Yield Curves & The Fed Model
I have been giving a lot of thought lately to the myriad of economists and analysts that have been discussing why it is highly unlikely for the U.S. to slip into a second recession in the coming months. The arguments center around something that Larry Kudlow stated in his article "Strong Profits Suggest No Double Dip"; "Stock and bond yields are sinking as Wall Street disses the debt deal and instead focuses on a likely double-dip recession. Everyone is gloomy. But is this pessimism getting a little overbaked?"
First, I don't think everyone is all that gloomy - analysts expectations for economic growth are just now being ratcheted down from hyper-unrealistic expectations fo 4% growth going to forward to just simply unrealistic 2.5-3% growth. In reality, the economy is growing at less than 2% currently and will likely be lower than that, at current run rates, in 2012. [Note: This is barring another round of Quantitative Easing or Stimulus program which will temporarily drag forward future consumption.]
In Larry's article he makes a very good observation: "Granted, the economy is sputtering, with less than 1 percent growth in the first half of the year. But if there is a recession in the cards, it will be the first time one occurs when the yield curve is steeply positive (an ultra-easy Fed) and corporate profits are strong."
Let me say first, to Larry's credit, that he is absolutely correct on a historical basis. However, this statistical view, however, may have a fly in the ointment which is the point I want to address today. Larry states that "The principal reason for the sub-par first-half economy is the rise of inflation, which severely damaged real incomes and consumer spending. We experienced a mini oil shock, which has dampened the whole economy. Actually, it's worth remembering that oil shocks and inverted yield curves, along with falling profits, are the most important leading indicators of recessions."
I recently wrote an article called "Why Oil Price Spikes Feel Worse" which addresses the issue of why price shocks due to oil increases crimps consumer spending. Oil price shocks reduce the disposable income of consumers which in turn impacts economic growth. Furthermore, the year over year declines in disposable incomes makes it much tougher to absorb oil price spikes. Larry is absolutely correct about that. However, I doubt that we have seen the last of oil price shocks and if there is another round of Quantitative Easing, as we expect there will be, oil prices will once again be shocking consumers.
However, the really interesting piece of his commentary centers around the yield curve and profit growth. He continues: "We don't have this right now.profits are at record highs as a share of GDP. Second-quarter earnings are coming in much stronger than expected. For some reason investors have chosen to ignore profits. But they're still the mother's milk of stocks and the economy. Stocks may well be undervalued right now.
At roughly $95 a share profits for 2011, stocks are running near a 13-times price-earnings multiple, which calculates to a near 8 percent forward-earnings yield. Compare that to a 2.6 percent 10-year Treasury bond or a 5.5 percent Baa investment-grade corporate bond, and you can see that stocks have good value. The equity-risk premium is very high."
In regards to the yield curve for the past two years the Federal Reserve has been on an unprecedented mission to support the financial markets and the economy through outright manipulation of interest rates. Through various interventions, such as Quantitative Easing, the Fed has been targeting varous parts of the yield curve in order to create a steeper yield curve than normally would exist. The goal of this, of course, was to ultimately get the economy flowing normally again at which time the artifical support could be withdrawn. The problem with the interest rate manipulation scheme is that while it steepend the yield curve it failed to revive the economy.
Therefore, with the yield curve artifcially steep the effectiveness of the yield curve's recession predicting capability may be somewhat suspect this time around. This is something I can't prove at the moment - but I do think that time will tell that this time "may indeed be different" in this one circumstance as i suspect that without the influence of $5.1 Trillion of stimulus and a massive expansion of the Fed's balance sheet the yield curve will be much flatter than it is today.
This brings us to profits and equity yields. Corporate profits have been strong for the past few quarters as cost cutting has made up the vast majority of the growth. Revenue growth, as the topline function of earnings, has not grown at a pace to support the rapid recovery in corporate profits. Accounting magic and other gimmicks, mass layoffs, cost cutting, etc. have been directly responsible for the majority of those profits. The problem with this, however, is that the growth rate of profits, when derived from these manners, is unsustainable.
The problem with Larry's statement, and he even states this but I don't think he realizes it, is that "record profits" usually symbolize the peaks in current trends. As you can see in the chart the year over year growth rate of profits is falling sharply and historically, going back to 1948, which is all the corporate profit data I could obtain, when that growth rate of profits becomes negative both the economy and the markets have experienced issues.
Negative prints in year over year profits have either signaled a recession or the economy was immeidately sliding into one. The only time that corporate profit changes really failed to predict a recession was during the massive deficit spending campaign under Reagan and the Asian Contagion in 1998 during the middle of the biggest stock market boom run on record.
The Fed Model Is Broken
Earnings yield is a different matter altogether and a completely bogus investment strategy. This has been the cornerstone of the "Fed Model" since the early 80's. The Fed Model basically states that when the earnings yield on stocks (earnings divided by price) is higher than the Treasury yield; you should be invested in stocks and vice-versa.
The problem here is two fold. First, you receive the income from owning a Treasury bond whereas there is no tangible return from an earnings yield. Therefore, if I own a Treasury with a 5% yield and a stock with a 8% earnings yield, if the price of both assets do not move for one year - my net return on bond is 5% and on the stock it is 0%. Which one had the better return? This has been especially true over the last decade where stock performance has been significantly trounced by owning cash and bonds. Yet, analysts keep trotting out this broken model to entice investors to chase the single worst performing asset class over the last decade.
It hasn't been just the last decade either. An analysis of previous history alone proves this is a very flawed concept and one that should be sent out to pasture sooner rather than later. During the 50's and 60's the model actually worked pretty well as economic growth was strengthening. As the economy strengthend money moved from bonds into other investments causing interest rates to have a steadily rising trends.
However, as we have discussed in the past in "The Breaking Point" and "The End Of Keynsian Economics" as the expansion of debt, the shift to a financial and service economy and the decline in savings began to deteriorate economic growth the model no longer functioned. During the biggest bull market in the history of the United States you would have sat idly by in treasuries and watched stock skyrocket higher. However, not to despair, the Fed Model did turn in 2003 and signaled a move from bonds back into stocks. Unfortunately, the model also got you out just after you lost a large chunk of your principal after the crash of the markets in 2008.
Currently, you are back in again after missing most of the run up in the current bull cycle only most likely to be left with the four "B's" after the next recession ends - Beaten, Battered, Bruised and Broke.
The bottom line here is that earnings yields, P/E ratios, and other valuation measures are important things to consider when making any investment but they are horrible timing indicators. As a long term, fundamental value investor, these are the things I look for when trying to determine "WHAT" to buy. However, understanding market cycles, risk / reward measurements and investor psychology is crucial in determining "WHEN" to make an investment. In other words, I can buy fundamentally cheap stock all day long but if I am buying at the top of a market cycle I will still lose money.
As with anything in life - half of the key to long term success is timing. Right now, with virtually all of the economic indicators weakening and pointed towards recession, a lack of support by the Fed in terms of stimulus and a vast array of varied risks from credit downgrades, Eurozone issuers on the brink of default, valuations not extremely cheap and a breakdown of technical strength in the market - timing right now could not be worse for long term investors. Of course, this is all assuming that "The Bernank" remains silent on the next stimulus induced market rally...otherwise the game is changed temporarily.