The message of TIPS, gold, and PE ratios

Starting from the premise that the world's capital markets are intimately bound together—that the expectations driving stock prices are the same ones driving bond yields, for example—it should be possible to infer from the prices of different assets the market's implied economic outlook and risk preference. In other words, there ought to be one "story" that explains the market prices we observe.

This post focuses on TIPS prices, gold prices, and PE ratios, and attempts to deduce what they tell us about the assumptions embedded in the market.

The chart above compares real yields on 5-yr TIPS with the real Fed funds rate. For one, this tells us that the real yield curve today is positively sloped (i.e., short-term real rates are lower than medium-term real rates), and that, in turn, means that the market expects the Fed to tighten monetary policy going forward. Real yields on 5-yr TIPS today (0.4%) can be thought of as the market's expectation for the average real yield on Fed funds (currently about -1%) over the next 5 years. This condition must hold in a market equilibrium, leaving investors indifferent between investing overnight or for 5 years.

The chart above compares the real yield on Fed funds to the slope of the nominal yield curve. Note that the yield curve is typically positively sloped in the early stages of a business cycle recovery, but that it becomes negatively sloped in the latter stages. Why? Because inflation has typically picked up as the business cycle matures, and the Fed typically uses tighter money policy (which takes the form of higher real yields) in order to "cool off" the expansion and suppress inflation pressures. Every recession in the past 50 years has been preceded by a significant rise in real short-term yields. The shape of the yield curve today and the low level of real yields tell us that we are probably years away from another recession, because the market doesn't expect any aggressive tightening from the Fed for many years.

The chart above compares the inverse of real yields on 5-yr TIPS (using that as a proxy for their price) to the price of gold. It's rather remarkable that the two have tracked each other so well for the past 8 years, since these two assets share almost nothing in common. The one thing they do share, however, is that they are both considered to be safe-haven assets. Gold is the favored port in any economic or financial storm, while 5-yr TIPS are not only risk-free but also inflation-protected. So the fact that they are moving together suggests that what is acting on these two prices is the market's degree of risk aversion. Risk aversion was high—and demand for TIPS and golds was strong—a few years ago, when gold hit $1900/oz. and real yields fell to close to -2%. Today we see less risk aversion, because the prices of gold and TIPS have fallen. But both are still well above their long-term averages. 

The market thus seems to be transitioning from a period of high risk-aversion to lower risk aversion. As a corollary we could say that optimism was in very short supply a few years ago and is now beginning to return. But we are still far from a market which is "irrationally exuberant." With the benefit of hindsight, the market was excessively confident when gold approached $250/oz and TIPS yields were 4%, in the 2000-2001 period. 

The chart above compares real yields on 5-yr TIPS to the PE ratio of the S&P 500 (as calculated by Bloomberg). Here again we see an interesting correlation, with the exception of the 2004-2007 period. This period was one in which the Fed was aggressively tightening monetary policy, which involves forcing real short-term interest rates higher. When the Fed is not forcibly intervening in the market, real yields show a strong tendency to track PE ratios.

What does this tell us? We know that rising PE ratios tend to correlate to a rising tolerance for risk and increased optimism about the future of the economy. Investors are willing to pay more for a dollar's worth of earnings when they believe the economy—and profits—are likely to improve. Today, PE ratios of 18-19 are only slightly above their long-term average. This confirms the message of gold and TIPS, which is that the market is transitioning from being very afraid to becoming cautiously confident. Valuations, in other words are somewhere between cheap and expensive.

The economy is growing at a sub-par 2-3% rate, the market is cautiously optimistic, and the Fed is about to begin raising short-term rates in a very gradual fashion. There's nothing big to worry or get excited about, and valuations are neither cheap nor particularly expensive. We've been in a sub-par recovery for years now, thanks mainly to very high marginal tax rates, excessive regulatory burdens, and policy uncertainty, and the market seems to have fully priced this in.

So: buy stocks if you think the policy environment is going to improve, and sell stocks if you think the policy environment is going to get worse. These choices are going to become easier to make as we approach the November 2016 elections.

October jobs not a big surprise

The October jobs report came in way above expectations (271K vs. 185K), and even more so considering upward revisions to prior months. Does this show the economy suddenly picked up speed? No. It's most likely just seasonal and/or statistical noise. As I've been arguing for months (and as I predicted yesterday) the monthly vagaries of the jobs numbers have not really changed the big picture of the economy, which continues to be one of disappointingly slow but relatively steady growth of 2-2.5% per year. 

If anything, today's headline should have read "BLS jobs catch up to ADP jobs." Both surveys have been tracking each other very well for the past several years, but the BLS numbers have proved more volatile. They were much lower than the ADP numbers as of yesterday, and now they are above. But both are saying the same thing for the past year and two years: private sector jobs growth is averaging about 225K per month.

The first of the above charts shows the monthly change in private sector payrolls, while the second shows the year over year rate of growth. Essentially, today's report simply confirmed that the economy is "steady as she goes."

If this had been a normal recovery, there would be many millions more employed and the economy would be about $2.6 trillion bigger, But let's not forget that there has been a net increase of about 5 million private sector jobs since the peak of the prior business cycle expansion. We are making progress, but it's painfully slow.

Businesses are not investing much, and the labor force is not growing much. The economy suffers from a failure to thrive, for a variety of reasons that are by now well-known: very high marginal tax rates (punitively high on businesses), increased and heavy regulatory burdens, generous transfer payments, policy uncertainty, and lingering risk aversion left over from the Great Recession.

The Fed can raise rates at the FOMC meeting (the implied probability of which is now 70%), and the sky is not going to fall. When they do raise rates, some of the policy uncertainty will fade, and the economic fundamentals will improve on the margin. This is all good news.

Random charts and thoughts

Just eyeballing the chart above tells me that the BLS's estimate of private sector employment tends to be more volatile than ADP's, and both tend to track each other over time. That further suggests that the BLS jobs number—to be released early tomorrow—has a decent chance of beating expectations (currently about 170K), since the ADP numbers have have been averaging just under 190K for the past 7 months. This ostensibly "good" news would probably be disappointing for the market (at least initially), since it would raise the probability of a Fed rate hike next month. The market wouldn't be caught totally by surprise, however, since the implied probability of a December rate hike has risen from 30% two weeks ago to 56% today. I think the market is beginning to realize that the economy is in decent enough shape (growth unlikely to change much from the 2-2.5% trend of recent years) to withstand a very modest increase in short-term interest rates.

In my view, the Fed can hike rates any time they like and it's not going to worry me. Rates naturally move higher as optimism increases and the economy matures. Higher rates would be a confirmation of growth, not a threat to growth.

As the chart above shows, large companies have not been very dynamic over the past two business cycles. Payrolls at large companies (500 or more employees) today are still about 10% below where they were in early 2001. Meanwhile, small and medium-sized companies have posted much more impressive growth.

Manufacturing hasn't been very impressive in the past year or so (weakness in the oil patch), but the service sector (which is far bigger) has been pretty impressive. The ISM service sector business activity index is at the high end of its range. More evidence of the hot-cold economy we're in: some do very well, others not so much. But on average things are growing at a fairly steady pace.

The employment sub-index of the ISM service release yesterday bounced back to a very strong level. This suggests that businesses feel pretty good about the future, because they plan to increase their hiring.

The service sector of both the U.S. and Eurozone economies are doing reasonably well. Between them, they account for a significant share of global GDP. Reason to remain optimistic or at least refrain from being pessimistic.

The prices of 5-yr TIPS (here proxied by the inverse of their real yield) and gold continue on a downward trend. The market is gradually losing its pessimism (which, at its height drove gold to $1900/oz and real yields to -2%) and coming to accept that the economy is likely to continue to grow, albeit slowly, and that the Fed is likely to acknowledge the improvement in expectations by raising rates a bit.

This last chart illustrates how real yields tend to track the economy's real growth rate. Both have been rising a bit in recent years. Nothing to get excited about, but somewhat reassuring nevertheless. Wake me when real yields on 5-yr TIPS break through 2%, and I'll wager the economy will be doing a whole lot better. And the Fed will be paying IOER of 3-4%.