I haven't written in a few weeks. It has been, generally, a fairly boring few weeks in terms of market action, with inflation breakevens oscillating in a narrow range and equities also fairly somnolent. But I can't blame my lack of posts on a lack of interesting things to remark upon, nor on March Madness, nor on New Jersey Transit (although each of these is a very valid excuse for the general lackadaisical nature of trading in recent weeks). In my case, I plead business exigencies as we are working on a few very exciting projects, one of which I expect to be able to announce in the next week or two.
But writing a blog post/article is never far from my mind. I've been doing it for far too long - since the '90s if you count the daily letters I wrote for client distribution when I was on Wall Street - and when I haven't written something in a while it is a bit like an itch on the sole of my foot: I am constantly being reminded about it and the only way to make it stop is to rip the shoe off and scratch. Which tickles. But I digress. What I mean to say is that I have a long list of things I've written down that I could write about "if I have time this afternoon," and it's only the lack of time that has stopped me. (Some of these are also turning into longer, white-paper type articles such as one I am writing right now estimating the cost of the "Greenspan Put.")
Some of these ideas are good ideas, but I can't figure out how to address my hypothesis. For example, I suspect that inflation swaps or breakevens, now that they are near fair value for this level of interest rates, have some component in them right now that could be interpreted as the probability that the Border Adjustment Tax (BAT) eventually becomes law. If the BAT is implemented, it implies higher prices, and potentially much higher depending on the competitive response of other countries. If the BAT fails, then breakevens may not set back very much, but they should decline some; if the BAT looks like it is fait accompli, then inflation quotes could move sharply higher (at least, they should). But prediction markets aren't making book on the BAT, so I don't have a way to test (or even illustrate) this hypothesis.
But enough about what I can't do or won't be doing; today I want to revisit something I wrote back in December about the stock market. In an article entitled "Add Another Uncomfortable First for Stocks," I noted that the expected 10-year real return premium for equities over TIPS was about to go negative, something that hadn't happened in about a decade. In fact, it did go slightly negative at the end of February, with TIPS guaranteed real return over ten years actually slightly above the expected (risky) real return of equities over that time period. At the end of March, that risk premium was back to +3bps, but it's still roughly the same story: stocks are priced to do about as well as TIPS over the next decade, with the not-so-minor caveat that if inflation rises TIPS will do just fine but stocks will likely do quite poorly, as they historically have done when inflation has risen.
But I got to wondering whether we can say anything about the current market on the basis of how far stocks have outperformed the a priori expectations. That is, if we made a forecast and a decade goes by and stocks have shattered those expectations, does that mean that the forecast was bad or that stocks just became overvalued during that period so that some future period of underperformance of the forecast is to be expected? And, vice-versa, does an underperformance presage a future outperformance?
The first thing that we have to confess is that the way we project expected real returns will not produce something that we expect to hit the target every decade. Indeed, the misses can be huge in real dollar terms - so this is not a short-term or even a medium-term trading system. Consider the following chart (Source: Enduring Investments), which shows the difference of the actual 10-year return compared with the a priori forecast return from 10 years prior. A positive number means that stocks over the period ending on that date outperformed the a priori forecast; a negative number means they underperformed the forecast. In context: a 5% per year miss in the real return means a 63% miss on the 10-year real return. That's huge.
What you can really see here is that stocks have - no surprise - very long 'seasons' of bear and bull markets where investors en masse are disappointed with their returns, or excited about their returns. But let me update this chart with an additional observation about real yields. During the period covered by this chart, there have been three distinct real yield regimes. In the 1960s and 1970s, real yields generally rose. In the late 1970s, 10-year real yields rose to around 4.25%-4.50%, and they didn't begin falling again in earnest until the late 1980s. (This is in contrast to nominal yields, which started to fall in the early 1980s, but that was almost entirely because the premium for expected inflation was eroding). Between the late 1970s and the late 1980s, real yields were more or less stable at a high level; since the late 1980s they have been declining. In the following chart (Source: Enduring Investments), I've annotated these periods and you may reasonably draw the conclusion that in periods of rising interest rates, stocks underperform a priori expectations in real terms while in periods of falling real interest rates, stocks outperform those expectations.
These rolling 10-year rate-of-change figures are interesting but it is hard to see whether periods of outperformance are followed by underperformance etc. It doesn't look like it, except in the really big macro picture where a decade of outperformance might set the stage for a decade of underperformance. I like the following look at the same data. I took the a priori 10-year real return forecast and applied it to the then-current real price level of the S&P 500 (deflated by the CPI). That produces the red line in the chart below (Source: Enduring Investments). The real price level of the S&P is in black. So the red line is the price level forecast and the black line shows where it ended up.
As I said, this is not a short-term trading model! It is interesting to me how the forecast real level of equities didn't change much for a couple of decades - essentially, the declining market (and rising price level) saw the underperformance impounded in a higher forecast of future returns. So the "negative bubble" of the 1970s is readily visible, and the incredible cheapness of stocks in 1981 is completely apparent. But stocks were also cheap in real terms in 1976…it was a long wait if you were buying then because they were cheap. Value investing requires a lot of patience. Epic patience.
However, once equity returns finally started to outpace the a priori forecast, and the actual line caught up with the forecast line, the market leapt higher and the twin bubbles of 1999 and 2006 are also apparent here (as well as, dare I say it, the current bubble). But since the forecast line is climbing too, how bad is the current bubble? By some measures, it's as large or nearly as large as the 1999 bubble. But if we take the difference between the black line and the red line from the prior chart, then we find that it's possible to argue that stocks are only, perhaps, 30% overvalued and not as mispriced even as they were in 2006.
This may sound like slim solace, but if the worst we have to expect is a 30% retracement, that's not really so terrible - especially when you realize that that's in real terms, so if inflation is 3% per year then you're looking at a loss of 10-15% per year for two years. That's almost a yawner.
On the other hand, if we are entering an up cycle for real interest rates, then the downside is harder to figure. In the last bear market for real yields, stocks got 60% cheap to fair!
None of this is meant to indicate that you should make major changes in your portfolio now. If all of the evidence that stocks are rich hasn't caused you to make alterations before now, then I wouldn't expect this argument to do it! Rather, this is just a different rationality-check on the idea that stocks are overvalued, and my words could actually be taken as soothing by bulls. The chart shows that stocks can be overvalued, and outperform a priori expectations that incorporate valuation measures, for years, even decades. Maybe we're back in one of those periods?
But we have to go back to the very first point I made, and that's that if you don't feel like betting the 30% overvaluation is going to get worse, you can lock in current real return expectations with zero risk and give up nothing but the tails - in both direction - of the equity bet. The equity premium, that is, is currently zero and stocks are additionally exposed to rising inflation. I see nothing tantalizing about stocks, other than the possibility that the downside is perhaps not as bad as I have been fearing.
Administrative Note: Our website at EnduringInvestments.com is about five years overdue for a facelift. We are currently considering how we want to change it, the look & feel we want, and the functionality we desire and require. If you have a suggestion for something you think would be helpful for us to include, please let me know. (Note that this is not a solicitation for web design services so please do not ask! We have picked a firm to do that. I'm just curious what customers and potential customers might want.)