How confident should diversified investors be that U.S. stocks can power ahead without the extraordinary stimulus of quantitative easing (QE) and zero percent interest rate policy (ZIRP)? Not too confident. Stocks that trade on the New York Stock Exchange are down roughly 7.0% from their May highs and down nearly 3.5% since the last QE asset purchase by the Federal Reserve occurred on December 18, 2014.
Some folks are glad to see seven years of extraordinary accommodation come to an end. Consider Andrew Huszar. He is the former Fed official who managed the acquisition of $1 trillion in mortgage-backed debt, then subsequently condemned the endeavor in 2013. Huszar told CNBC, “[QE] pushed up financial asset prices pretty dramatically. A lot of that is the Fed pushing the market’s paper value way above it’s true value.”
Is he wrong? Probably not. Metrics with the strongest correlation to subsequent 10-year returns – Tobin’s Q Ratio, P/E10, market-cap-to-GDP, price-to-sales – all suggest that current valuation levels are at extremes not seen since 2000. Worse yet, if previous cycle extremes are any indication, one should be prepared for a 40%-50% bearish decline for popular benchmarks like the S&P 500.
The typical argument against overvaluation – the “this time is different” argument – involves the assumption that unprecedented lows for interest rates render traditional valuation methodologies insignificant. There are at least two problems with this notion. First of all, for rates to stay this low well into the future, it would likely correspond to a feeble U.S. economy as well as anemic corporate revenue. (Corporate sales per share have already declined for three consecutive quarters.) It follows that a deteriorating fundamental backdrop would offset borrowing costs that remain low on a historical basis.
The second trouble with pointing to low interest rates to dismiss overvalued equities? It ignores the directional shift from emergency level QE stimulus to zero percent policy alone to the highly anticipated quarter point tightening. Again, a diversified basket of equally-weighted stocks is down nearly 3.5% since the last QE asset purchase. (Review the NYSE chart above.)
As always, overvaluation doesn’t matter until it does; exceptionally overpriced can become ludicrously overpriced for several years. On the other hand, understanding late-stage bull market phenomena help tactical asset allocators monitor changes in risk-taking. Here are two gauges of “risk off” behavior that I am watching:
1. Flattening Of The Yield Curve
When spreads between longer and shorter treasury bond maturities rise, the yield curve steepens. Investors are less inclined to purchase long-dated treasury debt because they have faith in the strengthening of the economy. In contrast, when spreads fall, the treasury yield curve flattens. Investors demand the perceived safety of longer maturities because they are concerned that economic conditions are deteriorating.
Now consider the current “risk off” behavior. One year ago, the spread between 10-years and 2-years chimed in at 1.8. Today it is roughly 1.3. The 2-year treasury bond yields have soared on the prospect of the Fed’s imminent rate hike, yet the 10-year yield has barely budged because investors are expressing concern about the potential for Fed policy error.
