Here’s a quick, one-question quiz — no cheating, please: Would a Dow Jones Industrials Average of 650 have been abnormally high, or abnormally low in the summer of 1981? …Play along for a minute because there’s method to the madness, trust me.
The answer, of course, is that unless you were a seasoned market watcher in the summer of 1981, you would have no immediate idea. This one thing is what makes equity investing so tricky: There doesn’t seem to be an absolute scale against which to adjudge whether markets are overpriced, or a bargain, or somewhere in-between, at least by anything like a long-term standard.
Instead we’re left to embrace a wide assortment of noisily second-best strategies based on noisy relative movements in the relatively recent past — from watching P/E ratios (and trying not to kick ourselves too much when we miss huge, P/E-defying moves), to playing the trend, to contrarianism, to what one might call “transitory contrarianism,” such as buying on the dip. All of these assorted strategies can and often do lead to losses because the thread running through all of them is that nobody really has any idea from moment to moment whether they are right or not. In the absence of any absolute measuring standard for whether equities are likely to go up or down, every strategy is little more than educated guess.
Except here’s the thing about that: There *IS* an absolute scale with which to gauge whether equities are likely to go up or down; we’ve just been looking in the wrong place for it. And to prove that point, I’ll add a bonus question to your quiz.
Would a prevailing 30-year mortgage interest rate of 18.5% have been high, or low, in the summer of 1981?
Those of you old enough to remember that time might be smiling a little wider than those who aren’t, but I’ll bet almost everyone who has read this far is at least grinning a little. Obviously a home mortgage rate of 18.5% is gob-smackingly high and, equally obviously, today’s home mortgage rates of about 3.75% are just as gob-smackingly low. And that turns out to be a much bigger deal than I think even some seasoned pros fully realize when it comes to trying to time the markets.
I had this thought driven home to me earlier today (local time) when I read a story on CNBC.com, in which an august expert at some titan-of-the-Street brokerage house or other was asked about his target range for the yield on the 10-year bond over the next twelve months. His quoted reply centered around the bombshell news that he and his team were revising their 12-month yield estimate for the 10-year Treasury upward, to a new range of 2.55% to 3.15%. (I would link to the article but I can’t find it again and this material will have an unusually short shelf-life, so you’ll just have to take my word for it.)
Point being, when I read his quote about that twelve-month range, two things struck me about it right away.
The first is that I fail to see any event on the twelve-month horizon that would cause the yield on the 10-year bond to go down from here. Policymakers in Washington have seen fit to adopt a sweeping — some would say reckless — economic stimulus, funded with public borrowing and enacted at a time when unemployment was already at or near historic lows. The Treasury, forced to auction far more paper than it had planned for, will have no choice but to cut its asking price at the daily auction, thus driving up yields. At the same time, an inflation-skittish Fed may have to raise its target rate as part of a concerted effort to de-leverage at least some of this overheated stimulus, and will probably sell off much of its own stake in Treasuries on the Open Market Committee side of the house in tandem, thus pushing rates even higher. For all these reasons, it seemed little short of bizarre to me that a wizened guru tasked with predicting future yields would include any values significantly below where things are today (which is at about 2.80% at time of writing).
But the second point that struck me is that said range is still — still — gob-smackingly low. I mean to say, even if our un-named expert is wrong by a factor of fifty percent, we’re still looking at a top yield over the next twelve months of less than 5%. And that is historically low as measured against an easy-to-remember, absolute scale — with zero at one end and, let’s say, twenty percent at the other. There *IS* an absolute scale available to amateur investors like you and me. It’s just not a scale having anything directly to do with equities per se. Instead it’s the interest rate on the 10-year bond.
Let’s be clear: Interest rates can, and do, occasionally fall below zero. Indeed the current prime rate in Japan is about -1%. But these events are so rare (and by the way so rarely efficacious in stimulating the sort of growth that was intended to result from them) that they serve as exceptions that prove the rule.
Interest rates can and do occasionally exceed twenty percent, too, albeit typically in the developing world. As the Volcker Disinflation of the late 1970s and early 1980s proved, modern post-industrial societies don’t actually need rates to go any higher than that to kill off even the most virile and seemingly indefatigable inflation. Lest we forget, those of us who are old enough had grown quite accustomed to annual inflation rates of ten percent as a hard floor by the time Ronald Reagan was sworn in as President, and the idea that they would ever be any lower seemed almost as absurd, then, as the idea that they will ever be that high again seems, now.
So, okay. Suppose I’ve convinced you that, yes, interest rates do in fact adhere to an easy-to-see and absolute scale, measuring when they are high and when they are low. So far so good, but why would any of that matter when it comes to timing our long and short positions in the equities markets? For the simple reason that equities markets *H*A*T*E* rising interest rates. They really, really, really hate them.
The quickest and easiest explanation is that higher interest rates tend to suppress business borrowing, which undercuts the prospects for earnings growth. This in turn cuts into the upside wiggle room of the price of the stock before it begins to challenge historical norms for P/E trading ranges. In short, higher rates make it more expensive for businesses to borrow, and if you can’t borrow, you can’t grow your business, and you can’t grow your profit.
Thus it is, in February of 2018, that we find ourselves confronted by a historically mature bull market, and an extremely high likelihood of rates going higher — even if only for the least technocratic of all possible reasons, namely that higher is the only easy direction for them to go. All of which leads us to one, pretty doggone inexorable conclusion, if you ask me:
The easy money to the upside in equities markets has all been made.
For the foreseeable future, as far as the JLI can tell, any successful long positions will be chosen with extreme care, robustly correct enough to withstand an increasingly potent twin-headwind of monetary and fiscal policy, and more than a little lucky to boot.
And luck, it need not be said, is the last thing we want to count on when it comes to the performance of our portfolios.
“The Jet-lagged Investor”
Content uploaded on 9 February, 2018
17:30 ICT, 05:30 EST