The following article was originally published at The Agile Trader on Sunday, March 5, 2006.
Dear Speculators,
The most interesting chart to my eye at the moment is this one.
The yield on the 10-Yr Treasury Note is making noises like it wants to breakout of a 19-month trading range (4% - 4.5%) and challenge its 2004 highs in the 4.9 - 5% area.
A move higher in long-term rates, should it occur and sustain, presents a complex matrix of implications.
On the one hand, with short-term rates now at 4.5% and likely to head higher this spring, there would be no place left on the curve where money would be really cheap to borrow. Pretty cheap, yeah, but not really cheap. Put differently, that would tighten monetary conditions and could slow aggregate consumption (final demand).
On the other hand, the Yield Curve (for our purposes the difference between the yield on the 10-Yr Treasury Note and the Fed Funds Rate) could steepen or at least remain flat, avoiding the inversion so much discussed in the financial media.
Indeed this Yield Curve (blue line above) widened to +0.18% last week, up from a low of +0.06%, providing at least some preliminary support for the idea that the market's PE could perhaps begin to expand rather than continuing to contract (or at least stop contracting).
That said, one has to wonder whether the nascent breakout in the 10-Yr Yield isn't perhaps a function of a US Dollar that is starting to weaken.
With the US Dollar Index having broken the lower limit of its rising wedge (and then having rallied to kiss that lower limit goodbye before again dropping below 90), it's possible that rising bond yields are less a function of renewed optimism about the US Economy and more a function of a waning interest in all financial paper that's dollar denominated.
And if that's the case then the risk arises of a somewhat less robust interest on the part of foreign investors to finance US deficits of a variety of kinds: US Government, US Trade Deficit, US Consumer's mortgage debt, you name it. What has been the self-reinforcing strength of "riskless" US assets (high price, low yield of long-term Treasuries) could unwind itself in a hurry if foreign investors perceive a decrease in "risklessness" (increase in risk) carried by the currency itself. And a mass flight from this asset class could itself develop a repellant sort of magnetic charge that expresses itself as a frenzy to exit, driving longer-term rates higher than expected.
The risk, of course, is that the debt-fed consumption party in the US economy would run into the brick wall of "no place to borrow cheap," leaving consumers no place to hide from the nasty "morning after" that follows binge partying.
"Ah," says apologist for our finance-based economy, "support for the US Consumer's consumption will come from new-found income growth engendered by a rebounding jobs market." But let's take a look at what that really amounts to.
Economist Paul Krugman, professor of Economics and International Affairs at Princeton University and Op-Ed columnist for the NY Times writes: "The 2006 Economic Report of the President tells us that the real earnings of college graduates actually fell more than 5 percent between 2000 and 2004." And that's the group that's supposed to be benefiting the most from the transition to a knowledge-based economy!
Krugman continues, talking about a new research paper by Ian Dew-Becker and Robert Gordon of Northwestern University, "Where Did the Productivity Growth Go?"
Between 1972 and 2001 the wage and salary income of Americans at the 90th percentile of the income distribution rose only 34 percent, or about 1 percent per year. So being in the top 10 percent of the income distribution, like being a college graduate, wasn't a ticket to big income gains.
But income at the 99th percentile rose 87 percent; income at the 99.9th percentile rose 181 percent; and income at the 99.99th percentile rose 497 percent. No, that's not a misprint.
Just to give you a sense of who we're talking about: the nonpartisan Tax Policy Center estimates that this year the 99th percentile will correspond to an income of $402,306, and the 99.9th percentile to an income of $1,672,726. The center doesn't give a number for the 99.99th percentile, but it's probably well over $6 million a year.
While aggregate real income gains may be at least modestly healthy in the US, the distribution of those gains is so increasingly lopsided as to pose a real threat to final demand once the debt bubble pops. With interest rates now showing signs of starting to rise across the Curve, "dawn" of the "morning after" could be coming sooner than many expect.
The problem with a "steepening yield curve" that's created by rising long-term rates, rather than by falling short-term rates, is that it functionally tightens monetary conditions, and indeed it can be considered a "bearish steepening."
In this context our Risk Adjusted Fair Value target for the SPX has begun to fall.
Indeed there is only a 6-point spread between our RAFV target and the SPX price. This RAFV price is derived by
RAFV = SPX F52W EPS / (TNX + Median ERP)
Where:
RAFV = Risk Adjusted Fair Value
F52W EPS = the consensus of Forward 52-WeekEPS for the SPX ($85.81)
TNX = 10-Yr Treasury Yield
Median ERP = Median Post-9/11 Equity Risk Premium (whereERP is the difference between the SPX Forward Earnings Yield and the 10-Yr TreasuryYield).
In this case: $85.81 / (.04684+.0195) = 1293.
What this convergence of the red and blue lines above is telling us is that the market is about as sanguine about risk as it has been on average since 9/11. And that any significant further upside would have to be motivated either by prospects for accelerating earnings growth or by a diminution of perceived risk.
Given that Crude Oil is trading smack in the middle of its recent range of $58-$68, it hardly appears that the perceived risk is diminishing. And given this chart...
...we continue to perceive a high degree of risk to the stock market for the period between now and October.
Of course, a durable breakout over SPX 1300 (one that survives tests down to that level and shows some upside resilience following those tests) would force us to alter our view and "go with the flow" of the "tape." COULD there be a very "soft landing?" Sure there could. But we regard that as the less likely scenario.
Absent a durable breakout of the SPX over 1300, we will continue to anticipate that the Fed will not ease up on raising short-term rates until something big in the economy is broken in some obvious sort of way.
We expect such a break to occur between now and the fall of this year. We don't know what it will be, but we'll know it when we see it.
Best regards and good trading!
