the Dynamist

Q3 '11 Market Update: The Beginning of the End

The Beginning of the End

The world's economic and political tectonic plates are starting to shift. I believe the next 12-24 months will mark a major transition period for the markets and the economy, as we will see several long term trends reverse course. We may finally be working off the investment hangover from the late 1990s in the US, and are setting up for a revival of US business investment and manufacturing. The long term US dollar bear market may be coming to an end, as may be the boom in gold, commodities and emerging markets. While I think we have several years before the bear market in stocks comes to a definitive close, and the US economy still has years to go to work off its excessive debts, the US economy may start to shine on a relative basis. In addition, a number of very long term global trends may be turning, with the worldwide collapse of the welfare state and the end of the global debt buildup. While much of the transition to whatever new worlds awaits us will occur over the course of this entire decade, many market trends will likely be turning over the next 1-2 years. It is time to prepare.

Interest Rates

Using today's interest rates, the market rates of Treasury Inflation Protected Securities ("TIPS"), Treasuries, implied inflation rates, Municipal bonds, investment grade corporates and high yield corporates versus their equilibrium yields at 2, 5, 10 and 30 year maturities looks as follows (click to enlarge):

Chart 1

 
Treasury rates have plunged, driven by both a decline in inflation assumptions and in real interest rates. Corporate bond yields have come down less (and high yield bond yields have risen) as the market turmoil has increased risk perception.

With the possible exception of long term municipal bonds, there is very little of value in the bond market these days, unless you are extremely bearish on the economy, in which case long treasuries could rally from these levels. High yield bonds are close to being attractive, but are vulnerable if we enter a second recession.

Overall, the bond market is telling us that the supply of savings far outstrips the demand for investment, and you see very low or negative real interest rates and below average inflation assumptions out for a very long time. I think this imbalance may turn soon in the US, in which case most of the money from the great bond bull market that began in 1980 has been made.

Stocks

I've updated my numbers and methodology a bit since my last stock market update. The net effect brings the implied and equilibrium returns up, but my overall view on valuation is the same. 

As a reminder, I base my valuation off of inflation-adjusted trend earnings for the S&P 500. While Standard and Poors' analysts project $95.66 for 2012 earnings, the forward trend earnings number is only $62.64. As can be seen in the chart below, earnings in the past two cycles have been unusually high, much of which is due to a series of one-time factors like high oil prices and extraordinary bank earnings. In time, we should expect earnings to revert to trend.

Chart 2

 

Using trend earnings, I assess the value of the S&P500 as follows (click to enlarge):

Chart 3

If I use the long term equilibrium inflation assumption of 2.25%, the stock market is pricing in a 7.8% long term equity return. Under my updated methodology, I use 8.25% as the equilibrium return target (which uses a 4.0% equity risk premium on top of the equilibrium 20-year treasury rate of 4.25%). The equilibrium return would be earned at an S&P500 value of 1011, or 13% below today's level. If we assume the bond market's long term inflation projection of 2.1% is correct (it was assuming 2.7% just last quarter), then we arrive at a long term implied return of 7.7%.

Looking back at Chart 1, we can see that the market is actually pricing in an equity risk premium of 5.1% to the 20-year treasury rate, which would imply an above-equilibrium return. The same can be said for corporate and high yield bonds, who have above-average spreads to treasuries, but lower than equilibrium yields. The problem with the risk asset markets these days is that the base real interest rate is so low. Thus the return on equities and corporate bonds are strong relative to treasuries, but low on an absolute basis. My assumption is that all markets revert to the mean eventually, so unless you're a professional investor that can short the corresponding treasury with the proper duration relative to your investments, it is dangerous to rely on relative values rather than absolute values.

The next chart plots absolute values over time. In this case, it is the earnings yield of the inflation-adjusted S&P500 relative to inflation-adjusted trend earnings. (The earnings yield is the reverse of the price-earnings ratio.)

Chart 4

When the earnings yield gets above 6.5%, you can be pretty comfortable that you are buying stocks at a good value. It was above that level in the great bull market of the late 1940s and 1950s and during the bull market of the 1980s and early 1990s. That said, just because we get above that level doesn't mean we're out of a bear market, as we saw in the late 1970s and late 1930s and early 1940s. Also, just because the yield drops below 6.5%, doesn't mean the bull market is over, as stocks kept rallying in the early 1960s and late 1990s.

What I will say, however, is that a necessary condition for a secular bear market cycle (like the one that we've been in since 2000) to end is that stocks reach a low valuation on an absolute basis, like they did back in the great bear market of 1973-74. Stocks may still bounce along the bottom for several years thereafter (like the period 1975 to 1982 or from 1937 to 1942), but these can be great periods to accumulate stocks as we set up for the next secular bull market.

If I had to guess, I would posit that the market will put in a major bottom sometime in the next 12-18 months. It could be soon, if the European crisis reaches its climax, or it could be next year, driven by something else (a crash in China?) After that, retirees and investors will leave stocks for dead and they may stay cheap for the rest of the decade as the economy continues to deleverage. In the latter part of this decade, we will then be set up for a new long term bull market. I hate making predicitions that concrete, but let's just say that's my "base case" and I accept that the actual timing and magnitude of events may vary greatly around that.

Commodities

Commodities in general are expensive (click chart to enlarge):

Chart 5

In general charts that look like these don't end well. Can gold or oil or commodities in general (represented here by the CRB Futures index) keep rallying for a few more months? Sure they can. Is buying into a rally like this "investing"? No, it is not.

In the last chart I map the ratio of commodities prices relative to the consumer price index (CPI). Here you can see that the long term trend price of commodities relative to everything we spend money on has been going down. That makes sense, as mining and farming technology has gotten more efficient, more markets have opened up and global transportation networks have expanded. Also, as we get richer, we spend less of our incomes on basic commodities. During both the last decade and the 1970s, that trend was broken. In both decades, all sorts of theories sprouted up to explain why we were running out of resources relative to booming demand. In reality, both spells of commodity inflation were just that: inflation driven by currency debasement.

The Dollar

At last we come to one of the only truly cheap asset classes in the world, the US Dollar. I am on the record stating that a new long term dollar bull market is in the offing, commencing sometime in the next 12 months (if it hasn't begun already).

Charts 6 and 7

Both dollar indices (the nominal major currency index and the real broad dollar index) are near the bottom of or below their long term trend ranges. Why would the dollar go up? The dollar benefits from market turmoil, which could be a near term catalyst. Also, I think markets are going to come to the realization soon that the US's problems are manageable next to the alternatives, particularly Europe and Japan, and there is a decent chance that the bloom will come off the emerging markets rose (which becomes a self-fulfilling feedback loop when the dollar goes up and commodity prices fall). I addition, I also think the US is setting up for a major business investment cycle after a relatively weak 10 years (as we have now digested the late 1990s investment boom). Once these big currency trends get rolling, they tend to build on themselves.

OK, you ask, but how do I invest in a dollar bull market if I'm not a professional currency trader? Good question. First of all, don't be afraid to hold cash and to reduce exposure to commodity-based investments, foreign bonds and emerging markets. Second there is an exchange traded fund called the PowerShares DB Long US Dollar Fund (ticker: UUP). If you find this argument particularly persuasive, you can buy the PowerShares DB 3x Long US Dollar ETN (ticker: UUPT), which is a 3x leveraged version of the UUP. At the very least, the UUP provides a decent hedge against near term market volatility.

I am not your financial advisor. I write these posts purely for my own enjoyment. Please consult your own financial advisor before acting on any recommendations made herein.

 

Are stocks cheap? Not quite…but close.

Given the recent plunge in the stock market, are stocks cheap? That is the multi-trillion dollar question.

My base case is that we are part-way through a long term (or "secular") bear market that began in 2000. While inflation has masked a bit of the decline in the overall stock market, it is clear that we put in a generational valuation peak in early 2000 and have been grinding our way lower since. The bear market turned into a "Kondratiev Winter" or economic bear in 2008 with the collapse of the real estate and credit markets. Since that time we have been in a "deleveraging" phase, which would have been deflationary if not for the desperate money-pumping and fiscal stimulus that has occurred since that time. Interest rates have collapsed, yet demand for borrowing is weak as consumers and business focus on improving their balance sheets. Many lack the collateral to borrow even if they wanted to. In addition, the baby boomers are staring at retirement having under-saved. The brutal decline in their net worth and the proximity to retirement are pushing baby boomers toward safer investments like bonds, even while the Fed punishes these savers with super-low rates in a futile attempt to get people to shift back into real estate and stocks.

S&P 500 below trend

In addition, the high inflation of the last 50 years has actually made stocks look like a better investment than they really are. If we convert the value of the S&P to 2010 dollars (as measured by the CPI), we can see that its trend line has only gone up by about 2.5% per year in real terms since 1960.

Source: Standard and Poor's, economy.com, calculations by tylernewton.com

The good news is that the market is now below its trend line. The bad news is that in bear markets like the 1930s and 1970s (or in bull markets like the early 1960s and 1990s) the market can get very far from its trend line. The good news is that the double-digit deflation of the 1930s and the double-digit inflation of the 1970s are probably special cases. The bad news is that the 1990s bull market and the 2000s credit bubble were also of unprecedented magnitude and ought to be followed by a major bear market to undo the excess. The good news is that the bear market in stocks should bottom before the credit bear market (if that can be called good news).

Valuation based on trend earnings

So what about valuation? To smooth out the business cycle and to adjust for the effect of swings in inflation, I base my market valuation on inflation-adjusted trend earnings. A graph of inflation-adjusted (as-reported) earnings and the calculation of the trend line is shown below.

Source: Standard and Poor's, economy.com, calculations by tylernewton.com

Expected inflation-adjusted earnings for 2011 are near the peak of 2006. Trend earnings, however, are only $62.15 in mid 2011. If I take the historical dividend payout ratio of 42.8%, the 2.7% long term inflation assumption implied by today's treasury curve and the long term real earnings growth rate of 1.55% as calculated above, I calculate that someone buying the S&P 500 today can expect a long term return of 6.6%.

Of course, the implied return is highly sensitive to inflation. If the inflation assumption fell to 2.25% (near the Fed's long term target), the S&P 500 would need to fall another 100 points just to earn the same return.

The matrix below shows the different levels of the S&P 500 that would generate target returns ranging from 6.0% to 8.0%, assuming long term inflation of 2.7%. Many market prognosticators assume 8% to be the long term return on stocks (wrongly, in my view). I assume the equilibrium return is 6.8%. (I realize that is weirdly precise…there is no exact right answer). To reach an equilibrium return, we "only" need to see the S&P 500 fall another 5%.

The effect of inflation

I am on the record that I believe in the intermediate term, inflation is more likely to surprise the market on the downside than on the upside. The chart below shows the inflation assumptions for the next 5 years, for 5-10 years and for 10-30 years, according to today's nominal and inflation-protected treasury curves. (I also included the actual inflation rates for 2009 and 2010 for illustration).

Source: Bloomberg.com (for treasury prices), economy.com (for historical inflation), calculations by tylernewton.com

If we assume that long term inflation expectations fall to 2.25% sometime in the next year or two, we would need to see the market fall to under 1,000 (20% or so lower than today) to be comfortably earning a return of 6.8% or more.

Earnings yield on trend earnings

Another way to look at stock valuations is to look at the market's "earnings yield" using trend earnings (the inverse of the price-to-earnings or "PE" ratio).

Source: Standard and Poors, economy.com, calculations by tylernewton.com

Looking at the chart above, it appears that we can be reasonably comfortable that we will earn a strong long term return at earnings yields above 6% (a 16.7 PE or below on trend earnings). That would imply an S&P 500 of 1,036 at today's level of trend earnings.

Conclusion

Using the methods above, we can say that the S&P 500 is fairly valued on a long term basis somewhere between 1,075 and 1,000 or so. We are currently at 1,121, so a drop of another 4-8% would put us in a good range. That said, from a trading perspective, the market could punch through to well below those levels if we have a deflation scare (which is certainly possible in this environment). We could also have one more big rally before the big bear market bottom is put in (also highly possible).

Given the monster rally in bonds, my investment strategy will be to average out of my bonds and gold into stocks over the next two years as long as the S&P is below 1,150. (Thankfully, I have been underweight stocks and overweight bonds for a long, long time.)

Good luck out there. These are not easy markets to navigate.

I am not your investment advisor. All opinions in www.tylernewton.com are solely my opinions and are written for my personal enjoyment only. Do not act on any advice given on this site without first consulting your own investment advisor.

Get Ready for a Dollar Bull Market

Get ready for a multi-year bull market in the U.S. dollar.

Yes, you heard that right.

No statement about investing right now could feel more wrong. And this is why it's probably time to start swimming against the tide.

First, I'll make a mundane case based on timing. Consider the following chart:

Since the Bretton Woods monetary system started breaking down under the strains of the Vietnam War and Great Society spending, there have been three dollar bear markets, each lasting roughly 10 years: 1968 to 1978, 1985 to 1995 and the current dollar bear market, which started in February of 2002. Currently the dollar is right against the lower bound of its long term trading channel.

You might say that the major currency index is no longer relevant due to the rise of emerging markets. Here is the broad dollar index (which incorporates all currencies on a trade-weighted basis) in real terms (adjusting for differences in inflation):

Not much difference in the timing of the bull and bear markets. Against the broad basket, the dollar has punched below the lower bound of its long term trading range, which means it might just be ready for a snap-back.

But things are so much worse now, aren't they?

In the mid-to-late 1970s, we experienced the loss of a major war and the resignation of a president, soaring inflation and commodity prices, union militancy, provocations by tin pot despots in the Middle East, years of bear markets in both stocks and bonds, weak leadership at the Fed and a general sense of American decline. Plus you had polyester leisure suits and disco.

In the early-to-mid 1990s, we were experiencing the "hollowing out" of American manufacturing and "downsizing" of white collar jobs, years of a brutal bear market in real estate, Japan was eating our lunch, years of large fiscal deficits, the aftermath of a major banking crisis and credit crunch that had followed a boom in high yield and real estate debt, a divided government with Congress controlled by firebrand conservatives that had forced a shut down of the Federal government and a general sense of American decline. At least we had flannel shirts and grunge rock…better than the late 1970s.

Hmm…for the most part these periods of time sound pretty similar to today.

There are major differences, of course. For example the transition to the dollar bull market involved a horrible recession in the early 1980s, while in the mid-1990s the transition was relatively smooth (in the U.S. anyway).

So what happens in a dollar bull market?

• Real interest rates rise. This might come from a rise in short term interest rates or a shift to falling prices or very low inflation (or both).
• US technology is hot. Leading edge technology attracts a lot of investment. The great venture capital bull markets coincided with the dollar bull markets of the early 1980s and late 1990s.
• US business investment rises. Higher real interest rates attract investment capital back into the US, which flows into software and business equipment.
• Emerging markets crash. It is no coincidence that the great emerging markets crises occurred in the early 1980s and late 1990s. The strong dollar draws investment dollars away from emerging markets and back to the US. This occurs after 10 years of an emerging market bull market during which untold unbalances build up. Would you really be surprised to find out that much of China's growth has been built on a mirage of cheap credit and wasteful infrastructure spending?
• Commodities and farm prices crash. A rising dollar is a net negative for commodity prices (which are priced in dollars). Plus, it usually turns out that much of a commodity bull market is built on financial speculation, which flees once it becomes clear that momentum has shifted.
• Large cap outperforms small cap. The long-awaited rotation from small cap to large cap and from value to growth might finally occur.

I am assuming that the transition to a dollar bull market will take a year or more. My plan is to gradually start moving to underweight in commodities, emerging market stocks and foreign bonds. As the Fed transitions from accommodating to neutral or restrictive, or if there is an inflation or financial crisis in emerging markets like China, there could easily be a major bear market US equities. I will wait to see how the market handles the transition in monetary policy before moving to overweight in large cap US stocks. There is also a dollar bull ETF, the Powershares DB USD Bull ETF (ticker: UUP), for those that want to get more aggressive.

I remember people yelling at me for being an idiot when I was buying gold and silver back in 2002. People argue vehemently against me now. I must be on to something.

I am not a financial adviser and write these articles purely for my own amusement. Please consult your financial adviser before acting on any of the recommendations posted here.

Market Review: Beware an Emerging Markets Inflation Crisis

Right now the only assets that aren't overvalued (according to my model) are long term treasury bonds and long term municipal bonds. You can be confident that this is likely true because it feels the most wrong. Global monetary policy is supporting stocks and commodities right now, even though they are artificially overvalued, and they should be expected to keep rising until the policy trend comes to an end. We should expect the trigger event for the next market takedown to be an emerging markets inflation crisis, which would cause the existing global policy trends to go in reverse.

Fixed Income predicts continued malaise

The bond market has changed very little from the end of 2009, although there was a wild ride in between.

(Data from Bloomberg.com, Vanguard Funds, Economy.com)

The fixed income market is telling us that the Federal Reserve will likely keep the Fed Funds rate very low for at least two years and maybe more. Policy should be normalized sometime between year 2 (2013) and year 5 (2016). After year 5, however, the market expects an extended period of higher-than-equilibrium interest rates all the way through year thirty (2041).

While the Fed's bond-buying program may be affecting the short-to-intermediate end of the nominal treasury curve, the Fed is not manipulating the inflation-protected market ("TIPS") which are pointing to low real interest rates and a return to normalized inflation after only several years of aggressive monetary policy.

The basic message that the market is sending is that the economy and the financial system will underperform for at least the next two years. This is consistent with my view that housing will remain weak through at least 2012. Housing weakness affects the collateral values that underpin most consumer and small business lending. Thus the deflationary undertow of real estate on the financial system will weaken both the supply and demand for these certain types of credit.

Housing remains overvalued

The Case-Shiller house price index points to real house values being 5-10% overvalued relative to their long term trend (which is about 100).

The Fed Gets It

The Fed understands all this, however. The Bernanke Fed is performing quite well under the extreme circumstances. All the hoopla blaming the Fed for inflation (which so far is showing up only in commodity prices), is misplaced. The real culprits in grand market manipulation and inflation-creation are the central banks in emerging market economies. They are refusing to rein in monetary policy by the proper amount because they don't want to let their currencies appreciate and potentially weaken their export-led growth models. It is rapid demand growth in emerging markets that is driving up commodity prices, not overheated monetary policy in developed markets.

The "Virtuous" Market Circle

So now we have a policy framework that is about as beneficial for equity and commodity markets as possible. Weakness in the real estate and banking markets in the developed world result in low interest rates. Corporate America, which is relatively unaffected by the real estate markets, is racking up profits as emerging markets expand and productivity surges. Emerging market policy makers are over-expansive for fear of hurting their export machines. Emerging market central banks thus purchase developed world assets, keeping interest rates low and asset prices high.

Stocks are still overvalued – but may remain so for a while

The S&P 500 is priced to deliver only a 6.6% long term return today.

Earnings are well above trend, as the playing field is tilted in favor of multinational companies at the expense of labor and small business. If domestic or foreign government policy toward multinationals was to change, today's record margins would shrink and earnings would return to their long term trend level.

This policy mix keeps interest rates artificially low, stock and commodity prices artificially high, and is artificially holding up housing prices. Stock prices are probably only one recession away from becoming cheap, however.

Historically, earnings yields (inflation-adjusted trend earnings divided by the S&P 500 level) in excess of 6% imply a safe time to buy stocks with a long-term buy-and-hold strategy. We're not quite there, but should expect the end of the secular bear market that began in 2000 to come with the next recession.

Beware an Emerging Markets Inflation Crisis

What would bring the policy circle to an end would be an inflation crisis in emerging markets, which would force them to let their currencies appreciate to slow their overheated growth. While this change would put an end to the great economic imbalances that bedevil the global economy today, a sudden policy reversal could be very disruptive. Interest rates and the dollar would rise and stocks and commodities would fall as liquidity dried up. My recommendation to world leaders would be to start making the necessary adjustments now. This is essentially the argument that the US and EU have been making to the likes of China for years and it has been falling on deaf ears. For now, the Fed will continue to stick it to the emerging market central bankers and stocks and commodity prices will continue to rise.

Investing in Bonds - Keep it Simple

Investing in bonds doesn’t have the same macho appeal as investing in stocks. Bonds aren’t always about betting on price appreciation; they are usually purchased for the simple purpose of generating interest income. It is possible to make money with price appreciation in the bond market, however, it means taking on a little bit of risk.

The remainder of this article can be found at the website Man Of The House.

Simple Rules for Investing in Stocks

Forget the hype. Investing in stocks is not a game. Unless you are a professional trader or a trained financial analyst on Wall Street, you should be wary about investing in and trading individual stocks. There is an army of well-paid professionals on Wall Street that are paid to trade and analyze stocks for a living, and they don’t beat the market as a whole.

Two rules for investing in stocks: keep it simple and diversify.

The remainder of this article can be found at the website Man Of The House.

Where to Put Your Money: The Basics

“Asset allocation” may sound like the kind of term used by rich money managers and Ivy League university endowments. In fact,  anyone with a savings account,  a 401(k),  a pension plan or real estate should be thinking about asset allocation. “Asset allocation” is just a fancy way of saying “don’t put all your eggs in one basket." By putting your money in several different baskets, you can reduce risk and potentially increase returns by diversifying your investments.

The remainder of this article can be found at the website Man Of The House.

Are You Your Biggest Investment?

When it comes to your investments, you might consider your 401k or your house as the most valuable. Little do you know that your biggest investment is your career. Your career is an investment like any other and once you determine the financial value of your career, understanding how to invest the rest if your portfolio becomes much easier.

The remainder of this article can be found at the website Man Of The House.

Is My House a Good Investment?

If you’re like me, deciding to buy a house was not only a big decision but also quite the investment. Regardless of the economy or whether I could make this house into a home, I had to put sentiment aside and think about real estate rationally. If buying a home is on your mind, take a look at my tips to consider while researching buying a home.

The remainer of this post can be found at the website Man of the House

Q3 Market Update: The Fed’s War on Savings

The Federal Reserve recently announced that it would purchase up to $600 billion of US Treasury bonds in a program known as "quantitative easing", which is a fancy way of saying "printing money". This is actually the second bout of quantitative easing since the financial crisis, and thus this round has earned the nickname "QE2". The policy of printing money is a blunt economic instrument, with wide range of consequences, known and unknown. The announcement of the policy has attracted no shortage of critics, from World Bank President Robert Zoellick, to Sarah Palin, to the leaders of Germany, Japan, China and Brazil. All deride it as inflationary currency manipulation.

The Fed's ultimate goal is to prevent a Japan-like malaise of falling prices and shrinking consumption from infecting the United States. With short-term interest rates at zero, the Fed can't lower short-term rates any further. By printing money to buy longer-dated treasury bonds, the Fed accomplishes two things. First, by increasing the supply of money, it decreases the value of the dollar which helps create positive inflation. Second, by reducing interest rates of "risk-free" investments like cash and treasuries to below the rate of inflation, those investments become money-losers in inflation-adjusted terms. The goal is to bribe savers to shift investments from cash and treasuries into "risky" investments like corporate debt, equities and real estate and also into near term consumption of goods and services.

Pushing on a string in the US

There are three major problems with this policy. Americans are unlikely to increase their consumption markedly, given that they are determined to rebuild their savings after years of under-saving. In addition, real estate suffers from a massive debt overhang and isn't likely to truly recover for years. Businesses will gradually increase their investment, but generally act in their own interest and can't be forced into making investments they wouldn't otherwise make. For these reasons, the Fed's war on domestic savings will not likely be successful. In economics parlance, the Fed is "pushing on a string". Instead, we are seeing a shift of savings from investments that have a negative real rate of return (like cash and bonds) and into those that are considered inflation hedges like precious metals and commodities like oil, wheat and cotton.

Taking the fight to China

The second front in the Fed's war on savings is against the biggest saver in the world: the Chinese government. The Chinese government has systematically manipulated the world trade markets by recycling its export earnings into US dollar-denominated assets instead of into US-dollar imports. By mathematical equation, this results in a trade surplus in China and a trade deficit in the US. In the past decade, China has accumulated over $2 trillion of US-dollar reserves. By increasing the supply of US Treasuries and by holding interest rates below the rate of inflation, the US is essentially taxing Chinese savings. The weak dollar also pushes up the currencies of countries that compete with China, not only those of emerging market economies, but also currencies like the Japanese Yen and the Euro. China, Japan, Brazil, Korea, etc. have all been using export promotion policies like currency suppression to enrich themselves at the expense of exporters from the United States. The Fed is finally saying "Two can play at that game".

The current long-term trend of artificially-suppressed interest rates, a weaker dollar and higher commodities will play out until the world cries "uncle!". No one knows when this will happen, but when it does, the current trends will be reversed.

Economic growth ahead

The Fed has clearly learned the lessons of the Great Depression and of Japan. The TARP and the first round of quantitative easing were designed to prevent a second Great Depression, and were successful. QE2 is designed to prevent a repeat of the past two decades of deflationary malaise in Japan from occurring in the United States. If the Fed is determined to prevent deflation, they will. The downside, because there is no "free lunch" in economics, is a weaker currency on a relative basis (next to other paper currencies), and on an absolute basis (relative to precious metals and commodities). The decline in the dollar pushes up the prices of imported consumer goods and commodity products like food and gas, even while overall inflation may be tame. This hurts low-to-middle income Americans most of all.

Fixed Income

Looking at the interest rate complex, we can see that treasury rates are far below their equilibrium levels, with the exception of the 30-year treasury. Treasury Inflation-Protected Securities are showing negative yields right now, which is a sign that investors expect the Fed to be successful at maintaining positive inflation. The 30-year, which is the least manipulated issue on the curve, is expecting inflation to average 2.6% over the next 30 years, which is over the Fed's target range.

Source: Vanguard Funds, Bloomberg Treasury Rate Data, tylernewton.com

These rates are even lower than what prevailed at the time of my last post on July 11, 2010 (when I declared that there was not much more fun to be had in the fixed income markets…oh well).

So while the treasury complex is artificially over-priced, risk assets like corporate bonds, high yield bonds, muni bonds and equities are priced at above-equilibrium "spreads" over treasury rates, even if nominal yields are below equilibrium levels. If you are a long-only investor, it would be better to keep your fixed income investments in less-volatile shorter term maturities. If you are the type of investor that can short the appropriate treasury while going long on corporate, high yield and municipal bonds, you can enjoy better-than-equilibrium returns.

Equities

The rise in long-term inflation expectations explains the rise in the equity market since July.

Implied market returns

7/11/10

11/8/10

The implied long term return on equities is 2.4 percentage points higher than the yield on the 30-year treasury, versus an equilibrium spread of 2.3 percentage points. (This equilibrium spread is based on an after-tax equilibrium spread of 4.5 percentage points above the after-tax return on the 30-year treasury. Because equities are more tax efficient than treasury debt, the nominal equilibrium spread shrinks to 2.4 percentage points.) Note that I use a lower spread than the 6% or so often used in valuation textbooks.

Equities are a decent buy at this point if you believe that the Federal Reserve's policy of quantitative easing will be successful at increasing long term inflation expectations, weakening the dollar and supporting economic growth. So far the price of the 30-year treasury bond and equities are telling you that the market thinks that quantitative easing will be successful.

The Dollar

The value of the dollar also shows that the market believes that quantitative easing will be successful.

Major Currencies Index (nominal)

Broad Currencies Index (real)

Source: economy.com

Both measures of the dollar index are trading at the bottom of their long term ranges, which means that further upside in foreign currency trades may be limited.

Gold and commodities

Source: economy.com

Both gold and commodities reflect the effects of quantitative easing.

On a relative basis, oil and other commodities are cheap relative to gold.

Source: economy.com, calculations by tylernewton.com

Conclusion: A crowded trade?

In the past week (November 8-12), the QE2 trade has been reversing itself. Treasury yields and the dollar have been rising and gold and stocks have been falling, reflecting a classic "buy the rumor, sell the news" situation. The QE2 rally reflected a liquidity-driven rally, where everything except the dollar (stocks, bonds, commodities, and foreign currencies) goes up, and since November 8, we've had a classic withdrawal of liquidity trade, with everything except the dollar going down. This is different from a crisis trade, during which treasury bonds would also rally.

Possible reasons for the break in the markets this week:

• European debt - In the past week, we've had the glimmerings of a renewal of the European debt crisis, as the yields on bonds of Ireland, Greece, Spain, etc. have returned to records relative to German bonds. If a renewed sense of fear regarding Europe were driving the markets, then we would see treasuries rallying, which we are not.
• China slowdown - Another possibility is fear that QE2-induced inflation in emerging markets, particularly China, is forcing them to take unpredictable actions to slow their economies, fight inflation and/or erect capital controls. This is a distinct possibility, although I would expect such a scenario to lead to a decline in the dollar, which we are not seeing.
• QE2 letdown - The markets may have been disappointed with the size of the QE2 program ("only $600 billion versus $1 trillion or more). This could be true, which would also support the following scenario.
• Just taking a breather - The markets are just taking a breather after a good run.

The balance of risks tells me that the markets are likely transitioning from a liquidity-driven phase to a phase that will discount moderate-to-strengthening economic growth. Such a scenario would favor equities and commodities and support the spreads of risk assets over treasuries. The valuation level of domestic equities is relatively high, however.

QE2 will continue to drive investors into emerging markets, which will likely to blow a bubble in emerging markets stocks and commodities. I don't think emerging markets stocks are cheap, but the "story" will likely stay favorable for some time.

Action plan

As the current market pullback runs its course, I will likely trim a few of my precious metals (gold and silver) positions and add other commodities (a net neutral change in the commodity weighting for the whole portfolio). I will trim a bit of my foreign bond positions (which I added last quarter) and add foreign stocks. I remain neutral/underweight domestic equities at levels above $1,000 on the S&P 500. I remain neutral on bond duration in the US.

Waiting for "regime change"

I suspect we are in the last phase of "casino capitalism" in the international capital markets. While the leaders of the G-20 couldn't agree to anything last week, it is only a matter of time before the international currency and trade system slams into a wall of nationalism. At that point, international regulation of currencies, trade flows, bank leverage and hedge funds will become widely accepted to save the real economy from the whims of the financial economy. The financial system is meant to serve the real economy, not the other way around. The transition to the new system will be messy, so stay on guard in the meantime. Be conservative in your investment decisions, don't be afraid to hold cash and don't be a hero. I still have a strong suspicion that the best investment opportunity still lies ahead.

I am not a financial advisor, and write these columns for personal enjoyment only. Please consult your own investment advisor before acting on any recommendations you find on the internet.