Saturday, September 29, 2018

What the Hell Happened 9/29/18

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The 10 year Treasury Note, which is the benchmark, is at 3%.  That is, its interest rate, its  yield is 3%.  The inverse of 3% is a price earnings ratio of 33.  Right now, the S&P 500 stock index is selling at a 25 PE.  Stocks are cheaper than bonds.

Should the 10 year note interest rate go to 5%, that is a PE of 20.  Now stocks at a PE of 25 are more expensive than bonds.  Why would you pay so dearly for a risk asset when you can get a safe asset a lot cheaper?

Let’s say stocks become more expensive relative to bonds to the point of a 20 PE, the same as the 10 year note.  Why would investors buy stocks which entail risk at the same price as a safe investment?  Let’s say they would do that.  The S&P is at 2900 on $116 earnings which is a PE of 25.  At a PE of 20 the S&P index moves down to 2320, a decline of 20%.  But really, investors will not pay the same for stocks that they do bonds.  So at a 5% bond yield or PE of 20, stocks could go down to a PE of 15 to make them more attractive than a safe bond to make up for the risk the investor takes buying stocks.  $116 at a PE of 15 puts the index at 1739, a 40% decline.

By the way, at 15 PE ratio for stocks is considered a hold, or neutral.  It is the long run average for stocks.

Should you go out and sell your stocks now that you have read this?  I think not.  While the FRB talks a big talk about a strong economy, growing wages, and increasing inflation, it hasn’t happened yet and the talk is always about the future.  They have been talking this way for a decade and the future never happens like that.

The bond market doesn’t seem to believe the FRB.  Over the last month the media has been screaming bond rout, meaning interest rates rise dramatically,  because the FRB is going to raise rates.  Proof was that the 10 year Note was approaching 3% (again).  And this time the future was going to arrive and thus the bond rout.

But it didn’t happen.  For some reason there are a lot of investors who will buy the note at 3% and they did it again and the rate dropped below 3%, again.  The bond market just doesn’t believe the FRB forecast that they are going to raise rates at the schedule they have forecast they would.

As long as the note does not get sold off stocks remain cheap compared to the note.  Should the 10 year rate jump higher the rout begins and stocks crash.  And there goes the wealth effect poof.  Then comes the recession.  Then comes the failure of the FRB to stem the economic decline because nobody believes in them any longer.  Then comes the fiscal failure as selling bonds by the Treasury becomes too expensive to maintain the budget deficit.  Then welfare gets cut.  Then the civil war begins.

Bank runs ensue.  Cash and barter become the only money.  Silver and gold coins are good to barter with.  So is ammo.  So is food.  So is wood and coal in the late spring time.  Propane becomes precious.

Or, economists could figure out what is really wrong that keeps the economy from actually growing.  There has to be more than raising and lowering rates to discourage and encourage lending.  Something is missing.

It may be that the lack of world growth is the problem for the US.  Maybe all countries have enough interlinkage that all are affected by zero to slow growth.  This may be a bigger impact than realized.  Since all countries are connected to the world dollar, I would look there.

The modern economic system of the world is one based on credit.  It is why it seems reasonable that all you have to do is lower rates to encourage lending and borrowing with the resultant increased spending.  And seeing how China’s private and public borrowing transformed that nation into a power house especially for countries that supplied resources to it.

But even with the world increasing its debt by a massive amount, the world economies just haven’t seen good growth.  Massive is an understatement and good growth is an overstatement.

Something is wrong.  Something is missing.

For one, public spending through debt is really really unproductive.  China’s empty trains and cities are a perfect example.  China’s private debt increased also and it seems to me that much of it was to build excess plant and equipment which isn’t producing.  Which means the debt isn’t good.  Which means the banks have problems.  If loans were in dollars then there is that link.

After the GR and financial crisis it seems banks are reluctant to lend.  Businesses seem reluctant to borrow.  Public companies see a better opportunity in stock buybacks as well as dividend increases and also M&A instead of investing in capital equipment and labor.  Why is that?  

The answer is the solution to slow growth.

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