Monthly Archives: May 2014

Market Surveillance — Bond Yields Define Gravity

Thurs, MAY 29th, 2014

Nope. That is not a misprint. Defy does not fit. I actually mean define, in the literal sense of the word (per Google).

De·fine /diˈfīn/

1. State or describe exactly the nature, scope, or meaning of.

That is precisely what bond yields have done this year, they have defined what gravity is — the force of attraction by which things tend to fall (inward).

So what gives?

My take on the current gravitational forces keeping yields lower (in no particular order):

Hedge against uncertainty, particularly geopolitical unrest in the Ukraine as Russia plays the bully and political tensions in Turkey, Thailand, Venezuela and other emerging markets have increased investor anxiety.

Pension funds shifting allocations at the margin after years of solid stock returns (the capstone being the +30% rally in 2013), which left many funds more flush on the asset side of the ledger while future liabilities have been reduced due to an increase in market interest rates (~1.6% on the 10-year to ~2.5% currently). As a result these fund managers have the latitude to take less risk to achieve their performance goals.

Lower quantity of Treasurys as the federal deficit falls (expected to be under $500B this year, the lowest level since 2008). If the U.S. Government is borrowing less (i.e., lower deficits) then fewer bonds are issued. Simple.

Meanwhile, the demand side is healthy. The Fed is still buying large amounts of bonds, even as they taper. In addition, the aging population means a greater demand for bonds as the Baby-Boomer wealth preservation phase replaces decades of wealth accumulation. This is a strong secular, demographic trend.

Lower bond quality, globally. U.S. Treasurys (10-year) gets you a yield somewhere between 2.5%-3.0% (throughout the balance of 2014) with a full faith and credit seal. At the same time, in Europe investors can get German bunds, UK gilts, Spanish, Italian and French bonds anywhere between 1.3%-3.0% (Germany’s the lowest, Italy the highest). Bunds are about -120 basis points lower than comparable U.S. Treasurys; that’s not terribly inviting. And why would any rational investor buy an Italian bond with all of their economic and fiscal troubles when you can get a lower risk U.S. Treasury with a similar yield? Risk/reward is completely out of balance. Japan is even less attractive at ~58 basis points for a 10-year JGB. Canada is ~2.2%.

Add to the prior point the notion that the ECB may further ease policy next week making U.S. paper even more attractive on a relative basis (i.e., the Fed is normalizing monetary policy while the ECB continues to loosen).

Inflation has not been and is not presently a threat. This improves the overall attractiveness of bonds as an investment. In fact, many central banks around the world (the Fed included) seem more focused on battling disinflation and even the specter of deflation as opposed to the threat of overheating economies.

A widespread sense that stocks are now overvalued and have run too far. This, coupled with some of the above items, have resulted in recent net fund flows moving into bonds pushing prices up and yields down.

Lower Treasury yields are the market story of the year (so far). Once again financial markets have done a fantastic job of confounding the masses. When Treasurys hit ~3% at the end of 2013 most analysts thought we would be at ~3.5% by now on the way to ~4%. And while they will probably be correct in the fullness of time, for the past ~6 months the bond market has done exactly the opposite. This is causing much hand wringing in the investment community. It is also prompting many — incorrectly in my estimation — to infer that the bond market is signaling a fundamental economic slowdown.

As I have persistently stated, from my perch the preponderance of macro data suggests otherwise: jobs figures, leading indicators, rail & truck loads, private consumption data, household net worth, rising yet tempered confidence, etc. all show an encouraging trajectory. This view discounts the economic perspective. If price confirmation of financial assets is more your speed (vs. economic data) you need not look any further than the relative out-performance of cyclical stocks including the Dow Transports, up nearly +10% on the year. If you believe that bond yields are signaling an economic slowdown (or worse-yet, recession), what are these cyclical and transport stocks telling us?

All told, lower bond yields against the backdrop of stable and improving economic fundamentals are a good cocktail for stocks. Indeed, at a ~2.5% 10-year with an upside range to, say, ~3% (and conversely elevated prices) I still want to be in stocks at those yields. This environment also keeps credit cheap, which is good for the economy. Too, general economic growth is supportive of sales and profits and thus stock prices. Finally, valuation on the stock market remains sensible across most measures, save for the CAPE ratio and market cap-to-GDP — though both metrics have their issues and neither implies impending doom at current quotations.

Jason L. Ware, MBA
Market Strategist, Chief Analyst
Albion Financial Group
(801) 487-3700; (877) 487-6200

Wealth Advice — Understanding your Social Security Retirement Benefit

Mon, MAY 19th, 2014

The Social Security Act, created in 1935, has been amended over the years but is still a major income component during retirement. Understanding and choosing a Social Security benefit can be one of the most important retirement planning decisions you make. However, many retirees do not understand the complexities of the options available to them.

Early Benefit

The earliest you can start receiving Social Security retirement benefits is age 62. Some people may not have an option to delay taking benefits. However, for those who don’t need the income now they may be better off by waiting. The age 62 benefit may be 30 percent lower than their full retirement benefit. Also if you plan to continue to work, your early benefit can be reduced even further. If you change your mind about taking an early benefit and are within the first 12 months, you can repay what you have received and restart your benefit at a later date. After 12 months, you can wait until full retirement age and then suspend your benefits. The income stops, but your benefits will begin to grow and a higher benefit can be taken in the future.

Full Retirement Age Benefit

The full retirement age benefit was originally established to be age 65. However, in 1983, an amendment was passed to increase the full retirement age from 65 to 67, beginning in the year 2000. Today, full retirement age is based on the year in which a participant is born. A full retirement age benefit will be significantly greater than an early benefit on a monthly basis—but it isn’t the maximum benefit you can receive. Your full retirement benefit will grow by roughly 8 percent for every year you wait until age 70. Those who have the option to wait past full retirement age will receive a healthy annual growth rate on their benefit.

Breakeven Analysis

A breakeven analysis is an important tool when trying to determine when a benefit should be taken. This analysis illustrates how many years it takes before waiting for a benefit pays off. By taking an early benefit, at age 62, you receive a benefit for more years but at a reduced rate compared to the full retirement age benefit. So at what point does waiting pay off? A high-level breakeven analysis suggest that an individual taking their full retirement age benefit would have to live at least 12 more years to breakeven versus the age 62 benefit. Someone considering the age 70 benefit would have to live roughly 13 more years to breakeven versus the full retirement age benefit. Please note that the above is high level—there are many variables and factors that will change the breakeven point.

Spousal Benefit

If you are married or were married, the decision on what benefit to take becomes even more complex. Having a spouse provides you the option to take a benefit based off your earnings, and/or a benefit based off your spouse’s earnings.

One advantage of having a spousal option is that a wife at full retirement age can take her benefit. Her husband can then apply for a spousal benefit and receive half of her benefit as long as he is also at full retirement age. He can then delay his benefit and begin taking it at age 70. I recently helped a client realize he could be receiving an extra $600 a month just by applying for a spousal benefit. The nice thing is his benefit isn’t affected by the spousal benefit and continues to grow.

Another strategy is to apply for and suspend a benefit. This strategy works if spouses are close in age and one spouse has a significantly higher full retirement age benefit. For instance, Jane’s full retirement age benefit is $2,500 and her husband John’s is $700. Jane could apply for her benefit at full retirement age and then suspend her benefit. Her benefit would continue to grow until she decided to take it in the future. In the meantime, John could start taking his spousal benefit based on Jane’s full retirement benefit amount. If John started drawing his own benefit, he would only receive $700 per month, but because Jane applied for and suspended her benefit, John could start receiving $1,250 per month, or half of Jane’s benefit.

Potential Risks

You may have heard that the Social Security Trust Fund is scheduled to run out of money by 2033. While we can’t know what the future holds we know there are risks.

There is the potential that the full retirement age could be raised further. Or perhaps more of your retirement benefit could be subject to taxes. A means test could be implemented, which would serve to reduce benefit amount for individuals with income and/or assets above a certain threshold.

While it is anybody’s guess what changes the future holds, it is certain that a significant risk to your Social Security benefit is making a decision without understanding and evaluating your options.

Devin B. Pope, CFP, MBA
Senior Wealth Advisor
Albion Financial Group

Market Surveillance — The Media Mania About Bubbles

Wed, MAY 7th, 2014

Valuation is a very complex financial topic. Too many people, especially the media, oversimplify it. So let’s dial back up the complexity [I know, you’re really excited now!]. I understand that this particular blog is very dense; there’s a lot information below. I have bolded areas of notable merit.

My views on valuation.

David Leonhardt of the New York Times paints stock market valuation with a very broad brush using but a single metric. And while he is correct that the Shiller P/E [AKA. CAPE] is presently at elevated levels, historically speaking, this alone is a woefully incomplete analysis in attempting to gauge the stock market. At Albion, we are continuously taking the temperature of the financial markets from a variety of angles. My view is that, on balance, when looking at general price-to-earnings ratios [despite Mr. Leonhardt’s contempt for this metric], earnings yield, equity risk premium, dividend discount, price-to-book, “the rule of 20” [20x subtract current inflation] and the general level of earnings, the market is not presently in a bubble. Additionally, net debt at companies [as measured by net debt/ebitda] is roughly half of what it was in the prior cycle and household balance sheets are in a state of great repair.

Sniffing out market tops can be more art than science, and in this qualitative vein there just doesn’t seem to be any excess of excess like in prior bull phases. More plainly, in 2000 too many people were day trading stocks and valuations hit over 100x on the Nasdaq and over 30x on the S&P 500. In 2007, everyone was financing frivolous consumption with credit and unfettered risk taking was alive and well on Wall Street. From my perch there is nothing like that out there today. What we actually have is an abundance of bubble watchers, crisis worriers, market-top-callers and a healthy dose of general skeptics. When stocks are truly bubbly virtually no one is looking to call the top; the party is just too much fun to leave.

For a further framework into thinking about how market tops often form, please check out this blog I recently wrote on Albion’s website.

I also reason that due to record highs in both the Dow and S&P 500 and two deep bear markets inside of a single decade, talks of a bubble are natural. I recently blogged about Investing at Market Highs.

On macroeconomic metrics the market doesn’t look overvalued either. Indeed, key items like GDP & GNI, retail sales/consumption, the relative health in U.S. banking, record levels of household net worth, low inflation, an improving labor economy and expanding energy and factory production all suggest that the economy has moved up enough to support equities at their current quotation, particularly given the flattish market over the past ~14 years [referred to as a secular bear market]. There are, of course, soft patches in the economy that haven’t fully recovered – namely jobs and housing, though both are on the mend. I think these two powerful sectors can drive the economy and the market higher over the medium- and longer-term. Other places like capital spending and general sentiment levels also remain tepid. Though, again, any pick-up here – which I believe is likely as the recovery lumbers along – provide incremental tailwinds to growth.

Finally, and perhaps most imperative, interest rates remain considerably lower than in any of the prior peaks meaning that equity valuations vs. bonds and cash look especially compelling. This valuation, a variation of the “Fed Model”, is one that is too often overlooked by people who currently see stretched valuations for stocks. History suggests that when rates are at extreme lows [conversely, bond prices are high] a trailing P/E [not CAPE, standard P/E] of >21x is not unusual. Indeed, market behavior since 1954 shows a mean of ~19x when long-term interest rates are below ~8%. We currently stand at ~17x on the S&P 500.

Market Context.

A study of long-run stock market data tells us that protracted bull markets – those that extend 5 years or more – generally do not end simply because valuations are perceived as overstretched. Valuations often stay elevated for a lot longer than people realize. What usually ends the party is a recession, a brawny Fed tightening cycle [no, tapering QE does not qualify] or some black swan event [i.e., exogenous shock].

At present, I don’t see a recession given the economic data, nor do I expect any time soon for the Fed to embark upon a classic tightening of monetary policy by violently raising the federal funds rate target *though, as I’ve stated many times before this would become a greater risk if we suddenly get money velocity in the economy*. As for black swans, by definition these are events that are completely unknowable so I will not venture a guess as to the likelihood of one swooping down and upending the market.

Some Considerations on CAPE.

Let us revisit what we began with, the NY Times piece on CAPE. At first blush this valuation tool does indeed suggest reduced returns looking out over the next few years. Given the run-up in stocks over the past five years this baseline is quite reasonable. That said, Robert Shiller himself has noted on many occasions that – except in extreme cases, like when it’s at say 35-50x – CAPE should not be used to as a tool to predict market tops. Bob doesn’t use it this way, so I won’t use attempt such a feat either.

To balance the landscape, this high CAPE argument isn’t the only game in town. Consider this CAPE counterpoint from Wharton school finance professor Jeremy Siegel, a market maven whom I have much respect for. He penned a compelling article in the Financial Times. I happen to agree with Mr. Siegel’s view. He also explained his views in an interview with Advisor Perspectives:

The CAPE has been a powerful predictor of long-term equity returns, forecasting strong returns in the early 1980s and poor returns from the market peak in 2000. But for many years its predictions have been very bearish. In fact, in all but nine months in the past 22 years the Cape ratio has been above its long-term average, and the ratio currently predicts well below-average stock returns.

I wrote a paper last summer, “The CAPE Ratio: A New Look.” I presented it at a Q-Group conference in October. Bob Shiller and I debated it the day after he won the Nobel Prize. (Because of all the media coverage he appeared by video-conference rather than in person)

The bottom line of the paper is I have a lot of problems with the CAPE predictions using S&P data, but not with the CAPE methodology. The CAPE methodology is brilliant and works. The data are the problem. I showed that the S&P 500 earnings data over the last 15 to 20 years, particularly in recessions, have been much different that prior to that, primarily due to the change in accounting conventions and the forced write-downs of assets. Changes in the accounting standards in the 1990s forced companies to charge large write-offs when assets they hold fall in price, but when assets rise in price they do not boost earnings unless the asset is sold. When I looked back at the historical data, S&P earnings compared to the business cycle, it was like night and day. You are not dealing with the same series.

I used the corporate profits from the National Income and Products Account (NIPA) data and plugged them in. Guess what? The Shiller overvaluation almost completely disappeared. And the cyclical behavior of the NIPA data is very consistent with the business cycle over the last 85 years. When you normalize for the data, the market is not overvalued by much at all. Because Shiller’s CAPE is based on the average of the last 10 years, the crash in earnings during those recessions really pumped up the CAPE ratio, and that is a major, major reason for today’s over-valuation.

Bob Shiller is my best friend. He invited me to the Nobel ceremony in Stockholm. I’m thrilled that he won. We have certainly a friendly back-and-forth on the direction of the market, but he is very well-deserving of his award. It’s not the CAPE methodology; it’s the fact that S&P 500 started dishing him a very different series from the one that he had constructed back at 1871. It was very interesting is that the S&P 500 series used to be more stable than the NIPA profit series but over the last 15 years has become less stable because of the new FASB guidelines. That’s the major problem.

The editor of the Financial Analyst Journal was at that Q-Group meeting. He came up to me afterwards and asked me to publish this. Bob acknowledged that there may be some marked inconsistencies with the series over time.”

Before you use the lone nut theory to explain away Siegel’s notion, consider that he isn’t the only one taking issue with modern CAPE data. This is from chief strategist David Bianco at Deutsche Bank:

Shiller method uses GAAP EPS for the entire time series. We use GAAP EPS from 1900 to 1976, S&P Operating EPS from 1977-88 and IBES pro-forma EPS from 1989 onwards. SEC was not created until the Securities Exchange Act of 1934 and it took decades for US GAAP to develop and many changes have been made to the accounting standards. Since 2000 goodwill and asset write-downs increased owing to the elimination of pooling accounting for mergers and there are now regular impairment tests of acquired goodwill. This causes GAAP EPS to understate true EPS as high value assets are never written up.

The current Shiller PE is usually compared to its 100+yrs average of 16.3x. This includes the WWI EPS cycle, when companies benefitted tremendously from supplying Europe. Profits tripled from 1914 to 1916, and then fell to less than a fifth during the 1921 post war recession. This exceptional profit swing distorts the long-term average 10yr PE a full point.

We advise comparing the current PE to its average from 1960 onwards as the S&P 500 didn’t exist until 1957. From 1926-56 S&P Index data is based on the S&P 90 composite which comprised of 50 Industrial, 20 Railroad and 20 Utility stocks. Prior to 1926 the data is based on Cowles Commission Index data. Considering all this, where does this put Bianco’s CAPE? Bianco’s CAPE is 17.0 now. The Shiller PE is 24.9. The 1960-2013 average for these PEs are 15.6 and 19.6, respectively. Shiller PE suggests that S&P is overvalued, Bianco PE is reasonable.”

Barclays, BofA/Merill and DoubleLine Capital all are beginning to look at a more modern CAPE through a similar lens.


Mr. Leonhardt of the Times says “be skeptical of ‘this time is different’ arguments.” I think David is a good journalist and a sensible guy, and there is some truth to this statement. But I would also enoucrage folks to be skeptical of folks who believe things can never change. While we at Albion certainly recognize that stocks are no longer cheap, we also posit that they are not wildly expensive either as the Times piece implies. Indeed, we believe valuation to be closer to fair value on known information. Looking out into the balance of this year and next we trust that as long as corporate earnings and the economy hang in there stocks will do just fine. This is presently our base case for the market.

For supplemental charts please see the attached images from Deutsche Bank, BofA/Merrill, Albion Financial Group, Thomson Reuters/Credit Suisse, and Strategas, respectively.

Jason L. Ware, MBA
Market Strategist, Chief Analyst
Albion Financial Group
(801) 487-3700; (877) 487-6200


Macro Focus — April’s Confusing Jobs Report

Fri, MAY 2nd, 2014

Extra! Extra! Read all about it! April jobs report crushes forecasts!

Indeed, on the report’s surface the data was stellar: 288K jobs added in April; upward revisions for both February and March; and the unemployment rate dropped to 6.3% from 6.7%, the lowest print in about 5 ½ years. Job gains were recorded across every sector. But like a shiny used car that conceals a clunky motor, a check under hood is warranted.

I won’t downplay the 288K jobs figure. Anytime folks find work this is worth celebrating. And this economy is adding jobs, don’t let anyone tell you different. In fact, with this number we have now virtually recouped all of the jobs this country lost during the Great Recession [see first chart courtesy of Calculated Risk]. Admittedly, this took much longer than in prior recoveries, but we also started in a much deeper hole and have battled greater macro challenges along the way. But that’s a topic for another confab.

Let us return to kicking the tires on today’s release. A deeper examination displays a few soft spots.

First and most critical, after gains in each of the three prior months April’s household survey – from which the official U3 unemployment rate is computed – experienced a loss of 806K people from the labor force. This is huge. As a consequence the participation rate fell to 62.8%, the lowest since 1978 [see second chart, from Reuters]. Had the labor force remained unchanged the jobless rate would have ticked up to 6.8%. It is unclear exactly why this mass exodus occurred. Some of it is certainly a continuation of ongoing secular drivers – longer-run social and demographic trends. These are structural issues, which policy can only marginally impact. On the cyclical side, this big dip in April could be explained by those long-term unemployed who lost their benefits when Congress failed to extend them earlier this year. Having only now become totally discouraged in their search for jobs, and without benefits as a motivator, they have given up. Indeed, the data is both clear and unjust – longer-term unemployed have a much harder time finding work.

The BLS offers a different explanation pinning the decline as “mostly due to fewer people entering the labor force than usual” as opposed to more people actually leaving. Perhaps. The labor economy is at its core a revolving door. People are always entering and leaving, but in order to have a stable inflow more need to be going in than coming out.

Of course it is equally possible that none of these fully explain this decline. It could be something more sinister; a reflection of a labor market that is significantly weaker than headline numbers suggest. Only time will tell.

Another area of lassitude in the report was average hourly earnings — dead flat month-over-month at $24.31. This is in-line with the sluggish wage growth we’ve seen so far in the five-year old recovery. Rising wages are important in keeping aggregate consumption going and thus the economy moving forward. One plausible theory here is that this pause simply echoes the true spot where adverse weather caused a “snap back” in the labor economy. To wit, hourly wages increased markedly during the winter months as hours worked declined [due to weather] without a corresponding drop in wage rates. If we are reverting back to a slower mean then incomes are not improving by the magnitude that the last few jobs reports would indicate.

On net, today’s jobs release was a curious one. Financial markets aren’t exactly sure what to make of it with stocks bouncing around the unchanged line so far in today’s session. Was this report good enough to suggest that the economy is accelerating? And if so, is this good for stocks? Should be, right? But wait, perhaps it’s bad because that may mean the Yellen Fed will move up the timing of monetary tightening? No wait … on the other hand, maybe this report is not so good? Perhaps it’s indicative of a softer economy? If so, is this good for stocks as it buys the Fed some additional latitude to keep their foot on the monetary throttle? Though … if it’s bad for the economy how can it be good for stocks?

The market is confused. And, to some degree, so is everyone else.

Jason L. Ware, MBA
Market Strategist, Chief Analyst
Albion Financial Group
(801) 487-3700; (877) 487-6200