Cooler Than The Sun

By: Michael Ashton | Fri, May 18, 2012
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In the long run, the market is a weighing machine.

It is imperative to keep that bit of Ben Graham advice always in mind whenever you invest. Day traders can ignore whether the market is a weighing machine in the long run, since they just look at the "voting" patterns and go along with price action. But those of us investors who make moves more deliberately can best add to our performance by simply avoiding assets that are expensive, even if they may become more so, and overweighting assets that are cheap, even if they may become more so.

If you're a good market timer, then bless you - keep at it. But you have to be a pretty decent market timer to outperform a simple value investor in the long run. I do believe these market timers exist. I just don't believe as many of them exist as think they exist.

This preface is of course a lead-in to the observation that the decline in equities recently, including today's -1.5% slide, is anything but shocking. The dividend yield and price multiples, the Q ratio, the high margins that necessarily must be sustained to justify these levels - I've written about these. Stocks aren't as overvalued as they have been at times in the past, but they aren't a cheap asset. About the best thing you can say about them is that they're cheap to Treasuries, but that's like saying Venus must be a nice place to live because it's cooler than the Sun.

While the proximate trigger for today's whipping may have been the weak Philly Fed index, which fell (see Chart) to the lowest level since the odd spike last year versus expectations for an increase, the market has obviously been in retreat for a while. Moreover, the idea that there was a "payback" due after strong weather-related growth in the spring isn't exactly an epiphany.

Philadelphia Fed Business Outlook

And, though it's probably fair to say that almost everyone was surprised with how quickly the European situation unraveled again, the notion that the crisis was probably not over was a reasonably widely-held belief. Interest rates are low, which means you don't gain much value to an investment by pushing the date of a negative cashflow further out...which is to say, whether Europe was going to implode in 2012 or 2013 or 2014 shouldn't have colored your view of fundamental equity value very much. Only if you thought it was not going to implode should the value have changed significantly...but many of us essentially decided to be market-timers anyway, figuring we could always exit stocks before the mess started up again.

This sounds like 'tough love,' and maybe it is. I should be more sensitive to those of us - and of course it's most of us - who are nursing our losses right now. I am long some equities, and though my market exposure is pretty flat because of put options I own, it isn't fun to watch your stocks decline.

But if you're a long-term investor, 8% from the highs shouldn't bother you anyway. If you're young, and have a lifetime of net investing into the market, you should be cheering for a 50% decline so you can invest in cheap companies! So buck up, it's not so bad, yet. And stocks might turn around and rally tomorrow and set new highs in a week. All I am saying is that the likelihood of those highs being sustained for a year are pretty small.

The same value observation applies to other assets. In general, when something has gone up for a long time, you want to own less of it, not more - so 10-year Treasuries at 1.70% should not have you rushing to buy more (and if you own long-dated Treasuries, you shouldn't own as many now as you did a week ago)!

The Treasury auctioned $13bln in 10-year TIPS today, though, at a record yield of -0.39%. What is more, the bidding was very strong, with a 3:1 bid-to-cover ratio and the awarded price was well through the market. Market participants were amazed at the strong bid for a harshly negative real yield, but why? The 10-year nominal Treasury has an implied real yield, based on 10-year inflation expectations extracted from inflation swaps, of -0.77%. Inflation 'breakevens,' which approximate the amount of inflation required to break even owning TIPS rather than nominal Treasuries, are around 2.1% and core inflation is at 2.3%. Historically, that doesn't happen very much (see Chart).

10-Year versus CPI

It is unusual to compare current core inflation to 10-year inflation breakevens, but the rationale for doing so is this: if current inflation is at the same level, or higher, than the 'breakeven' number, then you are essentially "carrying" the inflation option for free. When you own TIPS rather than Treasuries (at least, at low levels of inflation like we have now), you want to consider both the expected level of inflation over the holding period as well as the range of possible outcomes for inflation. When inflation is low so that most of those "tail events" are higher inflation, then you should be willing to pay a bit more than your true expectation, because all of the crazy things that can happen are good for you. That's essentially an "option value" to owning TIPS over Treasuries.

When the breakeven you are buying is far above current levels of inflation, then you're losing a little bit on that bet every day - like time decay on an option. But when the breakeven you are buying is below the current level of inflation, you are getting the inflation option with free carry.

So I am not at all surprised that buyers lined up to buy $13bln of TIPS. After all, many accounts must own fixed income (I am not one of them, which is why I own neither TIPS nor Treasuries at the moment). What I am surprised about is that buyers keep lining up to buy nominal Treasuries at this level. Those buyers are lining up to book a vacation to the Sun. H

I hope they bring enough sunblock. Because I think they might get burned.



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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