Juggling Dynamite

With a price of more than 5x book value (lower right), U.S. stocks are the most overvalued since the tech-mania top in March 2000. At 3x price-to-sales (lower left), the recent euphoria has returned to the fall 2021 level and significantly overshot the 2000 top.
As the S&P 500 has rebounded sharply over the past year (blue line below since 2016, courtesy of Isabelnet.com), earnings estimates (yellow line) have moved in the opposite direction. The extreme disconnect between earnings estimates and prices (circled below on the far right) is unusual. A lesser overshoot of prices in late 2019 (circle on the left) resolved with stock prices collapsing into spring 2020.

A similar disconnect is evident today between the price of oil (WTIC below in light green since May 2023) and the U.S. 10-year treasury yield (dark green), where oil prices have continued to slump (disinflationary) even as Treasury yields have rebounded since September.
Treasury yields typically back up first (on inflation expectations) and then fall during Fed cutting cycles as the economy weakens. However, since the Federal Reserve’s first rate cut on September 18, the degree of backup in yields has been larger than average (blue shown above in the lower panel versus past recessionary periods in dark green and rare soft-landings in light green).

Yields could back up further while investors believe that Trump’s policies might revive inflation. But for how long? The plan to slash government spending (which drives some 35% of the U.S. economy today), increase unemployment and boost oil production should all be disinflationary.

Higher yields/rates are ultimately self-correcting because they serve as a tourniquet on credit growth through the banking system. We already see higher mortgage and commercial credit rates in collapsing loan applications. That makes sense.

Hoisington Management’s Quarterly Review and Outlook is now available here and always worth a mull. Central banks have been cutting overnight rates, but the money supply has continued to contract, with the latest reading lower than during the 2008 financial crisis.

After years of zero-rate interest policies ballooned debt levels, the 2022-2023 monetary tightening cycle was the sharpest in decades and continues to move at a lag over the world economy.

In their actions since 2008, the five most impactful central banks–the U.S., China, The Euro Area, and the U.K.,–collectively have increased the risk of severe disinflation and poor economic performance. To wit:

With the September 50-basis point cut in the Federal funds rate, all five central banks have lowered their policy interest rate. However, reducing the policy rate differs from sharply accelerating real detrended M growth and boosting its much more crucial multi-year trend growth. The demand for real M is highly unresponsive to changes in the overnight interest rate, indicating high inelasticity. This causes a significant lag between an initial monetary policy action and a meaningful impact on economic activity and inflation.

The headline and core inflation rates will continue to recede in an environment of more excess capacity combined with the monetary restraint of the past two years, which is still working its way into economic conditions (Chart 4). Accordingly, the Federal Reserve will have the latitude to lower the policy rate further. Moreover, additional cuts will be needed to reverse the multi-year decline in real detrended M growth. At the same time, long-term U.S. Treasury bond yields will follow the downward path in inflation. This pattern has been extensively researched and well-documented. The current evidence of the slow growth of real M globally and its impact on the world economy suggests the pressure for long-term treasury yields to fall is increasing.

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