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The BondBeat Friday, September 22, 2017

See GP disclaimer HERE

 Yonhap: N.K. leader warns Trump of 'highest-level' actions over his U.N. speech

 RTRS: China's central bank tells banks to stop doing business with North Korea: sources  BBG: Europe's Economy on Track for Best Quarterly Growth Since 2015  BBG: Traders Have Thrown in the Towel on U.S. Deflation Bets  BBG: The New Fed Team Will Inherit Inflation Miss That’s Mystifying Yellen  BBG (9/20th): Bond Traders Smash Yield Curve Flatter on Fed Inflation Mystery

 @stevefeiss: Japan BUYING ‘Foreign Debt’ – 2wks in a row!!  BBG: U.S. Household Wealth Rises $1.7 Trillion to Another Record  BBG: Japan's Central Bank Keeps Policy Unchanged Amid Unexpected Dissent

 BBG: BOJ Masters Yield Curve But Inflation Failure Draws Critics Quick (& clickable) Links:

Items Of Interest Bloomy/EconODay Calendar

GP Documents:

- Econ Indicators - 5yr & Under - ML Index Spreads

- Pivots (end of TECHs)

POSITIONS UPDATES

TICS UPDATE: China BUYS (holdings near 1yr HIGH), Japan BUYS MOST In 4yrs; Foreign PRIVATES BUY!!

StreetStuffWkly 09.18.17

StreetStuff 09.22.17 Technicals 09.22.17

What Happened Overnight Fri 9/22/2017 5:05 AM Morning. USTs leaning into the GREEN as 5s30s hover at local / YTD lows (just south of 92bps) as risk offered (but coming back from o/n kneejerk lows in reflex TO NK h’lines). WTI over $50 into weekend (n)OPEC meetings – will they/won’t they XTEND cuts? USDJPY and EURUSD are worth watching/noting TOO for impact on US RATES. Many moving parts – as always – and this mornings techs.pdf greet you w/visual of 10s (DAILY, 5yrs) highlighting 233dMA HAVING HELD (2.29). Watching this level into the weekend – I’ve ALSO incl visual of 5s30s which flirts with 2017 LOWS – I’m CERTAIN there’s NO message TO the markets there … AND with ONLY IHS/Markit PMI data here in the US today, (COMPOSITE was 52.8 and is expected to rise TO 53) on heels of YUUUUUGE German data print ahead of elections there this weekend…we’ll clearly all be subject TO ‘ROCKETMAN’ commentary and watching OTHER MARKETS for guidance…stocks ‘over there’ STEADY (WEI) and rates TOO on what appears to be muted (futures) volumes so far….have a great start to the day and end to the week…

What’s On OUR Minds Today is mostly for catching UP thru the inbox and seeing the sell-side take victory laps about what happened Wednesday -- at least for US here. It is with that in mind, we are getting around to hitting SEND a bit later than normal and for that we apologize. It is ALSO with that in mind, we’ll TRY and be brief and CONTINUE to let all this sink and settle in … we DID manage to cobble together some updated TECHS -- sent along at O’Dark Thirty to a few (if not on THAT list and would like to be, say the word) … 10s so far HOLDING vs 233dMA (2.29) and so we’ll watch THAT level closely in to the close. On today’s TECHS you’ll ALSO note a cursory CURVE visual -- our preferred method is to look at 5s30s and have used BBG to etch in a regressed trend which says to US the nominal spread level is about in the MIDDLE of its current FLATTENING TREND. Make as much or little as you’d like but KNOW that we’re keen on re-circulating and thinking about what it is Wells has had to offer over the past several days/weeks … we’ve spoken about it and passed along in recent past and so will NOT labor the point -- much more than we already have. CHART OF DAY back on TUESDAY the 19ths NOTE, “...Today’s chart: ripped FROM pages of Wells report on model predicting RECESSION (2018 or 2019) “… The FOMC raised the fed funds rate in December 2015, the first time in the post-Great Recession era, so the first condition of our framework is fulfilled—a rising fed funds rate environment. The 10-year yield hit 1.36 percent on July 5, 2016, which is the lowest level in this cycle (Figure 3). Therefore, two conditions of the threshold framework are satisfied. The current level of the fed funds rate is 1.25 percent, which is lower than the 1.36 percent 10-year yield.7 …” NEXT STOP -- RECESSION??!!”

That was THEN and this is here and now … dig DEEPER thru WELLS offerings, though and you will ALSO stumble on this, back on the 8th, “Do we need to wait for a yield curve inversion to predict a recession? No….” Moving on then … to a couple more things on OUR minds -- things that aren’t the be all END all of thought process but that we saw and keep us funTERTained as well as on the hook in CONTINUING TO LIKE FI AND THINKING RATES LOWER FOR LONGER DESPITE WHAT WE NOW KNOW WILL BE A SepTAPER to remember. FIRST … you prob saw this BVIEW referencing JPM?? Fed Have You Down? JPMorgan Has a Pick-Me-Up …The firm's strategists noted in a research report that, in many ways, the rally in equities helps explain the surprising positive performance of bond markets. That's because the more stock prices appreciate, the more investors need to buy bonds to prevent their equity weighting from rising too much or to hedge their equity risk. In other words, the gains in equities are feeding the bond rally, preventing bond markets from selling off even in a "risk on" environment. How’s about THAT … logic. Higher STOCKS go, the moar NEED FOR FI there is. This is NOT an unknown/outta the blue reference though as FI guys we lean on the likes of Wells and others

who alert us REGULARLY as to month-end NEEDS -- which, by the way, will be topic of discussion NEXT WEEK … For now, though we’ll leave that sleepin dog lie and move along to OTHER SOURCES OF DEMAND … As in HQLAs anyone?? This from Ira Jersey/BBG Bank Regulatory Demand Could Sop Up T-Bill Supply During Runoff (Bloomberg Intelligence) -- Bank reserve balances will fall during the reduction of the Federal Reserve's balance sheet, forcing many banks to replace them with other highquality liquid assets (HQLA). This has the potential to create a bid for Treasuries and agency mortgage-backed securities. (09/20/17) 1. High-Quality Liquid Asset Ownership Is Necessary Evil for Banks Banks were required to increase their holdings of HQLA over the past several years in order to comply with new regulatory capital regulations. These were adopted by financial authorities on the recommendation of the Basel Committee on Bank Supervision after the 2008 global financial crisis. Reserves, Treasury securities and 85% of agency MBS are counted toward HQLA; a few other assets are as well but are less significant.

The chart is an estimate of bank HQLA using all U.S. commercial bank holdings of Treasuries, agency MBS and cash balances from the weekly Fed H.8 report. There was a large increase in HQLA in 2011, but it was the implementation of the Basel 3 rules in 2012 that saw the doubling of HQLA eligible assets. (09/20/17)

2. Fed Runoff Will Reduce Reserves, Likely Increasing T-Bill Demand…

AND to be sure, Ira’s NOT done just thinking HQLAs and front - end / T-Bill DEMAND … he’s followed THOSE posts up by 2. U.S. Long Rate Expectations Lowered in Part by Inflation Views Forward rates show that investors expect U.S. 10-year Treasury yields to increase 5 bps through year-end to 2.31%. Markets expect an added 13-bp gain through 2018. Expectations have declined since mid-March, for consensus as well, with the Street view now 2.46% for 2017 and 2.95% for 2018. Bond price gains since March have mitigated the selloff after the U.S. election, with rising uncertainty since around fiscal policy. Economists' 2017 estimates compare with 2.7% to start the year and the early-April 2.91% high. (09/22/17) 10-Year Consensus vs. Implied Forward Rate

CHANGE IN MEDIANS … not unlike the FED’s change in LONG RUN EXPECTATIONS … on that, this from ROSYs SPECIAL FOMC EDITION (password protected ...) A trifecta of the Fed, housing and oil. Some thoughts on the Fed, existing home sales and the price of oil…The talking heads on bubblevision are laying claim that this was a hawkish statement, the markets seem to believe it as well, and they are all wrong and I will tell you why. First, the Fed is a bit less sanguine about the economy, saying the ‘unemployment rate has stayed low’ and dropping the reference to ‘has declined’ since it has stopped declining. Household spending at the july 26th meeting was seen as having ‘continued to expand’ and now is seen as just ‘expanding at a moderate rate’. So at the margin, whatever the Fed was thinking about the labor market and the consumer six weeks ago, it is less robust today. Now as for these dot plots, what the talking heads miss is that back in June, there were four FOMC members who saw two more rate hikes by year-end. That is now down to one and three of these folks went to ‘one more’ camp. It would have been just a bit much for these hawks to have gone into the ‘on hold’ group that quickly, don’t you think? … Most of the upward yield activity is at the front end of the yield curve. The long bond has barely budged at 2.83%. There is nothing in today’s statement and forecasts that are bearish for the back end of the Treasury market. For one, the core inflation forecast for year-end was marked lower to 1.5% from 1.7% and to 1.9% from 2.0% for the end of 2018. That the Fed projects 2% thereafter is just its way of saying it expects its targets to be achieved (years of assuming it and not having it happen has not stopped this group from continuing along the same path of wishful thinking). The terminal (long-term) expected funds rate forecast also was taken down to 2.75% from the 3% estimate the Fed had published back to December 2016 and far below the 3.75% level expected in mid-2015 and the 4.25% anticipated equilibrium funds rates level in the opening months of 2012. In other words, for all the focus on the tweaking, the reality is that this anyone looking at how this expectation of the long-run fed funds rate has evolved over the years would only be able to come to one conclusion…lower for longer, on growth, on inflation and on long-dated bond yields.

And so there you go. SOME / few thoughts ahead of the weekend and will TRY to organize more/better re outcomes and forward thinking -- ie TRADE/INVESTMENT THEMES for Q4 and beyond -- over the weekend… For NOW, though, we’ll hit SEND and wish you a great start to the day and end to the week. Best, Saul/Steve

Items of Interest

EconoDay Economic Calendar AND, ripped from the BBG:

Bloomy’s Fed-speak Calendar SepTAPER 22nd, 2017

GPs Key Econ Indicators September 6th, 2017 -> Our “Economic Graph Package” is used by some of our clients to include in their monthly or quarterly reports. We have most of the major economic indicators included to give an accurate snapshot of the economy.

GPs 5yr & Under Summary September 1, 2017- > this is our chart package we call the “One to Five Year Daily”. It tracks agency bullet spreads to Treasuries, date to date, to compute the real maturity spread levels (in basis points) out to five years. We track agency callables against agency bullets and Treasuries. We compare equal maturity dates when tracking these spreads because the effective durations of callables are not stable. So over time we have a consistent methodology that we use to determine “value”. Please give us a call for more in depth explanation. GPs Index Spread Summary September 1, 2017-> We use certain Merrill Lynch indices, which are described at the top of each graph, to try and determine

optimal entry and exit points for each sector. Though the indices should have similar durations, they commonly don’t match precisely so we’ve included the green line (which should be read off from the right axis) to allow you to take the curve into account when looking at historical spread relationships.

GPs Daily Pivots SepTAPER 22nd, 2016 -> the pivot point is essentially a mechanism for analyzing the short-term supply and demand factors affecting the market. It has limited applications for long- term decision making. Professional futures floor traders, also known as locals, are the biggest proponents of the pivot technique. Scalpers, brokers, market makers, and other short-term traders also use the technique, while upstairs or longer-term traders occasionally look at the pivot for ideas of what the floor traders are doing. The pivot point is basically the weighted average price of the previous trading day, calculated as the average of the previous trading day’s high, low, and closing prices. It represents the major point of inflection each day. Unless there has been significant market news between the previous trading day’s close and the current trading day’s opening, locals often try to test the near term support, resistance, and pivot point. For example, many floor traders cover their shorts and go long into the pivot level if the market opens above the pivot point and starts to sell off. Well, it’s once again that time for information OVERLOAD and so we remind you … clicking up the StreetStuffWeekly.pdf will bring you to a few paged SUMMARY – a cliff notes version, if you will – of what some of the brightest minds and best SELLSIDE analysts are saying and thinking. WE have focused mostly on things directly impacting US RATES so you’ll find lots of specifics as well as economics AND EVEN a couple of the more notable equity thoughts. Just because. Here are OUR ‘cliff notes’ of what stood out this weekend and what you’ll find on the PDF WE’VE LINKED TO:

StreetStuff SepTAPER 22nd, 2017 this is a form of personal (inbox)therapy whereby I’ve missed a day SO what you’ll find today IS YUUUUUUGE compilation of sell-side thoughts INCL post-FOMC recaps – victory laps for everyone (except ME!). have at em and everything ELSE – tried best I could to TIMESTAMP ALL so you’ll know if ‘current’ or somewhat dated. AND oh, yeah, THIS from Barclays rates weekly? “…given the sell-off over the past few weeks, longer-tenor yields look fairly reasonable in light of neutral rate estimates and a business cycle that is fairly long in the tooth. Overall, long-term forward levels do not look low to us, as we expect neutral rates and term premia to remain subdued for the balance of the business cycle…” ALSO A NOTE WORTH READING … latest from KESSLER, “The Participation Rate Still Matters…” – point/click/READ why in HIS opinion we’re NOT at full employment and, “… In our view, this is why, from a Phillips curve perspective, that inflation continues to be weak, and has every reason to continue falling. The Taylor rule with a 9% unemployment rate would suggest a sharply negative Fed Funds Rate. Tightening into falling inflation seems like the wrong direction, we think the Fed is on the verge of repeating 1936…” StreetStuffWEEKLY SepTAPER 18, 2017 Please see THIS WEEKENDS RANT for CONTEXT AND OUR SPIN OF THEIR SPIN

Technicals SepTAPER 22nd, 2017 w/PIVS: 5s vs 1.88; 10s vs 2.27; 30s vs 2.80 Daily Pivots are SUPPORT What you’ll find and WHY you’ll wanna point/click:  GP: levels I’m watching 5s (1.86 is 200dMA, 1.84 T-line from MARCH, 1.82 is 233dMA and 1.80 is 100dMA; VISUAL of 10s, DAILY w/FIBBO retrace – 2.20% = 50% of 5yr range = RESISTANCE and 233dMA (2.29) HOLDING as momentum (slow stochastic) showing signs of rolling over BULLISHLY; CANDLE PATTERNS = Hanging Man = BULLISH … AND I’ve modified an MLIV trend CHANNEL 10s visual, too … AND since everyone’s talking/thinking CURVE (and what, if any, messages it is sending … watch 5s30s vs ~92bs – 2017 lows)  BMO (on 5s): … The broader channel for 5-year yields though has a top at 1.840% (now broken) and a bottom far away at 1.438%. That leaves us more wary of a break through to higher yields though we’d offer that with a channel tested in March and again in July, it’s unlikely that the level will give way readily. At this point we see very little support before 1.967% which is a former yield peak and at 2.146% which is the multi-year yield peak beyond that. On a rally, we see the 200-day movingaverage at 1.861% to offer first resistance, then the 40-day MA at 1.768% and past that see 1.671% as an important pause for the market.  Citi/OD (on Copper/Gold and 10s…as OD notes, though, ALL OTRs are ‘BEARISH AND OVERSOLD’): After diverging sharply during August, rising 10y rates and weakness in Copper have brought this correlation back into line.  CitiFX Weekly – BULLISH STOCKS, thinking 1983 analogy: Weekly Roundup: Déjà vu S&P. Following the path of ’83. With the S&P 500 breaking through 2,500 to new all-time highs, the chorus for an imminent collapse in Equities given their valuation grows louder. However, from our perspective, there is still more to go in this rally and we would expect at least a move to 2,620 by year-end… We continue to view the 1966-1982 period as the best roadmap for what we have seen in markets and the economy in 2000-2016. While nothing is exactly the same (e.g. high inflation economy versus low inflation economy) there are a lot of similarities that resonate…The close in 1982 saw the S&P just 49% above the high posted 16 years earlier in 1966 while the close in 2016 saw the S&P just 44% above the highs posted 16 years earlier in 2000. Not only did the S&P have a good 1983 (closed up 17%) but it did not actually have another down year until 1990 (7 consecutive up years after the bullish outside year- albeit 1984 and 1987 were very small up years) as we headed into what was the 2nd worst recessionary period of the modern era (again with housing/credit/banking at the core of that downturn). In 1983 it saw a 17% up year and as we go to print the S&P at this point is on a run rate of approx. 16.6%. (The only other outside year in nearly 100 years was in 1935 why was followed by a return of over 27% in 1936 (1937-1942 were not such positive years)).Given the building blocks in our backdrop we remain fully on the page that until proven otherwise 1982-1983 is the closest road map to 2016-2017. A like for like move would therefore target in the region of 2,620 for the S&P 500 by year end…

September 19-20 FOMC Meeting Recap

Thu, September 21, 2017 2020 Overshoot. As expected, the FOMC’s median forecasts assumed that the fed funds rate would have to move above its long-run equilibrium level in the new forecasts for 2020. As it

turns out, the median long-run funds rate estimate sank by a quarter-point (from 3.0% in June to 2.75% in September), while the median estimate for appropriate year-end level of the funds rate in 2020 came in at 2.875%. That’s a very minor difference, but the distributions of the 2020 dots and long-run forecasts indicate that almost all FOMC members anticipated that the funds rate would have to overshoot a little in the final year of the forecast horizon. The fact that the vast majority of FOMC members feel that the economy’s current trajectory is likely to require the Fed to push the funds rate above the neutral level in the current cycle is another reason to think the FOMC will be inclined to stay “on schedule” with a third rate hike this year. Bottom Line. The FOMC is on course for another rate hike in December. Another significant disappointment in the CPI data in the next couple of months could very well knock the FOMC off that path, but we have no reason at this point to expect the upcoming CPI data to be particularly problematic. If anything, the supply-shock disruptions from this year’s disastrous hurricane season are likely to add to, rather than subtract from, the existing level of price pressure. Heading into yesterday’s FOMC announcement, when the implied probability of a December rate hike was only about 50%, we thought market prices might be overstating the likelihood of another Fed move. Coming out of the press conference, our suspicion is that the ~65% probability of a December rate hike implied by the OIS market after yesterday’s rally might actually be too low.

MMO for September 18, 2017 It is a foregone conclusion that the Fed will leave rates on hold but announce the beginning of its balance sheet runoff at this week’s FOMC meeting. The big question is how the Fed will frame the debate over the possibility of a third rate hike in December. We assume that Chair Yellen will want to keep her options open at this point. As long as the Fed does nothing to take a rate hike off the table this week, the market in the near term may continue to bump up the implied odds of another move by year-end.

In The Press NOW:

Sept. 21, 2017 12:52 p.m. ET

$2 Trillion Later, the Jury Is Still Out on Fed’s Stimulus As the central bank sets out to reverse quantitative easing, there are at least three reasons not to worry too much about its impact on markets—and one good reason to be concerned. Updated Sept. 22, 2017 5:59 a.m. ET

OPEC’s ‘Problem Children’ Are Holding Down Oil Prices Rising output in strife-torn Libya and Nigeria is threatening the cartel’s bid to cut off oil supplies and balance the market. Updated Sept. 21, 2017 5:18 p.m. ET

Fed Says Total U.S. Household Net Worth Rose in Second Quarter The total net worth of U.S. households pushed farther into record territory, climbing by $1.7 trillion in the second quarter of 2017, to $96.2 trillion.

For Holiday Hires, It’s Already Beginning to Look a Lot Like Christmas With low unemployment and an expected increase in e-commerce orders, retailers and logistics companies are starting early and going the extra mile to attract seasonal employees.

Facebook to Turn Over Russian-Linked Ads to Congress

The company said it would turn over 3,000 ads linked to Russia to Congress after growing scrutiny about its role in last November’s presidential election.

Latest Obamacare Repeal Effort Is Most Far-Reaching

The Graham-Cassidy bill would turn federal funding for a law Republicans loathe into block grants to states, realizing a long-held goal of the party.

Wilbur Ross: These NAFTA rules are killing our jobs NAFTA has provided entry into a bigger market for outside countries, and we’re paying the price.

White House plan for tax cuts moves forward Senate Republicans reach tentative deal as GOP leans toward optimistic predictions about economic growth.

What regular investors should do about the Fed’s big move Higher interest rates are almost certainly coming. What's an average investor to do?

Lawrence Summers: The Cassidy-Graham vote is a chance for a Republican to be a hero

Published 2:53 p.m. ET Sept. 21, 2017

Warren Buffett predicts the Dow will hit 1 million and that may actually be bearish

Canada inflation quickens in August

Canada consumer prices rose by the most in four month in August, a figure that should give policymakers further room to raise its key lending rate again this year.

Draghi urges action on youth unemployment

Mario Draghi has made a fresh plea to eurozone governments to reform their labour markets and improve the prospects of young people, saying higher unemployment rates for younger workers had high costs for society.

German factory activity hits near 6.5-year high; manufacturing PMI at 60.6

Germany’s vast factory sector revved up to its quickest growth pace in close to six-and-a-half years in September, a closely watched survey showed, in the latest sign of strength for the eurozone’s biggest economy.

War of words over China’s economy as Xi readies for second term 22 Sep 2017 - 7:20am

S&P ‘wrong’ to downgrade China’s credit rating, ministry says

From The Blog-O-Sphere: Here you’ll find postings and research from the likes of Barry Ritholtz’s Big Picture, Pragmatic Capitalism, Kimble Charting and Zero Hedge - along with everything else we stumbled across that WE need to point out …The point of all this is to pass along things that strike us as interesting – even though they may NOT be our very own…

THURSDAY, SEPTEMBER 21, 2017

FOMC's cautious and correct plan to unwind QE

The bond market was little rattled yesterday after the FOMC announced that, despite the trauma of two major hurricanes, despite the absence of news suggesting the economy has strengthened, and despite the fact that inflation remains somewhat below their 2% target, they would proceed, starting next month, with the long-awaited unwinding of their Quantitative Easing efforts. This moderate surprise was somewhat offset by the FOMC's decision to hold off on hiking short-term interest rates, presumably until December. Now that the dust has settled, short-term interest rates are a handful of basis points higher, gold is down a bit, and the dollar is up a bit—all of which suggest a slight improvement in the market's outlook for the economy. People feel better knowing the Fed is finally on track to "normalize" its balance sheet, even though it will likely take several years to accomplish. (Their plan to start selling $6 billion per month of Treasuries and $4 billion per month of MBS, to be ramped up slowly, is very cautious and conservative and will take a long time.) A review of some key market-based indicators shows that the market's outlook for economic growth is has only improved marginally from sub-par levels. More importantly, however, there are few if any signs in the market that the Fed's plans to raise short-term rates modestly, while slowly paring down the size of its monster bond portfolio, pose any threat to growth. This tells me that the Fed is moving in the right direction, and its caution is warranted. The Fed is proposing to move slowly and cautiously to take steps to bolster the demand for money (by raising the interest rate it pays on excess reserves), now that there are increasing signs that money demand is beginning to ebb. I reviewed this in detail in a post last month, "Something to worry about." As long as the Fed keeps the supply of money in line with the demand for money, we won't have to worry about inflation. So far, it looks

like they have been doing their job, since inflation has been relatively low and stable for quite a few years, and forward-looking inflation expectations have not increased.

This first chart is one of the most important. Although neither the press nor the Fed normally talk about the inflation-adjusted Fed funds rate, that is the monetary variable which is the most important for the economy, since it sets the floor for the true cost of borrowing and the true benefit to saving. Today, the real rate of interest on overnight money is slightly negative (the funds rate is 1.25% and the inflation rate is about 1.5%). It's a lot less negative now than it has been for most of the current recovery, but it's still the case that although real borrowing costs are negative and real savings rates are very low or negative. This has been the case for years, and we have yet to see any unpleasant consequences. It can't go on forever, however. If the Fed holds the real funds rate to an unreasonably low level, that would inevitably result in an imbalance between the supply and demand for money, and that in turn would result in rising inflation, a weaker dollar, and rising gold and commodity prices. The real yield on 5-yr TIPS is best thought of as the market's expectation for what the real Fed funds rate will average over the next 5 years. 5-yr TIPS today carry a real yield of only 0.1%, while the current real yield on the Fed funds rate is about 0.15% to -0.25%. That means the market expects only very modest "tightening" from the Fed over the next 5 years. This squares with implied forward rates which show the Fed raising rates only 2 or maybe 3 times over the next several years. Both the market and the Fed believe that interest rates need rise only modestly,

and that in turn implies a belief that the economy will not pick up significantly from its 2% trend rate of growth that has prevailed since 2009. As I've said many times before, one thing to watch for and worry about would be the nominal funds rate exceeding the 5-yr real TIPS yield. That would be the market's way of saying that the Fed is entering "tight" territory and thus threatening real economic growth.

The chart above is also very important. It shows that every recession in the past 60 years has been preceded by a substantial tightening of monetary policy. Monetary policy is tight when the real Fed funds rate (blue line) is at least 3-4%, and when the Treasury yield curve (red line) is flat or inverted. We are likely years away from seeing those conditions…

Wednesday, September 20, 2017

Valuation Debate: Shiller vs. Goldilocks

The valuation question has been hanging over the current bull market. Valuation ratios such as price/earnings, price/sales, and market capitalization/revenues are uniformly bearish, showing that stocks are as overvalued as they were just before the tech bubble burst in 2000. On the other hand, valuation measures that adjust for inflation and interest rates, both of which are near record lows, suggest that the market is fairly valued. They are mostly in the Goldilocks range: Not too cold, and not too hot. I have been siding with Goldilocks. Not surprisingly, Yale Professor Robert Shiller strongly disagrees with Goldilocks. He is issuing dire warnings that stocks are as grossly overvalued as they were in 2000. The man won the Nobel Prize in economics, so he must know something. He won primarily for his work on speculative bubbles, including his book Irrational Exuberance (2000). (Goldilocks dropped out of high school, and is now doing jail

time for petty larceny.) The professor’s latest alarming views were reviewed last Friday in an article posted on Nasdaq.com titled “A Nobel Prize Winner's Dire Market Warning — And What To Do About It...” Here are some of the key points on the valuation question… … Adding the actual forward P/E and the Misery Index together produces the Misery-Adjusted P/E. It has averaged 23.9 since the start of the series in 1979. It was 24.0 during August, suggesting that stocks were fairly valued. This metric can be thought of as the Rule of 24: The fair-value forward P/E was 17.7 during August based on 24 minus the Misery Index, which was 6.3 last month. (6) Real earnings yield. There’s an alternative valuation measure that is adjusted for inflation in a more rigorous fashion than is reflected in the two rules of thumb above. Let’s flip the P/E over and focus on the S&P 500 earnings yield (i.e., E/P). It can be calculated on a quarterly basis back to 1935 using S&P 500 reported earnings data. The real earnings yield is the nominal yield less the CPI inflation rate. The average of the real earnings yield is 3.7% since 1935. When the yield is above (below) this average, stocks are undervalued (overvalued). The actual reading was 2.6% during Q2, suggesting that stocks were somewhat overvalued, but not excessively so. Excessive overvaluation would be reflected in a real earnings yield close to or below zero.

See GP disclaimer HERE