Introduction
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Headlines are blaming the recent market correction on rising rates. While this may have been a catalyst for the correction, or a tipping point, it was probably not the underlying cause.
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Over my career, I have observed that the best stocks have solid earnings growth, improving growth, are surprising positively, and price in low expectations. While economic growth is positive, the trend is toward slowing. Surprises have turned much less positive, if not outright negative. Plus, expectations, as implied in valuation, are high.
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The real reason for the correction is probably because growth is slowing while rates are rising, and since expectations are still high, surprises are turning less positive to negative.
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The Possible Catalyst
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People are blaming the market correction on the rise in 10-year Treasury yield. This argument has some merit, but problems as well.
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(MERIT)
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Figures 1 and 2 show that the sharp jump in rates in January and September to October (to 3.23%) are correlated with the month-to-month S&P 500 corrections. Plus, as rates retreated to 3.14% last Friday and 3.16% yesterday, the market has staged a partial recovery.
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(PROBLEMS)
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However, the increase in nominal and real rates in Nov/Dec, April/May, and July were positively correlated with monthly returns.
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Figure 3 shows that the correlation between monthly changes in interest rates and the S&P 500 has been generally positive since the 2000s. Figure 4 shows the historic positive relationship between annual changes in yields and annual returns since 2000.
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Higher yields are a sign of strength in the economy, which has been welcomed by the stock market, not punished.
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Just a few months ago, investors were worrying about the flattening yield curve as short-term rates rose without a corresponding rise in long-term rates. A inverted yield curve has historically been a sign of an ensuing recession. Now, people are worried about higher long-term interest rates which steepens the yield curve? Those who disagreed, back then, about the negative implications of the flattening yield curve argued that long rates were being held down by the very positive interest rate differential between the US and Europe and the flood of international investors into our markets. EU quantitative easing is about to end, so maybe money is starting to pull back from the US and negative flows drove up yields over the last month. Higher rates may also be due to rising debt associated with the tax cuts and the Fed reducing its balance sheet. However, didn’t the market recently cheer those tax cuts that helped boost EPS growth by more than 20% over the first three quarters of 2018?
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This market seems to be schizophrenic about the impact of interest rates. Or, maybe it is not.
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Last week, I showed my students figure 3 over a shorter period, and one very wise student observed that the correlation between the market and interest rates was negative before the 2000s (as shown in figure 3). He wondered why the relationship changed. This was a great question. Let me explain.
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The Math of Interest Rates and Stock Returns
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In the 1970s through 1990s inflation was on its way lower and this brought interest rates down and ushered in a golden time for the stock market. Lower inflation meant a falling discount rate that drove the S&P 500’s P/E ratio up (figure 5), which spurred returns (recall, price = P/E * E).
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The rising P/E ratio over this time can be explained by theory. Let’s derive the P/E ratio in four steps and then explain why the correlation between rates and returns has changed over time.
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- Recall that theory suggests that the value of a stock equals the present value of dividends to infinity, or P0 = D1 / (1+r)1 + D2 / (1+r)2 + … + D∞ / (1+r)∞ (equation 1). In reality, there is more to this story, with an important correction that involves replacing dividends with free cash flow, but let’s assume the equation 1 is correct.
- Equation 1 can be simplified to the Gordon Growth Model (GGM) if dividend growth (g) and the discount rate (r) are constant. Of course, this assumption is absurd, but again, let’s assume it is correct. The GGM states that P0 = D1 / (r – g) (equation 2), or the value (price) of a stock is just dividends in the next year divided by the required return on equity (the discount rate, r) less the growth rate.
- Substituting D1 = E1 (payout ratio) into equation 2, where the payout ratio is dividends/earnings, yields P0 = E1 (payout ratio) / (r – g) (equation 3).
- Finally, dividing both sides of equation 3 by E1 results in P0/E1 = payout ratio / (r – g) (equation 4).
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Recall from the Capital Asset Pricing Model that r in the above equations equals the risk-free rate + market risk premium (r = rf + RP) (equation 5). This states that the return of a stock should equal the return of the risk-free asset plus a premium, or extra return to compensate for risk.
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Now that the math is explained, let’s talk about returns and rates over the last four decades.
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Figure 5 shows that rates fell as inflation declined over time since a lower rate is needed to compensate investors to delay consumption when inflation is lower.
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If the risk-free asset (rf) in equation 5 is the 10-year bond, then its decline during the 1980s and 1990s drove r down (a lower rf drives r down in equation 5) and pushed up the P/E since r is in the denominator of P/E equation 4. Also, the market risk premium (RP) declined in the 1980s and 1990s as the economy became more stable after the 1970s and early 1980s which featured very high inflation, a stagnant stock market, and several recessions. A declining risk premium (RP) drove down r even further (see equation 5). The impact of a lower risk-free rate and a lower market risk premium both helped drive the P/E up from 5-10 in 1980 to over 30 in 2000 (see figure 5). So, declining rates associated with lower inflation and a better economy lifted the P/E (and price since price = P/E * E) over the 1980s and 1990s, resulting in a negative correlation between rates and returns during that period.
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Moving to the 2000s, inflation was already tame. Thus, a rising risk-free rate (10-year Treasury rate) generally meant an improving economy, just like a falling risk-free rate meant improvement the two decades prior. Conversely, and a declining risk-free rate since 2000 meant that the Fed was trying to stimulate a poor economy. A post 2000 improving economy resulted in a higher numerator (dividends) of equation 3 and a reduction in the extra return to compensate for risk (the market risk premium or RP). Furthermore, the declining risk premium due to a better economy has generally more than offset the higher risk-free rate associated with it, so r, or the discount rate, went down as the risk-free rate rose. The net impact of these three factors (rising dividends and a declining market risk premium with rising risk-free rates) has generally boosted stock returns since 2000, so the relationship between rates and returns of the S&P 500 has generally been positive the last two decades.
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Maybe the Recent Correction was Caused by Deteriorating Conditions with High Expectations
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As noted earlier, a good stock is one with growth, low expectations, improving fundamentals, and positive surprises. The current market environment exhibits perhaps just one of these four conditions. Namely, growth is expected to be positive over the next year. According to FactSet, consensus 2018 earnings are projected to be up 21.7% and 10.2% in 2019. However, expectations are high, fundamentals are slowing, and surprises are turning down.
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Expectations are High
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Figure 5 shows that the P/E ratio is elevated, which implies that expectations for growth are high and risk is low (see equation 4). Historically, it is 3X to 10X as likely to have a below average P/E than an above-average P/E (like now) when EPS growth is positive and slowing (see EPS Coming in for Landing when P/E is High). The current environment is unusual. If the market was anticipating peaking earnings, a proper P/E should be lower as it would imply that earnings are at risk of going down and growth is slowing (see equation 4).
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The rest of the world corrected earlier this year at the same time as the US correction in early 2018; however, it did not rebound with the US market. The MSCI Emerging Market index is down 8.3% and MSCI Europe is down 3.3% YTD through yesterday. Yet, the MSCI USA index is still up 6.7%, even after the recent correction and partial recovery this week. The outperformance of the US versus the Russell Developed Market ex US is stretched (figure 6) (correlation of annual returns since 1999 is 0.78), so maybe a US correction was warranted.
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It isn’t just the stock market that is optimistic. Figure 8 shows a composite of variables that correlate with stock returns. These factors encompass trends in earnings growth, earnings revisions, short- and long-term interest rates, yield spreads (shape of the yield curve, the real yield, and the high yield spread), and alternatives (dollar, commodities, and gold). On a weighted aggregate basis, they have crested from levels of the prior two past cyclical peaks.
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Trends are Slowing
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Many people focus on growth; however, change in growth is often what drives markets over the near term.
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The market may have corrected because, as noted earlier, earnings are expected to slow in 2019. My earnings model has clearly peaked (figure 9, see Positioning the Cycle for an explanation of the model), and the market tends to lead earnings by about six months (figure 10).
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Slowing earnings growth coincides with slowing underlying trends.
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Some of the largest expenditures a consumer may make are for (1) housing, (2) autos, (3) vacations (by air), and (4) computers. Large purchases tend to be cyclical, and growth trends for these items are slowing.
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Figure 11 shows a Big Ticket Index, a six-month average of the sum of the growth rates of housing permits, vehicle sales, industrial production for computers, communication equipment, and semiconductors, and a survey of expected vacations by air (note: adjusting the Big Ticket Index to be an equal weighted average of the growth rates instead of a sum of them yields the same conclusions). The Big Ticket Index six-month growth rate tends to slow gradually to about 0% just before recessions. The current six-month average is +11.4%, down from 15.5% in July, and the trend is concerning as September just came in at up just 1.7% (figure 12 shows that the one month annual growth rate is much below the six-month average annual growth rate so the six-month rate should continue deteriorating). Growth in September was -4.0% for autos, -1.0% for housing units authorized by building permits, +6.9% for industrial production (computers, etc.), and -0.1% for plans to vacation by air over the next six months. Perhaps the boost from easing tax policy was only temporary.
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The last tick in my macro model is also in the slowing phase (figure 13) when bonds perform a little better relative to their historic relationship versus stocks (like recently), large stocks outperform smalls stocks (like recently), emerging markets underperform (like recently), value outperforms growth (like recently), and gold performs better (like recently). See Tactical Allocation Over the Cycle for a detailed explanation of this model.
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Surprise is Turning Down
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Revisions and surprises, after being strong at the start of 2018, have deteriorated significantly.
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The US Citi Economic Surprise Index is now negative (figure 14). While earnings surprise is still positive, it has weakened significantly thus far this quarter for the S&P 500 (figure 15). Surprise is still strong for mid-cap stocks at the best rate (+13%) since at least 4Q 2014, but surprise is about zero for small cap stocks (they have more US exposure than large-caps). Overall, surprise data is up over the last week as the market began to recover, but the earnings season is still early. Plus, FactSet reported that 3Q 2018 has the highest percent of negative pre-announcements since Q1 2016 at 76%, up from less than 50% in Q1 2018. The number of positive pre-announcements is the worst since Q1 2016 as well.
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Furthermore, earnings expectations for 2019 are flat to being revised down (figure 16), and the market is highly correlated with revisions (figure 17).
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Despite the reduction in expected earnings, margins are still expected to expand in 2019 (figure 18). This may be unrealistic given rising commodity costs, rising wages, high capacity utilization, rising interest costs, the tariff war, anniversarying the boost from lower tax rates post 2018, and the rising dollar. Regarding the last point, companies are reporting currency as negatively impacting earnings, and the dollar is negatively correlated with sales growth (figure 19). Furthermore, my inflation model is beginning to hook down after being elevated for some time, and recent CPI readings have come in lower than expected.
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On a positive note, perhaps weakening inflation means that interest rate hikes may take a breather, or if they do not, margins could be squeezed from higher costs without corresponding higher prices.
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Finally, slowing is occurring while rates are still far from neutral. Fed Chairman Powell scared markets last week by noting that the Fed Funds rate is still far from neutral (the r* rate where the Fed is neither accommodative nor restrictive), which means many more rate hikes are yet to come. The Fed Funds target rate is currently 2.25%, and long-term neutral rate is forecasted at about 3%.
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The Taylor rule shows that the Fed Funds rate is still far too accommodative (figure 20). The rule states that Fed Funds rate should be r* + 0.5 x (real GDP growth rate – real GDP trend rate) + 0.5 x (inflation rate – inflation target rate). In the latest quarter, real GDP ran above 4%. Let’s just assume the new run rate is 3% since 4% is unusually high and perhaps not sustainable, and let’s use the 2.1% 20-year growth rate as the long-run GDP trend (note, real GDP growth from 10/98 to the Great Recession, which was fueled by leverage, was 2.7%). Inflation is above the 2% target and is about 2.2%, depending on the measure. Thus, the Fed Funds target should be r* + 0.5 x (3.0% – 2.1%) + 0.5 x (2.2% – 2.0%) = r* + 0.55%. People disagree over r* and it may be a moving target, but let’s assume it is 3%. This means that the Fed Funds rate should currently be 3.55%; five more quarter-point moves may be ahead of us.
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The Fed Funds futures curve (figure 21) is pricing in 2.77% by March 2019, while the Fed’s dot plot expects rates to be 3.02% in 2019. The market expects rates to peak at about under 3% by March 2020, whereas the Fed is at nearly 3.5% that year.
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Thus, rates could continue to rise as the economic environment continues to slow, yet expectations for stocks, as implied in valuation, are high. This is probably what has, rightfully, spooked the market. Happy Halloween!
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