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Question of the Week - July 14, 2014

Question of the Week - July 14, 2014

Guest Post - Monday, July 14, 2014

With the Dow at 17,000, when is the correction in equities coming? Aren't we about due?

Maybe. But maybe not. But if that type of logic ruled such things, we'd have already experienced one by now. This is the usual set of conditions we face in stock markets—climbing a wall of worry and dreading the worst while enjoying incremental gains in the meantime. We'll never know if a pause happens next week or after another 50% gain—which is why these things aren't possible to plan for. History can sometimes be a guide, but every cycle has its own quirks.

Based on analysis of stock market behavior over the last century, we should expect a -5% dip in prices about 3-4 times a year (we've had two -5% dips this year, in January and April, on track with this quarterly pace) and a more substantial drop of at least -10% about once a year. More extreme corrections in the -20% range or so happen less often, every several years, as one would expect with cyclical variations in the financial cycle. Last year, much of the S&P's gain was due to P/E expansion, while this year's return so far appears more substantiated by earnings growth—critical for the longevity of a bull market. In brief, short-term movements are largely geopolitical-, idiosyncratic-, and sentiment-driven.

We find this again reinforces valuation being as the most useful gauge from long-term hindsight. Using a variety of metrics, current valuations range from a bit cheap (earnings yield) to the more expensive side (market cap as percentage of GDP and Tobin's Q, based on asset replacement cost), with the classic price/earnings ratio and dividend discount model fair value falling right in the middle, near long-term average or 'fair value.' As always, there is debate about the respective meaning of these various statistics in each cycle.

When large-cap equities are trading near 'normal' fair value (like now), we have tended to earn 'normal'-type results, although the band is wide. The extremes of cheap and expensive create more dramatic long-term outcomes (naturally, strongly positive expected returns happen when stocks are cheap and everyone is afraid to buy them; weak or even negative expected returns occur when stocks are priced more richly and investors have become overly enamored).

There are other measures as well, but correlations are imprecise. We see the VIX pointed to quite a bit, as it's quoted by the minute and now that it's at lower levels in its range. In the past year, it has fluctuated between levels of below 10 and over 20. It's important to remember what the VIX is and what it's designed to measure. Specifically, it's the mathematical output of the Black-Sholes option pricing model for the S&P's near-term standard deviation. So, as much as anything, and in keeping with the timeframe for many option traders, it reflects the recent past. The 'father of the VIX,' Vanderbilt professor Robert Whaley, who developed it for the CBOE in 1993, also assuaged concerns about recent low levels and put it into perspective—reaffirming the point of the number is to describe nothing more than the level of volatility expected over the next 30 days. So, while it's a figure we keep tabs on, we also don't put undue pressure on its ability to measure with precision.

So far in 2014, equities are up at a pace just over their long-term average (if we use a figure of roughly 10% annualized), while bonds are also above their long-term average (which has tended to be 5-6%). How can everything be winning? There appears to be a fork in the road in terms of fear: sentiment has vacillated between optimism (economy takes off from the lackluster past few years and winter doldrums) and pessimism (China slowdown, European deflation, Ukrainian war, now Iraq). When you combine these two together, you get an 'average' year, which is what we seem to be having up until now at least. No doubt, this is probably healthier than extremes in either case and perhaps most realistic since there is always something to worry about (that is so easy to forget).

Some choppiness wouldn't be out of the question, whether it be from earnings in July (as investors see if the spring rebound translates to company top- and bottom-line growth), escalation of the Iraq situation (and accompanying higher oil prices that would be more worrisome than the conflict itself), or another wildcard of yet unknown origin.

How is sentiment? Getting better, although retail investors continue to appear skittish. Institutional investors have moved more bullish as underlying economic conditions now appear to be improving, and interest rates remain very low (which allows 'carry' or borrowing opportunities for those using leverage). We've seen this in the form of equity exposure, but also through increased merger and acquisition activity, and the issuance of IPO's. In the 2nd quarter, the number of firms going public rose by over 40% over last year at this time. While tech and consumer companies are always high-profile firms in the IPO arena, health technology/biotech represent a particularly large chunk in this cycle, as new and targeted technologies in the device and genetic arena have altered the paradigm for treating certain diseases and Wall Street has made note of it.

What about bonds?

Fixed income is the ongoing enigma in 2014. Despite theories about why long bonds have been so popular this year (such as heightened interest by corporate pension plans, etc.), analysis from PIMCO pointed out that foreigners and banks are by far the biggest buyers. There are some structural reasons that explain some of this—neither of which are directly related to U.S. economic conditions—such as Asian/European investors seeking an alternative 'safe haven' and regulatory considerations for safe capital that financial institutions needed to fulfill, as well as interest rate risk shifting among market players. Important, but not glamorous.

Now that economic and employment conditions are showing improvement, and inflation has risen somewhat, there's been increasing debate recently about where 'real' rates should be. A nominal yield at least as high as inflation is a historical must-have (over the long-term anyway), while the 'real' rate is the amount of additional premium needed for a bond to entice buyers. Short-term bonds don't need as much enticement, so anything around inflation plus a little bit of extra yield has sufficed. Longer-term bonds contain much more uncertainty about future prospects, so the real yield has needed to be higher to compensate and entice investors to take on this risk. Historically, this real rate has varied dramatically from sharply negative to sharply positive, based on conditions, but has averaged anywhere from 1-3% or so (that range intentionally ambiguous).

If inflation moved to the Fed's target of 2% (call it 2.25% on the CPI to account for differences in that versus the FOMC's preferred PCE index), that puts us at a nominal yield for Treasuries at 3-5%—again we're being vague on purpose as to not imply too much precision into the calculation. Rates are significantly below that right now, and real rates are also significantly below historicals (and negative in short-term bond assets). This unusual low real rate condition may be in place for a variety of reasons, including levels of financial leverage in the system, risk tolerances, and lower inflation uncertainty in recent years. But, despite still-slow growth and lack of upward move to this fair value more recently, this represents a steady pressure in the bond market, as there isn't much room for error. If things continue as they are now, the bump in rates might be delayed. If things improve more than expected, a rate rise wouldn't be at all surprising. (The only eventuality not mentioned, a recession or less severe downturn, could turn rates lower yet again, but the spring gets wound pretty tightly at levels below where we are currently—not saying it's impossible.)

Corporate bonds, of course, have an additional layer of spread to account for the probability of default. Credit has been good to us in portfolios over the last several years, but this will, too, someday come to an end. Both investment-grade and high yield spreads have moved tighter this year, and, eventually, the smaller reward won't be worth the risk. The high yield market is fairly new, so the graphs below (courtesy of the St. Louis Fed) provide some intermediate-term high yield spreads and a long-term historical context for AAA and BAA (top-grade and lowest level of investment-grade, respectively) corporate spreads versus the 10-Year Treasury. As you can see, spreads are tighter as conditions are stronger, so another area we're keeping close watch on.

Source: St. Louis Fed (using monthly yields, AAA and BAA 4/1953-6/2014, BofA Merrill Lynch High Yield 7/1996-6/2014)

Additional Reading

Read the nextQuestion of the Week, July 28, 2014.

Read our Weekly Review for July 14, 2014.

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