Tina Turner Impersonator

"TINA" is Back!

October 7, 2019

By Security National
Wealth Management

No, not Tina Turner, one of the greatest entertainers of our age. She turns 80 years old in November, and is happily retired in Switzerland after a 50-plus year career in rhythm & blues and rock ‘n roll. The “TINA” we reference is short for “There Is No Alternative,” a growing acceptance that equities are the only game in town.

What Changed?

Only a few weeks ago we were told a recession was around the corner. Growth was slowing in the U.S., developed international economies were (and are) moribund, and our Treasury yield curve inverted — yields on longer term maturities fell below those of shorter term issues. Inversions are a reliable indicator of problems ahead, but there are three complicating factors:

First, the timing of a subsequent recession is uncertain — generally six months to two years following an inversion.

Second, everything occurs in context. Interest rates are negative across the globe, and capital flowed to our markets in search of positive returns. Rising demand for long term U.S. debt pushed yields down more than justified by economic fundamentals.

Finally, and most importantly, as noted above the U.S. economy remains in good stead. Yes, manufacturing and agriculture are suffering because of trade and tariff concerns, and this hits close to home in the Midwest. But in aggregate, our prospects are solid. Unemployment is at modern lows, and wages are rising in excess of the inflation rate. Consumer spending, still two-thirds of GDP, is rising faster than expectations. And recent census data shows more households escaping poverty and an expanding middle class. These factors usually bode well for equity markets.

Sovereign Yield Curve for 12 countries

Yes, But Prices Are Problematic ...

Valuation concerns most often focus on equity prices. Traditionally, bonds have been seen as the stable foundation of a portfolio, generating a reasonable return with minimal price risk. Not so today. Due to extreme monetary policies in the European Union and Japan, about one-third of all public debt outstanding ($17 trillion dollars in value) sells at negative yields. The table above shows yields of EU nation sovereign debt. Nearly all are negative for shorter terms, with Germany, Switzerland, and the Netherlands below zero across their entire maturity spectrum.

As noted at the beginning of these comments, international capital is moving to the U.S., suppressing yields available to domestic investors — so much so, in fact, that the impact of a small increase in future yields will offset several years of income earned. Bond duration is a proxy for a bond’s price change for a given change in market rates. A bond with a duration of five years will fall in price about 5 percent, given a 1-percent rise in market rates. As shown, over the last 40-plus years, the Barclays Aggregate Bond Index produced an average yield of 6.6 percent with an average duration of 4.9 years.

Duration and Yield of Bloomberg Barclays Aggregate
Source: JP Morgan Guide to the Markets, Sept. 19, 2019

Rising rates hurt returns, but high yields hold the damage to a manageable amount. Today, however, a 1-percent rate rise will wipe out nearly three years of interest income. The bond markets today, particularly overseas, are as overvalued relative to their histories as at any point since the initial explosion of public debt in the 1970s.

That brings us back to TINA. All investing is relational; asset classes are evaluated against their own histories as well as against alternatives. Equity markets today are a little above the midpoint of their long-term averages by traditional measures (price-to-earnings, price-to-book value and so on). Comparisons of earnings yields on stocks and market rates on fixed income produces a different picture. Stocks are significantly less expensive than bonds. Fixed income is priced to perfection (in its world, one of slow-to-no-growth and accommodative policies forever).

Forward Price to Earnings Ratio for S&P 500
Source: JP Mortgage Guide to the Markets, Sept. 19, 2019

Thus the dramatic turn in sentiment from just weeks ago. With economic activity in the U.S. slowing but still positive, and high-grade bond yields at the inflation rate or below, stocks are the place to be — the only place, by some standards.

Our Position

We are in general agreement that equity markets will provide reasonable returns over the next few quarters, with the ever-present caveat that corporate earnings do not stumble. This is a big qualifier, but we believe that most market sectors will not disappoint. We also believe bonds reflect a too-pessimistic view of our prospects — one exacerbated by this flood of foreign capital.

At the same time, we honor one of the fundamental concepts of investing — long-term returns are highly correlated to valuations at the beginning of a measurement period. By every standard, both stocks and bonds are expensive to their histories. As such, the potential for a replay of the last decade’s superb results is low. The following chart from State Street Global Advisors suggests balanced portfolio returns in the mid-single digits over the next three to five years, and below that over the near term. Many strategists, if not most, are likewise reducing forecasts. Stocks are projected to provide the best relative and absolute returns, but enthusiasm should be tempered.

Chart of Forecasted Returns

Action Plans

We are more comfortable with stocks than bonds, but are unwilling to compromise risk control for near-term considerations. We will emphasize equity exposure where appropriate, with a tilt toward value here and abroad. Fixed income positions will remain conservatively structured, opportunistically adding yield components while keeping a short duration profile. This should allow us to participate in positive environments and protect value in less favorable times.

Talk to an advisor today, to see how our process works for you.

Economic & Market Commentary is written by the Investment Services Department at Security National Wealth Management.