Many of the entrepreneurs who eventually have a successful business will tell you that they had a secret : they faked it till they made it. It’s good advice to reinforce a positive behavior, but are the markets currently using the same technique to keep going higher?
The FED fakes it
We’ve heard for many years now that the FED plans to eventually increase its interest rates. It has been at 0% for 6 years and has increased to a small 0.5ish% end of last year. They had initially announced that they’d raise the rates 4 times in 2016. It quickly became 2. Now it’s maybe only 1 or nothing at all, who knows.
For the past couple of years, the FED has basically faked it hoping that they’ll make it. If they can convince the markets of future rate increases, they won’t create chaos when they actually raise them. Look what happened in December – January. This wasn’t expected, the markets caught a cold.
So how is the FED faking it?
First, after their meetings, they publish so-called “Dot plots”, which shows the rates in the near future that each of the board members is expecting. The average is shown with the dotted line.
Second, they hope the markets believe it and price them in the stock prices. This is visible in the FED Funds Rate futures. It currently shows a 50%/50% chance of rate increase in December 2016. But only a 11% that it reaches the level the FED wants between 0.75% and 1%.
I’m guessing a little more faking will be necessary until they make it.
Where is this information available ?
- On the FedWatch tool from the CME’s futures exchange. It tracks both the latest dot plot and the market’s estimates.
Hopefully, the FED will manage this game well and will avoid creating a market crash. Because it currently doesn’t have a great track record.
The stocks fake it too
Because stock markets believe that the future interest will remain so low for so long, it justifies high valuations. When the P/E of a stock is 25 for example, it’s the same as a yield of 100 / 25 = 4%. With bond yields so low, stock remain attractive even with a 4% yield.
So how are the stocks faking it?
First, the S&P500 has gained around 70% since late 2011 and today, which looks like a strong bull market and would signal a strong recovery. However, earnings haven’t increased a bit since then, because companies’ profits have been flat or down since Q4 2011.
What made the S&P increase is an increase in P/E which increased from 14 to 25.
Second, dividend stocks (eg. Oil & Gas) have become more attractive to yield seekers and are becoming a substitute for bond yields. Prices go up due with the stronger demand. These days 65% of stocks yield more than the 10-year bonds. For reference, it’s typically <5%.
Earnings have been flat or falling for many years now. Companies are trying hard to juice their profits with non-GAAP reporting, but it’s gone so far that the SEC has started cracking down on the widespread practice. I don’t think more faking will actually make it.
During a recent interview with Warren Buffet, someone asked if the stock market was currently overvalued. He replied “it depends on what the interest rate will be in the near future. If it’s still zero, they will indeed be cheap. If it significantly higher, they will be horribly expensive”.
Where is this information available ?
- The P/E is available on Multpl, with a host of other indicators
- Corporate profits after tax is available on FRED.
Will they make it?
About a year ago, I thought that the markets had reached a high point and were ready to go down. I reduced my exposure to stocks and increased my allocation to bonds. The bond portfolio has performed as well as the stocks portion so far.
This game of ‘fake it till you make it’ can continue for a little while.
As long as bond yields keep going down and no-one believes the FED, stock valuations have the potential to keep going higher. The problem only gets worse the longer this goes on.
Janet Yellen is due to have a speech on monetary policy out of Jackson Hole this Friday.
Like the previous ones, it’s probably going to be as clear as mud. There will be lots of predictions but no clear direction. So instead of making predictions myself this time, here are a few links for you to track the indicators that are usually discussed along with the FED rate hike articles:
- FED Dot Plot and Market’s own estimates : FedWatch tool
- P/E evolutions : Multpl
- Corporate profits after tax : FRED.
- Inflation rate : US Inflation calculator
- Workers’ wage growth : Atlanta’s FED
- Unemployment rate : FRED
- Oil prices : EIA
- Delinquencies on Corporate and Industrial Loans : FRED
Sometimes I feel like this is a real-life central-banks-themed-telenovela. So much drama and this goes on forever, with no end in sight.
Do you think the FED is still faking it? Will it eventually make it? Are there sources of information you like to get your data from?