The big picture macro strategy review

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On December 5, 1996, Federal Reserve Chairman Alan Greenspan gave a speech entitled ‘The Challenge of Central Banking in a Democratic Society’. We imagine many in the audience found it difficult not to nod off, but one phrase from his speech became memorable. “Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?” The S&P 500 more than doubled after Greenspan’s speech, climbing from 744 to 1,553 in March 2000, according to Bloomberg.

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The big picture macro strategy review

  1. 1. - The Big Picture - http://www.ritholtz.com/blog -Forward Markets: Macro Strategy ReviewPosted By Jim Welsh On June 6, 2013 @ 8:00 am In Think Tank | 4 CommentsOn December 5, 1996, Federal Reserve Chairman Alan Greenspan gave a speech entitled‘The Challenge of Central Banking in a Democratic Society’. We imagine many in the audiencefound it difficult not to nod off, but one phrase from his speech became memorable. “Clearly,sustained low inflation implies less uncertainty about the future, and lower risk premiumsimply higher prices of stocks and other earning assets. We can see that in the inverserelationship exhibited by price/earnings ratios and the rate of inflation in the past. But howdo we know when irrational exuberance has unduly escalated asset values, which thenbecome subject to unexpected and prolonged contractions as they have in Japan over thepast decade?” The S&P 500 more than doubled after Greenspan’s speech, climbing from 744to 1,553 in March 2000, according to Bloomberg. If he had reservations on a central bankersability to spot irrational exuberance before his speech, the doubling in the S&P500 in justover 3 years only reinforced it. Greenspan ultimately concluded that rather than trying toidentify a burgeoning bubble, and taking action to let the air out before it became too large,the Federal Reserve would simply deal with the fallout should one occur. After all, the FederalReserve had been able to handle the fallout from the stock market crash in 1987, which inpercentage terms was comparable to the 1929 crash. The 1998 collapse of Long TermCapital Management came close to being a systemic crisis, relatively small compared toLehman Brothers in 2008, but the Fed dealt with it. The Fed’s playbook under ChairmanGreenspan was the same: flood the banking system with liquidity, stabilize the financialsystem, and the crisis will pass. It worked in 1987, 1998, less well in 2001, but not so wellsince the 2008 financial crisis. We think the Federal Reserve overestimated its capability tohandle asset deflation, especially after an asset’s valuation was allowed to exceed priorvaluation peaks by 40% to 50%.The philosophical decision to be reactive rather than proactive in dealing with asset prices isinteresting since the Federal Reserve has always been proactive when dealing with theeconomy. If strong growth raised inflation during the 1950’s, 1960’s and 1970’s, the Fedwould eventually increase interest rates, slowing growth enough to bring inflation down andnot infrequently (1954, 1958, 1961, 1969-1970, 1973-1974, 1980, and 1981-1982) tip theeconomy into recession. Once a recession did develop, the Fed promptly lowered rates torevive growth. The Federal Reserve’s choice of allowing asset prices to find their own levelwas also based on the belief that markets are wiser than bureaucrats in establishing anappropriate valuation for any asset. While we generally support this view, we also recognizethat the dot.com bubble proved that markets are hardly infallible. What’s interesting is thatthe Federal Reserve, under Alan Greenspan’s leadership, had a ring side seat as the housingbubble was forming so soon after the dot.com bubble and still remained reactive rather thanproactive.As the Nasdaq Composite was doubling in 1999 and 2000, the philosophical decision to bereactive rather than proactive was reflected in the Federal Reserve’s decision not to increasemargins for stock purchases, which would have curbed the level of speculation in technologystocks in 1999 and 2000 without harming the overall economy. But how do we know whenirrational exuberance has unduly escalated asset values? [1]It’s a fair question, but ifsomething walks and quacks like a duck, its only common sense to conclude there’s a highprobability it’s a duck. In 1999 and 2000 the valuation of the stock market was 50% higherthan any time in the last 100 years, as measured by the Price/Earnings ratio, Q-ratio, orstock market capitalization as a percent of GDP. When the dot.com bubble popped, the Fedexecuted the game plan and lowered rates to 1% to contain the fallout. Even as businessspending plunged and September 11, 2001 stunned America, low rates kept consumerspending going so the recession was shallow and lasted only eight months.As the housing bubble was forming after 2004, the Federal Reserve failed to respond from aregulatory standpoint to oversee the availability of mortgages that allowed a home owner toborrow 125% of their homes value, or supervise the lax lending standards that becamepervasive throughout the country. Starting in June 2004 the Federal Reserve increased theFederal funds rate .25% at 17 consecutive FOMC meetings until it was 5.25%. Although rates
  2. 2. had been increased, homebuyers had many mortgageoptions which made it easy forthem to circumvent the impact ofthe higher Federal funds rate.Demand increased even as theFed raised rates, increasinglypowered by lax lendingstandards and liar loans. From1965 until 2000, the medianhome sold for about 333% ofmedian income. By 2006, homeprices rose to 475% of medianincome. In just six years, medianhome prices were more than40% higher relative to medianincome than they had been atany time since at least the mid1960’s. Many of the ‘hot’markets were even morestretched. Although a centralbanker may not be able to knowfor sure when a bubble is forming, these valuations were less than a subtle hint that homeprices had become unduly elevated.[2]We do not believe the Federal Reserve was primarily responsible for the housing bubble, assome have suggested. The housing bubble developed because there were manycontributions from many contributors. Each political party pursued their respective politicalagenda or philosophy; the rating agencies were compensated by the issuers of mortgagesecurities which created a serious conflict of interest that potentially compromised theirability to be ‘objective’; mortgage brokers who received higher commissions even when theysold a more expensive mortgage to an unsuspecting homeowner or assisted in filling out theapplication for a questionable home buyer; Wall Street investment banks which continued todistribute mortgage backed securities even after they suspected some of the MBS wasn’tworthy of their AAA rating; speculators who bought multiple homes with no money downexpecting a quick profit; and all those willing to game the system because there was simplytoo much money to be made for everyone involved. The gravy train gained speed as it rolleddownhill, while the Federal Reserve remained a passive observer.It is somewhat ironic that after not proactively responding to asset price fluctuations andallowing two bubbles to form in less than a decade, the Bernanke Federal Reserve in recent
  3. 3. years has pursued an aggressive proactive approach that is intended to influence assetprices. Rather than being indifferent to asset prices, the Fed is very much interested inmanipulating them as part of current monetary policy. By holding the Federal funds rate justabove 0% for the last five years, and launching quantitative easing programs that currentlyinclude purchasing $85 billion of Treasury bonds and mortgage back securities every month,the Federal Reserve has charted a course that has already resulted in a number of intendedconsequences. [3]Mortgage ratesare the lowestsince the GreatDepression, stockprices havevaulted to a newall-time high, andjunk bond yieldshave fallen to anall-time low. Therisk is rising thatequity valuationsare becomingdisconnected fromthe real economysince economicgrowth remainssub-par and themajority ofworkers areexperiencing adecline in theirdisposable income. According to Sentier Research, median disposable income has fallen from$54,275 to $51,320, a drop of 5.4% since the recovery began in June 2009. Corporate profitmargins are near record highs and earnings are growing but at the expense of the averageworker. Corporate stock buybacks have contributed meaningfully to the increase in earnings,so the quality of earnings is not as good as it appears. While this may make the marketseem reasonably priced based on a P/E ratio of 15 or so, this is like getting fat by eatingone’s leg. Sooner or later, incomes must grow in real terms for aggregate demand to reacha sustainable growth path. Absent that, the Federal Reserve has provided the financialmarkets a placebo, even as the patient continues to get weaker. We hope the FederalReserve is successful in using asset prices to improve economic growth, but we remainvigilant. In addition to the intended consequences, there are likely to be unintendedconsequences. Some might be positive, but they won’t all be positive. Here are twounintended consequences which are not positive.After working hard for decades, saving money, and possessing a nest egg that would allowthem to retire comfortably, those prudent savers who retired before 2007 have beencrucified by the Federal Reserve’s low interest rate policy. In 2007, they could safely invest ina 5-year Certificate of Deposit and earn at least 5.0% on their savings. When that CDmatured last year, they were confronted with a frightening new reality. Rather than receiving$5,000 each year for every $100,000 invested, they would be lucky to earn $1,000 – adecline of 80%. For those heavily dependent on interest income, this 80% plunge in incomeis why the demand for Reverse Mortgages is growing, and why the demand for incomeproducing bonds and stocks has been growing. [4]Those who previously were predominantlydependent on CD’s or money market funds never really had to accept principal risk. Nowmore of them do, and there’s a chance some of them don’t fully understand the additionalrisk. When interest rates rise and bond prices fall, or the stock market experiences the nextbear market, some investors could become two-time losers. First, lower rates slashed theirincome from safe savings accounts, forcing them to invest some money in higher yieldingbonds and/or stocks. Sometime in the next few months or years, bond prices fall from all-time highs. Or the stock market falls from an all-time high. Worse, bonds and stocks declinesimultaneously as they did from 1942 until 1981, whenever interest rates rose materially.Trees don’t grow to the sky, and there is nothing the Federal Reserve can do to change that.Another unintended consequence of the Federal Reserve’s proactive monetary policy is itsimpact on pension funds, both public and private. By law pensions are required to calculatethe present value of future liabilities using a discount rate based on current interest rates,
  4. 4. current assets,futurecontributions, andfor individualworkers, theirtime of service,income level, andlife expectancy.This is not anexact sciencesince employeescome and go, andinterest rates andinvestmentreturns can andoften changedramatically in anygiven year. Basedon all thesevariables pensionactuaries estimatehow much moneya pension fund willneed over thenext 10, 20, and 30 years to pay retired workers their promised benefits. In the followingexample we are excluding annual contributions to keep the math simple. For instance, anactuary determines a pension with $50 million in assets today will need $400 million in 30years to meet its obligations. What rate of return does the pension have to earn to ensurethere will be $400 million available in 30 years? The $50 million would double every 9 years ifthe fund earned an average annual return of 8% based on the rule of 72 (72/8% = 9 years).So after 27 years, the $50 million would have doubled three times and be worth $503 millionin 30 years. However, if a discount rate of 6% is used as the expected average annual rateof return, the $50 million will have quadrupled in 24 years (72/6% = 12 years) and only have$284 million to meet its obligations in year 30. The difference between 8% and 6% doesn’tsound like a lot, but over time the effect of compounding becomes very significant and has alarge impact on the annual employer contribution.The discount rate used by corporations to determine their pension contribution is based onthe yields of corporate bonds rated double A or higher with maturities equal to the scheduleof pension benefit payouts. As our example showed, the shortfall caused from a lowerinvestment return can be significant and must be narrowed by larger contributions by theemployer. As a result of the Federal Reserve’s monetary policy actions and quantitativeeasing programs, corporate bond yields have fallen dramatically. A good thing for corporateborrowing, not so good for corporate pensions.Mercer is an employee benefit specialist that advises pensions on all aspects of pensionmanagement. The Mercer Yield Curve Mature Plan Index is one of the rates used by largecorporations as their discount rate. Since December 2007, the Mercer Index’s yield hasplunged from 6.4% to 3.65%, which has created near record pension deficits. According toMercer, the 1,500 companies in the S&P 1500 stock index had a combined deficit of $607billion as of November 30, 2012. Although pension portfolios benefited from the 16% gain inthe S&P 500 in 2012, the decline in interest rates more than offset it, lifting the deficit from$484 billion at the end of 2011 by $123 billion. In 2013, Ford expects to contribute $5 billionto its pension fund, which is almost as much as it spent building plants, buying equipment,and developing new cars in 2012. In the fourth quarter, Verizon Communications contributed$1.7 billion to its pension plan. In a recent securities filing, Boeing said a .25% drop in itsdiscount rate would add $3.1 billion to its pension obligations. At the end of 2012, Boeingreported a pension deficit of $19.7 billion. According to J.P. Morgan Asset Management,companies hold only $81 for each $100 promised to pensioners.The pension underfunding gap for public pensions is worse. At the end of 2012, the shortfallin 109 of the nation’s state pension plans rose to $834 billion, up from $690.3 billion in 2011,according to Wilshire Consulting. In 2012, assets only amounted to 69% of liabilities, downfrom 93% in 2007. According to Wilshire Consulting, these plans expect to average a medianrate of return over the next 30 years of 7.8%. Returns over the last decade fell well short of
  5. 5. 7.8%, and with 30-year Treasury bonds and high quality corporate bonds yielding less thanhalf of 7.8%, it is an understatement to suggest this expected return is not realistic. Theprimary reason state and local governments have not lowered their expected return rate is alower rate would require larger contributions now and in coming years. With many state andlocal government budgets under pressure, it is easier for politicians to ignore the problem.Who knows, maybe trees can grow to the sky! Besides state and local governments have anAce in the Hole corporations don’t have. The California Public Retirement System (CalPers)has $255 billion in assets to cover present and future obligations for its 1.6 million members.In March, CalPers published a report that a number of state and school pension funds areonly 62% to 68% funded for obligations in the next 10 years, and only 79% to 86% fundedout to 30 years. To close the funding gap, CalPers approved a 50% increase in contributionsfor those cities and school districts for the next six years. These cities and school districts willlikely pay for the increase in their pension contributions by tapping taxpayers with highertaxes and fees, and rewarding those footing the bill with reductions in services. Chicago’spension fund is underfunded by almost $24 billion, and must contribute $404 million this yearto the teachers’ retirement system this year, which represents 8% of the 2014 educationbudget. Over the next three years, Chicago’s annual pension costs will soar from $500million to $1.1 billion, and that figure does not include the teacher’s pension contribution.One anti-dote for the pension underfunding problem would come from higher interest rates,as they would raise the discount rate corporations use, and lower the amount they wouldhave to contribute to their pensions. Higher rates would also help state and localgovernments lower their annual contributions since higher rates narrows the gap betweencurrent rates and the 7.8% median rate of return expected by state and local governments.But we live in a time when the law of unintended consequences is the rule rather than theexception. As policy makers address one problem, another problem pops up.After the financial crisis erupted, the Federal Reserve went to the playbook it has relied uponsince the 1987 crash. The Fed injected a massive amount of liquidity into the bankingsystem, cut rates to stabilize the financial system, and then waited for the recovery to takehold as it has in the past. It didn’t take long for the Fed to realize it would require anextraordinary proactive monetary policy to offset the deflationary forces of banking andconsumer deleveraging. Lowering interest rates to help housing and auto sales has alwaysbeen part of traditional monetary policy, and we would suggest the initial round ofQuantitative Easing was more of an extension of traditional policy. The goal of QE3,however,and the expansion of QE3, is to boost asset prices so consumption can remainstrong enough as fiscal tightening becomes a headwind. With stocks and bonds hitting newall time highs and home prices recovering, this strategy is working. With time and higherasset prices, the Federal Reserve and the other central banks can only hope real economicgrowth accelerates. This is a strategy that is fraught with unforeseen risks, but the centralbanks have no choice. This raises a good question. If central bankers aren’t able to identifyan asset bubble, even though the tech and housing bubbles were somewhat obvious, howwill they know when irrational monetary policy has unduly escalated asset values?If and when the Federal Reserve begins to scale back QE3, stocks and bonds are likely tofall, erasing some of the paper wealth created by the psychology of QE3. Some will point outthat the Fed will only reduce QE3 if the economy is doing well, so stocks should hold up.When QE1 and QE2 ended investors will remember the stock market declined, so they will beinclined to sell and ask questions later. Investors will also worry the economy may soften toomuch without the assist from QE, especially if a couple of data points come in weaker afterthe Fed has scaled back on QE3. Bond prices are likely to sag as well, since the supply theFed has been soaking up will have to be bought by other buyers. When the Fed decides toincrease rates, the higher rates will help savers and pensions, but hurt housing and autossales. Most importantly, higher interest rates will increase the interest expense on themountain of debt our economy is lumbering under. As noted last month, according to theFederal Reserve, for each $1 in GDP there is $3.50 of debt. Federal debt now exceeds $16trillion and the Treasury is paying an average interest rate of just 2.6%. For each 1%increase in the Treasury’s funding cost, the Congressional Budget Office estimates interestexpense will go up by $100 billion, which won’t make lowering our budget deficit any easierin coming years. The States Project, a joint venture of Harvard’s Institute of Politics and theUniversity of Pennsylvania’s Fels Institute of Government, estimated last December thatstate and local governments now owe a total of $7.3 trillion in debt. According to studies bythe Pew Center on the States, states and large cities have made more than $700 billion inpromises for retiree health care insurance, but have set aside only 5% of the money to payfor the insurance. Higher interest rates will not be beneficial for state budgets either.
  6. 6. We continue to believe the greatest risk to the Federal Reserve’s proactive monetary policyis that it will be as successful as the Fed’s reactive policy. As we noted at the beginning ofour discussion, Federal Reserve Chairman Alan Greenspan asked, “How do we know whenirrational exuberance has unduly escalated asset values, which then become subject tounexpected and prolonged contractions?” At this point we know the answer. What we donot know is what the unintended consequences of the Federal Reserve’s and other centralbanks proactive monetary policy will be. For investors the coming months and years couldprove treacherous, since the psychology of QE3 is likely to lift stock and bond prices further.We just don’t know when the music will stop. Should central banks’ proactive policy fail toresult in a self sustaining economic expansion, the global economy will be at risk to sufferinga Japanese like lost decade, and investors will lose confidence. If the central bank proactivepolicy succeeds, the financial markets could be vulnerable to a large increase in volatility thatresults in declines in both stocks and bonds as monetary policy around the world isnormalized at some point in the future. This suggests that a tactical approach to the financialmarkets is warranted, since no one knows whether this monetary experiment will succeed orfail.StocksAs discussed in the April commentary, the S&P 500 was approaching an important trend linewhich connected the highs in 2000 and 2007. The overall formation since 1999 is potentiallya broadening top which looks like a megaphone. On May 3, the S&P punched through thisresistance after a better than expected employment report. We thought a break out above1,600 could lead to a blow off that could carry the S&P to 1,680 – 1,700, inspired by thebullish psychology surrounding QE3. On May 22 the S&P traded up to 1,687 before reversinglower. [5]The run up above 1,600 hasstoked bullish sentiment, which under normalcircumstances would be worrisome.However, as we have often stated, marketsdon’t top because there are too many bulls.Markets top when investors are given areason to sell, and investors currentlybelieve as long as QE3 is maintained thestock market is immunized from a decline. Ifthe economy fails to pick up speed by yearend as we expect, investors may bedisappointed since the consensus is forearnings and the economy to accelerate.This is why we continue to believe the risk ofa meaningful market decline will increase inthe second half of 2013.The Major Trend Indicator (MTI) is a proprietary indicator we use to measure the strength orweakness of market rallies and declines. Whenever a rally carries the MTI above 3 (shadedarea), it is because investors have a number of fundamental reasons to be buyers and is asign of market strength. The recent rally pushed the MTI to 5.46, but that does not conveyhow historic the recent rally has been. A Buying Stampede occurs when the market doesn’texperience a three consecutive day of pullback as it progresses higher. The vast majority ofBuying Stampedes last between 17 and 25 trading days, with few lasting more than 30days, according to Raymond James. Since the end of December the current Buying Stampedehas persisted for 100 trading days, almost double the prior record of 53 days. [6]Accordingto an analysis by JP Morgan, the S&P has been up in 65% of the trading days this year.Going back over the past 50 years, JP Morgan estimates that the probability of such afrequency was only 2%. The market is extended and the odds favor a pull back after such anuninterrupted run. The S&P is likely to retest the break out level of 1,600 at a minimum. Wewould view a decline below the April low of 1,536 in coming months as a negative since itwould represent the first time the S&P would have violated a prior low since the bottom inMarch 2009. It would also potentially negate the break out above 1,600 and suggest it wasjust a bull trap.Source:Jim Welsh, David Martin, Jim O’DonnellMacro Strategy Team, May 2013
  7. 7. Article printed from The Big Picture:http://www.ritholtz.com/blogURL to article:http://www.ritholtz.com/blog/2013/06/forward-markets-macro-strategy-review-3/URLs in this post:[1] Image: http://www.ritholtz.com/blog/wp-content/uploads/2013/06/qratio.png[2] Image: http://www.ritholtz.com/blog/wp-content/uploads/2013/06/ratio.png[3] Image: http://www.ritholtz.com/blog/wp-content/uploads/2013/06/us-median.png[4] Image: http://www.ritholtz.com/blog/wp-content/uploads/2013/06/5-year.png[5] Image: http://www.ritholtz.com/blog/wp-content/uploads/2013/06/s-and-p.png[6] Image: http://www.ritholtz.com/blog/wp-content/uploads/2013/06/index.pngCopyright © 2008 The Big Picture. All rights reserved.

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