One way to look at how expensive the market is, is the Shiller PE. Shiller PE is a cyclically adjusted price to earnings ratio. In other words, it is the average inflation adjusted earnings multiple from the past 10 years. I looked at the Shiller PE of the market on a monthly basis since 1881. Out of the 1632 months, there has only been 66 months which have had a higher Shiller PE than the current Shiller PE of 28.18. This means the market is in the 96th percentile in terms of valuation. In September 1929, the Shiller PE peaked at 32.54. This gives you perspective on the unlikely potential for high returns over the next 5-10 years.
The chart below shows effects of central bank intervention. As you can see the S&P 500 and other equity markets along with high yield debt have led the charge higher while wages, housing, and commodity prices have all barely had any returns or declined. It is the financial economy versus the real economy. Considering the financial economy relies on the real economy, this trend cannot continue. One example of where there’s a possible disconnect is commodity producers. They make up a large part of the U.S. high yield bond market. How can investors continue to buy high yield bonds of commodity producers while the price of the commodity they produce goes lower? Recently commodities prices have rebounded even in the face of a strong dollar. I’m not making a comment on whether commodity stocks are a buy right now; I’m merely exemplifying the illogic of this past move in real assets versus financial assets.
Corporate profits have risen much faster than wage growth in this cycle. This is part of what is behind the movement to raise the minimum wage. Minimum wage increases could pressure profit margins. I’m not saying raising the minimum wage is the correct way to combat this problem; I’m simply pointing out the reason for the recent political push. Raising the minimum wage effectively punishes the low skilled workers who are on the bottom rung of the labor ladder because they become priced out of the labor market.
To solve this problem, central banks need to stop their asset purchases. Asset purchases reward corporations with cheap debt and high stock prices without them having to do anything. In Japan, the JCB is buying ETFs. Corporations in the ETFs don’t even need to produce amazing products and build their businesses to see their stock bought. When you remove incentives, the market doesn’t work. In Europe and America, there needs to be a decrease labor laws because each regulation lowers the pay of workers because regulations act as a cost. The problem is that when wages stagnate, it creates an environment where workers demand more from employers. Workers want laws to prevent them from being fired when there’s not a lot of jobs. What they don’t realize is the jobs are going away because of these laws.
As I mentioned, junk bonds have had great returns since 2009. Usually after junk bonds have a great run, it’s time to sell because the default rate is low and about to rise. The chart below shows the historical prices of junk bonds versus the 10-year bond yield. This differential considers historical default rates and the recovery rates of junk bonds. With that in place, the current spread between treasuries and junk bonds is 1.2% which is less than half of the 2.8% average. The time to buy junk bonds is when the yield is high because it reflects stress in the system when the economy is weak and default rates are high. As you can see, junk bonds can remain expensive for many years. While junk bonds can get more expensive, I think now is the time to avoid them. Last year I was wrong to be bearish on junk bonds because default rates on energy junk bonds lowered and their recovery rates rose. Junk bonds also had an amazing rally off the February lows as the ‘risk on’ trade returned to the market
The chart below shows that bond durations have been rising which makes them now the most sensitive to rising rates on record. Duration on bonds is the length of time it takes for bonds to repaid by internal cash flows. Low interest rates cause durations to rise which is why they are so high now. Being more sensitive is bad because it means rising interest rates, like the environment we are in now, carry high risk.
To determine where the cycle will turn we look at the economic data. Today’s big metric reported was the monthly wholesale inventory and sales report for November. I consider it to be moderately bad because the inventory to sales ratio increased to 1.32. The media reports that increasing inventory will help Q4 GDP growth, but if there’s too much inventory, then discounting must occur. This will hurt margins. As you can see from the chart below, the inventory to sales ratio started increasing again which is against the recent trend and puts it at recessionary levels.
On the bright side, wholesale sales for November were up 0.4% from October and 3.4% from last year. September and October sales were revised down from growing 1.4% to 1.1%. November inventories were up 1% from last month and 1.4% from last year. It’s interesting to see the inventory to sales data at recessionary levels without a recession. We will know in hindsight if this increase has to do with the shift towards online retail. Online retailing may require stores to hold more inventories. Amazon needs to have everything the consumer desires quickly. It’s also easier to hold inventory in a warehouse instead of in a brick and mortar store because brick and mortars have limited shelf space.
Stocks and junk bonds remain expensive. Central banks have caused the inflation in asset prices which usually rely on the real economy. The difference between the real economic weakness and the strength in the stock market will shrink at some point. It’s an unsustainable trend. Duration on U.S. bonds is high meaning interest rate sensitivity is high. The inventory to sales ratio says the economy is near a recession, but it may need to be re-evaluated because online retailers may be carrying more inventory.