Juggling Dynamite

North American investment grade bond prices have rallied strongly this month, even as stocks have levitated on 3 guys computers trading.  The benchmark US 10 year Treasury is nearing the next downside test at 2.4%.

Meanwhile other key risk-on bets (that are typically correlated with equity prices) like high yield bonds below and the Canadian dollar (bottom chart) have not been feelin’ the love.

The rabid risk trade–at the highest valuations since 2000–seems to be getting a little confused as we head toward the Autumn fall.  Oh well, wild-eyed speculators never get it all their way forever.

I have long appreciated Ed Easterling’s excellent and detailed historical data, some of which can be seen at Crestmont Research. At the end of June he updated the valuation measurements for the S&P 500 and notes that while stocks gained 5% in the second quarter, normalized earnings increased just 1% over the same period.

In fact over the past 24 months, 80% of the gains in stock prices have been driven by the willingness of buyers to pay a higher and higher premium for each dollar of expected earnings. At the end of June that premium had ballooned to more than 26 times 10 year average earnings and nearly 19 times consensus forward expected earnings. Easterling reminds us:

“historically (and based upon well-accepted financial and economic principles), the valuation level of the stock market has cycled from levels below 10 times earnings to levels above 20 times earnings. Except for bubble periods, the P/E tends to peak near 25…

The peak for P/E generally occurs at very low and stable rates of inflation. When inflation falls into deflation, earnings
(the denominator for P/E) begins to decline on a reported basis (deflation is the nominal decline in prices). At that point, with future earnings expected to decline from deflation, the value of stocks declines in response to reduced future earnings—thus, P/Es also decline under deflation.”

He also stresses that secular bears (where PEs mean revert from above 25 to below 10 again) are measured in distance not time.

They either get to the end zone via a period of sharp, steep declines from here (as in -55ish total return over the next 5 years, or -45ish total return over the next 7, or -26ish over the the next decade–want to see the Sharpe ratio on any of these outcomes?), or through a long, slow slog sideways of 2% nominal total returns annually over the next 20 years as earnings move up and prices stay flat long enough for PEs to finally grind lower. Pick your poison (aka strategy) accordingly.

In any of these outcomes, it requires suspension of reason to justify holdings stocks at present valuations and call them “investments”. See: The PE Report.

Investment grade bond yields have been falling in tandem with global growth forecasts over the past 7 months again, leaving the consensus, who are expecting a pick up in inflation, on the wrong side of the trade.

This segment offers a good summary of some of the reasons that present inflation expectations are likely to continue to over-estimate as demand and growth continue to slow. Here is a direct video link.

The largest factor not mentioned in the clip however, is debt. Debt is future consumption denied, and the world has tried to borrow its way out of the debt crisis of 2007-08 by adding on trillions and trillions of more debt every year since. The weight of this debt at all levels of the economy now from households to governments and large cap business has left a large hole in potential demand over the next few years. This means, slower growth and disinflation, not to mention necessary deflation in financial assets as markets finally recouple with the reality that the world economy is driven by customers not central bankers.