Stocks lost ground last week to the tune of about 1% but the route to that loss involved more volatility than we’ve seen in some time. The volatility index has moved higher by a third since that key reversal day a week ago Wednesday. And the volatility hasn’t been confined to stocks. The bond market has tacked on about 50 basis points in yield over the last month and rates continued higher last week. Japanese stocks are officially in correction territory with prices down over 13% since the peak just over a week ago. Japanese bonds have been even more volatile than their US counterparts. Other risk markets have also been taking it on the chin with the junk bond bubble deflating by over 3% which normally wouldn’t be a big deal but at recent prices represents over half a year’s worth of interest. Emerging market bonds, another of the yield reachers favorites, is down over 5%.
So what’s going on and why the sudden burst of volatility? A number of explanations have been offered with the most prominent being that this is a reaction to Fed talk of tapering its purchases of Treasury and mortgage securities. I suppose that could be true if one is talking about stocks but it leaves a lot to be desired when talking about the Treasury market. There is a belief that absent Fed buying Treasury yields would be even higher but that flies in the face of what we’ve seen with past episodes of QE. Bond yields tend to rise during the QE periods and fall as it ends. Logically then if the Fed is really contemplating the end of QE, bonds should be rallying and yields falling. Instead, what’s going on in bond land is perfectly consistent with what we should expect based on past experience. In fact, it seems to me that the bond market is saying that there is no end in sight for QE.
As for the risk asset side of the equation, I wonder if the problem might be that QE is finally being revealed as the economic equivalent of the Emperor’s New Clothes. The fact is that despite repeated doses of the QE medecine, the economy continues to plug along at sub par rates of growth and things don’t seem to be getting better despite what some Fed governors might want to believe. Risk assets such as junk bonds, emerging market bonds and any stock with a decent dividend yield have rallied based on the hunt for yield, not in anticipation of better growth. Earnings growth essentially peaked 6 quarters ago but hope springs eternal on Wall Street and estimates for the rest of the year are very optimistic. Absent some miracle on the growth front though, those expectations are going to be very hard to meet.
The main effects of QE have been felt in asset markets which has benefitted those who are able to participate but has yet to trickle down to the masses. NYC, Miami, San Francisco, London and other large cities – with the notable exception of Chicago – are in the midst of deja vu real estate markets complete with bidding wars and rapidly escalating prices. Stock markets, until last week have been on an almost relentless march higher but with average Americans almost completely unaffected. The market for luxury and conspicuous consumption is going gangbusters. The market for everyone else is moribund. Unfortunately, the rise in asset prices is based on a fallacy. QE cannot create real growth – indeed there is ample evidence that is does the opposite – and the real global economy is still shackled with high debt and economic policies that discourage growth.
All QE is able to do is reduce the discount rate at which future earnings are discounted back to the present. In other words, the returns investors have enjoyed for at least the last year are returns that have been borrowed from the future. At some point, for stock prices to keep rising, economic growth will have to pick up so that the future stream of earnings grows. If that doesn’t happen – and there is scant evidence of it yet – stock prices cannot keep rising. The only alternative to keep earnings per share growing – and therefore stock prices – is for companies to continue borrowing to fund higher dividends and stock buybacks. While that has worked for the last couple of years there has to be a limit and with corporate debt at all time highs we might be there already.
The most overvalued sectors of the market – utilities, REITs and consumer staples – are leading the market to the downside just as they led on the run up. All these sectors have limited opportunities for growth but with bond yields depressed, their dividends were seen as attractive and supportive of higher prices. As I pointed out a couple of months ago, paying over 20 times earnings for a company growing earnings at single digits just to capture a 3 or 4% dividend was and still is an extraordinarily risky strategy. Utilities and REITs are already down nearly 10% from their highs and consumer staples over 5%. That already wipes out more than a year’s worth of dividends in almost all cases and these stocks are still not cheap. Anyone who bought these thinking the dividend yield would support the price was betting, whether they knew it or not, that bond yields were going to stay well behaved. That has turned out to be a bad bet over the last month and if QE continues to push rates higher it will continue to be a loser.
This economic recovery has from the start been built on a very narrow slice of the economy. Real estate has been revived – if you think higher prices are what constitutes revival – because the Fed has directed credit directly at that market. But the “recovery” has not been driven by average Americans realizing the American dream of homeownership. It has been driven by “investors” buying houses to rent, a completely government supported mortgage market and foreclosure rules that limit the supply of houses on the market. Unfortunately, the real estate market may have reached its limit. Cash yields on rental real estate have fallen as prices have risen and a lot of the people who got in at the bottom are looking to cash out. Supply is still limited in some markets but if investors back away that could change rapidly.
The other slender reed on which this recovery rests is the rise in stock prices. Rising real estate and stock prices have resulted in a near complete recovery of the wealth lost in the crisis of 2008. Unfortunately, because most stocks are owned by wealthier Americans the recovery has not been uniform. With aggregate incomes still stagnant and gas prices still high from the effects of QE (although that seems to be reversing), consumption is being fueled by the small slice of the public that has benefitted from QE and from reduced savings. If the wealth effect has indeed been the driving force behind this weak recovery, a reversal in stock and/or real estate prices could have dire consequences.
As the stock market has moved higher over the last few months, I have become increasingly concerned that the rise isn’t sustainable. My concerns have been driven in the short term by a lack of earnings growth and higher valuations. It is impossible to predict how high speculators might kite valuations in the short term but in the long term, stock prices are driven by earnings and interest rates. With interest rates already at generational lows the only thing left to move prices higher was earnings growth which has been conspicuously lacking for going on two years. And most of what EPS growth we have seen has come from financial engineering. With emerging market economies slowing (did you see Brazil’s GDP last week?), Europe still in a depression (although possibly hitting bottom) and US growth dependent on a small slice of the population it is hard to be confident about future growth.
The volatility we’ve seen over the last two weeks isn’t really that extreme but volatility tends to beget more volatility. Stock prices have little in the way of fundamental support so prices will increasingly be driven by sentiment and emotion. The fears over the tapering of QE are probably overblown. Of much greater concern to investors should be that Bernanke & Co. are revealed as impotent. If the economy doesn’t improve soon, that is an increasingly likely event and when it happens, the volatility of last week will likely look quaint. My advice is to buckle your seatbelt.
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