Tuesday, October 3, 2017

Message to Buffett: Thanks a Million!

Among the various stock market valuation gauges, Warren Buffett has said he favors the ratio of the value of all stocks traded in the US to nominal GNP, which is nominal GDP plus net income receipts from the rest of the world. The data for the numerator is included in the Fed’s quarterly Financial Accounts of the United States and lags the GNP report, which is available a couple of weeks after the end of a quarter on a preliminary basis. Needless to say, it isn’t exactly timely data.

However, the S&P 500 price-to-forward-revenues ratio (a.k.a. the price-to-sales ratio), which is available weekly, has been tracking Buffett’s ratio very closely. In an interview with Fortune in December 2001, Buffett said: “For me, the message of that chart is this: If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%—as it did in 1999 and a part of 2000—you are playing with fire.” That’s sage advice from the Oracle of Omaha.

Buffett’s ratio rose back to 176% in Q2-2017, nearly matching the Q1-2000 peak of 180, and the weekly measure rose to 198% in mid-September. Yet Buffett chose to ignore all that, predicting that the DJIA will be over 1 million in 100 years. He said that on September 19, 2017, speaking at an event in New York City marking the 100th anniversary of Forbes magazine. Buffett noted that 1,500 different individuals have been featured on Forbes’ list of 400 wealthiest Americans since the start of that tally in 1982. “You don’t see any short sellers” among them, he said, referring to those who expect equity prices will fall. He added, “Being short America has been a loser’s game. I predict to you it will continue to be a loser’s game.” Buffett also said, “Whenever I hear people talk pessimistically about this country, I think they’re out of their mind.”

CNBC reported that Mario Gabelli joked on Twitter about whether Buffett’s normally sunny outlook had darkened given the numbers: “one million in one hundred years ... has Buffett turned bearish?,” Gabelli tweeted. He noted that the roughly 3.9% compound annual growth rate (CAGR) needed to get from where the Dow is today to where Buffett predicts it will be in 2117 would be lower than the 5.5% CAGR from the beginning of the 20th century until now. Let’s have a closer look at the numbers:

(1) I have a monthly series for the DJIA starting December 1920. I can put it on a ratio scale and compare it to alternative compounded annual growth rate (CAGR) lines. During the 1950s to 1970s, the DJIA crawled along between CAGR lines of 4%-5%. During the two bull markets of the 1980s and 1990s, it climbed from a CAGR of about 4% at the August 1982 trough to about 6% at the March 2000 peak. During the 2000s and 2010s, it has been rising around the 6% CAGR trend.

(2) Starting from the last trading day of 2016, when the DJIA was at 19,763, I calculate the following DJIA targets in 2117 in round numbers: 54,000 (1% CAGR), 146,000 (2%), 391,000 (3%), 1,038,000 (4%), and 2,729,000 (5%).

(3) Adjusting for inflation, using the CPI since December 1920, the real DJIA has been rising between the 2%-4% CAGR lines averaging around 3%. Since 2000, it’s been tracking the 3% line quite steadily.

(4) All of the above is based on the long-term annualized return of the DJIA ignoring dividends. Nevertheless, it is interesting that the 3.0% real annualized return from net capital gains isn’t far off the 3.3% average real earnings yield of the S&P 500 since 1952. I derived that yield by subtracting the CPI inflation rate from the S&P 500’s earnings-price ratio.

Tuesday, September 26, 2017

Janet in Wonderland

Borio vs Yellen. Last Wednesday, Fed Chair Yellen, in her press conference following the latest FOMC meeting, reminded me of Alice in Wonderland. She wondered why inflation remained so curiously low. In the world that she knows, ultra-easy monetary policy should stimulate demand for goods and services, lower the unemployment rate, and boost wage inflation, which would then drive up price inflation.

Since the time Yellen became Fed chair on February 3, 2014 through today, the unemployment rate has dropped from 6.7% to 4.4% (from February 2014 through August 2017). Yet over that same period, wage inflation has remained around 2.5% and price inflation has remained below 2.0%. Yellen expected that by now wages would be rising 3%-4%, and prices would be rising around 2% based on the inverse correlation between these inflation rates and the unemployment rate as posited by the Phillips Curve Model (PCM)—which apparently doesn’t work on the other side of the looking glass.

Last Friday, Claudio Borio, the head of the Bank for International Settlements’ (BIS) Monetary and Economic Department, presented a speech explaining to Janet in Wonderland that the real world no longer works the way she believes. The speech was titled “Through the looking glass.” The BIS chief economist started with the following quote:

“‘In another moment Alice was through the glass … Then she began looking about, and noticed that … all the rest was as different as possible’ – Through the Looking Glass, and What Alice Found There, by Lewis Carroll.” He might as well have replaced Alice’s name with Janet’s.

I agree with Borio’s underlying thesis that powerful structural forces have disrupted the traditional PCM, which logically posits that there should be a strong inverse relationship between the unemployment rate and both wage and price inflation. I have been making the case for structural disinflation for almost all 40 years that I’ve been in the forecasting business. I’ve discussed how globalization, technological innovation, demographic changes, and Amazon have subdued inflation and continue to do so.

The central bankers have been late to understand all this. Most still don’t, including Yellen. So it’s nice to see at least one of their kind showing up at the structural disinflation party, which has been in full swing for a very long time.

Yellen’s Mystery. Meanwhile, Fed Chair Janet Yellen is still trying to come up with the answer to the following question: “What determines inflation?” She first asked that in a public forum on October 14, 2016. She did so at a conference sponsored by the Federal Reserve Bank of Boston titled “Macroeconomic Research After the Crisis” that should have been titled “Macroeconomic Research in Crisis.” She still doesn’t have the answer, as evidenced by a review of what Janet in Wonderland said at her press conference last Wednesday about inflation:

(1) Transitory. “However, we believe this year’s shortfall in inflation primarily reflects developments that are largely unrelated to broader economic conditions. …. [T]he Committee continues to expect inflation to move up and stabilize around 2 percent over the next couple of years, in line with our longer-run objective.”

(2) Imperfect. “Nonetheless, our understanding of the forces driving inflation is imperfect, and in light of the unexpected lower inflation readings this year, the Committee is monitoring inflation developments closely.”

(3) Mysterious. “For a number of years there were very understandable reasons for that [inflation] shortfall and they included quite a lot of slack in the labor market, which [in] my judgment [has] largely disappeared, very large reductions in energy prices and a large appreciation of the dollar that lowered import prices starting in mid-2014. This year, the shortfall of inflation from 2 percent, when none of those factors is operative is more of a mystery, and I will not say that the committee clearly understands what the causes are of that.”

(4) Lagging. “Monetary policy also operates with the lag and experience suggests that tightness in the labor market gradually and with the lag tends to push up wage and price inflation….”

(5) Idiosyncratic. “So, you know, there is a miss this year I can’t say I can easily point to a sufficient set of factors that explain this year why inflation has been this low. I’ve mentioned a few idiosyncratic things, but frankly, the low inflation is more broad-based than just idiosyncratic things. The fact that inflation is unusually low this year does not mean that that’s going to continue.”

(6) Persistent. “Of course, if it, if we determined our view changed, and instead of thinking that the factors holding inflation down were transitory, we came to the view that they would be persistent, it would require an alteration in monetary policy to move inflation back up to 2 percent, and we would be committed to making that adjustment.”

(7) And again, mysterious. “Now, inflation is running below where we want it to be, and we’ve talked about that a lot during this, the last hour. This past year was not clear what the reasons are. I think it’s not been mysterious in the past, but one way or another we have had four or five years in which inflation is running below our 2 percent objective and we are also committed to achieving that.”

Borio’s Solution. The man from the BIS has the answer for Fed Chair Janet Yellen and all the other central bankers who have a fixation with their 2% inflation targets: “Fuggetaboutit!” In his speech, Borio sympathized with their plight: “For those central banks with a numerical objective, the chosen number is their credibility benchmark: if they attain it, they are credible; if they don’t, at least for long enough, they lose that credibility.” His advice to just move past the quandary rests on many of the points I’ve been making on this subject for some time:

(1) Inflation is neither a monetary nor a Phillips curve phenomenon. He starts off by challenging Milton Friedman’s famous saying that “inflation is always and everywhere a monetary phenomenon.” He also acknowledges Yellen’s confusion: “Yet the behaviour of inflation is becoming increasingly difficult to understand. If one is completely honest, it is hard to avoid the question: how much do we really know about the inflation process?” He follows up with two seemingly rhetorical questions: “Could it be that we know less than we think? Might we have overestimated our ability to control inflation, or at least what it would take to do so?” The rest of the speech essentially answers “yes” to both questions.

As Exhibit #1, Borio shows that, for G7 countries, “the response of inflation to a measure of labour market slack has tended to decline and become statistically indistinguishable from zero. In other words, inflation no longer appears to be sufficiently responsive to tightness in labour markets.” If the PCM isn’t dead, it is in a coma.

Borio mentions, but doesn’t endorse, former Fed Chairman Ben Bernanke’s view that central bankers have been so successful in lowering inflationary expectations that even tight labor markets aren’t boosting wages and prices. In a 2007 speech, Bernanke explained: “If people set prices and wages with reference to the rate of inflation they expect in the long run and if inflation expectations respond less than previously to variations in economic activity, then inflation itself will become relatively more insensitive to the level of activity—that is, the conventional Phillips curve will be flatter.”

So according to Bernanke, the PCM isn’t dead, but in a coma because inflationary expectations have been subdued.

(2) Globalization is disinflationary. Borio, who seems to be the master of rhetorical questions, then asks: “Is it reasonable to believe that the inflation process should have remained immune to the entry into the global economy of the former Soviet bloc and China and to the opening-up of other emerging market economies? This added something like 1.6 billion people to the effective labour force, drastically shrinking the share of advanced economies, and cut that share by about half by 2015.” Sure enough, the percentage of the value of world exports for the G7 countries fell from 52.4% at the start of 1994 to 33.1% in April, as the percentage for the rest of the world rose from 47.6% to 66.9%.

I am getting a sense of déjà vu all over again. In my 5/7/97 Topical Study titled “Economic Consequences of the Peace,” I discussed my finding that prices tend to rise rapidly during wars and to fall sharply during peacetimes before stabilizing until the next wartime spike. I wrote: “All wars are trade barriers. They divide the world into camps of allies and enemies. They create geographic obstacles to trade, as well as military ones. They stifle competition. History shows that prices tend to rise rapidly during wartime and then to fall during peacetime. War is inflationary; peace is deflationary.” I called it “Tolstoy’s Model of Inflation”.

Borio logically concludes that measures of domestic slack are insufficient gauges of inflationary or disinflationary pressures. Furthermore, there must be more global slack given “the entry of lower-cost producers and of cheaper labour into the global economy.” That must “have put persistent downward pressure on inflation, especially in advanced economies and at least until costs converge.” That all makes sense in the world most of us live in, if not to the central bankers among us with the exception of the man from the BIS.

(3) Technological innovation is keeping a lid on pricing. Borio explains that technological innovation might also have rendered the Phillips curve comatose or dead, by reducing “incumbent firms’ pricing power—through cheaper products, as they cut costs; through newer products, as they make older ones obsolete; and through more transparent prices, as they make shopping around easier.”

Wow—déjà vu all over again! In the same 1997 study cited above, I wrote: “The Internet has the potential to provide at virtually no cost a wealth of information about the specifications, price, availability, and deliverability of any good and any service on this planet. Computers are linking producers and consumers directly.” I predicted that alone could kill inflation. Online shopping as a percent of GAFO retail sales rose from 9.1% at the end of 1997 to 30.3% currently.

Borio concludes, “No doubt, globalisation has been the big shock since the 1990s. But technology threatens to take over in future. Indeed, its imprint in the past may well have been underestimated and may sometimes be hard to distinguish from that of globalisation.”

(4) The neutral real rate of interest is a figment of central bankers’ imagination. Borio moves on from arguing that the impact of real factors on inflation has been underestimated to contending that the impact of monetary policy on the real interest rate has been underestimated. In the US, Fed officials including Fed Chair Yellen and Vice Chair Stanley Fischer have contended that the “neutral real interest rate” (or r*) has fallen as a result of real factors such as weak productivity.

Borio rightly observes that r* is an unobservable variable. Ultra-easy monetary policies might have driven down not only the nominal interest rate but also the real interest rate, whatever it is. Last year, in the 10/12 Morning Briefing, I came to the same conclusion, comparing the Fed to my dog Chloe barking at herself in the mirror when she was a puppy:

“In any event, in their opinion, near-zero real bond yields reflect these forces of secular stagnation rather than reflect their near-zero interest-rate policy since the financial crisis of 2008. …. Their ultra-easy policies have depressed interest income, reducing spendable income and also forcing people to save more. Cheap credit enabled zombie companies to stay in business, contributing to global deflationary pressures and eroding the profitability of healthy companies. Corporate managers have had a great incentive to borrow money in the bond market to buy back shares as a quick way to boost earnings per share rather than invest the proceeds in their operations.”

(5) Ultra-easy monetary policies are stimulating too much borrowing. Borio concludes that central banks should consider abandoning their inflation targets and raise interest rates for the sake of financial stability. He is concerned about mounting debts stimulated by ultra-easy money. I am too, and I’m also concerned about a potential for stock market melt-ups around the world.

The risk he sees is a “debt trap … [which] could arise if policy ran out of ammunition, and it became harder to raise interest rates without causing economic damage, owing to the large debts and distortions in the real economy that the financial cycle creates.”

Wednesday, September 20, 2017

Valuation Debate: Shiller vs. Goldilocks

The valuation question has been hanging over the current bull market. Valuation ratios such as price/earnings, price/sales, and market capitalization/revenues are uniformly bearish, showing that stocks are as overvalued as they were just before the tech bubble burst in 2000. On the other hand, valuation measures that adjust for inflation and interest rates, both of which are near record lows, suggest that the market is fairly valued. They are mostly in the Goldilocks range: Not too cold, and not too hot. I have been siding with Goldilocks.

Not surprisingly, Yale Professor Robert Shiller strongly disagrees with Goldilocks. He is issuing dire warnings that stocks are as grossly overvalued as they were in 2000. The man won the Nobel Prize in economics, so he must know something. He won primarily for his work on speculative bubbles, including his book Irrational Exuberance (2000). (Goldilocks dropped out of high school, and is now doing jail time for petty larceny.) The professor’s latest alarming views were reviewed last Friday in an article posted on Nasdaq.com titled “A Nobel Prize Winner's Dire Market Warning — And What To Do About It...” Here are some of the key points on the valuation question:

(1) Trailing P/E. The article observes: ”The price-to-earnings (P/E) ratio of the S&P 500 … is about 24.5. This is about 67% above its long-term average of 14.7.” My data, using four-quarter trailing earnings for S&P 500 operating earnings, show the P/E at 20.7 at the end of June, 37% above its long-term average of 15.1 since 1935. It is still well below its record high of 28.4 during Q2-1999.

(2) Forward P/E. The article focuses on backward-looking P/E measures, including Shiller’s CAPE, which is a cyclically adjusted measure based on earnings over the past 10 years. The four-quarter trailing P/E, using operating earnings, has exceeded the forward earnings P/E since 1989, which is when the operating data series starts. The latter was 17.7 in August. That’s high, but still well below the record high of 24.5 during July 1999.

(3) CAPE. The article notes: “Nobel Prize-winning economist Robert Shiller's cyclically adjusted P/E ratio is also warning the market is overvalued. At 30.2, this ratio is more than 85% above its long-term average of 16.1.” Jeremy Siegel, the professor who wrote Stocks for the Long Run (1994), has yet to win a Nobel Prize despite his great long-term call. In a 2016 FAJ article, he sides with Goldilocks and counters Shiller’s pessimism as follows:

Robert Shiller’s cyclically adjusted price–earnings ratio, or CAPE ratio, has served as one of the best forecasting models for long-term future stock returns. But recent forecasts of future equity returns using the CAPE ratio may be overpessimistic because of changes in the computation of GAAP earnings (e.g., “mark-to-market” accounting) that are used in the Shiller CAPE model. When consistent earnings data, such as NIPA (national income and product account) after-tax corporate profits, are substituted for GAAP earnings, the forecasting ability of the CAPE model improves and forecasts of US equity returns increase significantly.
(4) Rule of 20. The Rule of 20 compares the S&P 500 P/E, on either a trailing or forward basis, to 20 minus the CPI inflation rate on a year-over-year basis. In August, the CPI inflation rate was 1.9% y/y. According to the Rule of 20, that meant that the P/E should be around 18.1. The average of this measure is 16.6 since 1935. That’s historically high, though obviously because inflation is historically low. Again, as noted above, the four-quarter trailing P/E was 20.7 during Q2, while the forward P/E was 17.7 in August. By the way, the Rule of 20 was devised by Jim Moltz, my friend and previous colleague at CJ Lawrence.

(5) Misery-Adjusted P/E. Another valuation metric that I devised is simply the sum of the S&P 500 forward P/E and the Misery Index, which is the sum of the unemployment rate and the CPI inflation rate. I’ve observed an inverse relationship between the forward P/E and the Misery Index. That makes sense: When consumers are less miserable because unemployment and inflation are low, investors are happier too and willing to pay a higher multiple for earnings.

Adding the actual forward P/E and the Misery Index together produces the Misery-Adjusted P/E. It has averaged 23.9 since the start of the series in 1979. It was 24.0 during August, suggesting that stocks were fairly valued. This metric can be thought of as the Rule of 24: The fair-value forward P/E was 17.7 during August based on 24 minus the Misery Index, which was 6.3 last month.

(6) Real earnings yield. There’s an alternative valuation measure that is adjusted for inflation in a more rigorous fashion than is reflected in the two rules of thumb above. Let’s flip the P/E over and focus on the S&P 500 earnings yield (i.e., E/P). It can be calculated on a quarterly basis back to 1935 using S&P 500 reported earnings data. The real earnings yield is the nominal yield less the CPI inflation rate.

The average of the real earnings yield is 3.7% since 1935. When the yield is above (below) this average, stocks are undervalued (overvalued). The actual reading was 2.6% during Q2, suggesting that stocks were somewhat overvalued, but not excessively so. Excessive overvaluation would be reflected in a real earnings yield close to or below zero.

Thursday, September 14, 2017

Another Seinfeld Episode for Stocks

The panic-prone bull market in stocks since 2009 has been less panic-prone. The bull turned a bit anxious again last week as Hurricane Irma threatened to level all of Florida after Hurricane Harvey swamped all of Houston and surrounding areas. Irma did lots of damage, but so have previous hurricanes without any consequences for the US economy and stock market. There was also some lingering anxiety about geopolitical tensions with North Korea. However, for now, the US continues to seek nonlethal options, particularly more UN-imposed trade sanctions. Immediate worries about the US federal debt ceiling vanished last Wednesday, when President Donald Trump cut a deal with congressional Democrats to raise the ceiling for three months and agreed to provide emergency funds for Texas and Florida.

When Seinfeld aired on television, millions of Americans viewed the show that was mostly about nothing. Nothing ever happened, which viewers found very entertaining. The bull market has turned into the Seinfeld market. During every episode, investors are watching for something to happen. When nothing happens, especially nothing bad, investors are bemused and show their appreciation by throwing more money at the bull. So it’s back to some of the basics that continue to drive the bull market:

(1) Fundamental Stock Market Indicator. Our Fundamental Stock Market Indicator edged down in early September, but remains in record-high territory. It has been highly correlated with the S&P 500 since 2000. Its two components declined slightly in early September.

Our Boom-Bust Barometer has been rising in record-high territory since late September 2016. It is simply the ratio of the CRB raw industrials spot price index to initial unemployment claims. The commodity index has been moving higher recently, led by the soaring price of copper. Initial jobless claims remain near recent cyclical lows, but rose in early September as a result of Hurricane Harvey, according to the Bureau of Labor Statistics (BLS). It has been highly correlated with the S&P 500 since 2000.

The Weekly Consumer Comfort Index rose at the end of August to a 16-year high, but edged down at the start of September. This index has been highly correlated with the S&P 500 forward P/E since 1995. When consumers are happy, investors tend to be willing to pay more for earnings.

(2) Forward revenues. S&P 500/400/600 forward revenues all rose to record highs last month. Also impressive is that analysts’ consensus expectations for S&P 500 revenues remain remarkably stable at elevated levels, with current estimates implying a solid gain of 5.0% in 2018, following 5.6% this year.

(3) Forward earnings. The forward earnings of the S&P 500/400/600 continue to trend higher in record-high territory. During the first week of September, forward earnings for the S&P 500/400 both rose to record highs.

For more on this extraordinary bull market, see “Obama-Trump bull market is now up 268%,” a 9/13 post on CNN Money:
The S&P 500 would have to more than double its gains to surpass the 582.15% surge experienced during that bull market [from 1987-2000]. And it would need to keep going for almost four more years to take the title of the longest in history. "That's asking for a lot -- but I wouldn't rule it out," said Yardeni.

Wednesday, September 6, 2017

Global Synchronized Growth: Why Now?

The global economy is running on all six cylinders. It may not be a global synchronized boom, but it is the most synchronized expansion of economic activity that the global economy has had since the recovery from the 2008/2009 recession. The direction of change can be seen in the titles of the past four issues of the International Monetary Fund’s World Economic Outlook: “Subdued Demand: Symptoms and Remedies” (Oct. 2016), “A Shifting Global Economic Landscape” (Jan. 2017), “Gaining Momentum?” (Apr. 2017), and “A Firming Recovery” (Jul. 2017).

Why is this happening now? The global synchronized expansion may be attributable to the plunge in the price of a barrel of Brent crude oil from a 2014 peak of $115.06 on June 19 to a low of $27.88 on January 20, 2016 followed by the recovery to $52.75 last week. Over this same period, Debbie and I calculate that global crude oil revenues dropped from an annualized $3.2 trillion during June 2014 to $952 billion in early 2016, back to $1.5 trillion currently.

The initial freefall in revenues depressed the global energy industry, which slashed capital spending rapidly around the world. The rebound in oil revenues has given a lift to this industry, but surely not enough to explain the global synchronized expansion. The flip side of crude oil revenues is outlays by users of crude oil. The drop in the cost to users of oil is like a 50% cut in the global “oil tax” on consumers. Now that the downside of the energy price shock is over, the benefits to the global economy are rising to the surface of the barrel. Let’s review some of the recent more buoyant global data:

(1) GDP & profits. The growth rate in real GDP was revised higher last week, from 2.6% to 3.0% (saar) for Q2. On a y/y basis, real GDP was up 2.2%. It has been fluctuating around 2.0% since mid-2010.

(2) Europe. The Eurozone’s Economic Sentiment Index rose to 111.9 during August, the highest since July 2007. It is highly correlated with the region’s real GDP growth rate on a y/y basis, which was 2.2% during Q2, the best pace since Q1-2011. The Eurozone’s M-PMI rose to 57.4 last month, matching June’s reading, which was the highest since April 2011.

(3) China. China’s official M-PMI edged up to 51.7 during August, the 11th consecutive reading above 51.0. However, its NM-PMI declined from 54.5 during July to a 15-month low of 53.4 last month.

(4) Japan. Japan’s real GDP rose 4.0% (saar) during Q2, the fastest such pace since Q1-2015.

(5) Global manufacturing. Last month, the global M-PMI rose to 53.1, the highest since May 2011. Solid increases were registered for both the developed economies and the emerging ones.