Excluding the hiccup in 2015-2016 (energy credit bust), the current economic and profit cycle remains intact. According to conventional wisdom, strong profits and a healthy economy are good for stocks. In fact, besides the belief interest rates will remain lower for longer, it’s one of the most popular talking points used to encourage equity ownership. Instead of finding comfort in extended economic and profit cycles, experience has provided me with an independent perspective.
[REITs]I have a long history of stock selection (over twenty years), including the purchase and sale of approximately 180 small cap stocks. After reviewing my largest winners and losers, I noticed a common theme. Specifically, at the time of purchase the underlying businesses were either generating peak or trough operating results. For example, many of my biggest losers were purchased when profits were strong and growing. Conversely, my biggest winners were often purchased when profits were weak and deteriorating. In other words, profit reversion was a major contributor to many of my past investment victories and defeats. This raises the question, should the “profits are high” argument frequently used to buy stocks, actually be used as a reason to sell?
Below is a chart of the S&P 500 and corporate profits that includes two profit cycle peaks and troughs. As you can see, investors who bought stocks when profits were weak (2002 and 2009), enjoyed large gains. On the other hand, buying stocks when profits were high (2007), was not nearly as successful and much more stressful.
What about today’s profit cycle (2017)? Considering the current cycle is ongoing, it’s too early to judge. That said, using history as a guide, investors paying peak multiples for peak earnings rarely land sunny-side up once market and profit cycles conclude.
Another lesson I learned over the past three market and profit cycles is the foundation of the cycle matters. I believe it’s important to note the current economic expansion – similar to the past two – has been accompanied by tremendous asset inflation. As we learned in 2000 and 2008, economic and profit cycles supported by asset prices tend to be very fragile and can end abruptly. Once asset dependent cycles conclude, it becomes increasingly clear (at least to me) that corporate profits weren’t inflating prices after all, but asset prices were inflating corporate profits.
Considering how the last two cycles of asset inflation and elevated profits ended, it’s not surprising central banks are proceeding very cautiously in their attempt to normalize monetary policy. Central bankers are choosing their words carefully to avoid upsetting financial markets, stating normalization will be “utterly uninteresting” and similar to “watching paint dry”.
An uneventful normalization is what central bankers want, but will it be what they get? Asked differently, can persistent asset inflation, combined with historically expensive valuations, coexist with rising interest rates and a shrinking Federal Reserve balance sheet? Although no one can know for certain (we’ve never been here before), the yield curve may be providing us with clues.
As most investors know, the yield curve has flattened as short-term rates have increased. While many view the flattening yield curve as a recession indicator, in this particular cycle, I believe it is also an indicator or measurement of confidence in the Fed’s ability to normalize policy. Specifically, the flatter the curve, the less likely the Fed will be able to accomplish its goal of raising rates and reducing its balance sheet.
Based on its current shape, the yield curve appears to be anticipating an event in the economy or financial markets that interrupts the Fed’s plan to normalize. Based on my bottom-up view, and barring a decline in asset prices, I do not expect the U.S. economy to enter a recession in the near future. Instead of recession, I believe the flattening yield curve is questioning the sustainability of current asset prices in the face of higher rates and quantitative tightening.
Until we discover what the yield curve is communicating with certainty, I expect the economy to continue to expand slowly. In this environment (see July’s post Patience a Possible Win-Win), I continue to believe further increases in equity prices will be met with higher short-term interest rates. With stocks reaching new highs and the 2-year Treasury yield recently hitting 1.84%, this is exactly what has happened over the past several months (see charts below).
As an absolute return investor waiting for an improved opportunity set, the current period is becoming increasingly comfortable. Even though stocks continue to rise and valuations remain very expensive, patient investors are at least being rewarded with higher short-term interest rates. Meanwhile, every basis point increase in short-term rates should make risk asset holders, that much more uncomfortable.
Risk free short-term rates are beginning to look more and more appealing in absolute and relative terms, especially compared to equities. Has anyone heard from T.I.N.A. (there is no alternative to stocks) lately?
Below is a chart of the 2-year Treasury yield and the S&P 500 dividend yield. Yesterday the 2-year yield surpassed the S&P 500’s dividend yield for the first time since 2008. What does this mean? I don’t know exactly, but I like it and hope it continues!
I find the 2-year Treasury to be an interesting option for absolute return investors. If the bond market is correct and the Fed’s effort to normalize is short-lived, the 2-year could be used to capture some of the recent rise in yield while remaining liquid. By riding the short-end of the yield curve, the addition of the 2-year in patient portfolios could increase average yields while assuming a modest amount of duration risk. For what it’s worth, I’ve been buying a 2-year each month in an effort to gradually create a 0-2 year Treasury portfolio without the associated ETF or bond fund fees.
In summary, investing patiently is rarely easy during periods of extended and elevated asset inflation. However, with short-term yields on the rise, the waiting game is getting easier and more comfortable. With the Fed’s normalization process finally in motion, I’m hopeful 2018 will be a year of higher interest income (if the Fed succeeds) or an improved opportunity set (if the Fed fails). I’ll take either, or even better, I’ll take both!
I’d like to wish everyone a Merry Christmas, Happy Holidays, and Happy New Year! With the year-end performance panic in full swing, I plan to step away from the markets and take the next two weeks off to spend time with my family. For those absolute return investors who continue to fight the good fight, it may be a good time to turn off the screens, take a break, and recharge your sanity batteries. Here’s to a prosperous 2018 filled with volatility and opportunity!
Article by Absolute Return Investing with Eric Cinnamond
