Lately, there seems to be a common refrain among any human being who pays attention to the news. There are many ways to phrase it, but we can generalize them into one catch-all question: “What in the world is going on?” Equally apropos would be something like “What the **** is going on in the world?” But this is a family-friendly blog, you know, lots of students could be reading this.
The list of current global threats is daunting; here’s just a smattering:
- The USSR’s, no wait, Russia’s, “stealth” takeover of Crimea/Eastern Ukraine
- ISIS, an extremist group that makes al Qaeda look like a glee club
- Israel and Hamas bombing each other
- Lingering risk in Afghanistan/Pakistan, north Africa, east Africa, North Korea
- Ebola spreading with no end in sight
- Airplanes going missing, getting shot down, or getting hijacked
- An influx of children migrating illegally into the U.S.
- Race tensions returning to the U.S.
- Scotland trying to leave the U.K.
- Venezuela and Argentina are near defaulting on their bonds
- The typical assortment of natural disasters
- Saving the worst for last, the mosquitoes here have been HORRIBLE!
A broader list of “things to worry about” could also include the doggedly slow U.S. economic recovery, the long-term unemployed, dysfunction in Washington, and the Fed’s overexuberant involvement in the economy. And yet, despite all our myriad anxieties, the market is still sitting at record highs, after gaining 4% in August, and up 7% for the year. This chart for the S&P 500 goes back 12 months:
Those dips in January, April, and July/August were just that…dips. The worst of the dips was -6% in January, far too benign to be considered a correction. So, just for the record, we haven’t endured a 10% correction since spring, 2012. At the end of that mini-correction, the S&P 500 stood at 1,278. Now it’s 1,987. The lack of corrections also shows up in the VIX, an index that tracks the underlying volatility in the market:
The higher the number, the greater the volatility in the market, or how wildly the market swings. Despite little blips up during those dips, volatility since 2012 has been a far cry from the corrections in 2010 and 2011, let alone the financial crisis that preceded those.
So of course, market watchers have new concern…not enough volatility! That’s kind of like worrying that your favorite sports team keeps winning! Although that common refrain that it’s always calm before the storm comes to mind. Or, the light at the end of the tunnel is a train. So, why the low volatility? We’ll get to that at the end…
Bonds Have Been Exciting!
Perhaps the most surprising activity in 2014 has been in the bond market. After getting routed in 2013, long bonds have performed well in 2014. The 10-year treasury bond yield has dropped from 3% at the start of the year to 2.5% currently, meaning bond prices have risen. While we believed (and still do) that bond yields are unnaturally low, we were among a vast consensus who believed the same. In the financial markets, when everyone expects the same thing, the opposite nearly always happens. For the record, the consensus still expects rates to rise.
Interest rates started falling immediately in 2014. Perhaps they went up too much in 2013. But there were some good reasons for the flight to safety of treasury bonds. First, Russia’s invasion of Crimea drove investors out of emerging market stocks into safer bonds. Next, the U.S. economy suddenly stopped growing in the first quarter. Weather surely had a lot to do with this, although there is vast disagreement as to how much. GDP growth rebounded in the second quarter, to +4.2%. In the third quarter, there is a growing list of economic indicators which show our economy strengthening even more, although a few others show a weakening economy. The slowdown in China’s consumption and imports, as well as sanctions in Russia, has affected some sectors and some parts of the world more than others.
Europe started emerging last year from its 6-quarter recession, but growth has been stagnant and inflation too low, prompting the ECB (European Central Bank) to pump up money supply there. This has all had the result of pushing bond yields in Europe down to incredibly low levels in 2014:
Unbelievably, bond yields are even lower in Europe than they are here. Yields have fallen by half in this year alone in France and Germany, and more than half in Switzerland, which now sport 10-year government bond yields of only 1.3%, 1.0%, and 0.5%, respectively. It’s almost impossible to believe that Italy and Spain, two very troubled economies during the Eurozone crisis (they were part of the PIIGS, don’t forget), now have yields lower than U.S. bond yields!? Does that mean they’re better credit than our bonds? Nope. While credit quality is part of the equation, inflation expectations are another. Our economic outlook is a lot brighter than theirs, and thus our outlook for inflation is higher. Bondholders need to be compensated, with higher yields, for higher inflation risk.
So, are bond yields rational or manipulated by central banks and the flood of money into financial markets? Good question. With yields so far below “normal” levels, it’s natural to assume that, someday, rates will normalize. If you don’t believe that, you’re treading into dangerous territory because the phrase “this time is different” can be applied to you. On the other hand, maybe we are in a long-term trend of capacity underutilization. With not enough demand growth to fully utilize the capacity in our labor markets, in our manufacturing infrastructure, and in our natural resources, maybe we won’t see inflation again until at least the next cycle. We wouldn’t bet on that, though, because betting on that means buying long bonds when they are very expensive.
This matters, to the extent that stocks are generally priced with bond yields in mind. If bond valuations are high (i.e. yields are low), stock valuations are normally high. In the short-term, anything can happen, but in the long-term, they do compete against each other. With that in mind, comparing bond yields to the earnings yield of the S&P 500 gives us an idea of how today stacks up compared to history. The ERP (Equity Risk Premium) is the earnings yield minus the bond yield:
Right now, stocks are ridiculously cheap compared to bonds; the higher the number the better news for stockholders. How cheap? Even after last year’s historic run for stocks and bad year for bonds, stocks are still cheaper than they were in March, 2009, which was the low point for the bear market. The ERP was 2.7% then; it’s now 3.1%. The ERP hit its high watermark in 2011, at 6.7%. The trip from 6.7% to 3.1% has been marked by a stock market which has risen 77% since then, and a bond yield which has risen 32%. So, we’ve come a long way back toward normal levels in just 3 years. But the current level is still so far removed from the historic average of around 0%. A return to “normal” from here would require bond yields to overshoot to 5.5% or stocks to go up 127%. Which will occur? We expect both higher yields and higher stock prices.
Again, you can say this whole exercise is a charade, because yields are unnaturally low; time will tell. But as Keynes once said, “the market can remain irrational longer than you can stay solvent.”
The Bottom Line
The bottom line is that stocks are still the best value out there in this value-starved world. Emerging market stocks are actually even better value than U.S. stocks, but they carry more risk. A “barbell” combination of higher-profit, safer American stocks coupled with lower-profit, riskier, cheaper emerging market stocks seems like a decent strategy.
In the short-term, we’re still very mindful that sentiment has become aggressively complacent, if that’s not an oxymoron. The percent of investment managers who are bears has dropped to the lowest levels since 1987:
In general, when everyone else is bullish, you should be wary. The early 1987 record low amount of bears is certainly cause for concern, given what happened in October, 1987 (the Black Monday crash). However, many other very low points for the Bearish camp have been early in bull markets (early 1992, mid-2003, late 2009, early 2011).
We acknowledge there is risk out there for a correction; there always is. But the fact that remains consistently true with this bull market is that it is, somehow, still underowned and underloved. You can’t find anyone out there who is wildly bullish. Flows of money into stock mutual funds and ETFs is close to $0 in 2014, and remain somewhere below $0 for the entirety of the 2009-14 bull market.
It is completely contradictory that surveys show investors being non-bearish, and yet being far from fully invested in stocks. While we’d lean more on the fund flows data, given the old adage that “money talks…,” we also think there’s still a psychological explanation. The scars from the financial crisis and ensuing bear market are still deep for some investors. Even if an investor is not bearish, they’re still keeping a lot more cash around now than they did pre-2008, and perhaps more in bonds too. It is almost unprecedented for this mental state to be so prevalent so deep into a bull market; the Depression is the only real analogy. This is really the best explanation for the lack of volatility. Put simply, investors are wary of either buying ORselling stocks. And it’s this wary backdrop that allows you to own stocks even with such strong returns in the rear view mirror.