Echo Chamber

 

Since the U.S. economic recovery from the 2008 financial crisis, institutional economists began each subsequent year outlining their well-paid view of how things will transpire over the course of the coming 12-months. Like a broken record, they have continually over-estimated expectations for growth, inflation, consumer spending and capital expenditures. Their optimistic biases were based on the eventual success of the Federal Reserve’s (Fed) plan to restart the economy by encouraging the assumption of more debt by consumers and corporations alike.

But in 2017, something important changed.  For the first time since the financial crisis, there will be a new administration in power directing public policy, and the new regime could not be more different from the one that just departed. This is important because of the ubiquitous influence of politics.

The anxiety and uncertainties of those first few years following the worst recession since the Great Depression gradually gave way to an uncomfortable stability.  The anxieties of losing jobs and homes subsided but yielded to the frustration of always remaining a step or two behind prosperity.  While job prospects slowly improved, wages did not. Business did not boom as is normally the case within a few quarters of a recovery, and the cost of education and health care stole what little ground most Americans thought they were making.  Politics was at work in ways with which many were pleased, but many more were not.  If that were not the case, then Donald Trump probably would not be the 45th President of the United States.

Within hours of Donald Trump’s victory, U.S. markets began to anticipate, for the first time since the financial crisis, an escape hatch out of financial repression and regulatory oppression.  As shown below, an element of economic and financial optimism that had been missing since at least 2008 began to re-emerge.

nfib earnings

Data Courtesy: Bloomberg

What the Federal Reserve (Fed) struggled to manufacture in eight years of extraordinary monetary policy actions, the election of Donald Trump accomplished quite literally overnight. Expectations for a dramatic change in public policy under a new administration radically improved sentiment. Whether or not these changes are durable will depend upon the economy’s ability to match expectations.

Often Wrong, Never in Doubt

The institutional economists searching for a coherent outlook for 2017 are now faced with a fresh task. President Trump and his cabinet represent a significant departure from what has come to be known as “business-as-usual” Washington politics over the past 25 years.  Furthermore, it has been 89 years since Republicans held control of the White House as well as both the House of Representatives and the Senate. The confluence of these factors suggests that the outlook for 2017 – policy, the economy, markets, geopolitical risks – are highly uncertain.  Despite what appears to be an inflection point of radical change, most of which remains unknown, the consensus opinion of professional economists and markets, in general, are well-aligned, optimistic and seemingly convinced about how the economy and markets will evolve throughout the year.  The consensus forecast based upon an assessment of economic projections from major financial institutions appears to be the result of a Ph.D. echo chamber, not rigorous independent analysis.

Economic Outlook – Consensus Summary

After a thorough review of several major financial institutions’ economic outlooks for 2017 and market implied indicators for the year, below is an overview of what 720 Global deems to be the current consensus outlook for 2017.

  • The consensus is optimistic about economic growth for the coming year with expectations for real GDP growth in the 2.0-2.5% range
  • Recession risks will remain benign
  • The labor market is now at or near full employment
  • Wage growth is expected to increase to the 3.0-3.5% level as is customary for the economy at full employment
  • Inflation is expected to reach and exceed the Fed’s 2.0% target level
  • The Fed is expected to raise the Federal Funds rate in 25 basis point increments two or three times in 2017
  • The Fed will maintain the existing size of its balance sheet
  • Some form of fiscal stimulus will occur by the second half of the year
  • Fiscal stimulus is expected to be modest and unlikely to have a big impact on fiscal deficits
  • Tax reform will occur by the second half of the year and is viewed as highly supportive of corporate profits
  • Regulatory reform will begin to take shape in the first half of the year
  • Trade will be affected by some form of border tax adjustment, the economic impact of which is expected to be low
  • The combination of fiscal stimulus, tax reform, and regulatory reform in conjunction with an economy that is growing above trend and at full employment easily offsets Fed rate hikes supporting the optimistic outlook for economic growth

Despite the low probability of accuracy, the consensus outlook for 2017 is the starting point from which a discussion should begin because it is reflective of what markets and investors expect to transpire. Markets are pricing to this set of outcomes for the year.

Deviations

Having established a consensus baseline, further attention is then paid to those areas where the consensus may indeed be wrong. Will inflation finally exceed the 2.0% level as expected? Will growth for the year end in the range of 2.0-2.5%? Can the new administration negotiate a fiscal stimulus package this year? These and many others are important questions that will dictate the strength of the U.S. dollar, the level of interest rates and the ability of equity markets to sustain current valuations.

If economic growth for the year is stronger than current projections and inflation is higher than forecast, then the Fed will appear to be behind the curve in hiking interest rates. In this circumstance, the Fed may begin to telegraph more than three rate hikes for the current year and a higher trajectory for rates in 2018. The interest rate markets will likely front run growth expectations and push interest rates higher. Given that investors have so little coupon income to protect them from price changes, such a move could occur in a disorderly manner, which will tighten financial conditions and choke off economic growth.

If, on the other hand, economic growth for the year falters and continues the recent string of disappointing, sub-2.0% readings, then fears of recession, and likely an abrupt change in confidence, will re-emerge.

This exercise undertaken each year by economists is akin to a meteorologist’s efforts to predict the weather several weeks in advance.  The convergence of high and low-pressure systems will produce a well-defined outcome, but there is no way to ascertain weeks or even days in advance that those air masses will converge at a precise time and location, or that they will converge at all.  It does in fact, as they say, very much depend on the “whether.”  Whether consumers borrow and spend more, whether companies hire and pay more or even whether or not confidence in a new administration promising a variety of pro-growth policies can fulfill those in some form.

The Lowest Common Denominator

Interest rates have already risen in anticipation of the consensus view coming to fruition.  Although higher interest rates today are reflective of an optimistic outlook for growth and inflation, the economy has become dependent upon low rates. Everything from housing and auto sales to corporate buybacks and equity valuations are highly dependent upon an environment of persistently low interest rates.  So, when the consensus overview expects higher interest rates as a result of higher wage growth and inflation, it is difficult to reconcile those expectations with the consensus path for economic growth.

Investors and markets continue to give the hoped-for outcome the benefit of the doubt, but that outcome seems quite inconsistent with economic reality.  That outcome is that policy will promote growth, growth will advance inflation and interest rates must therefore rise.  The problem for the U.S. economy is that the large overhang of debt is the lowest common denominator.  The economy is a slave to the master of debt, which must be serviced and repaid. The debt problem is largely the result of 35 years of falling interest rates and the undisciplined habits and muscle memory that goes with such a dominating streak.  Marry that dynamic with the fact that this ultra-low interest rate regime itself has been in place for a full eight years, and the economy seems conditioned for an allergic reaction to rising rates.

Episodes of rising interest rates since the 1980’s, although short-lived, always brought about some form of financial distress. This time will likely be no different because the Fed’s zero-interest rate policy and quantitative easing have sealed the total dependency of the economy on consumption and debt growth.  Regaining the discipline of a healthy, organic economic system would mean both a rejection of policies used over the last 30 years and intense public sacrifice.

Summary

Given the altar at which current day politicians’ worship – that of power, influence, and self-promotion – it seems unlikely that this new Congress and President are inclined to make the difficult choices that might ultimately set the U.S. economy back on a path of healthy, self-sustaining growth.  Rather, debt and deficits will grow, and the enthusiasm around overly-optimistic economic forecasts and temporal improvements in economic output will fade as has been the case in so many years past.  Although a new political regime is in store and it brings hope for a new path forward, the echo chamber reinforcing bad policy, fiscal and monetary, seems likely to persist.

 

720 Global is an investment consultant, specializing in macroeconomic research, valuations, asset allocation, and risk management.  Our objective is to provide professional investment managers with unique and relevant information that can be incorporated into their investment process to enhance performance and marketing. We assist our clients in differentiating themselves from the crowd with a focus on value, performance and a clear, lucid assessment of global market and economic dynamics.

 

Coming soon 720 Global will offer “The Unseen”, a subscription-based publication similar to what has been offered at no cost over the past year and a half.  In fact, what the subscription offers is precisely what we have delivered in the past, a substance in style and form that provides unique analysis and meaningful value to discerning investors. Those that have read our work understand the comparative advantage they have gained over the vast majority of investors that solely focus on the obvious. Our readers are prepared for what few see.

 

720 Global research is available for re-branding and customization for distribution to your clients.

 

For more information about our services, please visit us at www.720global.com or contact us at 301.466.1204 or email info@720global.com 

 

©720 Global 2017 All Rights Reserved

 

NOTICE AND DISCLAIMER: This material has been prepared by 720 Global, LLC. Opinions expressed herein are subject to change without notification. Any prices or quotations contained herein are indicative screen prices and are for reference only. They do not constitute an offer to buy or sell any securities at any given price. No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness, reliability or appropriateness of the information, methodology and any derived price contained within this material. The securities and related financial instruments described herein may not be eligible for sale in all jurisdictions or to certain categories of investors.

Neither 720 Global, LLC nor its directors accept any liability for any loss or damage arising out of the use of all or any part of these materials.

All rights reserved. This material is strictly for specified recipients only and may not be reproduced, distributed or forwarded in any manner without the permission of 720 Global, LLC. 

 

 

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Villanova vs. Kansas : Outcome vs. Process Strategies

 

email image

 

It is that time of year when the markets play second fiddle to debates about which twelve seed could be this year’s Cinderella in the NCAA basketball tournament. For college basketball fans, this particular time of year has been dubbed March Madness. The widespread popularity of the NCAA tournament is not just about the games, the schools, and the players, but just as importantly, it is about the brackets. Brackets refer to the office pools based upon correctly predicting the 67 tournament games. Having the most points in a pool garners office bragging rights and, in many cases, your colleague’s cash.

Interestingly the art, science, and guessing involved in filling out a tournament bracket provides insight into how investors select assets and structure portfolios. Before explaining, answer the following question:

When filling out a tournament bracket do you:

  1. A) Start by picking the expected national champion and then go back and fill out the individual games and rounds to meet that expectation?

 

  1. B) Analyze each opening round matchup, picking winners and advance round by round until you reach the championship game?

If you chose answer A, you fill out your pool based on a fixed notion for which team is the best in the country. In doing so, you disregard the potential path, no matter how hard, that team must take to become champions.

If you went with the second answer, B, you compare each potential matchup, analyze each team’s respective records, strengths of schedule, demonstrated strengths and weaknesses, record against common opponents and even how travel and geography might affect performance. While we may have exaggerated the amount of research you conduct a bit, such a methodical game by game evaluation is repeated over and over again until a conclusion is reached about which team can win six consecutive games and become the national champion.

Outcome Based Strategies

Outcome-based investment strategies start with an expected result, typically based on recent trends or historical averages. Investors following this strategy presume that such trends or averages, be they economic, earnings, prices or a host of other factors, will continue to occur as they have in the past. How many times have you heard Wall Street “gurus” preach that stocks historically return 7%, and therefore a well-diversified portfolio should expect the same thing this year? Rarely do they mention corporate and economic fundamentals or valuations. Many investors blindly take the bait and fail to question the assumptions that drive the investment selection process.

Pension funds have investment return assumptions which, if not realized, have negative consequences for their respective plans. Given this seemingly singular aim of the fund manager, most pension funds tend to buy assets whose expected returns in aggregate will achieve their return assumption. Accordingly, pension funds tend to be managed with outcome-based strategies.

For example, consider a pension fund manager with an 8% return target that largely allocates between stocks and bonds.

table revised

Given the current yields in the table above, and therefore expectations for returns on sovereign bonds of approximately 1%, the manager must instead invest in riskier fixed income products and equities to achieve the 8% return objective. Frequently, a pension fund manager has a mandate requiring that the fund hold a certain minimum amount of sovereign bonds.  The quandary then is, how much riskier “stuff” do they have to own in order to offset that return drag? In this instance, the manager is not allocating assets based on a value or risk/reward proposition but on a return goal.

To illustrate, the $308 billion California Public Employees Retirement System (CalPERS), the nation’s largest pension fund, has begun to shift more dramatically towards outcome-based management. In 2015, CalPERS announced that they would fire many of their active managers following repeatedly poor performance. Despite this adjustment, they still badly missed their 7.5% return target in 2015 and 2016. Desperate to right the ship, CalPERS maintains a plan to increase the amount of passive managers and index funds it uses to achieve its objectives.

In speaking about recent equity allocation changes, a CalPERS spokeswoman said “The goal is to eventually get the allocation to the right mix of assets, so that the portfolio will likely deliver a 10-year return of 6.2%.” That sounds like an intelligent, well-informed comment but it is similar to saying “I want to be in Poughkeepsie in April 2027 because the forecast is sunny and 72 degrees.” The precision of the 10-year return objective down to the tenth of a percent is the dead giveaway that the folks at CalPERS might not know what they’re doing.

Outcome-based strategies sound good in theory and they are easy to implement, but the vast amount of pension funds that are grossly underfunded tells us that investment policies based on this process struggle over the long term. “The past is no guarantee of future results” is a typical investment disclaimer. However, it is this same outcome-based methodology and logic that many investors rely upon to allocate their assets.

Process Based Strategies

Process-based investment strategies, on the other hand, have methods that establish expectations for the factors that drive asset prices in the future. Such analysis normally includes economic forecasts, technical analysis or a bottom-up assessment of an asset’s ability to generate cash flow. Process-based investors do not just assume that yesterday’s winners will be tomorrow’s winners, nor do they diversify just for the sake of diversification. These investors have a method that helps them forecast the assets that are likely to provide the best risk/reward prospects and they deploy capital opportunistically.

Well managed absolute return and value funds, at times, hold significantquote amounts of cash. This is not because they are enamored with cash yields per se, but because they have done significant research and cannot find assets that offer value in their opinion. These managers are not compelled to buy an asset because it “promises” a historical return. The low yield on cash clearly creates a “drag” on short-term returns, but when an opportunity develops, the cash on hand can be quickly deployed into cheap investments with a wider margin of safety and better probabilities of market-beating returns. This approach of subordinating the short-term demands of impatience to the long-term benefits of waiting for the fat pitch dramatically lowers the risk of a sizable loss.

A or B?

Most NCAA basketball pool participants fill out tournament brackets starting with the opening round games and progress towards the championship match. Sure, they have biases and opinions that favor teams throughout the bracket, but at the end of the day, they have done some analysis to consider each potential matchup.  So, why do many investors use a less rigorous process in investing than they do in filling out their NCAA tournament brackets?

Starting at the final game and selecting a national champion is similar to identifying a return goal of 10%, for example, and buying assets that are forecast to achieve that return. How that goal is achieved is subordinated to the pleasant but speculative idea that one will achieve it. In such an outcome-based approach, decision-making is predicated on an expected result.

Considering each matchup in the NCAA tournament to ultimately determine the winner applies a process-oriented approach. Each of the 67 selections is based on the evaluation of comparative strengths and weaknesses of teams. The expected outcome is a result of the analysis of factors required to achieve the outcome.

Summary

It is very likely that many people filling out brackets this year will pick Villanova. They are a favorite not only because they are the #1 overall seed, but also because they won the tournament last year. Picking Villanova to win it all may or may not be a wise choice, but picking Villanova without consideration for the other teams they might play on the path to the championship neglects thoughtful analysis.

The following table (courtesy invest-assist.blogspot.com and Koch Capital) is a great reminder that building a portfolio based on yesterday’s performance is a surefire way to end up with sub-optimal returns.

asset classes

Winning a basketball pool has its benefits while the costs, if any, are minimal. Managing wealth, however, can provide great rewards but is fraught with severe consequences. Accordingly, wealth management deserves considerably more thoughtfulness than filling out a bracket. Over the long run, those that follow a well-thought out, time-tested, process-oriented approach will raise the odds of success in compounding wealth by limiting damaging losses during major market set-backs and by being afforded opportunities when others fearfully sell.

 

720 Global is an investment consultant, specializing in macroeconomic research, valuations, asset allocation, and risk management.  Our objective is to provide professional investment managers with unique and relevant information that can be incorporated into their investment process to enhance performance and marketing. We assist our clients in differentiating themselves from the crowd with a focus on value, performance and a clear, lucid assessment of global market and economic dynamics.

 

Coming soon 720 Global will offer “The Unseen”, a subscription-based publication similar to what has been offered at no cost over the past year and a half.  In fact, what the subscription offers is precisely what we have delivered in the past, a substance in style and form that provides unique analysis and meaningful value to discerning investors. Those that have read our work understand the comparative advantage they have gained over the vast majority of investors that solely focus on the obvious. Our readers are prepared for what few see.

 

720 Global research is available for re-branding and customization for distribution to your clients.

 

For more information about our services, please visit us at www.720global.com or contact us at 301.466.1204 or email info@720global.com 

 

©720 Global 2017 All Rights Reserved

 

NOTICE AND DISCLAIMER: This material has been prepared by 720 Global, LLC. Opinions expressed herein are subject to change without notification. Any prices or quotations contained herein are indicative screen prices and are for reference only. They do not constitute an offer to buy or sell any securities at any given price. No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness, reliability or appropriateness of the information, methodology and any derived price contained within this material. The securities and related financial instruments described herein may not be eligible for sale in all jurisdictions or to certain categories of investors.

Neither 720 Global, LLC nor its directors accept any liability for any loss or damage arising out of the use of all or any part of these materials.

All rights reserved. This material is strictly for specified recipients only and may not be reproduced, distributed or forwarded in any manner without the permission of 720 Global, LLC. 

 

 

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Second to None

Today’s equity market valuations have only been eclipsed by those of 1929, and 1999.” Given the continuing equity market rally and multiple expansion, the quote above from prior articles, had to be modified slightly but meaningfully. As of today, the S&P 500 Cyclically Adjusted Price to Earnings ratio (CAPE) is on par with 1929. It has only been surpassed in the late 1990’s tech boom.

A simple comparison of P/E or other valuation metrics from one period to another is not necessarily reasonable as discussed in Great Expectations. That approach is too one-dimensional.   This article elaborates on that concept and is used to compare current valuations and those of 1999 to their respective fundamental factors.  The approach highlights that, even though current valuation measures are not as extreme as in 1999, today’s economic underpinnings are not as robust as they were then. Such perspective allows for a unique quantification, a comparison of valuations and economic activity, to show that today’s P/E ratio might be more overvalued than those observed in 1999.

Secular GDP Trends

Equity valuations are a mathematical reflection of a claim on the future cash flows of a corporation. When one evaluates a stock, earnings potential is compared to the price at which the stock is offered. In most cases, investors are willing to pay a multiple of a company’s future earnings stream. When the prospects for earnings growth are high, the multiple tends to be larger than when growth prospects are diminished.

To forecast earnings growth for a company, one needs to do an in-depth analysis of the corporation, the economy and the markets in which it operates. However, evaluating earnings growth for an index comprising many companies, such as the S&P 500, is a relatively straight-forward task.

Corporate earnings are a byproduct of economic activity. Earnings growth can differ from economic growth for periods of time, but in the long run aggregate earnings growth and GDP growth are highly correlated.  The two graphs below offer an illustration of the durability of this relationship. The graph on the left plots three-year average GDP growth and its trend since 1952, while the graph on the right highlights the correlation of GDP to corporate profits.

gdp-and-earnings-2x

Data Courtesy: St. Louis Federal Reserve (FRED), Bureau of Economic Analysis (BEA) and Bloomberg

Given the declining trend of GDP and the correlation of earnings to GDP, it is fair to deduce that GDP and earnings growth trends were healthier in the late 1990’s than they are today. More specifically, the following table details key economic and financial data comparing the two periods.

99-vs-16-fundamentals

Data Courtesy: St. Louis Federal Reserve (FRED), and Robert Shiller http://www.econ.yale.edu/~shiller/data.htm

As shown, economic growth in the late 1990’s was more than double that of today, and the expected trend for economic growth was also more encouraging than today. Trailing three- five- and ten-year annual earnings growth rates contrast the current stagnant economic growth versus the robust growth of the 90’s. Additionally, various measures of debt have ballooned to levels that are constricting economic growth and productivity. Historically low interest rates are reflective of the current state of economic stagnation.

The graph below charts price-to-earnings (CAPE) divided by the secular GDP growth (ten-year average), allowing for a proper comparison of valuations to fundamentals.

pe-vs-gdp-graph

Data Courtesy: Robert Shiller http://www.econ.yale.edu/~shiller/data.htm

The current ratio of CAPE to GDP growth of 19.77 has far surpassed the 1999 peak and all points back to at least 1950. At the current level, it is over three times the average for the last 66 years.  Further, based on data going back to 1900, the only time today’s ratio was eclipsed was in 1933. Due to the Great Depression, GDP at that time for the preceding ten years was close to zero. So, despite a significantly deflated P/E multiple, the ratio of CAPE to GDP was extreme. Looking forward, if we assume a generous 3% GDP growth rate, CAPE needs to fall to 18.71 or 35% from current levels to reach its long term average versus GDP growth.

Summary

Equity valuations of 1999, as proven after the fact, were grossly elevated. However, when considered against a backdrop of economic factors, those valuations seem relatively tame versus today. Some will likely argue with this analysis and claim that Donald Trump’s pro-growth agenda will invigorate the outlook for the economy and corporate earnings. While that is a possibility, that argument is highly speculative as such policies face numerous headwinds along the path to implementation.

Economic, demographic and productivity trends all portend stagnation. The amount of debt that needs to be serviced stands at overwhelming levels and is growing by the day. Policies that rely on more debt to fuel economic growth are likely not the answer. Until the disciplines of the Virtuous Cycle are understood and followed, we hold little hope that substantial economic growth can be sustained for any meaningful period. Given such a stagnant economic outlook, there is little justification for paying such a historically steep premium for what could likely be feeble earnings growth for years to come.

 

720 Global is an investment consultant, specializing in macroeconomic research, valuations, asset allocation, and risk management.  Our objective is to provide professional investment managers with unique and relevant information that can be incorporated into their investment process to enhance performance and marketing. We assist our clients in differentiating themselves from the crowd with a focus on value, performance and a clear, lucid assessment of global market and economic dynamics.

 

Coming soon 720 Global will offer “The Unseen,” a subscription-based publication similar to what has been offered at no cost over the past year and a half.  In fact, what the subscription offers is precisely what we have delivered in the past, a substance in style and form that provides unique analysis and meaningful value to discerning investors. Those that have read our work understand the comparative advantage they have gained over the vast majority of investors that solely focus on the obvious. Our readers are prepared for what few see.

 

720 Global research is available for re-branding and customization for distribution to your clients.

 

For more information about our services, please contact us at 301.466.1204 or email

info@720global.com

 

©720 Global 2017 All Rights Reserved

 

NOTICE AND DISCLAIMER: This material has been prepared by 720 Global, LLC. Opinions expressed herein are subject to change without notification. Any prices or quotations contained herein are indicative screen prices and are for reference only. They do not constitute an offer to buy or sell any securities at any given price. No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness, reliability or appropriateness of the information, methodology and any derived price contained within this material. The securities and related financial instruments described herein may not be eligible for sale in all jurisdictions or to certain categories of investors.

 

Neither 720 Global, LLC nor its directors accept any liability for any loss or damage arising out of the use of all or any part of these materials.

All rights reserved. This material is strictly for specified recipients only and may not be reproduced, distributed or forwarded in any manner without the permission of 720 Global, LLC. 

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The Sure Thing

The Sure Thing

The New England Patriots pulled off a stunning come-from-behind victory in Super Bowl LI, and one that was truly unprecedented in American football. Throughout modern NFL history, playoff teams that had a 19 point lead or greater in the fourth quarter, as the Atlanta Falcons did, were 93-0. A Patriots comeback was deemed virtually impossible by the odds-makers. There is an important lesson here worth considering. The Patriots improbable victory follows a variety of other unlikely, but surprising high-profile events in the past several months, some of which will have far greater impact on our lives than we may realize.

The British referendum to leave the Euro

Last summer, the odds of Brexit gaining a majority vote briefly dipped below 5% in the days preceding the vote. In a premonition to the upcoming U.S. election, The Sun newspaper in London mistakenly announced that the head of the Brexit campaign, Nigel Lafarge, conceded to the “Remain” vote.

 

Graph and Newspaper cover courtesy: Hypermind.com and The Sun respectively

Leicester City’s improbable Premier League Championship

Leicester City entered the 2016 Premier League season as a 5,000 to 1 underdog to win the league championship. Fortunately for Leicester City, the existence of long odds bear no direct influence on outcomes as they went on to win the Premier League Championship. For the sake of comparison, the worst team in the NFL, the Cleveland Browns who finished the 2016 season with one win, started the year with odds of 200-1 to win the Super Bowl. According to odds-makers, the Browns were 25 times more likely to win the Super Bowl than Leicester City was to win the Premier League Championship.

 leicester

Image Courtesy: ESPN

The U.S. Presidential Election

In the days leading up to the U.S Presidential election, Donald Trump was a serious underdog with only a 20% chance of winning the election.  Even after some states had closed their polls and results were trickling in, a Hillary Clinton victory was all but a foregone conclusion. Newsweek infamously released their upcoming issue with a picture of Hillary Clinton under the words “Madam President.”

 

Graph and magazine cover courtesy: New York Times and Newsweek respectively

Super Bowl LI

With the Patriots trailing 28-3 mid-way through the third quarter, the odds of a Patriots Super Bowl victory were placed at 0.3% or 333 to 1. The Falcons were a virtual lock to win. The graph below charts the progression of the in-game odds for each respective team winning. The gray line highlights the point where the Falcons had the greatest chance of winning.

super-bowl-2

Graph Courtesy: Matthew Cascio @mattcascio

Why?

Given that “impossible” events are seemingly occurring with regularity, we must ask, “Why?”

Maybe another question that should be entertained is why the favorite, at any point in the contest, is given such commanding status? Given what we have seen out of Tom Brady in his illustrious career, why would experts count him out with a seemingly eternal 23:29 remaining to play in the biggest game of the biggest sport in America?

To apply this concept to another great global sport, do U.S. equity market valuations imply similar false confidence in future outcomes for the pace of earnings and economic growth?

The Dow Jones Industrial Average just crossed the 20,000 mark with great fanfare. Immediately following the celebration, the media and market “experts” began discussing the next benchmarks they expect to fall, Dow 25,000 and 30,000.  Like those supporting the aforementioned clear favorites, everyone seems to be caught up in euphoria and the absolute certainty of an outcome. Like the attitudes that prevailed in 1929 and 1999, market experts appear to be convinced that the equity markets are moving in one direction, higher.

Spot VIX, an indicator that conveys confidence or concern about future equity price moves, is near-record lows. This implies tremendous confidence that stock prices will indeed move higher. Conversely, however, lesser followed VIX futures currently trade at historically steep premiums which suggest more than a few market participants harbor anxieties about the future.

We have been vocal in our thoughts about the confluence of historically high valuations, economic headwinds and the uncertainties of a new administration. It is hard for us to get on a bandwagon that is not supported by fundamentals. We feel like the sole Patriots fan listening to everyone around us debate whether Falcon’s quarterback Matt Ryan or star receiver Julio Jones will be the MVP.

Like all of the instances listed above, the odds are clearly wrong. The fundamentals governing each event were carelessly neglected, and probabilities radically miscalculated, sending the experts and their followers, in the wrong direction. While sports or politics may not be your thing, we urge you to pay attention.

The odds of equity market victory are very near 100%.  What could go wrong?

 

 

 

 

720 Global is an investment consultant, specializing in macroeconomic research, valuations, asset allocation, and risk management.  Our objective is to provide professional investment managers with unique and relevant information that can be incorporated into their investment process to enhance performance and marketing. We assist our clients in differentiating themselves from the crowd with a focus on value, performance and a clear, lucid assessment of global market and economic dynamics.

 

Coming soon 720 Global will offer “The Unseen”, a subscription-based publication similar to what has been offered at no cost over the past year and a half.  In fact, what the subscription offers is precisely what we have delivered in the past, a substance in style and form that provides unique analysis and meaningful value to discerning investors. Those that have read our work understand the comparative advantage they have gained over the vast majority of investors that solely focus on the obvious. Our readers are prepared for what few see.

 

720 Global research is available for re-branding and customization for distribution to your clients.

 

For more information about our services, please contact us at 301.466.1204 or email

info@720global.com

 

©720 Global 2017 All Rights Reserved

 

NOTICE AND DISCLAIMER: This material has been prepared by 720 Global, LLC. Opinions expressed herein are subject to change without notification. Any prices or quotations contained herein are indicative screen prices and are for reference only. They do not constitute an offer to buy or sell any securities at any given price. No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness, reliability or appropriateness of the information, methodology and any derived price contained within this material. The securities and related financial instruments described herein may not be eligible for sale in all jurisdictions or to certain categories of investors.

Neither 720 Global, LLC nor its directors accept any liability for any loss or damage arising out of the use of all or any part of these materials.

All rights reserved. This material is strictly for specified recipients only and may not be reproduced, distributed or forwarded in any manner without the permission of 720 Global, LLC. 

 

 

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Fed Up – A Look Behind the Curtain

 

Danielle DiMartino Booth, a former Dallas Federal Reserve official, released a new book this week entitled Fed Up. The book, a first-person account of the inner-workings of the Federal Reserve (Fed), provides readers with unique insight into the operations, leadership, and mentality of what is unquestionably the world’s most powerful financial force.  What it reveals about the Fed is neither flattering nor confidence-inspiring. By pulling back the curtain to reveal the Fed’s modern-day machinations, DiMartino Booth provides an assessment of the highest levels of economic thinking and how it is afflicting our economy.

Throughout the book, it is clear her purpose is equal parts entertainment and education with a dash of sermon to underline the gravity of the situation.  Fed Up is compelling, well-written and its objectives are clear; expose the hubris at the Fed which results in poor decision-making and generate much-needed debate to bring about change in how the Fed functions. As you read this review, and hopefully the book as well, we remind you the Fed is sworn to serve the American public and should be held accountable to this obligation.

We thank Danielle for giving us the privilege of reading an advance copy of her book so that we can provide this timely review to you. Neither 720Global, LLC nor its owners have received any form of direct or indirect compensation in exchange for the review of this book.

Confluence of Events

Skill, talent, temperament and career path often have a funny way of converging at just the right time to produce something that is needed at a particular moment to change the course of events. Danielle DiMartino Booth’s Wall Street experience and tenure as a journalist converge with her personal traits of curiosity, healthy skepticism and integrity to expose the powerful forces of the Fed and the means by which they use their influence.

DiMartino Booth spent enough time on Wall Street to become “enlightened” as to the ways of high finance and then went on to pursue a career in journalism at the Dallas Morning News.  Her insight and warnings in the years preceding the Great Financial Crisis of 2008 are well-documented and stand in stark contrast to the mindset of the Fed and then-chairman Ben Bernanke who “found little evidence to support the existence of a national home price bubble.” Fortunately, the President of the Dallas Federal Reserve Bank, Richard Fisher, was a rare exception within the Fed and took notice of DiMartino Booth’s articles. In the fall of 2006, Fisher convinced her to join the Dallas Research Department.

Theory Versus Practice and a Dose of Hubris

From her early days at the Dallas Fed, DiMartino Booth recognized that the Federal Reserve is run by Ph.Ds. from the premier economic schools of the nation. Referring to them as the “MIT mafia,” she notes that the large concentration of academicians at the Fed is a recent trend. Traditionally, Fed governors hailed from the banking sector where they came equipped with a deeper understanding of the workings of the main street economy and a real-world perspective of the benefits and consequences that accompany monetary policy. In years’ past, the practical experience of leadership naturally guided academically-oriented researchers and analysts on staff. According to DiMartino Booth, Richard Fisher was a Fed President of this mold. Unfortunately, the influx of Ph.Ds. over the last 15 to 20 years with virtually no practical experience changed the Fed’s thinking. In her words, “the overwhelming dominance of academics goes a long way toward explaining why the financial crisis of 2008 blindsided the Fed”.

Prominently throughout the book, DiMartino Booth highlights the arrogance and hubris that these academics-turned-central bankers possessed and the control they garnered. They believed that their textbooks, unproven theories, and complex research papers provided new sophistication and certainty with which to manage the domestic and, indeed, the global economy. They shelved simple models, and all but ignored real-time market data and the word on the street. In their pursuit of certainty, they forgot that human behavior could not be replicated in a petri dish.

This myopic academic perspective affected the staff economists and spread to the upper echelons of the Federal Reserve.  As DiMartino Booth writes, “not that Bernanke wasn’t listening, but over time, he fixated on academic theories. Real life reports by Fisher and other District Bank presidents counted for little.”  She added that current Fed Chairwoman Janet Yellen, who at the time ran the San Francisco Fed, was “more married to her models than Greenspan and Bernanke combined.

Despite warnings from DiMartino Booth and Fisher, the Fed failed to see that Malignant stars were aligning for a once-in-a-century global economic meltdown. Though precious few inside the Fed saw the crisis coming, it is patently false to suggest insiders hadn’t been fairly warned”.

As concerning as the Fed’s myopia was, she found their hubris equally troubling. From the Fed Governors and district presidents down to the staff Ph.Ds.’ the air of royalty and elitism permeated the atmosphere. Many of these economists lived in vacuums, where assumptions about human behavior and intricate modeling replaced real world experience and observation. It should be no surprise therefore that DiMartino Booth and Fisher, lacking Ph.Ds.’ were generally ignored despite their repeated expression of concern and warning.

Driving Animal Spirits

In giving us the proper perspective on the events of the financial crisis and the Fed response, DiMartino Booth effectively lays the ground work for historical events that influenced future course.  She describes the sequence of events beginning ten years earlier that would formally establish the ultimate term describing financial moral hazard, “the Greenspan Put.”

The once-mighty hedge fund, Long-Term Capital Management (LTCM), run by the so-called best and brightest Ph.Ds. (a theme that should start to sound familiar by now), including two Nobel Prize winning board members, thought they had developed a means by which they could guarantee profits from derivative trading. When their theories and models didn’t align with reality, massive losses ensued, and Wall Street was holding the risk. Fed Chairman Alan Greenspan, along with Treasury Secretary Robert Rubin and Treasury official Lawrence Summers, orchestrated a government-sponsored bailout of the hedge fund.

The LTCM bailout – to be clear, the American taxpayer bailout of a hedge fund and in turn Wall Street – sent a very clear “risk-on” signal to major financial institutions and investors which elevated Greenspan and company to a status akin to deity. Per DiMartino Booth: “They were hailed as geniuses. I imagined my fellow Wall Streeters going to the cathedral in my neighborhood and lighting candles. Thanks be to God and Greenspan”.

Fast forward to the aftermath of the 2008 crisis, and through many different forms of extraordinary and highly questionable monetary policy, DiMartino Booth makes a case that the Fed remains overly concerned with spurring animal spirits. In other words, they believe that continually boosting investor confidence and driving financial asset prices higher is a necessity. In DiMartino Booth’s words “and yet here was the Fed, with Yellen as its biggest cheerleader, once again trying to build an economic recovery on the back of frenetic animal spirits.” In the Fed’s mind, Bear Stearns, Lehman, Fannie Mae and other institutions lay testimony to what happens when the free markets are left to their own devices. Left out of their discussion, however, was the role the Fed might have played in creating the problems through ill-advised policy.

DiMartino Booth makes clear that Fed officials have both the free hand and the lack of humility to disregard the potential negative implications for the average citizen while at the same time emphasizing the needs of their primary constituent – Wall Street.  The Fed’s tactics are not just about investor confidence but backed by a faulty theory called the wealth effect. They erroneously associate financial asset inflation to wealth generation and wealth generation to prosperity for all. In retrospect, they either failed to recognize that artificially manipulating markets higher would predominately benefit the wealthy or they knew this but elected not to disclose it. In DiMartino Booth’s words “The problem was the bulk of these trillions was in the hands of a few. Those who were most insulated from the needs to earn a living were driving the rally. Any middle-class recovery was an illusion.” Further “Who will pay when this credit bubble bursts? The poor and the middle-class, not the elites. If those injured most by Fed policy could understand, they would be marching at Yellen’s door with protest signs, screaming show us the wealth effect!

Transparency

Touted increasingly by the Bernanke and Yellen regimes, emphasis on improving Fed transparency appears to be nothing more than a self-serving ruse designed to deflect congressional efforts to regulate the Fed. DiMartino Booth explains that, although intended to highlight the substance of Federal Open Market Committee (FOMC) meeting discussions, published FOMC minutes are altered well after the meeting to mollify Wall Street’s and the markets’ interpretation of the original statement.  She also discloses that Bernanke and Yellen brazenly “leak” information to the press to suit various purposes. Such purposes may include efforts to “correct” markets when desired or even as a bully tactic aimed at Fed members that may have stepped out of line with the Chairman’s preferences.

Fixing the Fed

DiMartino Booth is not supportive of the extreme call by some to “end the Fed”, but she firmly believes there needs to be dramatic reform. The various recommendations she offers include specific suggestions involving the way monetary policy is formed and implemented as well as the objectives of such policy.  Many of the economic woes facing the nation are either a direct or indirect result of an over-imposing and ham-handed monetary policy approach based on intellectual arrogance. She makes a compelling plea for change, listing numerous reasonable actions that should be undertaken to improve the Fed’s influence over the economy to the benefit of all Americans, not just the wealthy.

Summary

Wealth inequality, wage stagnation, massive debt loads, feeble economic growth and weak productivity growth are but a few of the economic and social problems that are the legacy of poor monetary policy.  Less than a decade after the Financial Crisis, we are again confronted with asset prices perched well above fundamentals, an unfettered shadow banking system and an even larger concentration of too-big-to-fail banks. Additionally, unprecedented interest rate policy is complicit in allowing lawmakers and the U.S. Treasury to shirk their fiscal responsibilities and recklessly expand the national debt.  It is unbecoming and irresponsible for Fed officials to continually neglect to accept any role in the prior two economic bubbles and the one now festering.

What DiMartino Booth describes in Fed Up is the manifestation of years of central bank evolution. To the academics who occupy the chairs in the Marriner Eccles Building today, it is the blooming flower of the seeds planted by John Maynard Keynes and nurtured by Alan Greenspan, Ben Bernanke, and Janet Yellen. The reality, as so well described by DiMartino Booth, is that of an intellectual contagion. The role the Federal Reserve has assumed today better resembles that of a global virus. By way of multiple global financial crises over the past 30 years, their influence and power have adapted and spread to cover all of the developed world.

By pulling back the curtain on this reality, DiMartino Booth accomplishes what may be the first meaningful step toward properly diagnosing an important source of present day economic illness. Fed Up provides a post-crisis update of how the Federal Reserve runs the country with substantial evidence of the short-cuts and manipulations employed as a means to their ends. The recommendations offered in the book are reasonable and actionable but will certainly be viewed as a threat to Fed independence. It is that independence which has served as the enabler of a powerful, un-elected governing body which bears no accountability or burden of proof for its actions. The time to reign in and redefine how the Fed operates is past due and Fed Up offers not only the rationale but a potent and lucid blueprint for doing so.

 

If you would like to order Fed Up by Danielle DiMartino Booth click here – LINK

 

Neither 720Global, LLC nor its owners have received any form of direct or indirect compensation in exchange for the review of this book.

 

Within the next two weeks 720Global will offer “The Unseen”, a subscription-based publication similar to what has been offered at no cost over the past year and a half.  A subscription offers what we have delivered in the past – clear, independent and unconventional perspectives, substance in style and form as well as macro and micro idea generation of meaningful value to discerning investors. Additionally, our soon to be released mobile-friendly website promises state-of-the-art publication delivery, access to 720Global archives and many other new features.


Those that have read our work understand the comparative advantage they have gained over the vast majority of investors that solely focus on the obvious. Our readers are prepared for what few see.

 

 
720 Global is an investment consultant, specializing in macroeconomic research, valuations, asset allocation, and risk management.  Our objective is to provide professional investment managers with unique and relevant information that can be incorporated into their investment process to enhance performance and marketing. We assist our clients in differentiating themselves from the crowd with a focus on value, performance and a clear, lucid assessment of global market and economic dynamics.

 

 

720 Global research is available for re-branding and customization for distribution to your clients.

 

For more information about our services please contact us at 301.466.1204 or email

info@720global.com

 

©720 Global 2017 All Rights Reserved

 

NOTICE AND DISCLAIMER: This material has been prepared by 720 Global, LLC. Opinions expressed herein are subject to change without notification. Any prices or quotations contained herein are indicative screen prices and are for reference only. They do not constitute an offer to buy or sell any securities at any given price. No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness, reliability or appropriateness of the information, methodology and any derived price contained within this material. The securities and related financial instruments described herein may not be eligible for sale in all jurisdictions or to certain categories of investors.

Neither 720 Global, LLC nor its directors accept any liability for any loss or damage arising out of the use of all or any part of these materials.

All rights reserved. This material is strictly for specified recipients only and may not be reproduced, distributed or forwarded in any manner without the permission of 720 Global, LLC. 

 

 

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The Lowest Common Denominator

At a recent investment conference, hedge fund billionaire Stanley Druckenmiller predicted that interest rates would continue rising. Specifically, he suggested that, consistent with the prospects for economic growth, the 10-year U.S. Treasury yield could reach 6.00% over the next couple of years. Druckenmiller’s track record lends credence to his economic perspectives.  While we would very much like to share his optimism, we find it difficult given the record levels of public and private debt.

Druckenmiller’s comments appear to be based largely on enthusiasm for the new administration’s proposals for increased infrastructure and military spending along with tax cuts and deregulation. This is consistent with the outlook of most investors today.  Although proposals of this nature have stimulated economic growth in the past, today’s economic environment is dramatically different from prior periods.  Investors and the market as a whole are failing to consider the importance of the confluence of the highest debt levels (outright and as a % of GDP) and the lowest interest rates (real and nominal) in the nation’s history.  Because of the magnitude and extreme nature of these two factors, the economic sensitivity to interest rates is greater and more asymmetric now than it has ever been.  Additionally, due the manner in which debt and interest rates have evolved over time, the amount of interest rate risk held by fixed income and equity investors poses unparalleled risks and remains, for the moment, grossly underappreciated.

Proper assessment of future investment and economic conditions must carefully consider changes in the debt load and the interest rates at which new and existing debt will be serviced.

A 45-year Trend

For more than a generation, there has been a dramatic change in the landscape of interest rates as illustrated in the graph below.  Despite the recent rise in yields (red arrow), interest rates in the United States are still near record-low levels.

yield-chart

Data Courtesy: Bloomberg

Declining interest rates have been a dominant factor driving the U.S. economy since 1981. Since that time, there have been brief periods of higher interest rates, as we see today, but the predictable trend has been one of progressively lower highs and lower lows.

Since the Great Financial Crisis in 2008, interest rates have been further nudged lower in part by the Federal Reserve’s (Fed) engagement in a zero-interest rate policy, quantitative easing and other schemes.  Their over-arching objective has been three-fold:

  • Lower interest rates to encourage more borrowing and thus more consumption (“How do you make poor people feel wealthy? You give them cheap loans.” –The Big Short)
  • Lower interest rates to allow borrowers to reduce payments on existing debt thus making their balance sheet more manageable and freeing up capacity for even more borrowing
  • Maintain a prolonged period of low interest rates “forcing” investors out of safe-haven assets like Treasuries and money market funds and into riskier asset classes like junk bonds and stocks with the aim of manufacturing a durable wealth effect that might eventually lift all boats

In hindsight, lower interest rates were successful in accomplishing some of these objectives and failed on others. What is getting lost in this experiment, however, is that the marginal benefits of decreasing interest rates are significantly contracting while the marginal consequences are growing rapidly.

Interest Rates and Duration

What are the implications of historically low interest rates for a prolonged period of time?  What is “seen” and touted by policy makers are the marginal benefits of declining interest rates on housing, auto lending, commercial real estate and corporate funding to name just a few beneficiaries. What is “unseen” are the layers of accumulating risks that are embedded in a system which discourages savings and therefore eschews productivity growth. Companies that should be forced into bankruptcy or reorganization remain viable, and thus drain valuable economic resources from other productive uses of capital. In other words, capital is being misallocated on a vast scale and Ponzi finance is flourishing.

In an eerie parallel to the years leading up to the crisis of 2008, hundreds of billions of dollars of investors’ capital is being jack-hammered into high-risk, fixed-income bonds and dividend-paying stocks in a desperate search for additional yield. The prices paid for these investments are at unprecedented valuations and razor thin yields, resulting in a tiny margin of safety. The combination of high valuations and low coupon payments leave investors highly vulnerable. Because of the many layers of risk across global asset markets that depend upon the valuations observed in the U.S. Treasury markets, deeper analysis is certainly a worthy cause.

At the most basic level, it is important to appreciate how bond prices change as interest rates rise and fall.  The technical term for this is duration. Since that price/interest rate relationship is the primary determinant of a bond’s profit and loss, this analysis will begin to reveal the potential risk bond investors face. Duration is defined as the sensitivity of a bond’s price to changes in interest rates. For example, a 10-year U.S. Treasury note priced at par with a 6.50% coupon (the long term average coupon on U.S. Treasury 10-year notes) has a duration of 7.50. In other words, if interest rates rise by 1.00%, the price of that bond would decline approximately 7.50%.  An investor who purchased $100,000 of that bond at par and subsequently saw rates rise from 6.50% to 7.50%, would own a bond worth approximately $92,500.

By comparison, the 10-year Treasury note auctioned in August 2016 has a coupon of 1.50% and a duration of 9.30. Due to the lower semi-annual coupon payments compared to the 6.50% Treasury note, its duration, which also is a measure of the timing of a bonds cash flows, is higher. Consequently, a 1.00% rise in interest rates would cause the price of that bond to drop by approximately 9.30%. The investor who bought $100,000 of this bond at par would lose $9,300 as the bond would now have a price of $90.70 and a value of $90,700.

A second matter of importance is that the coupon payments, to varying degrees, mitigate the losses described above. In the first example, the annual coupon payments of $6,500 (6.50% times the $100,000 investment) soften the blow of the $7,500 loss covering 86% of the drop in price. In the second example, the annual coupon payments of $1,500 are a much smaller fraction (16%) of the $9,300 price change caused by the same 1.00% rise in rates and therefore provide much less cushion against price declines.

In the following graph, the changing sensitivity of price to interest rate (duration- blue) is highlighted and compared to the amount of coupon cushion (red), or the amount that yield can change over the course of a year before a bondholder incurs a loss.

duration-coupon-protection-graph

The coupon on the 10-year U.S. Treasury note used in our example only allows for a 16 basis point (0.16%) increase in interest rates, over the course of a year, before the bondholder posts a total return loss. In 1981, the bondholder could withstand a 287 basis point (2.87%) increase in interest rates before a loss was incurred.

Debt Outstanding

While the increasing interest rate risk and price sensitivity coupled with a decreasing margin of safety (lower coupon payments) of outstanding debt is alarming, the story is incomplete. To fully appreciate the magnitude of this issue, one must overlay those risks with the amount of debt outstanding.

Since 1982, the duration (price risk) of nominal U.S. Treasury securities has risen 70% while the average coupon, or margin of safety, has dropped 85%. Meanwhile, the total amount of U.S. public federal debt has exploded higher by 1,600% and total U.S. credit market debt, as last reported by the Federal Reserve in 2015, has increased over 1,000% standing at $63.4 trillion. When contrasted with nominal GDP ($18.6 trillion) as graphed below, one begins to gain a sense for how radically out of balance the accumulation of debt has been relative to the size of the economy required to support and service that debt.  In other words, were it not for the steady long-term decline in interest rates, this arrangement likely would have collapsed under its own weight long ago.

debt-outstanding

Data Courtesy: St. Louis Federal Reserve (FRED)

To provide a slightly different perspective, consider the three tables below, which highlight the magnitude of government and personal debt burdens on an absolute basis as well as per household and as a percentage of median household income.

debt-tables

Data Courtesy St. Louis Federal Reserve (FRED) and USdebtclock.org

If every U.S. household allocated 100% of their income to paying off the nation’s total personal and governmental debt burden, it would take approximately six years to accomplish the feat (this calculation uses aggregated median household incomes). Keep in mind, this assumes no expenditures on income taxes, rent, mortgages, food, or other necessities. Equally concerning, the trajectory of the growth rate of this debt is parabolic.

As the tables above reflect, for over a generation, households, and the U.S. government have become increasingly dependent upon falling interest rates to fuel consumption, refinance existing debt and pay for expanded social and military obligations. The muscle memory of a growing addiction to debt is powerful, and it has created a false reality that it can go on indefinitely. Although no rational individual, CEO or policy-maker would admit to such a false reality, their behavior argues otherwise.

Investors Take Note

This article was written largely for investors who own securities with embedded interest rate risks such as those described above. Although we use U.S. Treasury Notes to illustrate, duration is a component of all bonds. The heightened sensitivities of price changes coupled with historically low offsetting coupons, in almost all cases, leaves investors in a more precarious position today than at any other time in U.S. history. In other words, investors, whether knowingly or unknowingly, have been encouraged by Fed policies to take these and other risks and are now subject to larger losses than at any time in the past.

This situation was beautifully illustrated by BlackRock’s CIO Rick Rieder in a presentation he gave this fall. In it he compared the asset allocation required for a portfolio to achieve a 7.50% target return in the years 1995, 2005 and 2015. He further contrasts those specific asset allocations against the volatility (risk) that had to be incurred given that allocation in each respective year. His takeaway was that investors must take on four times the risk today to achieve a return similar to that of 1995.

Summary

We generally agree with Stanley Druckenmiller. If enacted correctly, there are economic benefits to deregulation, tax reform and fiscal stimulus policies. However, we struggle to understand how higher interest rates for an economy so dependent upon ever-increasing amounts of leverage is not a major impediment to growth under any scenario. Also, consider that we have not mentioned additional structural forces such as demographics and stagnating productivity that will provide an increasingly brisk headwind to economic growth. Basing an investment thesis on campaign rhetoric without consideration for these structural obstacles is fraught with risk.

The size of the debt overhang and dependency of economic growth on low interest rates means that policy will not work going forward as it has in the past. Although it has been revealed to otherwise intelligent human beings on many historical occasions, we retain a false belief that the future will be like the past. If the Great Recession and post-financial crisis era taught us nothing else, it should be that the cost of too much debt is far higher than we believe.  More debt and less discipline is not the solution to a pre-existing condition characterized by the same. The price tag for failing to acknowledge and address that reality rises exponentially over time.

 

720 Global is an investment consultant, specializing in macroeconomic research, valuations, asset allocation, and risk management.  Our objective is to provide professional investment managers with unique and relevant information that can be incorporated into their investment process to enhance performance and marketing. We assist our clients in differentiating themselves from the crowd with a focus on value, performance and a clear, lucid assessment of global market and economic dynamics.

 

Coming soon 720 Global will offer “The Unseen”, a subscription-based publication similar to what has been offered at no cost over the past year and a half.  In fact, what the subscription offers is precisely what we have delivered in the past, a substance in style and form that provides unique analysis and meaningful value to discerning investors. Those that have read our work understand the comparative advantage they have gained over the vast majority of investors that solely focus on the obvious. Our readers are prepared for what few see.

 

720 Global research is available for re-branding and customization for distribution to your clients.

 

For more information about our services, please contact us at 301.466.1204 or email

info@720global.com

 

©720 Global 2017 All Rights Reserved

 

 

NOTICE AND DISCLAIMER: This material has been prepared by 720 Global, LLC. Opinions expressed herein are subject to change without notification. Any prices or quotations contained herein are indicative screen prices and are for reference only. They do not constitute an offer to buy or sell any securities at any given price. No representation or warranty, either express or implied, is provided in relation to the accuracy, completeness, reliability or appropriateness of the information, methodology and any derived price contained within this material. The securities and related financial instruments described herein may not be eligible for sale in all jurisdictions or to certain categories of investors.

Neither 720 Global, LLC nor its directors accept any liability for any loss or damage arising out of the use of all or any part of these materials.

All rights reserved. This material is strictly for specified recipients only and may not be reproduced, distributed or forwarded in any manner without the permission of 720 Global, LLC. 

 

 

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Great Expectations

 

“Never ever lose sight of long term relationships” Paul Krake – View from the Peak

 

Throughout 2016 we highlighted that various measures of equity valuations are at historically high levels and present an unfavorable risk/reward profile.

Comparing valuation metrics to their respective longer term averages is a good way to gauge richness or cheapness, but it does not necessarily paint a complete valuation picture. For instance, Amazon’s stock trades at an astronomical price to earnings ratio (P/E) of 172 or about seven times that of the S&P 500. Despite the seemingly high ratio, one cannot single-handedly declare that Amazon is expensive. If Amazon’s sales continue to grow at a torrid pace, a ratio of 172 may not be out of line.

The objective of this article is to form a complete valuation picture of the S&P 500. Although the work behind valuations and rich/cheap analysis is never complete, this exercise will help you understand the earnings growth priced into current valuation levels. It also provides a framework to evaluate the upside and downside of various combinations of earnings projections and price multiples. From there, you can make your own judgment about whether current valuations make sense.

P/E

The graph below plots the Cyclically Adjusted Price to Earnings ratio (CAPE) since 1883, its average and plus/minus one standard deviation levels from the average. The current ratio of 28.14 is approximately 1.75 standard deviations higher than average and stands perched above almost every prior observation in the last 130 years except those of the late 1920’s and the late 1990’s.

cape

Data Courtesy Robert Shiller – http://www.econ.yale.edu/~shiller/data.htm

Calculating P/E ratios may be done using CAPE, earnings for the trailing twelve months (TTM) or numerous other methods. While market practitioners tend to favor TTM, CAPE is used here for the same reasons Ben Graham and Robert Shiller preferred it – ten years of earnings data helps eliminate short-term noise that frequently distorts quarterly and annual earnings. CAPE takes an additional step and adjusts for inflation, thus normalizing the ratio for different inflation environments. While some may claim that these two approaches yield wildly different results, we found only a minor variance. TTM P/E for the S&P 500 is currently 1.50 standard deviations above its 130-year average, only slightly below that calculated using CAPE (1.75).

The bar chart below shows the distribution of CAPE values or the percentage of time the ratio was in each respective P/E band on the x-axis.

distro

Data Courtesy Robert Shiller – http://www.econ.yale.edu/~shiller/data.htm

While not a perfect bell curve, the chart above does have a similar shape, albeit with a long right tail. Over 80% of the data lies between a ratio of 8 and 20. The current ratio of 28.14 has only been eclipsed by 3% of the observations. Put more bluntly; the S&P 500 is in no man’s land by this measure.

Earnings

To gauge the expected earnings growth that is currently priced into the market, we could take the all too popular consensus forecasts published by Wall Street at face value. While that might be a fast approach, history, as discussed in “Earnings Magic Exposed”, has proven misleading.

Instead, we prefer to solve for the expected earnings growth rate using the CAPE ratio. If one believes in mean reversion, then it is likely CAPE will regress to its historical average ratio (16.7) within the next five years. If we further assume the price of the S&P 500 does not change, we can easily solve for expected earnings growth. Given those assumptions, the required annualized earnings growth for the next five years is nearly 11% at current valuations. In other words, the S&P 500 price would be unchanged over the next five years if corporate earnings grow 11% annually and CAPE regresses to its long-term average. However, if we assume investors expect the S&P 500 price to grow 5% a year as it has averaged this century, then earnings must increase 16.50% annually to offset the reversion to the mean of CAPE. If we take a more conservative stance and assume that CAPE will remain at one standard deviation above average at 23.35 and the S&P 500 price will grow 5% annually, earnings must grow at an annualized rate of 4.50%.

A scenario in which earnings grow annually at 4.50% may seem reasonable, but it is relatively optimistic when put in context with previous growth trends and economic impediments. Consider that over the last three, five and ten years, S&P 500 earnings have grown at annualized rates of -0.48%, 2.34%, and 1.80%, respectively. It is worth noting that the three- and five-year periods do not include a recession. Expecting that streak to continue five more years fails to incorporate reasonable recession probabilities into the analysis.

To put additional perspective on expected earnings growth, we analyze the nation’s economic growth rate. Since 1947, real GDP and corporate earnings have grown at nearly identical long-term rates. The graph below charts the cumulative growth of earnings and GDP over this period. Note that, while the growth rates vary wildly, they have been well-correlated over the longer-term as witnessed by comparing the less volatile earnings polynomial trend line (blue dotted line) with GDP (green line).

earng-vs-gdp

Data Courtesy: St. Louis Federal Reserve (FRED) and Bloomberg

The graph below aids in forecasting earnings growth by highlighting the secular trend of GDP growth since 1950.

gdp-trend

Data Courtesy: St. Louis Federal Reserve (FRED)

The trend was confirmed by Janet Yellen, who on January 18, 2017, stated that the long-run GDP growth rate is expected to fall under 2%. Based on the GDP trend line and the correlation of earnings to GDP expectations, one should assume earnings growth will follow GDP and be 3% or less.

The future growth rate assumption mentioned above is not solely a function of extrapolation from previous trends. It is truly arrived at with a thorough understanding of the economy’s structural impediments – debt, demographics, and productivity as we have noted in numerous prior articles.

Scenario Analysis

At this point, we have presented you with historical earnings trends and a way to estimate future earnings growth. Additionally, we provided a long history of the price to earnings ratio and the statistically significant distribution it has followed. With this data in mind, we present the table below which allows you to forecast stock price changes based on future P/E ratios and earnings growth estimates. Note the three colored boxes reflect what we consider to be optimistic, fair and pessimistic estimates. Here are the simple steps to evaluate forward returns:

  1. Select the CAPE ratio you expect to see in 2022. At the top of the table are six options ranging from 10.1 to 28.1 (current level). The range is based on standard deviations as shown above each P/E level.
  2. Select the expected annualized earnings growth for the next 5
  3. Find the intersection of your CAPE and earnings growth estimates. The number at the intersection is the expected annualized price return for the S&P 500 for the next five years. As a quick example, a projected CAPE of 20.0 and 3% earnings growth will result in an expected annual return of -2.57% for each of the next five years.

expected-returns-table

As illustrated in the table, the risk/reward profile is very unbecoming unless you believe CAPE will stay grossly elevated and earnings will grow significantly more than they have over the past ten years.  A relatively riskless strategy, whereby one buys and holds to maturity a five-year U.S. Treasury bond yielding 1.98%, beats all but the most optimistic scenarios highlighted above.

Summary

Many investors believe that the initiatives of the new administration will provide an economic spark generating economic growth and increasing corporate earnings. Although confidence is a cheap form of stimulus, reality is that the structural headwinds the economy faces are brisk. Given the historically high valuations and poor risk/reward ratio, we prefer to let the market prove us wrong.

One final note for consideration; since January 1, 2012, the S&P 500 has increased 75%, while earnings have increased 2%. In other words, for all intents and purposes, the entire rally from 2012 is a function of multiple expansion and is in no way supported by fundamentals. For investors who hold mean reversion as an important guiding principle, it is not unrealistic to expect the CAPE multiple to regress back towards its historical average. Indeed, it is entirely expected.

We leave you with the article’s opening quote as it is such an important concept to grasp.

“Never ever lose sight of long term relationships”.

                                                           

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