Thursday, January 29, 2015

Walls of worry persist

The market is still climbing walls of worry, and that's a good sign.

As I see it, here's the bearish case for equities: The Fed is no longer "printing money" and is soon going to begin to raise short-term interest rates. The market has enjoyed a great party for years, but the Fed is about to take the punchbowl away. Equity valuations are stretched, and earnings reports are turning mixed. The energy sector has been savaged, and there may well be nasty ripple effects: layoffs and defaults. China is in a slump and over-burdened with debt. Europe is in another slump and no amount of QE is going to make things better. Countries all over the world are trying to devalue their currencies in the hopes this will boost exports—but that's a fool's game. Policymakers have run out of tools to stimulate growth; growth is likely to be meager for the foreseeable future. The market's enthusiasm is likely to founder on the rocks of slow-growth reality.

In contrast, here's what I think the bullish case for equities is: QE was never about printing money; it was mainly about transmogrifying notes and bonds into T-bill substitutes in order to accommodate the world's demand for safe assets. Confidence is returning, however, and demand for safe assets is declining, so ending QE was the right thing to do. The economy still has plenty of unused capacity, but growth has definitely picked up in the past year. Congress is very unlikely to raise taxes, and may even succeed in lowering them, especially for corporations. Regulatory burdens are more likely to lighten than to increase further. Even if interest rates start moving up soon, they will still be very low relative to inflation for a long time. Equity valuations are no longer cheap, but relative to the yields on safer assets, equities still look quite attractive. There are still plenty of signs that the market is cautious, and that worries are more prevalent than exuberance. Absent a recession—which looks unlikely—equities are likely to outperform most other asset classes because of their superior earnings yield.

Here's how I read some of the more important market-based tea leaves:


The chart above represents the yield menu that investors have to choose from. If you don't want to bear any risk, you are not going to earn anything on cash. Cash (and cash equivalents such as 3-mo. T-bills) yields zero because the demand for safety is extremely strong. The market seems indifferent between owning equities with an earnings yield of about 5.5% and owning cash, with a yield of zero. That can only be taken as a sign that the market is still quite risk averse.


Risk aversion can also be seen in the chart above, which shows that spreads on corporate bonds have risen meaningfully from their recent lows. When confidence and the appetite for risk are strong, spreads are tight; that is not the case today. But doesn't the recent rise in credit spreads signal a coming recession? I don't think so, since swap spreads—the best leading indicator of economic and financial trouble on the horizon—are still quite low. Systemic risk is low, but there's still a lot of worrying going on, and that makes for a healthy market environment. The time to get really worried is when the market is priced to perfection. As it was in early 2000, when the economy was expected to grow 4-5% per year indefinitely.


The chart above shows that the market has been climbing walls of worry (worry being quantified here by the ratio of the Vix index to the yield on 10-yr Treasuries) for most of the past several months. The Vix index is high, which means investors are willing to pay up for the relative safety of options. The 10-yr Treasury yield is quite low, which means investors don't expect the economy to be very strong.


The chart above shows that the earnings yield on equities is significantly higher than the yield on 10-yr Treasuries. This is a clear sign that the market worries that the outlook for corporate profits is troublesome, to say the least. During times of strong growth (e.g., the 1980s), the earnings yield was well below the yield on 10-yr Treasuries. The equity risk premium has been unusually high for several years, during which time equity prices have marched continually higher. It's been climbing walls of worry all the way up.


The chart above compares the earnings yield on equities to the price of 5-yr TIPS (I use the inverse of their real yield as a proxy for their price). When the price of TIPS peaked in 2012, that was a sign of extreme risk aversion: the market was willing to pay a huge price for the relative safety of TIPS, which are default free and inflation-protected. At about the same time, the earnings yield on equities was also at or near a peak, which reflected great distrust concerning the outlook for corporate profits. In the past few years, demand for TIPS has weakened and confidence in the future of corporate profits has improved. But both are still far from where they would be in "normal" times. The market has become less fearful, but it is still somewhat risk averse.


As the chart above shows, it's unusual for the earnings yield on equities to exceed the yield on BAA corporate bonds, as has been the case for the past several years. Bonds are senior in the capital structure to equities, so they should normally yield more, especially since they don't have the upside price appreciation potential that equities do. Today's level of yields suggests that the market is still willing to "pay up" for the relative safety of bonds.


The prices of gold and 5-yr TIPS have been declining for the past two years, as shown in the chart above. (Here again I use the inverse of the real yield on TIPS as a proxy for their price.) Yet both are still high from an historical perspective. The demand for these two unique assets has weakened as the market has regained some confidence in the future, but they are still relatively expensive. The inflation-adjusted price of gold over the past century has averaged almost $600/oz., which is half of today's price. The average real yield on 5-yr TIPS since 1997 is about 1.4%, which is substantially higher than their current real yield of -0.2%.


As the chart above suggests, the real yield on TIPS should tend to track the real growth potential of the U.S. economy. GDP growth has picked up over the past year or so, and real yields have moved higher, both of which are good signs. But real yields remain quite low relative to the almost 3% rate of real growth over the past two years. That's a sign that the market is dominated more by worries than by exuberance.

Wednesday, January 28, 2015

Why I still like Apple

I've owned AAPL ever since 2002, and since late 2008 I have made numerous bullish posts on the company. Given yesterday's stellar earnings announcement—Apple set an all-time world record for quarterly profits—it's time to take yet another victory lap. I still own AAPL and have no plans to sell in the near future.


Here's the history of Apple's stock price (split adjusted). Astounding.


Even more astounding that Apple's market cap now exceeds the highest market cap Microsoft ever attained, and it is the reigning market cap champion of the world.


With a trailing PE of just under 16, AAPL is comfortably under the S&P 500's PE ratio of 17.9, especially considering all the cash it holds offshore (over $140 billion). Subtracting the cash, Apple's PE is a mere 13.6.


One reason the market has been relatively under-enthusiastic about Apple is that earnings had been relatively flat for the past three years—until now. First quarter earnings were almost 50% higher than in the year-ago quarter. Looking ahead, I think the market is still very skeptical that Apple can pull off further gains. How can a world record-holder in market cap and earnings keep racking up new records? That's the question investors are asking themselves. It's not easy to believe that Apple can remain on top forever. At some point they'll stumble, or a new product will blindside the company in disruptive fashion.

But for the time being, Apple still has upside potential. The Apple Watch will start shipping in April. To be sure, no one really knows whether it will be a must-have gadget or just a fashion accessory. I remember receiving my first iPad and thinking, "well, it's pretty impressive, but I'm not sure how I'll end up using this thing." It took awhile before great apps started appearing and the iPad started replacing laptops. I suspect the same thing will happen with the watch. 

Apple's laptops are still the best in the world, and their sales are growing at a time when PC sales are declining. The 27" retina-display iMac has no equal at any price, and is simply the most impressive computer on the market. The iPhone is still in the early stages of penetrating the gigantic Chinese market, and Apple will be opening dozens of new stores in China in the near future. The iPhone 6 and 6+ are the best in the business, and will undoubtedly get better in their next iteration. iPhones are out-selling much cheaper Android phones in every market. (Dirty secret: the Android OS has some severe limitations: it's much more susceptible to viruses, it suffers from extreme fragmentation, and only a fraction of the phones currently in use will ever benefit from future software upgrades, whereas nearly every iPhone will.)

Finally, Apple is a leading innovator in its field and has a deeply ingrained culture of design excellence. Moreover, Apple has figured out how to manufacture and sell some 76 million phones in just three months, all over the world, in addition to everything else it does. That's pretty impressive.

Thursday, January 22, 2015

King dollar comeback

It was just over three years ago that the dollar hit an all-time low against most of the world's currencies. Since then it has come roaring back, especially in the past several months. Gains have been uneven—huge gains against the yen, but not much against the pound, for example—and on balance the gains have simply restored the dollar to something close to its average value since the early 1970s. These gains may continue and could become problematic if they are excessive and rapid—strong and stable currencies are the healthiest—but for now it's appropriate to cheer the return of King dollar. 


The dollar has gained 22% against the euro since last March, and it is up 40% from its all-time low against the euro in 2008. The green line represents my estimate of the euro/dollar purchasing power parity: the level of the euro that would make prices for goods and services in the Eurozone roughly comparable to those same prices in the U.S. At today's exchange rate, American tourists in the Eurozone are likely to come away thinking that prices over there are about the same as they are here. Changes in the level of the PPP exchange rate are driven by changes in relative inflation rates. The upward slope of the green line over the decades means that inflation has been higher in the U.S. than it has in Europe.


The Australian dollar soared coming out of the Great Recession, boosted by soaring commodity prices. A lot of that has been reverse in the past several years as commodity prices have weakened. Still, the Aussie dollar remains quite strong vis a vis the dollar, according to my PPP calculations.



Like the Aussie dollar, the Canadian dollar has been on a roller coaster ride, driven by swings in commodity prices. The dollar has gained 30% vis a vis the Canadian dollar since its low of 0.95 in 2011. Prices in the U.S. and Canada are approaching parity these days.


The British pound has been relatively stable against the dollar, on balance, for the past six years. However, higher inflation in the U.K. should tend to depress the value of the pound over time. The U.K. is still somewhat expensive for U.S. tourists.


The dollar has gained an impressive 55% against the yen in the past three years, rising from a low of 76 to 118 today, thanks largely to the Bank of Japan's aggressive monetary easing. The yen had been appreciating against almost all other currencies for decades, and had reached a very expensive level. With the yen now more "normally" priced, manufacturers and exporters should find some relief. But the economy is not likely to strengthen meaningfully unless and until fiscal policy becomes more growth-friendly.


Using the Fed's Real Trade-Weighted Dollar Index (based on the latest reading as of the end of November), I estimate that the dollar today has gained about 30% against a basket of major currencies in the past three years. This puts it about 5% or so above its average since 1973. That's an impressive comeback in three years, and it owes a lot to the fact that the U.S. economy—despite suffering  its weakest recovery ever—is arguably the strongest of all developed countries.