Monday, January 19, 2009

December's Money Supply Numbers

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Most of the time, the money supply numbers are boring and mundane. However, these days, nothing seems to be boring and mundane. The unprecedented bout of capital destruction we've witnessed over the past year, along with the unprecedented cut of the Fed Funds rate to a level that is effectively zero, has finally made itself felt in the M2 data.

A year ago, M2 was growing at a rate of around 5.5%, which is generally consistent with a modest rate of inflation. The capital destruction endured by the financial sector as everything mortgage-related collapsed slammed the brakes on M2 growth. By last summer, M2 growth had dwindled to 1.2%... a level that's usually associated with extreme deflationary risk.

The last 3 rate cuts have sharply turned around the M2 numbers. By September, M2 had grown over the past quarter at an annualized rate of nearly 7%. For November, the figure was 13.9%. And now, with the most recent data being release, we see that M2 for the fourth quarter of 2008 grew at an annualized rate of 17.4%

You can probably draw the following conclusions from this data:

(1) The Fed has achieved it goal of avoiding a 1930's style deflationary spiral,

(2) There should be a decent rebound in economic growth this year, probably some time around the 2nd or 3rd quarter, and;

(3) Yields on long-term Treasury Bonds are completely irrational given this surge in the money supply data.

Treasuries have already dropped significantly since I first initiated a position against them. However, there is still a long way for bonds to fall. I now expect to see the yield on the 30-Year exceed 4.5% before year-end and I wouldn't be surprised if they broke the 5% barrier.

Monday, January 12, 2009

Previewing 4th Quarter Earnings

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With earnings season about to kick off, now is a good time to gauge 4th quarter expectations as well as do some forecasting for 2009.

S&P Global has drastically cut back their expectations for the 4th quarter. As recently as September 10th, their forecast for 4th quarter operating earnings for the entire S&P 500 was 24.12. By year end, they had trimmed that number down to 16.19, and that number might still be overly optimistic. Furthermore, 16.19 would represent a 6.4% year-over-year gain compared to 4Q2007 earnings. Given the steep, double-digit drops in y/y earnings for the other 3 quarters of 2007 (-26%, -29%, -24%), forecasting growth for 4Q2008 seems like a stretch. However, the comparable was already low as 4Q2007's y/y was -31%.

The following chart shows year over year operating earnings growth for the S&P 500 for 2007 and 2008. The 4th quarter estimate is from SPGlobal.

To make matters worse for 4Q2008, the yield curve didn't become very stimulative until early 2008. It generally takes about a year for a stimulative yield curve to start generating earnings growth again. So while the 16.19 currently forecast by S&P Global is significantly lower than their September forecasts, we might still see operating earnings that fail to eclipse 15. It's no secret that retail was in a slump for the 4th quarter and the only recent bright spot, energy, did not fare well either.

For 2009, given the rate environment we experienced for all of 2008, I do expect to see a resumption of y/y earnings growth, though I don't expect earnings growth to be quite as robust as it's been with past recoveries. Currently, I expect 2009 operating earnings to come in around 70 to 72 for the entire year. With the S&P closing yesterday at 890, that would give us a forward P/E in the vicinity of 12.5.

Stocks are relatively cheap right now. It takes some guts to hold them at a time like this, but it's times like these where stock ownership is highly rewarded going forward.

Wednesday, January 7, 2009

What a Bond Market Crash Means for Stocks

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Despite the time and space devoted to the bond market since initiating this blog, I am predominantly focused on stock investing. That bonds had gone bonkers as I was starting this blog was just odd timing on our part. If you're out hunting rabbit and a big, fat squirrel crosses your path, you have to shoot it. They's tasty animals, too. And so it was with our call on the bond market last month.

In the long run, bonds and stocks are only slightly correlated. However, there is an excellent tool for evaluating the investment merits of stocks relative to bonds: the Fed Model.

The Fed Model is not without its detractors and I don't intend to go into great detail in this blog entry about the rationale for, or the efficacy of, using the Fed Model as an asset allocation tool. What is beyond dispute is that over time, stocks have tended to trade at the levels suggested by the Fed Model.

By the Fed Model, it is expected that stocks will tend to trade at a level found by dividing 12 months of forward corporate earnings by the yield of the 10 Year Treasury Note. Arguments about which earnings data to use, whether or not there should be a risk premium added to the equation, or the problem of forecasting future earnings aside, a rise in long-term interest rates tends to make stocks less appealing to investors. And so we would expect a bond market crash to create a drag on future stock returns.

Once again, 1994 serves as an excellent example to review events external to the bond market as the bonds were crashing. At the end of 1993, 10 year Note yields were 5.78%. 1994's S&P operating earnings were 31.75. The Fed Model would suggest that the S&P should trade at 549.30. (On 12/31/1993, the S&P closed at 466.45.) One year later, the 10 year Note was yielding 7.83%. 1995's S&P operating earnings were 37.70. (Fed Model ---> 481.48) The S&P 500 closed the year 1994 at 459.27. So despite a more favorable earnings outlook, against the backdrop of rising long-term interest rates, stocks through 1994 performed poorly.

There are other reasons declining bond prices tend to hurt stocks. Some investors allocate, and reallocate, capital between stocks and bonds in fixed ratios regardless of fundamental valuations. Investors who use an 80/20 asset allocation ratio that rebalance their portfolios quarterly will be taking money out of stocks as bonds decline. Bonds will always compete with stocks for investor dollars, so in the midst of a bond market decline, more attractive bond prices will draw capital away from stocks.

Conditions for stocks should improve through 2009, especially the prospects for forward earnings growth. But the turmoil in bonds this year will probably hamper stock returns. Looking back at 1994 again, the good news is that two to five year stock market performance should be much improved. By the end of 1996, the S&P had risen to 740 and would break 1000 by the first quarter of 1998. We could be setting up for a similar resumption of stock market gains out to the year 2014 or so.

Sunday, January 4, 2009

How Bad Was the 1994 Bond Market Crash?

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To get a feel for what a bond market crash looks like and how it inflicts pain upon bond investors, it's useful to examine the fall-out from 1994. The bond market crash of 2009 will occur for reasons that differ somewhat from the events of 1994, but the consequences will be similar.

Just as a stock market crash tends to hurt certain sectors and certain individual stocks more than others, so, too, does a bond market crash inflict varying amounts of pain on different bond investors. A Treasury Bill investor, where maturities never exceed one year, will not endure the losses incurred by a Treasury Note or a Treasury bond investor, with maturities of ten to thirty years, when interest rates rise. And the most acute pain will be felt by Treasury STRIP investors, where the lack of coupon interest serves to make these instruments a highly leveraged bet on interest rates. When rates go down like they did last year, Treasury STRIP investors can make a lot of money.

But when rates turn back up, STRIP's investors get killed.

There's a great, old article I found this weekend that discusses the trying times of 1994:


At the beginning of 1994, the yield on the 30-Year Treasury Bond was around 6 1/4%. By October, it was flirting with 8%, a nearly 175 basis point rise. (In the bond world, one "basis point" is 0.01%.)

A 175 basis point rise from a much lower yield, the 30-Year T-Bond closed with a yield of 2.815% on Friday, is much more destructive to bonds with longer maturities. If long-term yields break 4% this year, the pain will be far worse than what bond investors experienced in 1994.