Value as an inflation bet.

Value as an Inflation Bet

 I really liked this post by Lawrence Hamtil on value as an inflation bet. He touches on an old William Bernstein post discussing the relationship between inflation and the value factor. It makes sense if you think about it – growth stocks become increasingly predictable when inflation is low because the variance in cash flows is reduced. This makes value stocks relatively less attractive. So value is a more stable strategy when inflation is high because growth cash flows become more variable.

Stock Buyback Blackout Months.

January, April, July and October have lower repurchase rates because for the 1 month before an EPS report companies are not allowed to repurchase their stock.  This reduced demand can potentially exacerbate volatility in those stocks.

The Best Suboptimal Strategy

being able to execute your plan or strategy is more important than find a perfect strategy because most of the time people are terrible at following their plan.  

“a suboptimal strategy that you can execute is better than an optimal strategy you can’t execute.”

A decent sub optimal strategy is to just own the market over any 7 year period.  The dividend adjusted nominal SP500 return has been positive over basically every 7 year period

http://www.simplestockinvesting.com/SP500-historical-real-total-returns.htm

However, inflation adjusted returns have a few 7 year periods that under performed.  The main question to consider in your sub optimal portfolio is how cheap or expensive the market is compared to 5 year T-notes. About 90% of the time markets will outperform the notes.  If you're young put every dollar that you don't need into the SP500 unless the market is in the upper 2nd standard deviation of DCF using Sp500 expected earnings compared to 5 year T-notes.  

Rate hikes and how they've affected market historically:

Four phases of monetary policy

In a recent report by Bank Credit Analyst (BCA) Research they highlighted the four phases of a monetary policy cycle based on the interaction between the level of rates and their direction. Policy is deemed to be easy if the fed funds rate is below its equilibrium level (Phases I and IV), and tight if it's above that level (Phases II and III). You can see the four phases, and the accompanying stock market performance, in the table below.

Source: BCA Research Inc. *Table excludes Phase III (July '95 to September '98) and Phase IV (April '01 to May '04) incidences distorted by the dot-com bubble. If they were included, Phase III's mean and median CAGRs (compounded annual growth rate) would be -4.4% and -1.1%, respectively, over 7 incidences and Phase IV's would be 20.3% and 9.2% over 9 incidences. The 2-month Phase II incidence spanning the October '87 crash (-80% CAGR) has also been excluded.

We have been in Phase IV since January 2008 and will remain there until the first rate hike. As noted by BCA, the durations of Phase IV and Phase I are significant because the level of rates (easy or tight) has trumped their direction (lower or higher) when it comes to explaining S&P 500 returns. In fact, all of the stock market's returns in the past 50-plus years were achieved when monetary policy was easy.

Neutral / Equilibrium fed funds level, not a fixed number but a non-dampening/ non-stimulative rate.  Estimated at 3.5 - 5.5% fed funds rate
https://www.frbsf.org/education/publications/doctor-econ/2005/april/neutral-monetary-policy/

Pullbacks have been mild historically

It is common to experience some volatility and initial pullbacks when moving toward the initial rate hike. In looking at the past five rate hike cycles, the average pullback—nearly always having concluded before the actual first hike—was less than 6%, therefore not even qualifying as a "correction," which is -10%. The magnitude of the pullback was directly tied to the magnitude of the back-up in two-year Treasury yields. So keep an eye on those as we approach the initial rate hike.

Dot plot

2/2018 still in Phase 1, easy / hikinh mode

fred.stlouisfed.org/series/FEDFUNDS  2/2018 = 1.42%

Fed Funds Rate

www.bloomberg.com/graphics/fomc-dot-plot/       2/2018 =     2.75%

Equilibrium Level

Ray Dalio Linked in post:
https://www.linkedin.com/pulse/its-all-classic-main-questions-timing-what-next-downturn-ray-dalio/

In the “late-cycle” phase of the short-term debt/business cycle, when 
a) an economy’s demand is increasing at a rate that is faster than the capacity for it to produce is increasing and 
b) the capacity to produce is near its limits, prices of those items that are constrained (like workers and constrained capital goods) go up. 
At that time, profits also rise for those who own the capacities to produce those items that are in short supply. Then the acceleration of demand into capacity constraints and rise in prices and profits causes interest rates to rise and central banks to tighten monetary policy, which causes stock and other asset prices to fall because all assets are priced as the present value of their future cash flows and interest rates are the discount rate used to calculate present values. That is why it is not unusual to see strong economies accompanied by falling stock and other asset prices...

What we do know is that we are in the part of the cycle in which the central banks’ getting monetary policy right is difficult and that this time around the balancing act will be especially difficult (given all the stimulation into capacity constraints and given the long durations of assets and a number of other factors) so that the risks of a recession in the next 18-24 months are rising. While most market players are focusing on the strong 2018, we are focusing more on 2019 and 2020 (which is the next presidential election year). Frankly, it seems to be inappropriate oversight to not be talking about the chances of a recession and what that recession might look like prior to the next election.

the bond market is, after all, a fairly short-term instrument with an aggregate average maturity of 8 years and an effective duration of 5.7 years.

Yield spread suggests diminished odds of a recession in the next 12 months

All yield spreads calculated as 10 year less 3 month yield except Mexico (5 year less 3 month).

Historical time period begins: U.S. 1967, Eurozone 1970, Germany 1970, UK 1970, Sweden 1970, Mexico 2000.

VIX Term Structure

Why are Treasury Bonds the Ultimate Safe Haven?

The last 10 years have exposed a very important reality for any global asset allocator – US Treasury Bonds are the ultimate safe haven investment.  For decades we have heard stories about how gold, silver, real assets or other types of financial instruments would serve as the “safe haven” investment during times of crisis.  Many of these stories were based on mythical ideas about the coming collapse of fiat money or the bankruptcy of the US government.  There have also been endless discussions about the coming collapse of the T-Bond market due to a “bond bubble” or the end of QE. But every time the global economy encounters a hiccup it is T-Bonds that investors demand.

Tadas Viskanta wrote a very good piece about how T-Bonds tend to perform well during times of market uncertainty, but I wanted to take a more operational approach because I think this can be explained in a very simple way.  Importantly, running performance backtests doesn’t help us much here because the global economy is dynamic and the current state of T-Bonds as a safe haven is something that is not guaranteed to persist simply because it has been true in the past.  Byunderstanding the modern monetary system and taking a more operational perspective we can better understand why T-Bonds are so unique within the global economy.

The primary reason that T-Bonds are the world’s financial asset safe haven is a function of the US government’s tremendous revenue stream.  With the USA generating 22% of global output the US government has the ability to tax more output than any other safe haven entity.  In short, the US government has the largest high quality income stream in the global economy.  Interestingly, the US government is the only entity in the world that issues a liability that is attached to such a large and reliable income stream.  China, for instance, issues bonds, but we can’t trust their economic data let alone the financial instruments they issue. Europe would be the US equivalent except for the fact that they don’t issue a supra-national liability.  Instead, each country within the EMU issues its own liabilities and the safety of those individual liabilities has come under serious question in the last few years.

The main point is quite simple though.  When people want to protect their financial assets they can’t, in the aggregate, “get rid of them” so they necessarily deviate to the largest high quality income generating entity in the world.  For the investor who properly weighs their risks between maintaining purchasing power and permanent loss risk the T-Bond becomes the obvious choice since it provides you with safety characteristics similar to cash, but protects you against inflation better than cash.  But most importantly, it gives you access to the largest high quality income generating liability issuer in the global financial system.  This could change going forward and very likely will at some point, but for now, this remains an operational reality resulting from the USA’s unique position as the highest quality output producer with a federal government that can generate income from that underlying output.

When does overvaluation matter?

• High valuations lead to large stock market declines during recessions.
• During secular bull markets, modest overvaluation does not produce large stock market declines.
• During secular bear markets, modest overvaluation still produces large stock market declines.

Using shorter term time frames, what matters more to stock prices is macro-economic and earnings momentum. Macro Man recently created a simple model that regressed retail sales, industrial production and durable goods, ex-transportation, to the stock market. The fit is remarkably good.

This got Macro Man to thinking.   Retail sales, like the SPX, are very comfortably above pre-crisis highs, IP is marginally so, and orders are basically at the level.   What would happen if we regressed these 3 series against the SPX?  The results are set out in the chart below.

To mitigate the impact of leverage, Macro Man ran the same regression, but on the natural log of the SPX to smooth the swings in stocks relative to the economy.  Upon obtaining model output, it was a trivial matter to reconvert the data back into SPX terms.  The results of this study are below.

Here is what we will need to see in the data to confirm a change in market trend has commenced:

1. More new lows than new highs
2. New low daily readings registering triple digit figures, consistently
3. The NH-NL differential must turn negative
4. The 10-d and 30-d average differentials must go negative (this is essentially the first sure sign that the market is changing direction – especially the 30-d diff.).
5. Differential readings start registering figures larger than -300, -400, -500+.

March 2013 NH-NL Readings for NYSE:

1. NYSE New Highs: The number of stocks making New Highs on a specific date
2. NYSE New Lows: The number of stocks making New Lows on a specific date
3. New High –New Low Differential: This is simply the number of stocks making new highs minus the number of stocks making new lows.
4. NH-NL 10d Diff: This is a simple 10-day moving average representing the number of stocks making new highs minus the number of stocks making new lows.
5. NH-NL 30d Diff: This is a simple 30-day moving average representing the number of stocks making new highs minus the number of stocks making new lows.
6. NH-NL % Ratio: To calculate the percentage correctly, use this formula: (New Highs – New Lows) / (New Highs + New Lows) * 100 = X%
7. NH-NL % Ratio 10d Ave: This is a simple 10-day moving average representing the percentages listed in the column terms #6 in this list

• It can take many months for the top to form.  In 2007 it took 10 months.  the 30wk MA and 40wk MA were broken and the market could not recover them.

 Specifically, anyone who engaged in the simple "even" strategy of buying the stocks of the S&P 500 on the day before a Fed policy announcement, selling them a week later, then buying them again the following week and sticking with the pattern until the subsequent Fed meeting generated a whopping 650% return since 1994, far outperforming the inverse "odd" strategy which shocking had a negative return over the past two decades years

How to piggyback on institutional buying:

Phase One  - apply my “Permission to Buy” filters to the broad market indexes.  If I get a green light there continue;
Phase Two - ascertain which of the nine S&P sectors is outperforming the market.  
Phase Three  - focus on the top industries that comprise the leading sector.  Once I have identified the top two industries, 
Phase Four -  identify the individual stocks that are the leaders within those industries.  These are the equities that institutional money managers have identified as “great ideas” and where they are committing their investable dollars.

3/31/1960 - 12/31/2011
Y/Y% Change in Real GDP

Y/Y % Change in Real GDP	SP500 Annualized Gain
> 6.0	-4.60%
.5 - 6.0	7%
< 0.5	10.50%

Liz Ann Sonders Analysis of when to buy stocks vs GDP.  

Leading Indicators are:

Avg Workweek

Initial Unemployment Claims

ISM New Orders Index

New Orders: Non-defense Capital goods excl aircraft

Leading Credit Index

Interest Rate Spread

Avg Consumer Expectations for Business & Economic Conditions

Don't mix up facts and opinions
The Reformed Broker:
This business is not about making calls and sticking with them for the sake of being able to say you were right all along, it is about processing new information that will make a difference and dropping the opinions that have been invalidated.  I come to work every day hoping I’ll be able to do that.  It’s easier to write about than to actually do.  Is your decision making process flexible?  Are you hung up on what “should happen” rather than what is likely to happen?


Barry Ritholtz
I know my job is to look out over the world and assess where opportunity and risk lay. I can critique people’s analytical errata all I want on the blog all I want but that is merely a mental exercise — not what I actually get paid for. Clients do not give their hard earned cash to managers who are the most acerbic critics of fill in the blank; rather, they go to money managers who know how to navigate around whatever it is that is driving asset prices. And these days, that is the FOMC. “Critique the Fed but manage your assets” is the monetary policy equivalent of “Praise the Lord and Pass the Ammo.”

Twitter and Google trends is mostly search related to retail traders.  Since the majority of retail traders do not short, they typically only buy.  It has been proven that a spike in interest w/ retail traders will cause them to buy those stocks.  However, after the interest dies down, the stocks typically fall about 5% / year on average.

After a show like mad money recommends a stock to buy, especially a small cap stock, if it is mostly uninformed buying, the stock will go down after.  This is a lucrative shorting entry point.

Prospect Theory - based on the way a problem is framed ( make X amount vs I will loose X amount), different outcomes are chosen.

Since people are loss averse, a loss the same size as a gain has a much greater affect (Prospect Theory).  Also the prospect of a small loss vs a large gain is undesirable (myopic loss aversion).  So if presented an opportunity that was favorable, it would not be taken because of this (Equity premium puzzle - stocks have outperformed bonds but standard economic theory says that .  However framing the question differently may lead to taking that risk (ie: thinking in another language led to better results because less emotional bias was used in deliberation)

how much equity to invest during a decline, if you want to be fully invested after a 50% sell off

decline	equity to invest	start equity	equity after decline	% of original equity invested
2.5	2	100.0	98.0	2%
7.5	10	97.9	88.1	10%
12.5	17	87.6	72.7	15%
20	28	71.4	51.4	20%
35	42	47.2	27.4	20%
50	100	21.1	0	21%

Since 1928 there have been 294 pullbacks of at least 5%.  

94  (>10%)

43  (>15%) 

25 (>20%) bear market

So in a statistical sense once you hit the 5% threshold your chances of a 10%, 15%, and 20%+ drop are as follows:

10%: 32.0%

15%:  14.6%

20%+: 8.5%

According to TPC expansion contraction model, no recession 2012, but risks increase in 2013 greatly.

• Deficit according to CBO estimate will decline from $1.08T to $585B = domestic private surplus will shrink 2% assuming current account remains at $400B (currently at 5%)
• Private sector household debt accumulation is at 2.9% yoy.  This is good, but consumer credit, and total loans at commercial banks need to improve
• Policy makers have extended bush taxcuts until to 1/2013, and enactment of mandatory spending cuts on 1/2013.  These could be changed which will increase deficit
• If everything stays the same 12Q3 will start showing economic contraction, leveling off at -1.5% in 2013.