A Debtor’s Paradise: The Bull Case for Equities
“Worrying is like paying a debt you don’t owe”- Mark Twain
- With interest rates at historic lows, there has never been a better time in history to be a debtor, in contrast this is perhaps the worst time to be a saver.
- Demographics shows that the ratio of savers (actively working age) versus spenders (in retirement) is rapidly declining which normally coincides with higher bond demand and lower equity valuations.
- US interest rates remain at relatively high levels to other countries but still offer poor absolute future returns.
- In contrast the dividend yield for the S&P500 is substantially higher than the treasury yield – sitting at the highest gap since the 1980’s while the Fed model shows the stock market is substantially undervalued.
- Direct asset purchases by Central Banks are still strong globally, and this should also be supportive of risk assets. Some Central Banks are now shifting to more unconventional measures of monetary policy such as direct asset purchases of stocks and ETFs as demonstrated by the recent moves from the Bank of Japan. Other central banks may follow suit which would further boost returns for equities and risk assets.
- Bullish sentiment is currently at low levels relative to the last 7 years – this is a good contrarian sign for future stock returns in the intermediate-term.
- In summary, we believe that equities may offer the best future return source for investors in retirement while bonds offer limited value. However, to control volatility and ensure a higher probability of being able to navigate retirement, one needs to use a risk-managed approach to investing.
It is easy for investors to get lost in all of the headlines, but to understand where we are and where we might be going the key is to understand that the world is becoming increasingly dependent on debt. This has implications for future returns for different asset classes.
The idea of debt dates back as far as the Sumer civilization in 3500 BC. It was used primarily by farmers in order to fund their crop development. Some historians consider debt to be the original form of currency. In civilized economies, debt was used prior to coinage or paper currency as a means of exchange. In contrast, cash and barter was often used in transitional communities during war time or between two communities that were in conflict with one another1. Debt is essentially a form of trust between two parties; those that are believed to be trustworthy (or creditworthy) are eligible for loans while untrustworthy parties must provide some form of collateral or cash in order to secure a transaction.
Over three thousand years ago a Babylonian king named Hammurabi provided the first guidelines on interest rates. These strict guidelines were enforced to protect both borrowers and lenders. Interestingly enough the so-called low risk loans that were secured by silver carried an incredibly high interest rate of 20%! 2
Times have certainly changed since the early days of Mesopotamia. The concepts of trust and collateral are no longer a prerequisite for lower interest rates. Creative financial engineering, lax credit standards and regulation, and most importantly coordinated global central bank intervention have lowered interest rates to historically low levels. As a result, there has never been a better time in history to be a debtor. On the flip side there has never been a worse time to be a saver.
Source: Business Insider
The chart shows that interest rates remain at the lowest levels ever in history. Many market commentators use this data to support the argument that interest rates will rise imminently. But history doesn’t seem to support this claim. The most striking yet subtle observation is that rates almost never rose immediately after falling to new major lows. If you look at the last two hundred years many of the secular changes in interest rates (moving from low to high) took decades to develop. Here is a closer view (source: Bianco Research via Business Insider)
If you look carefully at the circled major secular lows you can see that it often takes at least 10 to 20 years for rates to hit their trough and turn around. So for all of the investors and advisors fearing rising interest rates, the lesson is that changes are unlikely to happen overnight. Furthermore, those changes are not that large in magnitude. So it is far more reasonable for us to expect that interest rates will either stay low for some time (and possibly move even lower) or at worst gradually rise. This means that the return to holding safe assets like Treasury bonds should remain low for some time.
If we take a real case study example like Japan, the peak of the bubble in their stock market occurred close to the beginning of 1990. From the peak we see in the chart below that interest rates or 5-year Japanese bond yields declined from that point and never really looked back.
The reason why interest rates in Japan have stayed so low is because of: 1) low economic growth 2) low or negative inflation (deflation) 3) demographics – a disproportionate number of retirees versus savers. The challenge is that all three of these factors are creating a secular global problem for policy makers. As a result, central banks around the world have been cutting interest rates in near unison in recent years. This has been terrible for savers but a paradise for debtors. We can see this trend by looking at the current level of interest rates across major developed countries:
Currently Germany, France, and Japan have negative interest rates while the U.K., Canada, and Italy are hovering close to the zero bound. In contrast, the U.S. and Australia offer comparative value with interest rates slightly over 1%! It is well-know that the yield curve incorporates future expectations for inflation and economic growth, and clearly the U.S. market has higher long-term potential for growth than many of the Eurozone countries. However, investors in quality fixed income such as pensions and other institutions as well as retirees face the prospect of earning very low future returns on safe investments. Traditionally investors would increase their fixed income holdings over time as they approached retirement in order to secure stable income and reduce volatility, but the current environment makes this age-old solution much less viable.
This situation is exacerbated by the fact that global capital markets face a “demography trap” – the ratio of working age savers to retirees is rapidly falling. This trend has been going on since the turn of the millennium and is one of the main reasons why bond yields are currently so low: the demand for low-risk yield grows every year.
But now that most countries are below or approaching the zero bound for interest rates, it stands to reason that demographics should eventually push investors into riskier asset classes. The reason is that other asset classes present better value – especially equities. Currently the S&P500 dividend yield is at long-term highs versus 10-year Treasurys (+.42% as of 8/8/2016 via CNBC). The chart below from Fundstrat shows the trend in relative yields since 1950:
Source: Fundstrat via Business Insider
When you can earn a higher dividend yield with the prospect for growth in the dividend and potential capital appreciation, it makes sense that investors would prefer stocks over bonds which pay a fixed coupon. Research from Bespoke shows that positive excess returns occur when the dividend yield rises above the Treasury yield.
We know that 2015 was a tough year for markets, so perhaps the positive returns in equities this year reflects the beginning of this trend.
The common counterargument to looking at dividend yields is that they may be artificially boosted by borrowing and don’t reflect true earnings power. However, the “Fed Model” looks at total earnings yield relative to Treasurys and this indicator also confirms that stocks are significantly undervalued:
Critics could point to a wide range of arguments such as slowing earnings growth or abnormal interest rate conditions. But conventional analysis of the data and simple common sense dictates that capital flows to equities should continue over time.
Another beneficial trend is the recent continuation of various quantitative easing programs by global central banks that take aim at direct asset purchases. This means simply that the central banks are actually buying up risky asset classes.
While the Fed has slowed, the other central banks have more than picked up the slack. However, should the data show that U.S. growth is faltering, we can probably expect the Fed to join the party. Monetary policy is getting increasingly creative as witnessed by the Bank of Japan which has been growing their ETF purchases and is now the largest owner of ETFs in the Japanese market:
In the recent BoJ meeting the bank indicated that they would be ramping up the purchase of publicly traded securities including ETFs to the tune of 6 trillion yen per year. The reason for this move was cited as (BoJ): “preventing these uncertainties from leading to deterioration in business confidence and consumer sentiment as well as to ensure smooth funding in foreign currencies by Japanese firms and financial institutions” We believe that other central banks may follow suit over time and this will also contribute to rising equity markets.
The last question is whether some of the recent positive returns for the stock market have already built in optimistic expectations. Despite the fact that these other supportive trends are secular in nature, it is always interesting to see how this relates to current investor sentiment. Bespoke Investment Group shows research comparing the American Association of Individual Investors (AAII) bullish sentiment over time since the beginning of the bull market:
Source: BESPOKE Investment Group
Currently bullish sentiment is at low levels, and this tends to be a good contrarian signal. As we have said before, bull markets often climb a “wall of worry” and clearly the disconnect between the S&P500 and sentiment is confirming this observation.
On the flip side, there is no question that “black swans” and hidden risks lurk below the surface of these generally calm market waters. No indicators have a perfect track record, and it is entirely possible that a recession could still loom in the near future. As we have shown before, the consequences of being “long and wrong” are devastating. So we believe that it pays to actively manage risk rather than buy and hold and hope for the best. Our models follow trends and market momentum, and currently we are well-exposed to risk assets. If the market happens to fall substantially over time we will reduce our exposure. By following the trends, we can benefit from capturing the upside of this bull market while having a dynamic stop loss to ensure that we do not fall victim to an unexpected bear market.
- Graeber: “Debt: The First 5000 Years”
- Homer: “A History of Interest Rates
This article is copyrighted by Blue Sky Asset Management, LLC (“BSAM”) with all rights reserved. Any reprinted material is done with permission of the owner. This material has been prepared for informational purposes only and is not an offer to buy or sell any security, product or other financial instrument. Past performance is not necessarily a guide to future performance. All investments and strategies have risk, including loss of principal.BSAM and its affiliates do not render advice on tax and tax accounting matters to clients. This material was not intended or written to be used, and cannot be used or relied upon by any recipient, for any purpose, including the purpose of avoiding penalties that may be imposed on the taxpayer under U.S. federal tax laws.
The author(s) principally responsible for the preparation of this material are expressing their own opinions and viewpoints, which are subject to change without notice and may differ from the view or opinions of others at BSAM or its affiliates. Any conclusions presented are speculative and are not intended to predict the future of any specific investment strategy. This material is based on publicly available data as of the publication date and largely dependent on third party research and information which we do not independently verify. We make no representation or warranty with respect to the accuracy or completeness of this material. One cannot use any graphs or charts, by themselves, to make an informed investment decision. Estimates of future performance are based on assumptions that may not be realized and actual events may differ from events assumed. BSAM is not acting as a fiduciary in presenting this material. Benchmark indices are presented or discussed for illustrative purposes only and do not account for deduction of fees and expenses incurred by investors. “MRI” is our proprietary Macro Risk Indicator.
The strategies discussed in this material may not be suitable for all investors. We urge you to talk with your investment adviser prior to making any investment decisions.