Monthly Archives: November 2008

Valuing Stocks Relative to Bonds

A popular method for determining whether equities are cheap is to compare the stock market’s dividend yield with the yield on long-term government bonds. Using the amount of dividends paid by companies in the S&P 500 index during the past 12 months, the dividend yield is currently 3.22%. Meanwhile a ten-year treasury yields 3.75%. The following is a historical look at how dividend yields and long-term treasury yields compare.

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Currently, the spread is as tight as it has been since the early ’60s. Does this mean stocks are cheap relative to treasuries? Or is it likely that going forward stocks will yield more than treasuries as was the case for most of the period before 1958.

Treasuries have zero default risk, but plenty of inflation risk since the amount of the coupon is fixed. Stocks, on the other hand, have little inflation risk (because companies can increase profits in inflationary conditions), but carry default risk.

During periods of high monetary inflation, where the value of money is losing value at a rapid pace, the market will assume that inflation will continue to be very high in the future and demand a higher yield from bonds than from stocks to compensate them from future loss of purchasing power. At the other end of the spectrum are periods of deflation when the money supply contracts. Deflations cause corporate profits and dividends to decline in nominal terms, though they may increase in real terms. Therefore, expectations of deflations usually result in stocks having higher yields than treasuries.

Independent of inflation or deflation, the economy could be growing or contracting. Over long periods of time the economy usually expands. Ignoring any effects from changes in the money supply, investors will be willing to accept lower dividend yields than treasury yields because dividends are likely to increase over time. On the other hand depressions, which are economic contractions that last for many years, can increase the risk of bankruptcy causing investors to demand greater yields from stocks than from treasuries.

Combining the effects from monetary inflation and economic growth on treasury and stock yields give the following table:

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I have inserted question marks for deflationary economic growth which characterized most of the 19th century when corporate profits steadily increased in real terms, but not necessarily in nominal terms; during such times there should be no significant difference between treasury and stock yields. Also, there should not be much of a difference in yields during highly inflationary depressions because it is not clear whether businesses can increase profits in nominal terms.

The table does a good job of explaining why dividend yields exceeded treasury yields during the time frame from 1871 to 1957 if one considers that this was a mostly disinflationary period punctuated by a couple of deflationary depressions. Consider that during this entire period of 87 years, inflation, as measured by the CPI, increased by 128% and corporate earnings rose by an average of 5.2% annually.

But since 1957, a period of just 50 years, the CPI has increased by 634% and corporate profits grew by an average of 7.9% annually. Thus, it should be of no surprise that since 1957 investors have demanded greater yields from treasuries than from stocks when the rate of inflation has been so high and there was not a single depression. Dividend payouts steadily increased throughout the period except for only a few short-term reductions.

So to form an opinion on whether stocks should yield more than treasuries one needs to know if the economy has entered a period of inflation or deflation and if a depression will be avoided. It is my belief that the US has entered a depression, where real earnings will decline and not recover for several years. If the Fed prints enough money and creates substantial inflation, earnings could bottom in nominal terms in 2010 at the earliest at which point I expect treasuries to yield more than stocks.

Until then I expect the depression to be disinflationary, rather than a deflationary because the government is preventing any significant bank failures which is a necessary condition for deflation. Although asset and consumer prices are declining, this is not deflation; instead it is a reflection of a drop in the velocity of money as individuals and businesses hoard cash. So if indeed this is a disinflationary depression, I expect the difference in yields between treasuries and stocks to diminish over the next year.

Japan offers a recent example of a disinflationary depression and as can be seen in the chart below the yield on Japanese stocks exceeded the yield on long-term government bonds during a significant part of the past two decades.

Google Image Result for http___www.utopia-global-portfolios.net_images_figure_1.gifI am expecting similar results in US markets and would not be an aggressive buyer of equities until they yield more than treasuries.

Buying November ‘09 Fed Funds Futures

Last Friday I purchased fed funds futures contracts for November 2009 at 98.25. I went long fed funds futures earlier this year and closed the position in September with a huge gain. In retrospect, I could have made even more if I held on to the position, but I didn’t anticipate the Federal Reserve slashing the overnight rate by 100 basis points in October.

If I would have known in advance that October would be the ninth worst month in stock market history, the CRB index would register its largest monthly decline on record, and the US dollar would attain its biggest monthly gain against a basket of currencies in more than 17 years then, of course, I would have predicted the Fed’s policy decisions. But October was an unusual month to say the least.

What I find strange is that the market is pricing in only another 25 basis points cut by the next FOMC meeting on December 16th, after which the Fed is expected to embark on a tightening campaign next year by such an extent that the overnight rate would reach 1.75% by November.

I think only two conditions would necessitate such a policy response: (1) the US economy soon begins to stage a rapid recovery or (2) confidence in the US dollar is shaken and its value plummets. The first condition is highly unlikely, in my opinion, given that the US consumer is early in the process of decreasing consumption and increasing savings in order to repair his balance sheet from the damage done by declining real estate and equity values.

As for the possibility of a dollar crisis, I certainly expect one at some point in the future, but not in the next 12 months. The US dollar is the world’s reserve currency and in a period of de-leveraging, it will be in great demand. Only if the Fed prints money in a far more rapid fashion would confidence in the US dollar be shaken, and even then the Fed would have first resorted to a zero interest rate policy (ZIRP) for a period of time before attempting such a risky action.

During the last recession, the Fed began easing in January 2001 and didn’t raise rates until June 2004 or 41 months later. In the current cycle, the Fed first cut rates in September of last year or 14 months ago. If the Fed emulates its policy actions from the previous downturn then rates won’t increase until February 2011. I don’t know if the Fed will wait that long before it begins to hike rates, but given that the current recession will be far more severe than the previous recession, I am confident that there won’t be a hike in 2009.

Lowering of the fed funds rate helps the two groups most affected by the current crisis: banks and consumers. Banks benefit because their business is based on borrowing short and lending long, so their net interest margin will expand. Consumers benefit because many adjustable rate mortgages and loans are based on the banks’ prime rate which is influenced by the overnight rate. Therefore, there is a lot of incentive for the Fed to implement ZIRP.

However, I don’t think it will be enough to offer much of a stimulus for the economy because banks are barely solvent and don’t want to lend in order to preserve capital. And consumers have too much debt relative to the total value of their assets to want to borrow more. Therefore, credit growth, which factored in each time in the past as the Fed cut rates to pull the economy out of a recession has disappeared. Once the Fed cuts rates close to zero, it will realize that additional actions will be required.

Japan held rates at zero for nearly six years in its decade-long struggle against deflation. When that was not enough it resorted to “quantitative easing”, a technical term for what amounts to printing money on huge scale. I expect the Fed to follow the same game plan. Though it has already started to print money via its normal open market operations, I expect more aggressive money printing through unconventional means when it realizes ZIRP is not making much a difference.

The following table lists the profits or losses I would incur under various fed funds rates for each November 2009 contract that I buy at a price of 98.25:

Fed Fund Futures Risk/Reward

My intention is to hold the contracts until they rise to at least 99.50 (i.e. the market prices in a 0.50% fed funds rate or lower) so that I can make a profit of more than $5,000 per contract. This would be a spectacular return since the Chicago Board of Trade requires a maintenance margin of only $1,200 per contract.