Not the Champion We Want
Comparing the S&P500 to 30yr Real Rates Offers Some Sobering Conclusions
There has been a dramatic increase in 30yr TIPS yields
The real rate in these securities climbed from -0.60% in December 2021 to 2.12% recently, indicating a substantial increase in the cost of borrowing for the government in real terms and an inflation-adjusted return profile that is remarkable in an environment of subdued real growth expectations. Despite this increase in TIPS yields, implied inflation expectations have remained stable.
Questioning Current Asset Valuations:
Either the forward dividend expectations for the S&P 500 are significantly too low, implying either a dramatic expected increase in corporate productivity, particularly for large multinational companies; 30-year TIPS are substantially undervalued; or equities are significantly overpriced.
Erosion of Expected Equity Returns Due to Volatility Drag:
Historical equity returns do NOT result in “expected returns.” The 'volatility drag' effect, where actual compounded growth is less than simple arithmetic averages suggest, means that even if the S&P 500 delivers similar statistics, the realized returns are almost certainly lower than expectations.
Implications of Increasing Market Inelasticity and Passive Investing:
The realities of these dynamics have been obscured by a larger-than-realized increase in passive investing, raising valuations as the stock market becomes more inelastic (less responsive to price changes) on inflows. This inelasticity has potential repercussions, including making momentum strategies more prominent and causing value investing (which often involves a contrarian stance) to be riskier and less rewarding. The growing market inelasticity and dominance of passive strategies create feedback loops that further distort the market.
Demetri Kofinas puts forward another master class with Professor Charles Calomiris (who taught me as an undergrad in the pre-electricity era). Combined with Calomiris’ paper on fiscal dominance and the return to zero interest rate reserves, I view this as required. Many are focused on Calomiris’ message of inflation, which I largely agree with AFTER the crisis created by Jerome Powell’s incoherent rate-hiking assault on the US economy. While you may be tempted to focus on the inflation message, listen/read Calomiris closely. Deflation and default come first. Based on demand, I may expand this brief comment into a weekly piece.
Rob Henderson offers a brief review of Eric Hoffer’s “The True Believer.” Get your feet wet with the review and then READ THE DAMN BOOK. It remains the best template for understanding what gives rise to mass movements (Bitcoin!) and the Covid benefits snatch-and-grab has set the stage for further radicalization of America.
Finally, Melody Wright is a newcomer to my reading list. Her commentary on the continued shenanigans in the housing/mortgage space is rapidly becoming my 2005/6 “Housing Bubble Blog” (which you can still find here and offers commentary this week that should raise red flags for anyone who has taken my advice and read “The True Believer”!).
Derek: Late comment here, but great post anyway. Thanks!
And here’s a request to shed some light on the Atlanta Fed GDP Now currently showing 5% growth this quarter!?!?
A. How credible and reliable is this estimate?
B. How do they get that percentage?
MWG: Derek coming in late, but hot! The Atlanta Fed GDPNow is certainly topical, currently suggesting a 5.8% GDP growth rate for Q3. Needless to say, this is NOT consistent with my concerns for a recession, although there are obviously ways the quarterly number can jump around in statistically meaningless ways. However, GDPNow may be one of the most cited, but least understood tools in the toolbox. Understanding the methodology can help to add clarity to the current forecast. The full methodology can be obtained here. The VERY simple explanation is that the number is not at all accurate in the early stages of a quarter.
The very simplified methodology is understanding that the Atlanta Fed is taking 13 GDP subcomponents and running forecasting methodology against each. The simple starting point is a five-period rolling linear regression. While not a truly accurate statement, you can “guess” the initial GDPNowcast level by trending the average of the last five GDP reports. For this quarter, that super simple approach yields 3.4%, almost precisely the starting point for GDPNow at 3.5%:
This is NOT the exact methodology, but it’s a helpful shorthand tool. Economic surprises further modify the initial estimate. And those “surprises” are based on the revised data, so the downward revisions of prior information raise the Atlanta Fed number. For example, the housing starts data this month was up 3.9% this month — an enormous surprise vs the estimated 1.1%. But the actual number was only 2K higher than the survey estimate, while the prior month was revised sharply lower. GDPNowcast treats the revisions like Tommy Lee Jones treats Harrison Ford (“I don’t care!”).
The NowCast cares even less about the almost certainty that this month’s release will be revised lower. Over the last few years, several competing Nowcast models have been introduced. For example, Bloomberg is forecasting a 2.4% rGDP for Q3 2023. I’d argue this is a more likely GDP number.
The Main Event:
Once again, I will try to split the note into a few pieces. We take a detour this week with “brief” (if only I could stick to this) commentary on the move in interest rates, and then we’ll dig into the implications for equity investors.
On interest rates, specifically the explosive move higher in 30yr TIPS. Is there a productivity renaissance in the making? Or is this being driven by rate policy?
If you’re not following the esoteric long-dated TIPS market, there has been an unprecedented move higher in the “real” cost of long-term funds for the US government. From Dec 2021, the real rate level in 30yr TIPS has climbed from -0.60% to 2.12%. The magnitude of this move can be explained in present-value terms using a simplified zero coupon bond.
As of Dec 2021, if you wanted the government to guarantee you the purchasing power (CPI-adjusted) of $1,000 in Dec 2051, you would have had to pay $1,198. Today, you would have to pay $534. And amazingly, over this period, there has been ZERO change (some volatility, to be fair, but even that has evaporated) in implied inflation expectations:
Now under economic theory, this should be incredibly important. Because if all else equal, you can turn $534 into $1,000 of purchasing power-protected USD risk-free, I should be far less excited about putting current USD into risky assets. Under prevailing economic theory, the expected forward return of cash from risky assets should be tied to this real rate. Historically it has been reasonably related. Since 2022, not so much. So much for economic theory!
There are only two possible explanations here:
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