Mourning a Giant and Bracing for a Fall

Spring may have come to Pittsburgh but it’s been a sad few days for the Yinzer Analyst as we mourn the death of Sir Terry Pratchett, creator of Discworld and one of the greatest fantasy writers of the last thirty years. His gift for creating worlds where he could both explore and parody the logical underpinnings of our own had no equal and with characters like Rincewind, Sam Vines and Lord Vetinari offered me an escape from the dull day-to-day drudgery that was grad school. I think I learned more about microeconomics from “The Truth” or finance in “Making Money” than I did by going to class and in a world where Hollywood seems focused on “rebooting” movies that were made in the last decade; he offered something truly unique and wonderful. I’d encourage you all to learn more about him here. But there’s more to today’s posting than just mourning the passing of a great author; today’s action in the market has me more convinced than ever that the time has come to get serious about reducing my equity exposure.

First, let’s recap where we’re at with the S&P 500. Yesterday’s powerful move higher seemed to be the start of another up-leg after two negative weeks that cut heavily into February’s rally but there was another story behind the strong action. March’s weak performance delivered a major hit to the Yinzer Analyst’s momentum models for the S&P 500; yesterday’s powerful move had more to do with touching lows not seen since mid-January than anything else and even more interesting is the lack of follow-through today. Prognosticators will lay the blame at Europe’s feet or even the University of Michigan Consumer Sentiment Report but either way it confirms the persistent equity weakness that has dominated the headlines in 2015.

Looking at the charts, you can see that the S&P 500 has struggled to make ground this year and remains firmly entrenched in the ascending wedge (bearish pattern) although we’re close to testing the lower support band. The market seems to want to hold the 20 week moving average but even that’s in doubt at this point.

SPXW2

Even if we do break the pattern, there’s firm support at 2000 then again at the 50 week moving average although with the FOMC coming up again next week, we could see more volatility that might push us through that support.

SPX

But the topic of this positing isn’t about the death of Terry Pratchett or simply chartology; we’ve talked a lot about the work of Peter Oppenheimer, the need to understand what drives a bull cycle and it’s time to consider what might happen in a rising rate cycle. Oppenheimer showed that the trailing price-to-earnings ratio moves in somewhat-predictable cycles over long periods of time and across multiple equity markets, confirming that successful investing requires understanding psychology as well as mathematics. And in each bull market cycle, there’s been a major driver that pushes equities to new heights. In the 1990’s it was the birth of the internet marketplace, in the 2000’s it was a low cost of capital and in the 2010’s it was zero interest rates. If you don’t want to take my word for it, look at these charts again:

QE1

QE2

SPXW

You can see a clear pattern of stronger performance around QE start dates with volatility increasing as the each program was wound down until the advent of QE3, which was the only program without a pre-specified end date and targeted amount. It was “data-dependent” and supposed to go on for as long as needed to get inflation back to 2%. But even then the Fed was reluctant to let inflation actually get above 2% and they pulled back on the throttle at the first opportunity, which is why it’s no surprise that the S&P 500 has been range bound since the end of the program. There’s been a clear loss of momentum since the “tapering” announcement as investors adjust their expectations about monetary policy and the few powerful rallies we’ve enjoyed have been off deeply oversold corrections and usually are sparked by a Fed President talking about the need to be patient when it comes to rate hikes. Looking at you Evans.

But that aside, what does the end of low-interest rates and the introduction of tighter monetary policy mean for the markets? The primary view in the market is that it should have no impact at all. Their argument lies in historical comparison most noticeably in the 2004-2007 bull cycle where the S&P 500 continued to rise well into the first rate hikes and only topped out significantly after the end of the rising rate cycle. Some like Cleveland Fed president Loretta Mester take it a step further and believe that a rising rate cycle might spark higher spending by both consumers and business owners as they rush to lock in lower rate now while simultaneously reducing the demand for liquidity. We’ve talked about the link between velocity and interest rates before (here) and how the Fed is concerned that a rising rate cycle might increase GDP and lead to higher inflation rather than curbing it.

My counterargument to their viewpoint is that the Fed is typically way more proactive about raising rates after a recession (more here) and that hiking rates now might well send the markets lower even while the economy continues to chug on ahead. While the Yinzer Analyst does love his charts, the argument I want to make has way more going for it than simple charts or fear mongering. Think about the impact that lower rates have on literally every calculation used by millions of financial professionals every day. While everyone has written off the capital asset pricing model (CAPM), it remains the most widely used tool for estimating the required return on equity or an equity index and the risk-free rate remains the core of it so rising rates will raise the required return on equity. CAPM feeds into alpha which will be significantly lower going forward. What about dividend discount models which remain a staple of equity analysis despite their limitations (Goldman Sachs loves the DDM.) Or calculating lease rates on commodities? Or the Black-Scholes model?

Literally, investors have been getting a HUGE free pass from the Fed for years and they know it. Ben Bernanke has never been shy about some of the reasons behind the uber-loose monetary policy; it created a wealth effect that supported consumer spending and kept the economy from a European/Japanese deflation nightmare. With incredibly low or even negative real interest rates; there was no opportunity cost to consider when making your investment decisions. If you couldn’t get 1% on a one-year CD, why wouldn’t you think about short-term bonds or even short-term high yield? If you have a longer investment horizon, your advisor told you that the only way to support a 4% spending target was to go equity heavy.

Well what’s going to happen when whatever risk free rate your using in those calculations begins to rise back to normal levels? For a lot of investment professionals, this is going to be their first experience with rising rates and there might be tendency to overreact. But instead of relying on intuition, let’s turn to Terry Pratchett’s Discworld for an incredibly basic example of the impact rising rates on equity valuations.

Anki-Morpork Stock Exchange (AMSE)

So to honor Terry Pratchett, let’s go to the Ankh-Morpork Stock Exchange (AMSE) to demonstrate what might happen to equity values in a rising rate environment. First let’s set the stage by pointing out that the AMSE is a lot like the S&P 500, it’s just entered the seventh year of a bull-market that has recently shown signs of faltering as the central bank contemplates hiking interest rates. Like the S&P, the AMSE is trading at lofty valuations that has investors nervous about what the future might hold. Unlike the S&P, the AMSE is a very basic market because while Discworld may have its own version of the internet and the only working economic model now to humanity, its banking system is still stuck in the 19th century. So in this example, let’s assume no share buybacks or taking on new debt to finance more dividends and buybacks.

(For those readers who feel the need to pick fights with people over the scientific accuracy of Star Trek or Mystery Science Theater, I’d say you should just punch out now. The Yinzer Analyst uses more complicated models but those are for paying customers and anyway this is just a demonstration. Killjoys)

So what if the Discworld’s famous first tourist, Twoflower, visited the AMSE and wanted to determine if the market was overbought or not? He’d start by using the classic one-stage Gordon Growth Model, one of the easiest models to apply to a mature market.

First of all, let’s get the text book stuff out of the way:

 textbook

Look familiar? Well it should, it’s the most up-to-date information lifted directly from the Standard and Poors website because hey, why reinvent the wheel on this one. First step is to use the Gordon Growth Model (GGM) to estimate the required rate of return for the index, but before that can happen we still need to estimate the dividend growth rate. Since this is a basic example, I’m going to go with a long-term rate of 4.1%, which is well below the growth we saw in 2014 as well as the three and five year dividend growth rates.

Estimating dividend growth rates is hard; most college textbooks would tell you to estimate it using retained earnings and ROE or off of historic growth rates but my process is even simpler. First of all, we’re in the seventh year of a bull-market and both the three and five year annualized growth rates are in the double digits. On a five year basis, the S&P 500 dividend growth rate is at an annualized 11.97% and has only been this high in two prior periods. First time was post-Bush in 2007-2008 and before that in 1980-1981. Impressive right, but guess what happens after they hit double digits? Yup, the growth rate crashes to low single digits, even in the post-Bush Tax cut era. Secondly, dividends in the LONG-run can only grow as fast as the national economy. Think about it, if the S&P 500’s dividends grow 10% a year and the economy grows 3% a year, how long before the S&P 500 is the economy? And over a very long period, dividend growth tends to match growth of gross domestic income.

So with a growth rate of 4.1%, we can rearrange the GGM so that the required rate of return is equal to next year’s dividend of $41.06 (39.44×1.041), divided by the value of the market today (2065.93) and then add the growth rate (4.1%) to get a big old whopping 6.087%. Wow, doesn’t seem like a lot right? Now you need to subtract out your risk free rate to get your true equity risk premium. Using the ten year rate gets you to 4%, which seems low for the amount of risk you’re taking on right?

Now what about that risk-free rate in a rising rate environment? Although it’s a rare event, what would happen if the yield curve shifted up by 100 basis points along even point of the curve? Let’s start by using the current Treasury yields to get a better idea of where the market is at currently:

textbook 2

Now first of all, the index value using the 1 year T-bill rate as your risk-free rate isn’t a calculation error; divide 41.06 by .14% and let me know what you come up with. One of the biggest drawbacks of the GGM is that there are periods of either super high dividend growth or in our case, incredibly low interest rates, where it’s possible to have a required rate of return so close to the growth rate. The value of the index will approach infinity the closer they get without R falling below G. Now what would happen if the yield curve shifted higher by 100 bps?

textbook3

Literally, if nothing else changed we could expect that the fair value of the market would drop by nearly 34% as investors demand higher returns for holding equities. While that may be an incredibly unrealistic model to work of off, it was designed to demonstrate the outcomes of a rising rate environment. Think of the number of investors who have been pushed out of the credit markets in search of higher yields whether that was in utilities, reits, or consumer staples? Beyond the capital that left as the initial shockwaves rolled the market, at least some capital would leave the equity markets permanently and find its way back to Treasuries or even long-term CD’s. And ironically, a pullback to 1375-1400 would put the market back to where it was at the start of QE3 mania.

So does that mean we should stick with the rigid logic of cold-hard mathematics?  Not necessarily, if there’s one lesson to be learned from Discworld is that you should always be prepared for the unexpected.  If we break the ascending wedge to the downside, the Yinzer Analyst is going to get serious about reducing his beta and hunkering down for the pullback to come.

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