Stock and Bond Valuations are a Warning to Investors
The last decade and a half rewarded investors with healthy stock and bond returns. But high valuations, low interest rates and high inflation are signals to reassess risk tolerance and asset allocations.
In his new, excellent book, Investing Amid Low Expected Returns, Antti Ilmanen showed that equities have performed best in “growth up and inflation down” periods and worst in opposite periods, while government bonds have performed best in “growth down and inflation up” periods. In my role as chief research officer at Buckingham Wealth Partners, I have noted a significant increase in investor concerns caused by: the much greater increase in inflation than either the Fed or the financial markets anticipated; the additional inflationary pressures created by the invasion of Ukraine; the large reduction in fiscal stimulus that was provided to mitigate the effects of the COVID crisis; and the Federal Reserve finally moving to tighten monetary policy (both by raising interest rates and reducing its balance sheet). The result is that investors are concerned about heightened risks to the economy, and to both equity and bond valuations – with many now worried about the dual risks of recession and inflation (stagflation).
With these concerns in mind, it is helpful to review what the financial literature has to say about the ability to predict crises. Then we will look at how the current situation relates to the indicators that provide predictive information.
Research, such as the 2021 study, “Predictable Financial Crises,” the 1997 study, “Leading Indicators of Currency Crises” and the 2009 study, “Credit Booms Gone Bust: Monetary Policy, Leverage Cycles, and Financial Crises, 1870-2008,” has found that rapid credit creation, money supply growth, asset price bubbles (especially in housing – booms in housing prices are one of the leading indicators of financial crises), investment booms, savings shortfalls, large capital inflows, low credit spreads, yield curve inversion and overvalued exchange rates inform the predictability of financial crises. The research also finds that late-stage indicators, such as rising real interest rates, incipient inflation, falling bank deposits, international reserve depletion and trade shocks, are useful predictors of crises. In addition, composite models, combining the individual leading indicators, produce superior crises forecasts. And finally, composite models could have predicted many major historical crises, including the global financial crisis (GFC) that began in 2007.
The economic theory behind the role of the credit cycle is that as credit expands, a positive-feedback process develops – credit growth promotes a rise in asset prices, speculation, capital inflows, investment and economic activity that eventually erupt in currency crises, banking crises and recessions. Economic theory also posits that low interest rates cause capital to be misdirected toward long-term investments that do not reflect the true intertemporal preferences of consumers. Low interest rates may enable investors to undertake marginal investment projects that would not otherwise be feasible. Furthermore, asset price bubbles send false signals that attract excessive amounts of capital to particular economic sectors. This is of particular importance given the extended period of exceptionally easy monetary policy implemented by central banks around the globe – with persistent negative real rates of interest. And finally, the theory and research demonstrate that rising real interest rates and inflation mark the final stages of the boom, with the end of the credit cycle marked by a sharp drop in the growth of credit, the initiation of a process of deleveraging and, in general, de-risking by investors.
With the economic theory and empirical findings in mind, we can consider the risks facing investors today. The period since the GFC has been characterized by at least several of the indicators of the increasing risk of financial crises:
- We have witnessed a boom in housing prices, as U.S. home prices grew 17.1% year-over-year (YoY) in December 2021 following an all-time record increase of 18.4% YoY in the previous quarter. Contrast that with the 2.1% rate of increase from 2009 through 2020.
- U.S. equity valuations are near record highs, with the Shiller CAPE 10 index at 36.31 (as of April 6, 2022), resulting in an earnings yield of just 2.75% – the earnings yield is the best predictor of future real returns for equities. And if you believe the high valuations were justified by low interest rates, you should also believe lower valuations should accompany rising rates.
- Equity markets saw signs of speculative excesses, with the meme stocks (stocks with a cult-like following), such as GameStop (GME), being the poster children. As another example, in late 2021 almost 70% of the stocks in the Russell 3000 Growth Index had negative earnings, yet growth stocks had far outperformed value stocks for several years as their valuations increased (repeating the performance of the dot-com era). As further evidence of speculative excess, in 2020 the U.S. IPO market boomed, with 165 operating companies going public, raising $61.9 billion. IPOs by a special purpose acquisition company (SPAC) set records. A total of 248 SPAC IPOs raised $75.3 billion, more capital raised than in all previous years combined. And SPACs, which are highly speculative investments, have a terrible history in terms of returns for investors who retain ownership once they are de-SPACed (merged with another company).
- The February Consumer Price Index increased YoY by 7.9%. At the same time, the Federal funds target rate was just 0.25%-0.50% and the 10-year Treasury bond was yielding just 2.68%.
- The Federal Reserve has announced that it not only expects to begin raising rates aggressively (Saint Louis Federal Reserve President and Fed board member James Bullard is calling for a fed funds rate of above 3%), but Federal Reserve Governor Lael Brainard stated that in order to reduce the upside risks of inflation, the Fed will begin as early as May to unwind at a rapid pace the massive stimulus created by its policy of quantitative easing (buying bonds), which repressed rates and resulted in the Fed’s balance sheet growing to about $9 trillion. The result could be that it will be selling off as much as $80-100 billion a month. That could put pressure on bond yields, just as quantitative easing repressed rates. And markets have never had to deal with such quantitative tightening. That has led many observers to question whether the Fed can engineer a “soft landing” while achieving its goal of reducing inflation to its target of 2%.
In 2013, when the Fed announced it would begin reducing purchases only at some future date (not selling bonds, just reducing the amount it was buying), the markets had what came to be called a “taper tantrum,” with bonds selling off sharply. The yield on 10-year U.S. Treasuries rose from around 2% in May 2013 to around 3% in December. That tantrum led the Fed to abandon its plan. At that time, the Fed’s balance sheet was only about one-third the size it is today, at about $3 trillion.
If you believe, as many do, that interest rates have been held down by the Fed’s policy of buying bonds, then it seems logical to believe rates will have to rise, not only because of the high level of inflation but because the Fed will be selling large amounts of bonds, removing liquidity from the market. In addition, if you believe the repression of interest rates led to investors increasing their tolerance for risks (to increase returns, as safe bonds were yielding zero or close to it), then you should believe the reverse will occur as the Fed tightens policy, putting pressure on not only bond yields but credit spreads and equity prices. At least, that risk must be recognized.
To suppress inflation, historically the Fed has had to raise interest rates well above the rate of inflation, creating positive real rates for the Fed funds rate. That is why Bullard and others have been calling for the Fed to raise the rate above 3%, and perhaps higher, if inflation remains above the Fed’s long-term policy objective of 2%. Raising short-term real rates to higher levels, causing yield curve inversions, has historically resulted in recessions, increasing equity and credit risks.
As if that isn’t enough to concern investors, especially those who shifted assets from safe bonds to riskier equities and riskier bonds, there is another geopolitical risk. The sanctions placed on Russia could lead China, and possibly other countries, to question the role of the U.S. dollar as the world’s main reserve currency, leading to a reduction in its holding of U.S. dollar assets. That could cause them to reduce their holdings of Treasuries and other U.S. dollar assets, putting further pressure on interest rates at the same time the Fed is selling bonds to reduce its balance sheet and raising the Fed funds rate. The dollar’s role as a world’s reserve currency allows U.S. interest rates to be lower than they otherwise would be. If there is a reduction in that role, that could put upward pressure on interest rates and have negative implications for the value of the U.S. dollar, which could also impact inflation (import costs rise).
Another concern, given that the globalization of supply chains helped to minimize inflation, the COVID crisis as well as the invasion of Ukraine demonstrate the risks to globalization. That has led to a move to reverse at least some of the reliance on international supplies. The move to bring production back to the U.S., while reducing risks to supply, will have negative impacts on inflation.
While the facts suggest that there is heightened risk of an economic recession, falling equity valuations and rising bond yields (a double whammy for the traditional 60-40 portfolio), there are some positives. Financial crises tend to be caused by problems in the banking system. Today, banks are in much stronger financial positions than they were in the period leading up to the GFC, with stronger capital positions and tougher lending standards in place. Also, having used the lower bond yields to refinance debt, corporations are in better financial shape. So too are consumer balance sheets, with debt-to-income ratios having fallen sharply (now at the lowest level since at least 1980), housing loans having been refinanced at much lower levels, and consumers sitting on large cash balances (an estimated $2.5 trillion). The result is that consumer net worth is at record levels. At the same time, unemployment is at historically low levels, with initial jobless claims falling to a 54-year low of just 166,000, and there are 1.8 job openings for each unemployed worker (this could put pressure on corporate profits going forward, a negative for equities).
While inverted yield curves have provided information as to future recessions and the yield (as of April 7, 2022) on the five-year Treasury (at 2.69%) is above that of the 2.64 yield on the 10-year, the yield curve at the short end is actually very steep, as the Fed funds rate is about 0.2%. And the predictive ability of curve inversions is stronger at the short end. Thus, there is a long way to go before the full curve inverts, and given all the positives mentioned, the risks of recession seem relatively low, at least for the remainder of this year and perhaps well into 2023 (unless the Fed has to tighten more than the market currently expects). The story is not at all one-sided.
Finally, the market knows everything we have been discussing and thus incorporates that information into current prices.
Unfortunately, uncertainty prevails when it comes to forecasting the economy and interest rates. If active managers were able to forecast accurately, they would be generating persistent outperformance. However, the evidence suggests they have been unable to time markets well. Thus, smart investors don’t try to time markets. They recognize that risks will show up from time to time, and they build an investment strategy that allows them to live through them with equanimity, avoiding panicked selling during tough times. That means taking no more risk than you have the ability, willingness or need to take. In doing so, instead of panic selling, you can rebalance, buying what has done poorly at now lower valuations and higher expected returns.
With that said, the academic evidence and my 25 years of experience as an investment advisor informs me that after long periods of strong performance, such as we have experienced since the GFC (interrupted briefly by the COVID crisis), many investors become complacent about taking risks. In addition, low interest rates have led many investors, especially those who take a cash-flow approach to investing (living off income and distributions), to take on more risk than they can stomach, replacing safe bonds with riskier bonds, dividend-paying stocks and other risk assets. If the risks show up, they will likely engage in panicked selling, from which it is notoriously difficult to recover (because there is never a green light telling you it is once again safe to invest).
My comments are not a forecast, just as a warning about possible outcomes. While the Federal Reserve’s goal is to achieve a “soft landing,” historically that has been difficult to achieve. Complicating matters is that it has never had to unwind a $9 trillion dollar balance sheet. In addition, the increase in the government’s debt-to-GDP ratio to well over 100% and now 12th worst in the world (rising interest rates increase the cost of that debt, putting more stress on the ability to finance it) creates further risks.
I hope that this discussion has helped make you aware of the risks so that you don’t treat what you think is unlikely as impossible. One way to address the risks we have discussed is to reduce your portfolio’s exposure to them – both equity and term risks. Alternative investments, such as reinsurance (e.g., XILSX, SHRIX and SRRIX), and long-short factor-based strategies, such as AQR’s Style Premium Alternative Fund (QSPRX), have little to no correlation with traditional stock and bond portfolios, providing diversification benefits at the same time they offer premiums for accepting their unique risks. In addition, fixed income investments that either eliminate or minimize term risk in the form of interval funds, such as CCLFX, CELFX and LENDX, offer large risk premiums related to their illiquidity as well as incremental credit risk – accepting that trade-off. Investors who are concerned about the issues discussed should at least consider them as a means of diversifying away the risks of traditional stock and bond portfolios. Other investments are available in private vehicles, such as drug royalties and life and structured settlements (CELFX has allocations to them), that also diversify away traditional stock and bond risks. These should be considered by those with access to such vehicles.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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