Yields

[Gone4Good]

Relax. We are on the way to deflation. Depression follows.

The Fed is out of ammunition, no matter what Bernanke says. What can they do after interest rates are zero?

The Fed is out of political will, but has plenty of ammunition if there is a will to use it. With the God-Like powers to create unlimited money out of thin air, the Fed has deep enough pockets to buy every asset on earth. It can manufacture inflation if it wants to. It won't because such actions have risks, not least of which is to the Fed's independence.

Alternatively, if the Fed were to commit to a credible long-run inflation target of 3% to 4%, that would have the effect of reducing real rates below zero. It's announcement that rates will stay at zero to the middle of 2013 is a half step in that direction. This could be more effective policy than QE3.

 

[Gone4Good]

Those lousy real yields are telling us it pays to take some risks now.

SP500 PE=14.1 trailing and PE=11.9 estimated. Throw in a 2.2% dividend yield which is very close to the 10 year Treasury, and stocks look very good right now.

I'm not quite as optimistic about stocks as you are. I'm not comfortable being forced out of one overvalued asset into another one. Chasing yield almost always ends badly. True, PE ratios look attractive, but long-run measures like PE-10 still say we're in overvalued territory. I'm slightly uncomfortable with buying in at record profit margins and I believe that all the liquidity flowing through the financial system has the effect of boosting asset prices and making fundamentals appear better than they really are.

Having said that, stocks are a somewhat better buy today than they were a couple of weeks ago and bonds are a far, far worse buy. Here's an interesting chart that partly gets to your point: S&P 500 Yields are now above 10-Yr Bond Yields.

Something to note here, though. Unlike in 2008, when last these yields crossed, nearly the entire move today is because bond prices have rallied so strongly. Stocks aren't nearly as cheap as they were in 2008 when yields reached 4% (they're half that now and in the neighborhood of where they were prior to the last crash).

I'm not generally of the view that stocks are attractive simply because bonds suck so bad. It's entirely possible they both suck.

 

[Lsbcal]

I'm not quite as optimistic about stocks as you are. I'm not comfortable being forced out of one overvalued asset into another one. Chasing yield almost always ends badly. True, PE ratios look attractive, but long-run measures like PE-10 still say we're in overvalued territory. I'm slightly uncomfortable with buying in at record profit margins and I believe that all the liquidity flowing through the financial system has the effect of boosting asset prices and making fundamentals appear better than they really are. ....

I'm never comfortable with the stock market so that makes two of us.

In my view people are looking at PE10 and not realizing there is an underlying problem with it. If you look at the standard deviation of those 10 year earnings (the E10 in the denominator) they are up much higher then historical values. It is not completely up to date, but you'll get the idea. Here is a chart, check out that yellow line:

 

[Nords]

I've always been confused by people who think high interest rates (especially on CDs) are a good deal. They don't see all the other bad economic factors that accompany high rates.

In 2004 I sat next to a man at a Schwab "investment dinner". In late 1974 he'd put over 75% of his net worth into 30-year Treasuries... at 9%. He was in despair trying to figure out how to replicate that 9% yield with the latest asset classes. The Schwab advisers were drooling into their napkins.

 

[Chuckanut]

I think a healthy fear of the stock market is good. Along with a healthy fear of inflation. And a healthy fear of extreme interest rates.

 

[Ed_The_Gypsy]

The Fed is out of political will, but has plenty of ammunition if there is a will to use it. With the God-Like powers to create unlimited money out of thin air, the Fed has deep enough pockets to buy every asset on earth. It can manufacture inflation if it wants to. It won't because such actions have risks, not least of which is to the Fed's independence.

Alternatively, if the Fed were to commit to a credible long-run inflation target of 3% to 4%, that would have the effect of reducing real rates below zero. It's announcement that rates will stay at zero to the middle of 2013 is a half step in that direction. This could be more effective policy than QE3.

How does this work? The Fed can't buy anything, as far as I know. They set rates.

 

[GregLee]

Article from the WSJ from last April.

I'm with Mr. Lehman.

Mr. Lehman's taste for stocks goes against the traditional advice of financial planners, who urge older Americans to keep a majority of their assets in relatively safe, fixed-income investments.

I just don't believe that traditional advice, these days when interest rates are low. I hold only stocks -- no bonds.

 

[FIREd]

I'm with Mr. Lehman.

I just don't believe that traditional advice, these days when interest rates are low. I hold only stocks -- no bonds.

If I had a pension like you do, I might share your belief.

 

[youbet]

If I had a pension like you do, I might share your belief.

Excellent point FD! As I've mentioned numerous times on this board over the years, poster's comments regarding investment strategies should always be taken in light of their other financial resources. AA's for folks with large pensions/SS should/could be very different than folks living exclusively off of investment income.

Another AA determining factor is the ability of the retiree to be flexible in spending, a young single person vs a middle age parent with kids for example.

Context is important.

 

[GregLee]

AA's for folks with large pensions/SS should/could be very different than folks living exclusively off of investment income.

So those living exclusively off of investment income should be more willing to buy bonds? But isn't this thread about how that's not working out too well?

 

[Lsbcal]

All my views expressed here are from the standpoint of a standard stock/bond allocation with some SS thrown in. The only long term bonds I own are Ibonds purchased in 2000. Should have held those longer dated TIPS.

I do think it's possible to achieve reasonable real rates even in a rising interest rate environment. That is, over any reasonable long period like over 10 years (see rate history from 1950 - 1980). Short term it could be painful at times. That's where the balance of stocks comes into play.

 

[Purron]

I'm with Mr. Lehman.

I just don't believe that traditional advice, these days when interest rates are low. I hold only stocks -- no bonds.

Here's the thing I worry about. You impress me as someone who understands how to manage risk. With rates so low, I fear many people, particularly the elderly who've always invested in CDs, are tempted to take on risk they don't understand or be preyed on by those promising high returns.

 

[youbet]

So those living exclusively off of investment income should be more willing to buy bonds? But isn't this thread about how that's not working out too well?

So folks whose financial needs are met by large, secure pensions should invest the same as folks with no pension? IMHO, income sources outside the FIRE porfolio do have a bearing on the portfolio's AA strategy. But we all decide on our own AA's, so you do it your way, Ill do it mine.

 

[Gone4Good]

How does this work? The Fed can't buy anything, as far as I know. They set rates.

Q: How do they set interest rates?

A: Through "Open Market Operations" (a.k.a buying and selling bonds on the open market).

Beyond that, here is a very short summary of what Bernanke previously said the Fed has the authority to do.

This is an excerpt from his actual speech . . .

A second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral. For example, the Fed might make 90-day or 180-day zero-interest loans to banks, taking corporate commercial paper of the same maturity as collateral. Pursued aggressively, such a program could significantly reduce liquidity and term premiums on the assets used as collateral. Reductions in these premiums would lower the cost of capital both to banks and the nonbank private sector, over and above the beneficial effect already conferred by lower interest rates on government securities.


The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations, as the quantity of foreign assets eligible for purchase by the Fed is several times the stock of U.S. government debt.

. . .


Each of the policy options I have discussed so far involves the Fed's acting on its own. In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. . . . the government could increase spending on current goods and services or even acquire existing real or financial assets. If the Treasury issued debt to purchase private assets and the Fed then purchased an equal amount of Treasury debt with newly created money, the whole operation would be the economic equivalent of direct open-market operations in private assets.

That last paragraph may seem a bit cryptic, but he's basically saying that in conjunction with the help of Treasury, the Fed can essentially finance the acquisition of any asset. He can buy the whole world.

 

[Gone4Good]

In my view people are looking at PE10 and not realizing there is an underlying problem with it. If you look at the standard deviation of those 10 year earnings (the E10 in the denominator) they are up much higher then historical values. It is not completely up to date, but you'll get the idea. Here is a chart, check out that yellow line:

So what you're saying is that annual earnings have become far more volatile, which stands to reason considering we've had the 2000 and 2008 debacles within the last 10-yr window. That probably makes PE-10 somewhat less reliable, but I'd also argue that it makes normal PE completely unreliable.

I'd continue with the thought that if earnings are now far more volitile than was true in the past, equities are far more risky than was true in the past. Therefore higher risk premiums (lower PE's, however measured) seem appropriate. No?

 

[Lsbcal]

So what you're saying is that annual earnings have become far more volatile, which stands to reason considering we've had the 2000 and 2008 debacles within the last 10-yr window. That probably makes PE-10 somewhat less reliable, but I'd also argue that it makes normal PE completely unreliable.

I'd continue with the thought that if earnings are now far more volitile than was true in the past, equities are far more risky than was true in the past. Therefore higher risk premiums (lower PE's, however measured) seem appropriate. No?

PE10 was suppose to be more reliable because it used a smoothed "E", i.e. real earnings over a 10 year past. I'm just saying that this has too be viewed with suspicion when the standard deviation of the E10 is so much higher then historical numbers.

What we care about is the near term future earnings. The estimated PE1 that I mentioned above comes from a Wall St. firm. It's true that these estimates have to be taken with a grain of salt -- some may say a large grain. But note that even if those estimated values are off by 20%, forward PE's would be reasonable.

Also the SP500 dividend yield is quite good now compared with bond yields. Yes, dividends could be cut in a recession. Are we headed into a recession? Some say we are at "stall speed" i.e. just treading water but not headed down yet.

I'm optimistic that things will get better. That's my bet anyway.

 

[Gone4Good]

PE10 was suppose to be more reliable because it used a smoothed "E", i.e. real earnings over a 10 year past. I'm just saying that this has too be viewed with suspicion when the standard deviation of the E10 is so much higher then historical numbers.

Go back to your chart and compare the dotted blue line (E-10) with the green line (E). If increased volatility of that blue line is to be viewed with suspicion, then the green line needs to be viewed with absolute terror. Whatever predictive power Wall Street had with respect to PE1 over the long-term (not so good, BTW) it is orders of magnitude worse over the recent past.

If you want to discount PE-10 as a measure because of increased volatility in E, that's fine. But then you have to accept that PE or PE1 needs to be discounted even more heavily.

Also the SP500 dividend yield is quite good now compared with bond yields.

True. But bond yields stink like poo. And while it's likely that stock valuations are more attractive than bond valuations, that's not so impressive when you realize that what you're really saying is that stocks are more attractive than poo.

Edit to add: After a second thought, I'm not so sure that increased volatility has much bearing on PE-10's usefulness. The idea wasn't to smooth earnings for smoothing sake, but to average earnings over a business cycle. The problem with PE is that 'cheap' or 'rich' really depends on where you are in the business cycle. Late in the earnings cycle, a low PE is justified because you're at peak earnings. In the middle of a recession, higher PEs can be tolerated because presumably earnings growth will be higher coming out of the trough. But because we don't know until after the fact whether we're late or early in the earnings cycle, PE is a difficult measure to evaluate. That's even more true if the amplitude of the cycle has increased, which it has, as you've pointed out.

 

[Chuckanut]

Here's a discouraging article: Savers Stuck With Recovery Bill - WSJ.com

 

[Lsbcal]

...(snip)... But because we don't know until after the fact whether we're late or early in the earnings cycle, PE is a difficult measure to evaluate. That's even more true if the amplitude of the cycle has increased, which it has, as you've pointed out.

Well Gone4Good, I cannot disagree with what you've said. You bring up some good points. I think PE is just one facet of the market.

I personally use it (PE10) along with another valuation measure plus stock/bond comparisons and momentum to decide my course of action. Whatever I use has been backtested for 80 years or so. But I could be wrong. I'm just trying to be data driven in a modest way, rather then hunch driven. Unfortunately there is no science to this stuff. The test of a good model in science is predictability, but in the stock/bond markets we have to be satisfied with highly imperfect models.

FWIW, my current model says to stick with the market. The model will not work well for sharply declining (panic like) markets like Oct 1987 or Sept 1998.

 

[Gone4Good]

FWIW, my current model says to stick with the market.

FWIW, I'm not a seller of equities today.

Was a seller in Nov 2010 and April 2011. Sold a big chunk of 30 year bonds last week. That money may find it's way into the equity market to buy back some of those equity sales at better prices, but I don't feel pressured to do anything. The prices still aren't that good.

Sometimes, when the table odds don't look favorable, the best thing to do is sit on your wallet and watch.

 

[FIREd]

I will contend that, while equities as a whole seem expensive, there are pockets of value in this market.

 

[pletal]

I have been buying CD's from Apple Federal Credit Union . 10 Yr. 3.5% . Maybe it is foolish. But I can't invest in this crazy market. Inflation may eat me up, just have to save more now. If the rates go up, figure the hit and go from there. If I owned a bank I wouldn't lend at these rates, too risky.

 

[rescueme]

FWIW, I'm not a seller of equities today.

Was a seller in Nov 2010 and April 2011.

Same here. "Harvested" the YTD gains on the same month/year as you and added to DW/my respective cash bucket (for retirement income).

I've never been one to count on yields for long term income, but than again, that's only me.

It could be because our joint portfolio runs 50-55 equities most of the time (with a 50/50 AA) and I've found that it's easier to make decisions concerning equity sales to fund expenses at this time.

 

[Gone4Good]

It could be because our joint portfolio runs 50-55 equities most of the time (with a 50/50 AA) and I've found that it's easier to make decisions concerning equity sales to fund expenses at this time.

For me it's the simple fact that I have a very low return bogie to hit . . . my WR. If an asset is up 100%, as many were over the past two years, I can lock in many, many years of withdrawals without needing to take any additional risk. It becomes a pretty simple sell decision when your investment objective isn't to maximize returns, but simply to beat a fairly low hurdle rate.

An example: I bought 30 year TIPS at auction 18 months ago with a real coupon of 2.125% in an IRA. My intention was to hold these to maturity considering that the real return more than covers my need. Last week I sold these bonds at a 41% gain. That gain gives me eight years of 2.125% real returns (assuming today's TIPS breakeven inflation rates). I can bury the cash in the back yard and wait the better part of the next decade for rates to normalize before reinvesting that money. I can wait even longer sticking that cash in low break-fee CDs. I simply don't need to have that money invested in risky assets today because so much of my expected return was front end loaded.

Same story with the equities I bought in 2008 and 2009.

 

[chinaco]

For me it's the simple fact that I have a very low return bogie to hit . . . my WR. If an asset is up 100%, as many were over the past two years, I can lock in many, many years of withdrawals without needing to take any additional risk. It becomes a pretty simple sell decision when your investment objective isn't to maximize returns, but simply to beat a fairly low hurdle rate.

An example: I bought 30 year TIPS at auction 18 months ago with a real coupon of 2.125% in an IRA. My intention was to hold these to maturity considering that the real return more than covers my need. Last week I sold these bonds at a 41% gain. That gain gives me eight years of 2.125% real returns (assuming today's TIPS breakeven inflation rates). I can bury the cash in the back yard and wait the better part of the next decade for rates to normalize before reinvesting that money. I can wait even longer sticking that cash in low break-fee CDs. I simply don't need to have that money invested in risky assets today because so much of my expected return was front end loaded.

Same story with the equities I bought in 2008 and 2009.

Yes. But over the longer haul, your average return will probably average out... still a bird in the hand....

I did a similar move by exiting bonds after the increase... thinking that the fed would stop the manipulation sometime shortly after QE II.

So I have some gains from fixed... now what?

I am working on an approach.