“Toto, I have a feeling we are not in Kansas anymore,” Dorothy famously said in the children’s classic The Wizard of Oz. In the same vein, this letter cautions investors that important changes are occurring in the markets and, while much feels as safe and predictable as Kansas, things are fundamentally shifting. Most importantly, rising interest rates are steadily undermining the valuation cases for stocks, bonds and real estate.
- Since January, the stock market’s increased volatility indicates a major turning point in this 10-year-old bull market in equities.
- Bond legends Bill Gross[note]Bill Gross https://en-us.janushenderson.com/retail/bill-gross-investment-outlook-bonds-men-its-about-time/?utm_campaign=Bill_Gross_Investment_Outlook&utm_medium=Email&utm_source=Salesforce&utm_content=Retail [/note] and Jeffrey Gundlach[note] Barron’s Jeff Gundlach of DoubleLine Capital Markets November 21, 2016. https://www.barrons.com/articles/gundlach-bond-yields-could-hit-6-in-five-years-1478929496?mg=prod/accounts-barrons[/note] have called a bear market in bonds—with Gundlach calling for 6% 10-year US Treasury yields in 2021.
- The real estate market is softening as illustrated by a 25% decline in sales of all condos and coops in Manhattan—the worst decline since 2009[note] https://www.bloomberg.com/news/articles/2018-04-03/manhattan-home-sales-tumble-most-since-2009-as-buyers-push-back[/note].
The chart [note]Advisor Perspectives https://www.advisorperspectives.com/dshort/updates/2018/04/05/treasury-yields-a-long-term-perspective[/note] below graphically displays the cycle of unprecedented financial accommodation since the financial crisis of 2008. The chart below shows how Fed Fund rates dropped from over 5% in 2007 to nearly zero and are now rising with the Federal Reserve signalling further hikes. 10-year Treasury rates fell from 5.3% to 1.36% in July 2016 and now are headed over 3%. In recent years, the yield on safe liquid investment options like money market instruments and Treasuries, dropped so low that they offered virtually return and forced investors into risky assets. Now increasingly attractive yield instruments are undermining the stock, bond and real estate markets.
What is profoundly different, in this cycle, is that interest rates are rising from extreme and artificially low levels. In response to the 2008 financial crisis, the Federal Reserve and global central banks provided unprecedented accommodation by buying nearly $15 trillion in securities. This unprecedented action artificially lowered interest rates such that there are currently $9.7 trillion in negative interest rate bonds[note]$9.7 Trillion in negative interest rate debt. Fitch Dec. 11, 2017.[/note] globally. With the economy recovering, the Federal Reserve is attempting to unwind these bond and accommodation bubbles. The Federal Reserve is raising interest rates and will likely tighten three more times this year. Additionally, the Federal Reserve is letting its $4.5 trillion in debt on its balance sheet expire–turning a nine-year period of “Quantitative Easing” into “Quantitative Tightening.” This action effectively ends tens of billions in Treasury and mortgage purchases every month, further pressuring the bond markets and, by extension, the equity and real estate markets.
The stock market now exceeds the extreme valuation peak of 1929 and is only exceeded by the 2000 Tech Bubble as measured by the Shiller Cyclically Adjusted Price Earning (CAPE) ratio.
The Fed Model:
While the Shiller CAPE ratio may have some critics, it does suggest high valuation levels. To properly value the stock market, we prefer more pragmatic asset pricing models that recognize investment alternatives. Both the “Fed Model” or “Risk Premium” offer this more pragmatic approach by comparing the S&P 500 earnings yield to the 10-year US Treasury bond yield.
Carefully study the colorful three panel chart below (bottom pane) which shows the 10-year US Treasury yield compared to the earnings yield of the S&P 500. The bottom panel shows that earning yield (S&P earnings/S&P price) in 1999 and 2000 is lower (less expensive) than 10-year US Treasuries. The “Risk Premium”, shown on the top pane, is the difference between the earnings yield of the S&P 500 and the yield of 10-year US Treasury. Note the precise timing of the market’s 2000 and 2007 declines below. While the stock market was quite overvalued in 1999 and 2000, it was not until earnings slowed that the market turned down in March 2000 and October 2007. The red line is a blend of trailing earnings and expected earnings so it is both forward looking and historically accurate.
Last year, expectations of lower taxes and an improving economy, drove the red earnings line and stock market higher. With the passage of The Tax Cut and Jobs Act of 2017, the red earnings line spiked up from December through February with the passage of new tax law and earnings. In March, the red earnings line appears to have peaked. The year-end jump in blended earnings reflects lower corporate tax rates being incorporated into estimates. The recent flattening of the red earnings line suggests that the market has largely discounted the tax cuts. [See the middle panel of the chart above.]
Earnings and Yields:
A closer examination of the spreadsheet data below provides insight into recent market volatility. The chart below shows the 10-year US Treasury rate rose at an accelerating rate from 2.354% in November to 2.85% on February 2nd and inspiring our Echoes of the 1987 crash before the market declined intraday 1500 Dow points on February 5th. Estimated earnings also rose from 144.82 in November to 170.38 in early March where they have paused. Since markets (and computer programs) are forward looking and Risk Premium is simply an indication of valuation, we focus on the trend in earnings and trend in interest rates. Presently, the S&P 500 Risk Premium is 3.21%; the market is expensive, but not perilously priced given the low interest rate environment. However, absent obvious exogenous factors like wars, trade wars, or negotiations with North Korea…,the market will likely decline, if interest rates trend higher and or earnings trend lower.
In the last two years both short and long-term interest rates have moved up. Given the recent 18% increase in expected S&P 500 earnings for 2018 (from $144.82 in November to $170.32 at the end of March) the market has likely discounted the benefit of the tax law change and leaves the S&P 500 at 15.5 times forward earnings–a reasonable valuation level. However, for interest rates to move meaningfully higher from here, a return of in inflation would need to occur.
The Next Great Bull Market?
A resurgence in inflation scenario would be devastating to the bond market. Inflation can come from commodity inflation or wage inflation. DoubleLine CEO, Jeffrey Gundlach has raised the specter of inflation stating “commodities are very, very cheap. Commodities have long cycles, as well. A fascinating chart that has been circulating the investment industry. It compares the total return of the Standard & Poor’s 500 index to the total return of the Goldman Sachs Commodity Index, and it goes in tremendous cycles. In the 1970s, commodities started to outperform. They outperformed the S&P 500 by 800%, and then gave it all back. Then there was another wave up, and commodities outperformed again by 800%, actually 900%, and that continued into 2008.” If we have a resurgence in inflation comparable to recent cycles, as the chart below suggests, it could have a devastating market impact.
IGA Risk Management:
Income Growth Advisors offers several strategies to mitigate risk in client portfolios. We believe that major cycle tops are forming in the stock, bond and housing markets. If commodity inflation takes off, the downside risk to stocks, bonds and real estate will be far more immediate and severe. To reduce portfolio risk, we offer hedging strategies to clients with concentrated stock positions in extended stocks. To generate a high growing streams of income, we offer several MLP portfolios. The recovery in the energy markets should drive growing MLP distribution yields and provide commodity hedge. We also are developing income portfolios for a rising interest rate environment and commodity portfolios for a potential commodity bull market.
Encore Une Fois:
We focus on Master Limited Partnerships and believe they offer compelling economic and valuation merit. Since oil peaked in July 2014, we have frequently touted the merits of MLPs. Given the disappointing returns of MLPs since 2014, it would seem that performance could not get any worse. However, on March 15th, “FERC” the Federal Energy Regulatory Commission issued a statement regarding a lawsuit ruling that disallowed income taxes as a line item in the calculation of tariffs for interstate pipelines. This headline “disallowing their income tax” [exemption] prompted a panic in MLPs as investors “sold first and asked questions later”. While the ruling proved to be limited in scope, the knee jerk reaction pushed MLPs to new lows in a frightening two hour 10% downdraft. It is useful, at times like this, to remember that investment giants like Templeton, Graham and Buffet advocate buying when “nobody is buying”, or “everyone is selling”. We view this FERC announcement as a psychological “coup de gras” for the MLP sector, but, from a contrarian standpoint–it is a buy signal.
MLPs are an attractive source of high, growing and tax advantaged income. One factor we did not properly evaluate, in recent years, was the collective impact that the energy bear market had on MLP fund and ETF distribution profiles, and their subsequent negative fund flows. While we avoided the weakest MLPs, sector weakness and distribution cuts in MLPs which IGA did not own for our clients hurt MLP ETF and mutual fund distribution trends. With the proliferation of computerized strategies and simplicity of ETF portfolio investing, the declining MLP ETF distribution profiles led to several years of declining fund flows and poor sector wide MLP performance. Now that the energy sector has bottomed, and the vast majority of financial restructuring in energy sector has ended, MLP ETFs are now poised to increase their distributions. With increased distributions, MLP ETF and mutual funds should again attract fund flows which should reverse the MLP sector’s bear market. Consider the AMLP-the Alerian ETF’s distribution history below:
- Feb 08, 2018 0.207 Dividend
- Nov 09, 2017 0.205 Dividend
- Aug 09, 2017 0.215 Dividend
- May 10, 2017 0.215 Dividend
- Feb 08, 2017 0.225 Dividend
- Nov 09, 2016 0.24 Dividend
- Aug 10, 2016 0.24 Dividend
- May 11, 2016 0.24 Dividend
- Feb 10, 2016 0.299 Dividend
The Alerian distribution declined 31.4% from .299/quarter share in February 2016 to 0.205/quarter/share in November 2017. The reason to own MLPs is their growing distributions and high yield. Now that broad based ETFs and funds are starting to raise their distributions again, MLPs should be poised to appreciate from here.
MLP Performance and Reversion to the Mean:
IGA’s long term 17-year MLP SMA performance record shows a 8.25% outperformance to the S&P 500 after fees. Since 2014 MLPs underperformed the S&P 500 dramatically due to the collapse in oil prices and ensuing disruption of the North American shale boom. Now that the energy sector has bottomed, fundamentals are improving. Oil prices have risen improving earnings and distribution prospects. The Alerian Index of MLPs currently yields 8.78%. With distribution growth returning to the sector, improving oil prices and a robust future for natural gas, MLPs are a timely investment due to their attractive growing tax advantaged income streams generated from durable hard assets. In a world of overpriced asset classes, inexpensively priced MLP portfolios yielding 8.78% with solid distributions are a sensible safe harbor.
The performance of our SMAs versus the S&P 500, the Alerian Index and the Alerian ETF show, in the chart below, a long-term record of outperformance. The chart also shows recent underperformance and a likelihood for a performance reversion to the mean. MLPs should start outperforming the S&P 500 given their valuations, improving distribution profiles, and history of exceptional performance following periods of poor performance.
Market risks are rising and they will continue to rise as interest rates normalize from this unprecedented bubble in prices. This rising interest rate environment could present potentially significant risks to stocks, bonds and real estate. Fortunately, there are intelligent and pragmatic steps that you can take.
This is not a time to invest by looking in the rearview mirror. We recommend “skating to where the puck will be” as Wayne Gretzky famously attributed to his hockey success. Both Warren Buffett and Steve Jobs have similarly cited this Gretzky quote for their investment and business success.
We welcome any and all questions and comments.
Tyson Halsey, CFA