What Is Bad About The Top Of The Hill

By: Michael Ashton | Tue, Sep 14, 2010
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Bonds rallied again today, with the 10y note yield down to 2.66%. Stocks were higher for most of the day - again, at the same time as bonds - although they settled back to be mixed at the close. Commodities rallied again and gold set another record as the dollar dropped again. The greenback now has seen its worst 2-day decline in over a year. Inflation swaps were down a smidge (when yields fall, it is hard for inflation breakevens to head aggressively the other way repeatedly), but otherwise it sounds very similar to Monday's price action.

And my suspicions from yesterday, that this might be related to market intuition about the increasing likelihood of QE2, were partly confirmed. Goldman Sachs' Jan Hatzius (who is really good, and regular readers will know I rarely say that about an economist or strategies) said in a customer note that he sees QE2 coming, probably in November or December. I've said the same thing for a month or so. While the Fed doesn't care what I say, however, the fact that Goldman is projecting quantitative easing actually makes it marginally more difficult for it to happen since the Fed would prefer not to look like Goldman's lackeys (like, for example, the Treasury often does).

Not only did Mr. Hatzius write this, however; it was also picked up by the Wall Street Journal. So it isn't far-fetched to me to relate some of the recent market action to the hypothesis that QE2 is drawing nearer.

Retail Sales didn't make the case for quantitative easing any easier, as core Retail Sales was slightly above expectations at +0.6%. There are some signs from retail outlets that consumption might be recovering somewhat, but given the problems with seasonally adjusting economic data this year - since the historical seasonal patterns were not generated during a depression - I would not get overly excited about a small beat.

Inventories rose, and several recent inventory numbers have been modestly better-than-expected. I don't tend to focus on inventories because the answer to "is a rise in inventories good or bad" is "it depends." If inventories are rising "intentionally" because manufacturers see increasing demand, that's a good sign; if inventories are accumulating "unintentionally" then it means growth has disappointed and manufacturers will need to cut back on production. With the trajectory of growth in Q1-Q2-Q3, I would tend to suspect the latter, but I would never bet on it. I am mentioning it only because I want to make another point, and that is that lower interest rates cause the opportunity cost of inventories to be lower. Lower interest rates, combined with the prevalence of cash on defensive company balance sheets, means that 'investing' in bigger inventories for the insurance value of doing so isn't as costly. At the margin, this may tend to increase carried inventories.


Just for fun, let's suppose for a moment that the economy bulls are right and the world is pulling out of this contraction. You might think this would create a salutatory environment for equities: low interest rates, improving growth. The problem is that in such an environment, interest rates will not be staying low of course, especially as growing businesses compete with Treasury debt for funds. It isn't so much the level of interest rates that matter as it is the direction of rates. You may be standing on top of a sunny hill that offers many advantages, but all paths (at least in terms of interest rates) lead down the hill. Especially since growth is already mostly discounted, but higher interest rates are not, it would seem to me that growth which obviates the need for crisis-level interest rates would be bad for equities, not good.

Think about it this way. The Gordon Growth Model says that the fair price of an equity is D1/(k-g), where D1 is next year's dividend, k is the required return, and g is the expected long-term growth rate. Some people say that stocks are cheap because, essentially, k compares favorably with interest rates. This may presently be true. Right now the dividend yield of the S&P is right at 2%. Let's use 5.0% for g (2.5% real growth, 2.5% inflation); with SPX at 1121, this implies that k is 7.1% with 10y rates at 2.66%. That's a spread of 4.44%.

But what happens if near-term growth rises? Presumably, that shouldn't change the assessment of long-term growth very much, but what if 10y interest rates rose to, golly, 5% to be equal with the long-run nominal growth we assumed? Then stocks that are priced to deliver a return of 7.1% are going to look pretty expensive. If the spread between the bond yield and the required return on equities narrowed to a mere 4%, the SPX would be priced at 1121*2%*1.05 (D1) / (9%-5%) = 588.

Something between 588 and 1121 probably makes sense if we really are recovering a little, but unless we are about to experience a new Renaissance, I don't think the stock market is prepared for a repricing of competing assets.


If equities do need to reprice lower at some point, they will have to do so largely without traditional market-makers. An article on Bloomberg today suggested that the flash crash may have triggered an "oh rats[1]" moment at the SEC, which has abruptly realized that driving away the market-makers by removing their advantages means they also have no one to adopt the specialists' responsibilities, one of which was provision of liquidity (buying when no one would buy and selling when no one would sell). The rest of us would call this a "no rats,[2] Sherlock" moment. Here is hoping that they recognize this is exactly what the Volcker Rule is doing to the rest of the markets!


In other strange news today, Cisco initiated a dividend. This isn't strange; merely the timing is a bit strange since dividends are scheduled to lose their tax rate advantage in 2011. (This is in fact something I bite my fingernails about every day, since I give a lot of attention to dividend yield. These securities may well cheapen. I still prefer the margin of safety to something that doesn't have a cash flow, though). I guess timing like this helps to explains why Cisco, one of Cramer's former "Four Horsemen" of tech, has a 16 multiple.

The data calendar stays active tomorrow with Empire Manufacturing (Consensus: 8.00 from 7.10) at 8:30ET followed by Industrial Production/Capacity Utilization (Consensus: +0.2%/75.0%) at 9:15. Neither is a top-tier report, but as we get closer to decision time on QE2 even these lesser reports will begin to take on more gravity.


[1] Not the word I wanted to use.
[2] The same word, which makes no sense here. If you use the word I intended, though, both phrases make sense.



Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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