The S&P 500 has appreciated 3.6 percent in price terms in the first eight days of trading this year. It seems highly unlikely that the index will match this pace for the year’s remaining 242 trading days, so it’s reasonable to wonder what’s going to happen next. It’s always a fool’s errand to predict the timing and magnitude of future price movements; for clues, though, one’s best bet would probably be to follow the bond market. Amid all the exuberance in equities, there is a palpable edginess in the once staid world of fixed income. That edginess was on full display for a few hours Wednesday morning. A rumor floated out that China’s monetary authorities (who also happen to be the world’s principal consumers of US Treasury debt) were considering scaling back their purchases of US sovereigns, presumably as a cautionary move to diversify the composition of their foreign exchange reserves. Bond yields spiked immediately, and the 10-year yield shot up perilously close to last year’s high mark of 2.63 percent. That’s also the 10-year’s peak yield since the crazy days of 2013’s “taper tantrum” – remember those good times? The chart below shows the 10-year yield trend over the past five years.
At the Mercy of Supply and Demand
Wednesday’s mini-panic dissipated soon enough; the 10-year yield fell back and remains, as we close out the week, around 5 to 8 basis points below that 2.63 percent threshold (a handful of bond pros out there believe markets will all go haywire if that threshold is breached, for reasons with which we don’t necessarily agree). The Chinese put out an anodyne denial of any intentions to scale back Treasury purchases. The S&P 500, which Wednesday morning futures indicated could suffer a meaningful pullback, briskly resumed its winning ways. And all the while volatility has remained in the fetal position which has been its custom for the last year.
But that hair-trigger reaction to the China rumor underscored just how antsy the bond market is right now, and how exposed it is to the basic laws of supply and demand. Bear in mind that intermediate and long term bond prices are subject to many variables, while short term bonds tend to much more closely track the Fed. One of the key drivers keeping yields in check for the past several years has been robust demand from overseas – robust enough to make up for the reduction in demand at home when the Fed ended its quantitative easing program. If international investors turn sour on US credit – for whatever reason, be it inflationary concerns, a bearish outlook on the dollar or even jitters over our chaotic politics – that has the potential to push yields well past the notional 2.63 percent ceiling. A subsequent move towards 3 percent would not be out of the question.
Visions of 1994 Dancing In Their Heads
The bond market angst has its own mantra: “Remember 1994!” That, of course, was the year the Greenspan Fed surprised the markets with an unexpectedly aggressive interest rate policy, starting with a rate hike nobody was anticipating in February of that year. Investors will remember 1994 as being a particularly roller-coaster one for stocks, as the surprise rate hikes caught an ebullient bull market off guard. The chart below illustrates the volatile peaks and valleys experienced by the S&P 500 that year.
Now, the conventional wisdom in 2018 is that the Fed will do its utmost to avoid the kind of surprises the Greenspan Fed engineered over the course of 1994 (which included a surprise 50 basis point hike in the middle of the year). But investors are also cognizant of the reality that there are new faces populating the Open Market Commission, which of course will feature a new chair in the person of Jerome Powell. All else being equal, the new Fed is likely to proceed cautiously and not risk unnerving markets with a policy surprise. But all else may not be equal, particularly if we get that inflationary surprise we’ve been discussing in a number of these weekly commentaries. Then, a new Fed trying to get its sea legs may face the urgency of making decisions amid a tempest not of its own making.
We’ve had some reasonably benign price numbers come out this week: core producer and consumer prices largely within expectations. Bond investors appear relieved – yields have been fairly muted yesterday and today even while equities keep up their frenetic go-go dance routine. But there is not much complacency behind the surface calm.
Sometimes the New Year starts off with a genteel slowness, allowing folks to ease their way back into the normal routine of things after the holidays. Sometimes, though, the New Year accelerates from zero to eighty in the space of barely a day. 2018 seems a likely candidate for that latter description. Not that any of the headline events thus far appear much different from those that dominated 2017 -- crazy weather, even crazier politics and a stock market that seems to only know how to go one way -- this is continuity, not change. It’s the tempo that’s different -- more frenetic, as if a marathon runner suddenly broke into a 100 meter sprint pace. Heaven help us if we have this much breaking news to digest for each of the next 51 weeks.
Let the Good Times Roll
The nascent economic headlines of 2018 could be summed up with a single folksy refrain: “and the skies are not cloudy all day.” Business confidence indicators are close to decades-long highs, global GDP is predicted to come in around 3.7 percent, and US corporate earnings are positioned for a year of double-digit growth. The first job numbers out this morning were a bit slow on payroll gains, but wage growth stayed predictably on-trend at 2.5 percent.
Perhaps more significant than earnings, which represent the company’s bottom line net profit, is the outlook for top-line sales. After languishing for years at near-flat levels, sales for S&P 500 companies this year are estimated to grow in mid-to-high single digits. Sales are in many ways a more useful economic measure than earnings, as they are less affected by all the arcane accounting gimmicks that pile up as one goes down each line of the income statement. Strong sales suggest that global demand is back in a meaningful way. Most importantly for investors, sales and earnings growth can provide a steady tailwind for continued gains in share prices.
The Market’s Post-QE Life
Is that rosy economic and earnings picture strong enough to withstand the final coda on supportive monetary policy? So far, so good -- the Fed has managed to wind down QE and raise rates a few times without upsetting any apple carts. Investors will be watching the final acts of monetary stimulus play out in several venues this year. While the Fed plans to continue with rate hikes and to get on with reducing its balance sheet, the ECB will need to provide clarity on timing for winding down QE, and even Japan is expected to start applying the brakes on its expansive embrace of the Japanese Government Bond market.
Assuming that the overall macro/earnings picture doesn’t change much from what the numbers tell us today, we do not see any particular reason why an orderly winding down of global monetary stimulus should be disruptive to financial markets. The caveat to this, as we have discussed on numerous occasions, is that a sudden resurgence of inflation in wages and consumer prices could pressure the Fed to take more dramatic action, which would likely result in a radical repricing of bonds and, by extension, most risk asset classes.
The Dollar Conundrum
One asset that has not fared well thus far this year is the world’s reserve currency. The US dollar fell against most of its major trading currency partners this week, sending the euro back up over $1.20 while the pound sterling and Aussie dollar also rallied. Investors appear curiously bearish on the greenback. Strong corporate earnings and expected higher bond yields from Fed action should make dollar-denominated assets attractive. There does not appear to be a single compelling narrative to explain dollar weakness, with opinions varying from uncertain domestic politics ahead of the November midterm elections to a vague sense of “better opportunities elsewhere.”
We do not necessarily share the bearish consensus on the dollar. Washington shenanigans, for all their train wreck-like “must-look” qualities, are likely to have little impact on actual economic activity. As for “elsewhere” -- well, there are plenty of risks where those other opportunities may lie. Europe’s optimistic headlines aside, there are plenty of challenges ahead both economic and political for the currency union. China is once again intent on reining in the highly leveraged sectors of the economy that it had to turn to again last year for hitting GDP growth targets. And the world trade picture is anything but assured in a world wrestling with still-potent nationalist-populist sentiments.
Watch the Numbers, Not the Pundits
All that being said, we are not quite ready to join the growing chorus of Cassandras in pundit-land warning that the bubble is nigh. Equity valuations are stretched, no doubt about it. Bargains are hard to come by. But a bubble will only truly form if share prices accelerate much faster than underlying earnings. In other words, the sprint we have seen in share gains from January 2 to today is most likely unsustainable, but a measured pace of growth over the coming months is achievable. If investors get too carried away by animal spirits and the January melt-up continues, we could expect a reversal to potentially follow. But if the larger economics & earnings picture hasn’t changed, we would expect any such reversal to be short and not indicative of a more prolonged reversal.
One way or the other, it’s likely to be an interesting year, probably at times for better and at times for worse.
So, it’s that time of year again. Those endless “year in review” digests, the “10 best songs/books/episodes/tweets of 2017” listicles, the prognostications about what 2018 has in store. As if anyone actually knows. Yet, despite the fatuousness of the Old Year / New Year content factory, we absorb it all nonetheless, because we align the pace of our lives to the metronome of the calendar. The 365 days bookended by January 1 and December 31 are inherently no different than any other random sequential span of days. Yet we endow them with special meaning. How many investors know how their portfolios performed from, say, May 7 2015 to May 6, 2016? Some particularly assiduous types, perhaps, but not many! But how that mix of assets performed over the 12 months ended 31 December – well, to that particular performance metric attention must be paid.
683 Days and Who Cares
There’s nothing wrong, of course, with ordering our lives around the calendar. After all, that annual portfolio performance number does factor into something very real, namely the taxes on interest, dividends and capital gains to be paid by April 15. The problem with our calendar-centricness comes when we overplay the importance of these arbitrary dates in the context of asset market trends. 2017 was a good year for US equities. So was 2016 and for that matter so were 2013 and 2014 (2015 was so-so). There is a tendency to think, as one year ends and another begins, that some new dynamic must be at hand: some confluence of factors that will lend their distinct imprimatur to 2018. Nowhere do we see this tendency more pronounced – particularly this long into a bull run – than in people’s expectations about the arrival of the next reversal.
On February 11, 2016, the S&P 500 had retreated 14.2 percent from its previous all-time high reached on May 21, 2015 -- an elapsed time of 266 days. In between that high and low point, the blue chip index experienced another correction, falling by 12.4 percent from that May 21 high to October 25 (the market recovered again before falling in that subsequent Q1 2016 pullback). By popular convention, a “correction” represents a pullback of 10 percent or more from a previous high.
Here at MVF, we have our own metric of defining a meaningful pullback / recovery event: a retreat of more than 5 percent from a previous high, followed by a recovery of at least 5 percent from the low. We make note of this because it has been 683 days since the last 5 percent-plus pullback (corresponding to that 2/11/16 event). Now, 683 days is a long time. A very long time. Longer, in fact, than any other elapsed number of calendar days between two pullbacks of 5 percent or more in the S&P 500 since the end of the Second World War (the previous record being 593 days between December 18, 1957 and August 3, 1959). We came close – the S&P 500 fell about 4.8 percent from its previous high just before last year’s election. But close doesn’t count; the record stands. If we wake up on the morning of February 11, 2018 having not experienced a pullback of 5 percent or more from 2690 (the last high point on 12/18/17) then a full two years will have elapsed without a meaningful reversal in the market’s fortunes.
Pullbacks Don’t Need Reasons…
The question is, should anyone care that the current stretch of calm waters is the longest in postwar history? The answer is no, but the answer requires establishing the difference between a pullback (which can happen any time and often for no apparent reason at all) and a bear market (which tends to happen for specific reasons, is structural in nature and is also very infrequent). Perhaps the best illustration of this is the extremely brief, but nonetheless “meaningful,” pullback the market experienced in October 2014. The S&P 500 fell about 7.4 percent over a period of just less than a month from late September to early October (in reality, most of the carnage happened in a very brief few days leading up to the October 15 floor). And then it was over, and nobody quite knew what had happened. There was a brief “flash crash” in Treasury yields, there were some disconcerting headlines about the Ebola disease, and there was a freak-out of very short duration. And then it was over and back to business as usual.
…Bear Markets Do Need Reasons
That 2014 freak-out was largely due to chance – a random confluence of events that just happened, on that particular calendar week, to engender a brief market squall. It is also largely a matter of chance that the market didn’t pull back by more than 5 percent in late October 2016 (before the election), and it is largely a matter of chance that none of the various X-factors that bubbled up over the course of 2017 managed to form a vortex of disruption strong enough to pull down asset prices. In other words, that 683 day record from the last meaningful pullback event is due more to chance than to some unique set of circumstances. Another squall similar to the Ebola frenzy could also break out at any time, also largely due to chance.
Bear markets are different. The difference between the market crash of 2008 and that Ebola pullback wasn’t just a difference in magnitude, but in character. The 2008 event came along with an economic recession, which for its part came about on account of a systemic financial crisis that threatened to disrupt everything from bond markets to corporate payroll direct deposits. The textbook bear market, which ran from 1968 to 1982, came alongside the US economy’s running out of gas after its breakneck pace in the 1950s and 1960s. The high inflation, high interest rates and lackluster growth throughout much of the 1970s supplied plenty of reason for investors to avoid or dramatically reduce exposure to common stocks and bonds, in favor of real assets like precious metals and fossil fuels.
As this calendar year turns, we see very few signs of the kind of economic or financial unrest that could metastasize into a full-fledged bear market. That’s not to say that everything is rosy, and you can count on us to cast a cold eye over the particulars of the global landscape in our Annual Outlook next month. But the key features of that landscape – low inflation, moderate growth in output and stable labor markets – do not appear positioned for any kind of major sea change. Corporate earnings look set to continue to grow in the high single or low double digits, on average. We suggest keeping this in mind if you wake up one day and find your favorite stock market index pulling back by a few percent. Remember the Ebola freak-out. Remember that these things happen largely by chance. And remember that markets don’t march to the beat of the calendar.
Happy New Year to you and yours.
At least tulips were pretty to look at, on 17th century Amsterdam streets. Pets.com actually facilitated the sale of real products in its millennial heyday (at a steep loss, sure, but still). Was gold really 300 percent more glittery in January 1980 than it was in January 1979? Who knows, but, you, know, gold! Where there’s a bubble, there’s always something that at one time made sense, long before triple- or quadruple-digit annual returns turned the “thing” from obscure novelty to popular get-rich-quick sensation.
So what is the “thing” about so-called crypto-currencies and their most visible public face, bitcoin, which at the end of November was worth more than 1,700 percent of its value at the beginning of 2017? The crypto-currency phenomenon appears to be one of the only viable newsworthy events that can compete with Trump’s tweets for air time as this oddest of years finally approaches its end. It’s not our cup of tea, but as commentators on all things investment markets, we would be remiss by not giving the crypto-craze at least one column’s worth of consideration.
Bitcoin has been around for a scant nine years, presciently coming into the world around the same time that financial markets were falling apart in the great market crash of 2008. A mysterious figure going by the name of Satoshi Nakamoto (whose actual identity remains a mystery today) posted an arcane description of the protocols for a decentralized financial ledger technology onto an obscure mailing list for techies with a libertarian bent. The technology, called blockchain, is what bitcoin runs on much in the way that all websites run on the decentralized technology protocols that govern the Internet. Initially, bitcoins were an object of interest for only two groups of users: computer programmers, who earned rewards for solving complex programming issues (“mining” bitcoins), and shadowy denizens of the “dark web” of illegal drug traffickers and the like, who were attracted to the opaque features of blockchain through which they could trade and deal anonymously.
The Price of Everything…
Clearly, crypto-currencies’ days of nerdy and shady obscurity are long gone. They are now, for better or worse, in the process of transitioning to something resembling a mainstream asset class. This week, bitcoin futures began trading on the Chicago Board of Options Exchange (CBOE) and are due to launch on CBOE’s longstanding rival, the Chicago Mercantile Exchange (CME). A handful of large financial institutions are pushing the SEC for approval to launch bitcoin ETFs so that all the world can join in the fun. In a bit of sideline humor, the first ETF application earlier this year was submitted by none other than the Winklevoss twins, of Facebook notoriety. That application was denied. Fans hope that endowing the nascent crypto-currencies with the respectability of established platforms and institutions will facilitate efficient price discovery, expand the participant base and encourage liquidity.
…The Value of Nothing
Price efficiency and liquidity are noble aims, but they do not solve the fundamental question anyone planning to take a punt on crypto-currencies should ask: what exactly are they, and how should they be valued? Clearly, crypto-currencies do not bear the characteristics of either fixed income (legally binding claims to a known set of cash flows) or equities (residual nonbinding claims on company profits). They are more like commodities, perhaps, in having no intrinsic worth other than what people are willing to pay for them (bars of gold, barrels of oil and the like generate no cash flows and pay no dividends). But all commodities have specific uses in the real world, whether powering internal combustion engines or glittering from the necks of fashionable humans. Thus far, at least, there is no convincing use case for crypto-currencies outside of those obscure digital corners where they have resided to date.
Moreover, to call them currencies at all is to take very generous liberties with the meaning of “currency.” A reliable currency fulfills three specific use cases: a store of value, a medium of exchange and a unit of accounting measurement. An instrument capable of rising or falling by double digits on any given trading day falls woefully short of any of these three uses. Imagine, for a moment, that you live in a world where your home mortgage is denominated in bitcoin. How thrilled would you be to have no idea whether next month’s payment obligation would be a fraction of this month’s, or greater by a magnitude of ten or more? Until and unless these use case problems are solved, bitcoin and its ilk are no more currencies than are beads or clamshells.
Moreover, the claim made by some that bitcoin has the potential to be a new variation of the old gold standard is ludicrous. The argument here rests on the fact of bitcoin’s scarcity: baked into the computer code it runs on is a hard limit of 21 million bitcoins that can ever be issued. Like gold, goes this argument, the scarcity makes it a durable store of value. This argument fails for two reasons. First, bitcoin itself may be limited in maximum quantity, but there are now plenty of competing crypto-currencies out there and thus potentially no limits at all. Second, what made the gold standard work was not the inherent nature of the commodity itself but the fact that one ounce of gold was always exchangeable for a fixed amount of a national currency – the British pound sterling for most of the gold standard era – so there was never a doubt as to the relationship between a yellow rock mined from the ground and the cash that facilitated activity in the real economy. Sure, you could theoretically fix the value of a single bitcoin in US dollars or euros and call it a standard – but what would be the point?
When the Music’s Over
The most likely end to the crypto-currency craze, like those of bubbles past, will be pain for anyone left holding the bag when the music stops. But that does not mean there is no future for digital money. After all, the crash after the dot-com bubble did not arrest the rapid development of the Internet. In the case of the crypto-currencies it is the underlying technology – the blockchain distributed ledger system – that has real potential to revolutionize the world of financial payment systems. The technology is being widely studied by central banks – not as a way to decouple payment systems from national regulators, but as a way for the banks to provide better oversight to the rapidly growing marketplace for financial technology. Such oversight, of course, is radically opposite the original libertarian impulses of Satoshi Nakamoto’s protocols, which aimed instead to free money from its government monitors.
We will continue to study blockchain’s evolution, and will likely have more to say about it in future posts. As always, though, we caution our friends and clients to beware the lure of the free lunch…because it never is.
As 2017 draws to a close, two data points strike us as particularly noteworthy candidates for summing up the year in asset markets. The S&P 500 is up more than 20 percent in total return, and the Fed has raised interest rates three times. Investors have good cause to bemoan the exit of Janet Yellen at the end of next month, for the good professor has given us an extended seminar in how to handle interest rate policy with minimal collateral damage either in financial markets or the real economy of goods and services. Incoming Fed Chair Jerome Powell has some large shoes to fill; fortunately he, by all appearances, has been a diligent student under Yellen’s tutelage over the past several years. He will need all the benign tailwinds he can get, because the road ahead may not be quite so calm as that we leave behind heading into 2018.
Follow the Dots
This week’s 25 basis point increase in the Fed funds target range was widely anticipated by the market (again, thanks to clear and prudent forward guidance). Investors quickly skimmed past the headline announcement to see where Fed minds were regarding policy action for next year: the famous “dot-plot” showing where FOMC voting members think rates will be in the coming three years and beyond. Very little has changed since the dot-plot’s last iteration in September, with the mean expectation of three more rate hikes in 2018. The lack of upward movement on rate expectations came at the same time that the Fed raised somewhat its expectations about economic growth and labor market conditions.
Dr. Pangloss’s Market
From an investor’s standpoint the market would seem reminiscent of Dr. Pangloss in Voltaire’s “Candide” -- the best of all possible worlds, with growth supported by still-accommodative monetary policy. That pleasing state of affairs, of course, comes courtesy of inflation that refuses to budge out of its narrow range of about 1.3 to 1.8 percent, depending on which measure you prefer. Markets seem satisfied this best of all worlds will continue. Even now, Fed funds futures markets ascribe only a 20 percent or so chance of even those three rate hikes occurring next year. An unexpected surge in inflation is quite likely the most impactful variable that could upset the present state of things. It would cause a rethink in the pricing of most assets, starting with intermediate and long term bonds. Intermediate Treasuries, in particular the 10-year note, serve as a proxy for the “risk-free rate” calculations used in valuing and pricing most risk assets. Disrupt expectations for the 10-year, and you disrupt most everything else.
The Curvature of Markets
In July 2016 the 10-year yield dipped as low as 1.36 percent, which by some accounts was the lowest yield for a benchmark risk-free rate ever in the 800-plus year-history of recorded interest rates. Today, the 2-year yield -- a short term reference benchmark closely tied to monetary policy trends -- is over 1.8 percent. With today’s 10-year around 2.4 percent, the spread between short and intermediate yields is lower (flatter in yield curve-speak) than it has been any time since 2007. Intermediate yields are affected by many market variables, but inflationary expectations are prominent among them. Briefly put: if that inflationary surge were to happen, there would be plenty of upward curved space for the 10-year yield to occupy. Up go all those discount rates used to make present value computations for risk assets. All else being equal, a higher discount rate lowers the net present value of a future series of cash flows. The calm waters of 2017 would likely seem a distant memory.
All that being said, there is no hard evidence today suggesting that this kind of inflationary surge is around the corner. Other factors, such as low productivity growth and hitherto modest wage growth, continue to keep consumer prices in check. But sub-2 percent inflation in an economy where unemployment is just 4 percent runs counter to all the data and experience that have informed monetary policymakers for the past seventy years. It has been a pleasant, if confounding, feature of the Yellen years. Figuring out where it goes from here may well be incoming Chair Powell’s biggest challenge.