With 2017 coming to its close, we continue to find conflicting opinions on the state of the economy and the outlook for the stock market. On November 14th, Bank of America shared the results of a survey that it says demonstrates investors are “increasingly showing signs of ‘irrational exuberance’, putting more chips on the table even as they worry equities have become overvalued.” Bank of America’s chief investment strategist was quoted as saying, “Icarus is flying ever close to the sun.” On November 29th, Bloomberg published an article referencing a research report from Goldman Sachs that says, “pain is coming.” St. Louis Fed President James Bullard recently said, “within a year, short-term interest rate Fed action may cause an ‘inversion’ of the yield curve that is a signal of economic weakness...” An inversion of the yield curve is when the short-term rate (defined as the 3-month Treasury) is higher than the long-term rate (defined as the 30-year Treasury). The last three inversions of the yield curve were in 1989, in 2000, and in 2008.
Fed President Bullard’s comments on the yield curve inverting are particularly interesting because many times before a bear market we experience an inverted yield curve. As such, we will discuss each of the last three yield curve inversions. Our goal is to provide a factually based outlook on where we think the economy and markets may be going from here.
Starting with the inversion in 1989, we observed that the stock market really did not experience significant losses like what were experienced after the inversions in 2000 and 2008. This indicates to us that NOT ALL YIELD CURVE INVERSIONS ARE CREATED EQUALLY. This also leads us to question what may have contributed to the differences between the 1989 inversion and the 2000 and 2008 inversions.
One observation was that valuations were fair in 1989. In January of 1989 the S&P was trading at 11.8 times its earnings (undervalued by historic measures). In 1999, the S&P 500 was trading at 33 times its earnings (well over-valued by historic measures) and in 2008 it was trading at over 21 times its earnings (reasonably fair value). Another important observation was the difference in America’s debt structure. Most consumers’ largest debt is their mortgage, and historically most mortgages have required borrowers to repay principal and interest with every mortgage payment. However, in the 2000s there was a wide-spread adoption of the Interest Only Mortgage where for a period (frequently between 3 and 5 years), borrowers only made interest payments. After the Interest Only period ended, the loan would become amortized over the remaining term, and the borrower would begin to pay both principal and interest.
To show the peril of interest only loans, a borrower who had a $300,000 mortgage with an interest only loan of 3% for 5 years would have had a mortgage payment of only $750 per month for the first five years. However, at the end of the interest-only period, assuming NO RATE INCREASE, their payment would have increased to $1,423 / month, or roughly double their initial payment. Considering the average family income in America, it would be very difficult for many families to absorb the additional $8,000 of mortgage expense when the Interest Only period ended.
By the latter half of the 2000s, many of the Interest Only Loans were now requiring the repayment of principal in addition to interest payments; we believe this materially contributed to the climb in the Consumer Household Debt Service Ratio. As this ratio climbed, it became harder for consumers to pay their bills, and by 2008, it appears many homeowners identified the cause of the increase in their debt service – their house. Shortly thereafter, homeowners began turning their homes back to the banks and the foreclosure crisis began. The drop in outstanding consumer credit experienced in 2008 and 2009 (mostly through mortgage default) was the MOST DRAMATIC DROP in consumer debt since 1950.
So what does all this mean? To us, what stands out is that VALUATIONS ALONE or YIELD CURVE INVERSIONS ALONE are not responsible for bear markets. At the heart of Bank of America’s and Goldman Sachs’s statements is valuation. The S&P 500 is now trading at 25 times its earnings, which is above its historical average value. Their presumption appears to be that since the market is above its historical average, it must come back down. And while we would agree that markets eventually revert to their mean, one could have made the same argument in January of 2017. At the heart of Bullard’s statement is that INVERTED YIELD CURVES = RECESSION. However, as with the valuation in a vacuum analysis, the data just doesn’t support this claim.
The data does however suggest that a shock to the system at a time when financial risks are high may result in a RECESSION and BEAR MARKET. In 2000, excessively high valuations with no regard for sustainable growth, combined with the personal savings rate falling from over 7% in 1990 to 3.5% in 2000,left the markets vulnerable. As the tech rally slowed, and investors again looked at sustainable business practices, the markets corrected.
The high debt levels in 2008 with irresponsible borrowing and lending practices and a low savings rates (about 3.5% again) increased the risk of a bear market too. When homeowners began walking away from their mortgages, the market was again sent into a bear market.
Fortunately, we do not see investors arbitrarily investing irrespective of earnings or growth. While the S&P 500 is at a relatively high multiple (25 times its earnings), we do see signs of investor restraint when it comes to where they allocate their capital. As one example, over 50% of the S&P 500 is trading UNDER its average price to earnings ratio of the last 20 years. With respect to debt, while the Consumer Household Debt Service Ratio is climbing, we do not see anything like the Interest Only Mortgages we saw before 2008. Without something to create a shock, it will be more difficult to have the same type of reaction that we saw in 2008.
Further, we believe it’s rational that investors may pay more for the combined growth and yield of an equity in a low interest rate environment,like the one we’re now in, than they would have paid when the 10 year Treasury was yielding over 5%. When the 10 year US Treasury yields 2.37% and the S&P 500 yields 2.0%, it’s easier to justify owning equity even for the more risk averse. And with respect to other Macroeconomic factors, we continue to see improvement in housing, shipping (The Baltic Dry Index), Consumer Confidence, Total Household Net Worth, Labor Output, and the S&P 500 Trucking Index.
We do have a number of issues we view as potential risks. One of them being the drop in the savings rate, and another being that we are on the high side of historical valuations. We are also cognizant of the high levels of government debt and geopolitical risk. We will continue to monitor the data and are looking for indications the economy may begin to weaken. As we see the data change, we will share that information and look at adjusting portfolio allocations. If you’d like to have a more detailed, personal portfolio review, please let us know. Your monthly reports are also now posted to your client portal. You can get there by going to www.fortemfin.com and clicking on client login button in the upper right of the webpage.
