Interest Rates and Stock Multiples

(Updated 03/13/2018)

Job creation remained solid in the small business sector as owners reported a seasonally adjusted average employment change per firm of 0.22 workers, a strong showing and a repeat of last month.

A headline on Bloomberg —"Goldman Says Stocks May Plunge 25% If 10-Year Yield Hits 4.5%" —said that:^[1]

If the 10-year U.S. Treasury yield hits 4.5 percent by year-end, the economy would probably muddle through -- stocks, not so much, according to Goldman Sachs Group Inc.

Goldman’s base-case scenario calls for a 10-year yield of 3.25 percent by the end of 2018, though a “stress test” out to 4.5 percent indicates such a move would cause stocks to tumble, economist Daan Struyven wrote in a note Saturday. He also said the economy would probably suffer a sharp slowdown but not a recession. 

“A rise in rates to 4.5 percent by year-end would cause a 20 percent to 25 percent decline in equity prices,” the note said.

Remember that US Treasury traders are relatively unconcerned about credit risk. They believe that the US government can simply print sufficient dollars to pay its debts. The bigger worry is about the purchasing power of those future payments. In other words, they are almost exclusively concerned with inflationary expectations. 

In this article, we will touch upon the sensitive issue of rising interest rate and how far it rises is too much for the economy to accommodate.  Note that we will not cover another related topics—the speed of rising interest rates, which could be summarized as follows:

While stocks have historically tended to advance in the first year of policy tightening, the pace makes a big difference, according to Ned Davis Research, which defines a fast cycle as a hike per meeting. Since 1946, the S&P 500 fell 2.7% on average in this scenario while rising 11% during slower ones. 

Interest rate

 

Interest rates move in very long cycles. They went up from the mid-1940s to the early ’80s, when long-term government bonds peaked at close to 16%, and T-Bills at over 16%.  Then, they went down ever since.  Years ago they hit bottom, but the cycle overshot.  In Feb 2018, they finally broke out the downtrend line, which is a significant event.^[2]

Low interest rate levels

While a recent drop in stocks may have been fueled by concerns tied to the 10-year yield approaching 3 percent, many strategists have said they felt equities could continue to rise until reaching 3.5 percent or 4 percent.

For example, Russ Koesterich, CFA, a Portfolio Manager for BlackRock’s Global Allocation team and a regular contributor to The BlackRock Blog, has commented that:^[3]

Rates and multiples are more likely to rise in tandem when interest rates are rising from unusually low levels, as is the case today. Under these circumstances, faster growth is treated as a positive as it alleviates recession and deflation fears. In addition, faster nominal growth is also associated with faster earnings growth.

Unfortunately, there is a caveat. Rates and valuations can rise together—to a point. At some point the negative relationship between rates and valuations reasserts itself. In other words, at a certain level higher bond yields create real competition for stocks, particularly dividend stocks, and put downward pressure on multiples.

Based on Wednesday’s market action we’re clearly not at that point yet. That said, if bond yields were to climb substantially, let’s say towards 4%, history suggests that the negative relationship between bond yields and equity valuations will begin to reassert itself. I would be particularly concerned as higher rates would be rising against a backdrop of an older population with a taste for income and elevated debt levels. But for now, higher rates and higher stock prices can probably co-exist.

Current 10-Year US Treasury Yield 

Current reading of the 10-Year US Treasury Yield was 2.88 on 02/23/2018.

References

1. Goldman Says Stocks May Plunge 25% If 10-Year Yield Hits 4.5%
2. This chart warns that the 30-year downtrend in interest rates may be over
3. Yes, rates and stocks can rise together…. for now
4. Foreign Investors Have Lost Confidence In US Government
• Based on some assumptions he made, John M. Mason said that the nominal yield on the 10-year Treasury note could rise to as high as 3.7 percent
5. More About the Bond Market’s Transitory Thinking
   
6. Knowing the Basics of P/E Ratio
7. It Starts With Inflation (Ray Dalio)

Financial Markets and the Business Cycles

Bull Market

A bull market normally goes up in 5 waves and has 3 phases:

1. Smart money moves in
• Smart money guys — who are not market timers, they’re value finders 
2. Institutional money moves in
3. Public moves in
• Wall Street will provide the story to catch everybody's attention and public money moves to the market

Market Topping

Market topping is a process which normally includes different asset classes peaking in a specific sequence.  Using tech bubble as an example:

1. Bond market peaked in 1999
2. Stock market peaked in early 2000
• Stock market historically peaks an average of seven months before every recession
3. Commodity market peaked in fall 2000

A bear market is normally triggered by the following series of events:

1. Inflation rises
2. Interest rate rises
3. Oil price rises
4. Fed hikes rate

Note that official recession calls are the responsibility of the NBER Business Cycle Dating Committee.  Since WWII, every recession is preceded by either an oil shock or a Fed's tightening its monetary policy.

Figure 1.  Bond peaked in July 2016

Current Business Cycle

For this business cycle, we have already seen:^[8]

• Bond peaked in July 2016 
• US Dollar peaked in Jan 2017
• Oil bottomed in Feb 2016
• Consumer and Producer prices bottomed last Summer
• Commodity prices are rising
• Wages are rising
• Rising inflation which have caused bond yields rising

At this moment, we haven't seen either stock or commodity markets peaked yet.  However, we have seen that consumer, corporate, and government debts are all at record levels.  So, it won't take that much interest rate hikes by Fed to bring about the next recession.

Based on Financial Sense, it predicts that the economy could begin to slow down probably the end of 2018 or the beginning of 2019. However, economists from both ECRI and ITR Economics are saying that this coming recession would be mild or brief because we still have:

• Tax cuts as a tail wind
• New government spending
• 300 billion dollars are coming in as an economic stimulus through government spending 
• New infrastructure spending
• Trump's still working on a trillion dollars infrastructure programs. 

So,  Financial Sense has said that this coming recession could be more like the one we had seen in 2001, but not like in 2007.^[8]

Figure 2. US Dollar peaked in Jan 2017

Figure 3.  Oil bottomed in Feb 2016

Figure 4.  LEI Changes in the 2000 recession vs 2007 recessions

Figure 5. Household % of Disposable Income vs Personal Saving Rate

What to Expect at Stock Market Top?

When stock market peaks, you should see the following transitions happening:^[8]

• Sector strength rotated from Consumer Discretionary to Consumer Staples
• Sector strength rotated from from Technology and Consumer Discretionary to Energy and Material
• Precious Metal start rising

References

1. Sector Rotation Analysis (Business Cycle)
2. In the Words of Dr. Seuss's The Lorax, "Unless..."
3. What Is the Gold-to-Silver Ratio Saying About Emerging Markets?
4. When commodity prices fall
5. Value Stock Outperformance May Indicate Stronger Economy Ahead
6. Why It Matters That Value Stocks Are Outperforming Growth Stocks
7. The Darkening Skies
8. The Final Phase Will Be an Epic Battle
9. Economic Patterns - Part 2: Road To The 2001 Recession
10. Who Thinks This Recession Is Over?
11. 5 Reasons Why Commodities Are the Place to Be in 2018
12. What's next for US stocks?
• "This market's current temperament feels so much like either Japan in 1989 or the United States in 1999. And the events that have transpired so far this January make me feel more convinced than ever of this repeating history," hedge fund great Paul Tudor Jones wrote in a note to clients.
13. Inflation, General Data Flow, Fiscal Stimulus, And Implications For Monetary Policy
14. Commodities: It's The Year Of The Bull
• Commodities prices react to many factors including fundamentals and technical issues:
• On the fundamental side, demographics point to more people in the world with more money competing for raw materials, which are finite assets.  
• At the same time, technical factors point to capital looking for a home as stocks are at high valuations and bonds appear to be moving lower. 
15. What Are Indicators Saying about a Potential Recession?
16. Take the Long Way Home: Economic Expansion Gets a Boost (Charles Schwab)
• Higher inflation and tighter monetary policy tends to signal late-cycle conditions; and tends to be accompanied by higher equity market volatility. 
• Volatility spikes don’t tend to signal finales to expansions; but they do tend to signal late-cycle conditions.
• Spikes in volatility have not historically signaled the end of business cycles; however, 60% of the spikes outside of recessions occurred during the late stages of the cycle.
17. JPMorgan Co-President Sees Possible 40% Correction in Equity Markets
• JPMorgan Chase & Co. executive Daniel Pinto warned equity markets could fall as much as 40 percent in the next two to three years.
18. Summers Warns Next U.S. Recession Could Outlast Previous One
• The next U.S. recession could drag on longer than the last one that stretched 18 months. That’s the assessment of former Treasury Secretary Larry Summers.
19. Trends For New Home Sale Prices At The Beginning Of 2018
20. Anticipating Anticipation 
• Adam breaks down these groups as follows, from earliest trend spotters to later adopters:
1. Metal traders (earliest trend spotter)
   
2. Bond traders
3. Equity Traders
4. Oil Traders
5. Currency Traders
6. Economists
7. Central Bankers (last adopter)

Technical Analysis: USD to CAD Currency Exchange Rate

(Updated 06/30/2018; Click Read More to view the original article)

• The greenback had a strong quarter ending on 06/30/2018, appreciating against all the major currencies. The Canadian dollar's 2.25% decline made it the strongest of the other majors and is consistent with the loonie's tendency to outperform in a strong US dollar environment.

Stock Market—Primary Trend & Secondary Trend

Two main indexes are used as metrics in the analysis:

• S&P 500
• NYSE
• Which is broader than S&P 500

For discussion, terms used here have the following meanings:

• Primary trend
• Long-term trend 
• Secondary trend
• Short-to-intermediate term trends

In this article, I will summarize ways of monitoring the primary or secondary trends of  stock market.

Primary Trends

When SPY hits all time high on 01/26/2018, it is around 11.5% above its 200-day moving average (MA), which is historically frothy.

To monitor the primary trends, here are some gauges you can use:

• Slope of the 200-day moving average ($SPXEW)
• $SPXA200R
• For a primary uptrend to manifest itself, most of the index constituents need to trade above their 200-day averages
• Death Cross
• Considered a bearish signal within the market, a death cross occurs when the short-term, 50-day moving average, also called a price trend, crosses below the long-term, 200-day moving average.
• Some analysts use   EMA (50) and EMA (200)
• $NYAD
•  In the past, the NYSE Advance/Decline Line (measure of breadth) has always topped out several months before the end of the bull-market and its ongoing  strength is favorable for the broad stock market.
• $NYA200R
• Generally speaking, the line has to be above 50% to be in an uptrend. 
• In other words, more than half of NYSE stocks need to be above their 200-day averages. 
• But some analysts prefer to use the 60% and 40% lines. During market corrections, it's not unusual for the black line to drop to 40% before turning back up again.
• Drops below 40% usual signal a bear market. Moves back above 60% reinstate the major uptrend. That's especially true after a bear market.
• Some analysts also look for MACD bearish crossover for signals
• MA (200)—200-day Moving averages
• Uptrend
• When the 200 DMA has an upslope
• Conservative Mutual funds tend to stay in growth sectors (Technology, Energy, Consumer Discretionary, Financials) 
• Downtrend
• When the 200 DMA has an downslope 
• Or $GSPA:$SPX in an uptrend
• Conservative Mutual funds tend to stay in slower growth , dividend paying defensive sectors like health care, consumer staples (toothbrushes, groceries) and Utilities. 
• If the market can move above the 200 DMA, they start allocating money to more aggressive sectors.

Secondary Trends

To monitor the secondary trends, here are some gauges you can use:

•  $SPXA50R (S&P 500 % Above 50-day MA; a breadth indicator)
•  If fall below 70%, it triggers a immediate-term sell signal
•  If rise above 30%, it sends a immediate-term buy signal
• $NYA50R (NYSE % Above 50-day MA)
• $SPXA150R (S&P 500 % Above 150-day MA)
• Monitors the health of intermediate-to-long term trends
• $NYA150R (NYSE % Above 150-day MA)
• $NYADV:$NYDEC
• Readings of its MA(10) below 1.50 suggests market is in downtrend
• SPY:$VIX (with SPY shown "Behind Price")
• As long as the SPY:$VIX line remains above the SPY line, it signifies that the smart money is comfortable and confident in the bull market,  and one should stay long.
• Same for SPY:XLU ratio
• Bollinger Band
• When the weekly mid Bollinger band turns down, it implies the intermediate term trend turns down. 
• When the bottom band is starting to move lower, it suggests price action could be starting to head that way. 
• When the price bumping into the upper band lines, it doesn't inherently mean the price has to pull back.
• The upper Bollinger bands could end up simply guiding the index higher indefinitely.
• $BPSPX (S&P 500 Bullish Percent Index)
• Overbought
• $BPSPX > 70%
• Oversold
• $BPSPX < 30%
• Strong buy signals occur when the Bullish Percent Index falls below 30% and then reverses up by at least 6%. 
• Conversely, promising sell signals occur when it goes above 70%, and then reverses down by at least 6%. 
• Some analysts use its point-and-figure graph (P&F) to look for signals too
• $SOX:$SPX
• If the ratio in in uptrend, the market is bullish
• Could be used as a market leading indicator
• MA (50)—50-day Moving averages
• An intermediate technical indicator that will rise and fall with the trend or not at all if there is no trend. 
• Typically, when the market is trending, it will act as a support for the trend.
• RSI
• In down markets if the weekly RSI tops in low 50's
• $DJCB:$UST
• Overlay $DJCB:$UST with $SPX to see the trend
• $DJCB (Dow Jones Corporate Bond Index)
• $UST (10-year US Treasury Note)
• $SPXUDP (S&P 500 Volume Advance-Decline Percent Index)
• Advancing Issues/Declining Issues is a picture of current market breadth. 
• $SPXUDP w/ 4 & 13 week EMAs and a 13,26,5 MACD. Chart Type is Cumulative

January and April Effect 

January’s bonus money buys stocks and April’s IRA contributions have a similar impact and they will likely remain the best bet for bulls.  

• January effect
• Performance in January has been proven to quite closely predict the subsequent full-year performance.
• Sort of measures investors’ appetite to buy up stocks that were sold off for tax purposes before year-end.
• The first five trading days of the year accurately predict the next 360 something like 84% of the time.
• April effect
• April still commands the best inflows as IRA money and pension money tends to be invested before the April 15th tax cutoff.
• Since 1950, April has been one of the best months for the stock market, as it has been up 47 years and down just 21 years, with an average return of 1.34%. Over the past ten years, April has been the third best month with an average return of 2.2%.^[3]

Time to Buy 

The best time to buy a stock (assuming the market has not topped yet) is after a

• Price correction
• Time correction
• When the stock trades sideways for a couple quarters while it digest earnings growth after reaching the upper end of its valuation.

If a market is in a price correction (i,e, not entering a bear market), drawdowns of 5-10% are completely routine, often occurring several times a year. The last two years have been quite unusual for not seeing such corrections.^[1]

References 

1. Weighing The Week Ahead: The Return Of Volatility
2. 9 Key Steps to Avoid a Bear Market, And Catch a Bull
3. The Week Ahead: Rough Waters or Smooth Sailing Ahead For Investors?
4. Technical Analysis—200-day Moving Average
5. Technical Analysis—Percent Above Moving Average