Tuesday, March 22, 2011

Systemic Bullish Bias Returns in Short Order

There were signs last week of it returning.  A prominent market strategist appeared on Bloomberg TV and stated that U.S. stocks were attractively priced at only 13 times forward operating earnings.  He went on to state that they were especially attractive when compared to U.S. Treasury notes, which were trading at 30 times. I wondered at the time, “Thirty times what?  Earnings of the U.S. Government?” 

U.S. Treasuries pay interest—guaranteed—by the U.S. Government.  A common stock represents in today’s dollars the future stream of cash generated by the underlying business.  On average today, a stock’s current cash payout in dividends to investors is only 1.9% (using the Standard & Poor’s 500 Index).

The strategist’s comparison of earnings on stocks to interest on bonds is known as the “Fed Model” because it was reportedly one of Alan Greenspan’s favorite measures of the stock market.  (You remember him, don’t you?  The former head of the U.S. central bank, called the “Maestro” by author Bob Woodward for his purported mastery of the economy and markets.  I prefer “Mr. Bubble,” because he never met a bubble he didn’t like.)  By taking the inverse of the stock market’s p/e (in this case 1/13, or 7.6%), this gives the “yield” on the stock market’s earnings.  This is then compared to the yield on bonds, typically the 10-year U.S. Treasury Note (now only 3.3%).
This makes stocks look like an outstanding investment, at least when compared with the usual alternative, bonds.

There are several problems with this line of reasoning, which essentially is that when interest rates are low, it is a good time to buy stocks.  Most pragmatically, it doesn’t work.  Or at least it hasn’t stood the test of time.  (Refer to the work of James Montier and John Hussman for a thorough discussion of the theoretical flaws of this approach.)  This approach, e.g., would have supported aggressive purchases of Japanese stocks for much of the last two decades because interest rates on government notes averaged 1% or less.  But Japanese stocks are down about 70% in price over that time.  The approach also would have argued in favor of buying U.S. stocks right before the 1929 market crash.

Instead of this widespread view that money has to go somewhere other than a money fund that yields 0.2%, history shows that bull markets have tended to begin when interest rates were HIGH, not low, and they fell over time.  Long-term bear markets have tended to occur when rates started low and rose over time.  Given the huge borrowing requirements of the U.S. government, unprecedented monetary stimulus, and rising commodity prices that could well cause a surge of inflation in the years to come, along with erosion of the value of the U.S. dollar, rising interest rates over time seems likely.  The world’s currency regime seems unsustainable, and a currency crisis is probably in the shadows.

But that’s evidently not a worry now.  Today’s Bloomberg headline, “All Clear Signal Sounded as Global Markets Shrug Off Multiple Black Swans,” reveals the powerful systemic bias for cheerleading the stock market (and economy), as policy makers, institutional investors, and individuals desperately try to make the crisis of 2008 a distant memory (despite a lack of meaningful reforms to prevent something similar).

S & P 500:  1296
Russell 2000:  812

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