It is a typical May day here in Ireland. The temperature is 48 degrees this morning. It is cloudy and grey.
We are staying over here in Youghal…pronounced ‘yawl’…so that we can keep up with our renovation project.
Scaffold is up. The floors and roofing have been taken off so that we can inspect the ‘timbers’ and replace those that need it.
Renovations begin on Bill’s new Irish home
[Click to enlarge]
‘It is in remarkably good shape for a house that old,’ said the architect.
We are putting a small, glass conservatory next to the kitchen. We asked what it would be like in the summertime. Will it be too hot?
‘This is the summertime,’ said he.
Trough to trough
We’ve been keeping our eyes on the important news: the yield on the 10-year Treasury note. It hit a seven-year high yesterday, 10 basis points above 3%.
Well, there’s more than $230 trillion of debt all over the world. And most of it is related by marriage or blood to the US Treasury market. Even if it is not quoted in terms of US debt, it is heavily influenced by it.
Yields on the 10-year note have risen nearly 200 basis points since hitting a bottom in July 2016.
But they’re still far below the historical ‘norm’. The last time bonds traded at such high prices (low yields) was around when your editor was born — a couple of years after the end of World War II.
The full cycle, from trough to trough, lasted almost a lifetime…68 years. And now, it looks (because you never know for sure) like we are set to begin again.
We are reborn…at the very beginning of a new cycle.
Already, the financial geniuses on TV are preparing for 4% yields. From what we can see, they are split into two camps.
One says that 4% will hurt stocks. They predict that stocks could be down 20% when 4% yields are reached.
The other, including Mad Money host Jim Cramer, says that 4% yields will be no problem; the US economy is strong enough to survive them.
Both are probably wrong.
The first point of view is consistent, more or less, with the ‘Fed model’.
Investors compare what they can get from Treasuries to dividend yields in the stock market. When Treasury yields rise, stocks must fall to provide competitive yields.
No, no…says the other side…In real terms, 4% is just 2% (adjusted for inflation)…and this great economy can handle that, no problem.
After all, unemployment is almost non-existent. Inflation is under control. And there’s a boom coming from the big stimulus of the tax cut.
The idea here is that the economy is strong. Corporate profits should rise, followed by stocks.
A corollary to this hypothesis is that yields are rising, not in response to inflation fears or ‘crowding out’ by the Fed, but in reaction to a stronger economy. (The ‘crowding out effect’ describes how increases in government borrowing force up interest rates for everyone.)
Interest rates should go up as businesses and individuals bid for loans so they can increase investment and consumption — both of which spur the economy to even faster growth.
This reminds us of a joke we once heard…
An engineer, a doctor, and an economist went hiking in the Alps.
After a while, they realised that they were lost. They studied the map.
The engineer suggested retracing their steps. The doctor suggested taking a break to rest. But the economist stood up triumphantly, pointing to a distant peak.
‘There…see that mountain? That’s where we are.’
The problem with both points of view is that we’re not where they think we are.
We’re at the top of a very steep mountain of debt and asset prices, with an economy that is addicted to super-low rates…and stocks that are priced for Everest.
Floating on bubble finance
The Dow was below 8,000 when it hit bottom in the last credit crash in 2009. Now, it’s over 24,000.
This was not a natural or normal climb. While the Dow has more than tripled, the economy that supports it has not.
GDP was nearly $15 trillion in 2008. It’s only $20 trillion 10 years later. That is not a triple…not a double…not even a 50% increase. It’s just a 33% boost.
In other words, the hikers didn’t get up there by putting one foot in front of the other…following the economy.
Instead, they floated up on bubble finance — about $12 trillion has been pumped into the markets by the world’s leading central banks.
Getting down the mountain won’t be easy. Some necks will be broken. And some hearts, too.
Super investor Warren Buffett’s favourite indicator is the stocks/GDP ratio. It compares the price of America’s capital assets — its large, publicly traded businesses — to output.
Logically, asset prices ought to reflect what they produce. And Buffett says that as long as the value of stocks is 80% (or less) of GDP, investors can safely buy.
When stock prices go above that level, watch out.
Today, US GDP is the aforementioned $20 trillion. And the value of all equities is about $28 trillion (no point in trying to be precise…this isn’t science).
That gives us a ratio of 1.42. (It is so high for an obvious reason, mentioned above — stocks have gone up a lot faster than GDP.)
This is the second highest the indicator has ever been…higher than in 2007.
The previous record — set in the first quarter of 2000 — was 1.51, which was nearly twice the long-term average.
So here’s the big picture:
Interest rates are going up. As for assets, our guess is that when the stock market gets a load of what 4% rates will do, it will panic…and drop more than expected, faster than expected.
When prices get back in Warren Buffett’s buy zone of 80% (or less) of GDP — which they must sooner or later — stocks will have lost about 45% of today’s value. Dow 13,000, in other words.
When they get to that level, buy!