ERP (earnings yield minus the risk-free rate) or--my preferred index-- the ratio of the ERP to the risk-free rate. Equities can only be valued by reference to interest rates.

If you agree with me, and accept that the ERP/RFR ratio is THE index*, then you should sell everything you own and put it into equities. If you were a real hombre, you would also borrow up to your debt capacity and buy stocks (please don’t do that!). If you accept the internal logic of the ERP/RFR ratio, then you should be overweight equities. Below I have excerpted from the NY Fed’s most recent paper on the ERP, and have provided my parenthetic exegesis. The NY Fed’s words are italicized.

There is broad agreement across models that the ERP has reached historical heights [as of mid-2013] even when the models are substantially different from each other and use more than one hundred different economic variables. Our preferred estimator places the one-year-ahead ERP in July 2013 at 14.5%, the highest level in fifty years and well above the 10.5% that was reached during the financial crisis in 2009.

Translation: The best time to buy stocks in our lifetimes was last summer. If you mentally adjust the ERP to reflect the subsequent market appreciation, we are still in historic territory.

The ERP is high at all foreseeable horizons because Treasury yields are unusually low at all maturities.  In other words, the term structure of equity premia is high and flat because the term structure of interest rates is low and flat.  Current and expected future dividend and earnings growth play only a minor role.

Translation: The reason that stocks are a buy is that bond yields are at deflationary levels.

A high ERP caused by low bond yields indicates that a stock market correction is likely to occur only when bond yields start to rise.

Translation: Unless something happens to upset current inflation expectations, the ERP will remain elevated into the foreseeable future, making stocks a compelling investment.

Another implication of a bond-driven ERP is that we should no longer rely on traditional indicators of the ERP like the price- dividend or price-earnings ratios, which all but ignore the term structure of risk-free rates.

Translation: Shiller’s CAPE and similar crude valuation measures are flawed because they ignore the expected returns from alternative investments. When rates are low, PEs are high. That doesn’t make stocks expensive. We should compare the PEs of stocks with the PEs of bonds. Right now the 10-year PE is ~35x--and bond yields can never rise.

The current high levels of the ERP are unusual in that we are not currently in a recession and we have just experienced an extended period of high stock returns, with 60% returns since July 2010 and almost 20% since the beginning of 2013. During previous periods, the ERP has always decreased during periods of sustained high realized returns. It is unusual for the ERP to be at its present level in the current stage of the business cycle, especially when expectations are that it will continue to rise over the next three years.

Translation: We are living in a period of unprecedented prospective equity returns. This an historical opportunity to buy stocks.

Our analysis provides evidence that is consistent with a bond-driven ERP: expected excess stock returns are high not because stocks are expected to have high returns, but because bond yields are exceptionally low.

Translation: You should only be bullish on stocks if you are also bullish on bonds. That requires an opinion that the FOMC will continue to be unable to raise inflation and inflation expectations.

There was a moment when I thought that Yellen would be the catalyst for higher inflation expectations; I was wrong. She is a catalyst for nothing. We should expect low inflation, low bond yields, and an attractive equity yield premium until stock prices go much higher. Investors who currently hold metals, cash and bonds will look back on 2014 and regret it. Where we are today is 1933, 1974, 1980, 1987, and 2009.

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* It was subsequently explained to me (at Seeking Alpha) that the ERP/RFR ratio is unreliable because of its sensitivity to small changes in the RFR when the RFR is very low. Consequently, I suggest that we focus on the ERP itself.

Valuing The Bull Market

• PE measures suggests the market is overvalued.
• ERP measures suggest that it is undervalued.
• A lot depends on the outlook for bond yields.

Earlier this month, the Post-Crash Bull Market turned five years old, which some people think is close to its expected life span. Everyone has an opinion about whether it is now time to sell or to hang in there. As readers know, I am in the latter camp.

Serious investors need a sophisticated understanding of the tools available to judge whether the stock market is over or under valued. Such a judgement is highly actionable from an investment perspective, unless you still believe in the EMH and the tooth fairy. You can’t look at the market over the past decade and say that market-timing doesn’t matter. If you bought in 2007 and sold in 2009, it mattered. If you bought in 2009 and have held on, it mattered. The market is volatile and inefficient.

Given just how highly actionable market valuation tools are, you would expect Wall Street to be falling all over itself to publish research and data on the subject. But, because the data is so valuable, they don’t. 

The Street is very close-mouthed on this subject. The ignorant blather on TV about the stock market never goes near a discussion of valuation techniques. To get the data you need to calculate it yourself (no thanks!) or go to academia. There are two schools in academia in this discipline:

The PE School: Bearish

One school believes that equities can be valued without reference to bond yields, or argues that the Fed has used QE to artificially depress bond yields below their natural level. This view has particular appeal to those who believe that QE has artificially held down bond yields since the crash. This school, let’s call it the PE school, makes adjustments to the  reported PE ratio in order to smooth out earnings and inflation noise. For example, Prof. Robert Shiller at Yale calculates a cyclically-adjusted PE ratio, which uses averaged earnings and constant dollars to calculate the CAPE. Shiller’s index indicates that the market is substantially overvalued in a historical context. The current CAPE is 25.5%, versus an historical mean of 16%. That means sell, unless you are very bullish about earnings growth--which I am not.

The ERP School: Bullish

Another school believes that equity yields, meaning the reciprocal of the PE ratio (the EPR), should be be compared with  the risk-free rate (RFR). This makes sense to me because, historically, the EPR has been correlated with interest rates: when interest rates are high, so is the EPR: the higher the bond yield, the higher the premium demanded by investors to hold stocks. There is therefore a need to abstract from the level of interest rates in order to measure the equity yield. Hence, this school looks to the equity risk premium (ERP) as a measure of  the yield premium offered by stocks over the RFR. This school, which I will call the ERP school, seeks to adjust the earnings yield to reflect the level of long-term interest rates. This can be done in two different ways: (1) by subtracting the RFR from the EPR which leaves the ERP; or by dividing the ERP by the RFR, the ERP/RFR ratio. (We could also divide the EPR by the RFR, but no one does that.) Intuitively, both measures look useful to me. I want to know how big is the premium that I am being paid to own stocks, and I want to know how big the premium is in relation to the RFR. Luckily, both measures are calculated and published by Prof. Aswath Damodaran at NYU.

Damodaran calculates the ERP from 1961 until now. The historical range has been from 2.7% in 1972 to 6.5% in 2009. The median is 4.0%. As of March 1st, Damodaran calculated the ERP at 5%, which is 25% above its historical median, and is comparable to the elevated levels of the 1970s, when inflation was out of control and bond yields were in the double-digits. This measure suggests that today’s S&P is very undervalued, unless you think that bond yields are artificially depressed and/or are likely to go much higher--which I don’t believe.

Damodaran also calculates the ratio of the ERP to the RFR for the period 1961 until 2013. Over this period the minimum observation was .32% in 1999, and the maximum was 3.3% in 2012. However, the data stayed within a narrow range for 30 years, from 1962 until 2001, when the median was around .5%, and the range was .4% to .9%. Then something happened in 2002: the ERP started to climb out of its historical range to a level of 1.1% between 2002 and 2007. Since the crash, the ERP has been literally off the charts, reaching an all-time high of 3.2% in 2011 and 2012. Since then it has declined to the region of 1.6-1.8%, far below its post-crash high, but far above its historical range and median. Using this ratio alone, it appears that the market is still very undervalued. If this ratio were to return to its pre-crash levels, the market would be twice what it is today, ceteris paribus. That makes today’s stock market an historical investment opportunity--unless you believe that the price of Treasuries has been artificially inflated by the Fed, which I don’t.

Bond Yields Are Not Artificially Depressed

A word on bond prices and yields. I don’t think that bond yields have been artificially depressed by QE, or at least not by much. Bond yields have been depressed by very subdued inflation expectations (which logically should have risen due to the Fed’s “massive monetary stimulus”). The Cleveland Fed calculates an estimate of the market’s 10-year expected rate of inflation. Despite the Fed’s massive monetary stimulus, expected inflation has declined over the past five years, from above 2% to below 2%. This might be because inflation under QE has been considerable lower than it was pre-crash. Before the crash, core inflation was consistently above the Fed’s 2% target; since the crash, it has been consistently below the 2% target, and has lately been bouncing around 1.1%, which is about half of its precrash level. Therefore, the reason bond yields are low is not because of QE, it is because of declining inflation and declining inflation expectations. There is nothing artificial about today’s 2.8% yield. And I would add that today’s yield is much higher than it was in mid-2012. The bond selloff has already happened--and is baked into the current ERP.

Conclusion

The age of the bull market and the level of the S&P are meaningless data. The market must be objectively valued. By one measure it is overvalued, while by another it is undervalued. I find the latter measure to be more congenial intellectually, and also more predictive historically. Hopefully some smart Ph.D. candidate will someday run the regressions and tell us which is the most predictive valuation measure.

Decoder:

EMH: The efficient market hypothesis, which holds that the stock market efficiently incorporates all of the knowable data and is the best estimate of future market value.

QE: Quantitative easing, the Fed’s policy of buying Treasury bonds.

PE: The ratio of the price of an equity or equity index to annual earnings.

CAPE: Robert Shiller’s cyclically-adjusted PE ratio.

EPR: The ratio of earnings over price, the reciprocal of the PE ratio, also known as the earnings yield.

RFR: The risk-free rate, a proxy for which is the 10-year Treasury bond yield.

ERP: The equity risk premium, which is the EPR minus the RFR; in other words, the premium of stock yields over bond yields. (Think of it this way: the inverse of the RFR is the bond market’s PE, which today is 36x).