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Thought of the Week: Don’t set much store in the equity risk premium, 05.20.2013 - Christian W. Thwaites

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

An old measure but a useful one. It should give us some indication of the market after the 23% gain in the S&P[1] since November. The measure is simple enough: the forward price earnings yield less the yield on the GT30. This makes sense because the duration of equities is around 16.5, which is close to the GT30 of 19. By the way, other sources, notably the New York Fed use different approaches, for example Cyclically Adjusted Price Earnings and a shorter duration risk-free rate. But it’s the vectors that matter not the scale.

Right now earnings estimates for the S&P are $122. The earnings yield is 7.3% and the ERP 4.2%. Last June it was around 5.3%. So it narrowed as investors priced in i) less uncertainty ii) QE running longer and iii) sustainable profits and margins. Another bullish line was that ERP since the 1970s had bounced between 1% and 7.7%, so stocks were cheap. The problem is that the mean we’re looking to revert to is all over the place. Since 2008, it has been 3.8%. Since 2002, 2.5%. But, whoops, closer to 10% in the 1950s and negative in the 1990s. Pick your period for how cheap or expensive you think the market.

We would caution: never use one metric. The issues we’re facing today are: i) a highly managed yield curve, similar to the 1950s when the Fed held a 2.5% peg to finance war loans (so if yields were at normal levels -- yes, this is a counterfactual -- the ERP would be negative), ii) slowing earnings growth, iii) sales growth at around 2%, and finally iv) GT10s reversing their recent “growth is picking up” trend, which accounted for the 1.65% to 1.95% move in May, to “growth is moderating,” as a bunch of indicators last week suggested. In that case, bonds could rally 20bps and the ERP reverse back to the 4% to 5% range.

So the ERP is not telling us too much. Which means we’re back to individual stories to make the case for equities.

The Vanishing Debt
The Fed has misread the economy several times over the last few years. Back in 2011, it assumed that we would now have 4% growth, 7% unemployment and 2% inflation, all of which we’ve missed by yards. No matter. The Fed adjusted policies quickly and didn’t tighten too soon.

Over at the CBO, the forecast errors were larger. In March, the estimates were for a $845bn deficit. But after a record $113bn surplus in April, a 20% increase in tax receipts, and a 9% cut in discretionary spending outside of the Big 5 (so that’s Social Security, Medicare, Medicaid, Defense and Interest), the new projected deficit is $642bn or 4% of GDP. Down from 10.1% in 2009. So the quickest way to improve deficits, is, it turns out, not spending cuts, sequesters and austerity but, well…getting people back to work. Who would have thought?

Source: Federal Reserve Bank of St. Louis, Economic Research

Sources: Bloomberg; Barclays; Capital Economics; Federal Reserve Bank of St. Louis; Trend Macro; Congressional Budget Office; Factset; Federal Reserve Board; JP Morgan; “Implied Equity Duration: A New Measure of Equity Risk,” Patricia M. Dechow, Richard G. Sloan, and Mark T. Soliman; Liberty Street Economics; Federal Reserve Bank of New York; US Department of the Treasury; Sentinel Asset Management, Inc.

[1] Standard & Poor's 500 Index is an unmanaged index of 500 widely held US equity securities chosen for market size, liquidity, and industry group representation. An investment cannot be made directly in an index.

Thought of the Week: Changing Face of High Yield, 05.13.2013 - Christian W. Thwaites

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

High yield has been on a tear. A series of fortunate events have made this one of the best asset classes in recent years. It has outperformed the S&P[1] nine out of the last thirteen years. In those that it lagged, underperformance averaged 1.9%. Outperformance averaged 9.7%. From 1985 to 2012, high yield had five down years averaging (-8.8%). The S&P had five down years averaging (-16.6%). Over the entire period, high yield underperformed the S&P by around 180bp but with about half the risk and a 0.58 correlation. Since 2000, high yield wins hands down with an annualized return of 7.8% compared to the S&P of 1.6%.

Along the way, we saw the widest and lowest spreads, record supply, higher recovery rates and the lowest level of fallen angels. Here's the spread:

Source: Federal Reserve Bank of St. Louis, Economic Research

The spread as of this past Friday was in the low 400s, compared to 468bp in January and over 2,000bp in March 2009. So the market has done well. Why?

First, start with the premise that QE distorts fixed income markets. One of the outcomes of QE and a ZIRP has been disinflation and some removal of duration risk in capital markets. Low inflation and high nominal rates set us up nicely. Second, credit. It’s only recently that the Fed’s Senior Loan Officers Opinion Survey showed any loosening in credit conditions. But lending standards remain high and, more important, demand for C&I loans has barely moved. Much of the demand shifted into credit markets bypassing commercial banks altogether. And, third, supply of credit has shown up with insurance companies, always hungry for yield to match long-term liabilities, and retail. High yield mutual funds are now the third largest fixed income category with assets equivalent to about 30% of the index. Compare that to equity mutual funds, which are about 18% of the S&P.

Breaking Down High Yield Risk
The tail wind of low yields, defaults, spreads and better recovery means shifting sources of return in high yield. In a more mannered environment, spreads comprise:

(1-Recovery Rate) x (Default) + (Excess Spread) + (Liquidity Premium)

So the bonds trade mostly on default, recovery and liquidity. And that made them more equity than fixed income-like. What’s missing, and what is far more important in sovereigns and IGs, is duration risk. That’s changing. The traditional drivers in high yield are less important in a market where companies have plenty of access to credit, better balance sheets and therefore lower default risk. So we’re left with duration risk. The Treasury 10-Year note trades with a 9.1 duration. If rates rise 200bp in the next two years, the loss will be around 7.2%. If we’re right and high yield trades with more duration, then the traditional diversification benefits diminish.

We still like the market but it means we’ll hedge out duration risk using treasuries and the capital structure risk using equity derivatives. That’s not anything we’ve had to do much in the past. But we're in a very different world.

Sources: Bloomberg, Barclays, Capital Economics, Federal Reserve Bank of St. Louis, High Frequency Economics, Federal Reserve Board, ISI, JP Morgan, Strategic Insights, Mainly Macro, Sentinel Asset Management. Inc.

Thought of the Week: Sell in May but stick around, 05.06.2013 - Christian W. Thwaites

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

A bit odd, perhaps, to worry about deflation as the S&P[1] hits all time highs. But the whiff of deflation is in the air. The YOY PCE core (the one the Fed likes) came in at 1.1% which is the lowest it has ever been. Here it is:

Source: Federal Reserve Bank of St. Louis, Economic Research

The PCE doesn’t affect things like COLA. It has component differences to the CPI, mostly in housing and medical. Its use as a policy tool is to separate out noise. Outright deflation tends not to occur much primarily because of wage and price stickiness, especially with leveraged companies. How? In the first case, employees will take a 10% reduction in the workforce over a 10% reduction in wages. The clearing mechanism to lower wages can work through the labor market but takes time. And in the second case, any company reducing prices to create demand puts immediate pressure on its P&L. Creditors then play rough on things like loan covenants. So that tends not to happen either.

The broad lesson is that deflation redistributes income from debtors, who have a high propensity to spend, to creditors, who don’t. So demand falls. And if the wage stickiness persists, then real labor costs increase. That’s why 2% deflation is a lot more pernicious than 2% inflation.

The central bankers know that and that’s why the Fed reaffirmed its commitment to QE citing “restraining” fiscal policy and “inflation” below target. A simple extrapolation of current inflation doesn’t get us to the 2.5% target until...2021. Over at the ECB, Draghi mentioned the ever so remote possibility of cutting the deposit facility rate. Sounds ok, except the rate is 0%. So negative rates? He’s clearly trying to push banks to lend more but for now excess money will just go into sovereign bonds. Surprise, Bunds rallied hard on the news.

So put these together, and we have worryingly low inflation, low demand and sub-par job growth. Any monetary stimulus will remain.

Conventional Wisdom
Everyone knows the “Sell in May” rule. I originally heard (or misheard) the other half of it as "Buy again on Derby Day" (the British one) which is in June. But have also heard “Buy again on St. Leger Day” which is in September. Either way, the link with horse racing and investing is clear. Does it work? The most often cited period of outperformance is October to April which returned 6.7% from 1942 to 2010 compared to 3.5% for long-term trend growth. Trouble is that record was pretty dismal from 1886 to 1942. Another period that works over the longer period is February to August which has a far more consistent, albeit smaller, return premium over long-term trends. These rules can work but experience tells us that the best advice is “Sell in May, but be prepared to buy again at any time, and go away, but be prepared for a call back to your desk at any time.” Which some people say is not quite as catchy.

Sources: Bloomberg; Capital Economics; Federal Reserve Bank of St. Louis; High Frequency Economics; Federal Reserve Board; ISI; Pantheon MacroEconomic Advisors; The Chart Store; ECB; “Deflation, the New Threat?” Manmohan S. Kumar, IMF; Mainly Macro; Sentinel Asset Management, Inc.

Thought of the Week: Cruel Top Line Growth, 04.29.2013 - Christian W. Thwaites

Christian W. Thwaites
President and Chief Executive Officer
Sentinel Asset Management, Inc.

The current earnings season is a very mixed bag. Start with the economic background where nominal growth decelerated in 2012 from around 4.4% to 3.6%. The first quarter may be marginally higher but some of that is from a low base effect. It’s very difficult for companies to raise prices, increase share or volumes when demand is simply deficient. Sure, balance sheets are in much better shape, as evidenced by robust bond issuance, but many companies are in excess savings mode. Here are undistributed corporate profits as a percent of GDP.

Source: Federal Reserve Bank of St. Louis, Economic Research

Companies have three choices when it comes to profit: i) spend it, which is the same as reinvesting in the business ii) distribute it in the form of dividends or share buy backs or iii) save it. They have clearly been in “save” mode and gradually passing into “distribute” mode. But what we’re not seeing is a lot of “spend.”

In this season, sales growth is around -0.4% and earnings growth at 1.6% for half of the S&P[1] companies reporting so far. These compare to 3.6% sales growth and 9.2% earnings growth last quarter. This is why the market has little tolerance for any misses even after expectations were revised down. The price action for an earnings miss last quarter was +/- 0%. Now it’s around +/-2%.

Companies are at least increasing dividends faster than earnings which means the all important dividend yield on the market is holding up well. Say it again, some 40% of long-term stock returns comes from dividends. We got into the craze for share buybacks some years ago and that still permeates the market. But dividends are what counts.

Overall we are encouraged by: consumer spending, some wage growth, housing and a rollover in oil and gas prices. Claims are reasonably strong, although they tell only half the employment story. You still need someone to hire the other side of the claim to arrive at employment growth. So this means QE remains in place. The hawks are i) pressing on asset price inflation ii) extremely uncomfortable with both the unemployment mandate and iii) QE buying. The only people that count are Bernanke, Yellen and Dudley. QE will continue until they see “substantial improvement” in the labor market.

Curious Fact: All last week we saw index futures rally first thing pre-opening. The S&P 500 futures for June settlement rallied 15 to 20 points in the two hours before opening regardless of some major earnings disappointments from the night before. What this suggests to us is that investors are working hard to gain exposure to the biggest, most liquid names as an asset class, not necessarily for the idiosyncratic risk. This might be foreign buying, foreign central banks, some arbitrage between stocks paying over 2.3% on forward estimates, compared to 1.7% on treasuries or just a desire to not miss rallies and upsides. For now, take it that the market remains well bid.

Sources: Bloomberg, Capital Economics, Federal Reserve Bank of St. Louis, High Frequency Economics, Federal Reserve Board, ISI, Pantheon MacroEconomic Advisors, Sentinel Asset Management, Inc.

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This article contains the current opinions of the author but not necessarily those of Sentinel Investments. The author's opinions are subject to change without notice. This article is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.