Goldilocks Is Getting Old, Very Old
By John R. Taylor
Not too hot, not too cold. That is how the porridge must be to satisfy Goldilocks, the young blond interloper in the bear family’s house, and that is how the economic and inflation data must be to satisfy the market and the strategy that Greenspan initiated and Bernanke perfected. Stimulate when the economy looks tepid and threaten to slow money growth when things are percolating too fast. The investing world has caught on, with some hints and winks from Washington. Greenspan praised his discounted valuation model for US equities, which compared their projected future return with the yield on the 10-yr US Treasury Note. This works fine especially when inflation and interest rates are declining over time. There is no way the stock market can’t rally in that situation. Of course, Greenspan’s analytical framework is the same as Friedman’s and Schwartz’s when discussing velocity. They said the money multiplier could be disregarded as a variable because it had not moved since World War II – unfortunately, now it is all over the place and their analysis has its relevance.
Comparing the earnings and dividend returns of the equity market with the interest rate on government securities is fine when inflation is declining, and when Goldilocks’ porridge is neither scalding hot nor stone cold. Declining inflation is the sweet spot but negative inflation tends to become a zero-divide situation – it blows the system. At the extremes the numbers don’t work and today the inflation and interest rate situation seem to be approaching the breaking point. One of two things can happen. Most of the market sees the long, slow decline in interest rates coming to an end and this will put the equity market into a long-term decline, perhaps matching the length of the bond/equity rally from 1984 to now, which would be a 29 year decline. The other possibility is that inflation drops below zero. Considering that core inflation is now at 1.1% and dropping, this is not as outlandish as it seems. Do equities go up to an infinite multiple of their earnings yield? Although Greenspan’s formula would imply some sky-high valuation, history says it won’t happen. Something called Gibson’s Paradox seems to come into play. Although there are many quirks that economists are still arguing about, even though this anomaly was identified by Keynes more than 80 years ago, it implies equity prices will rally when interest rates go up – i.e. interest rates will follow the price level not the opposite. Equity valuations climb while bond yields climb as well. Our conception is that at the point of very low inflation – as we would see under the gold standard (or what we have today) – equity holders become nervous about future earnings or dividend returns when bonds are rallying. In that case, lower interest rates mean a lower stock market. If there are no earnings and many bankruptcies in the future, why buy stocks? All of a sudden the dividend discount model is turned on its head. At some point, the Goldilocks phenomenon comes to an end. Bonds have a bottom limit before Gibson takes over and equities decline, and if interest rates turn higher, equities will decline according to the orthodox calculation. Clearly Bernanke does not want to see deflation and his stimulus means to avoid that, but as the stimulus works, a turn in rates occurs. Rates are moving up now, but if the Fed stops them in a month or so, will the next rally appear as expected? We think so. But the next time around? Maybe not.
Asia Long-Term View Mr. Abe’s Third Arrow
by Jonathan Clark
Japanese Prime Minister Shinzô Abe entered his current term armed with three arrows. First arrow - monetary stimulus comprised of a 2% inflation target, increased asset purchases of extended duration and monetary base doubling. Second arrow – fiscal stimulus comprised of $50 billion in
public works projects and $100 billion of additional government spending. The first two arrows hit the target as they boosted consumer and business sentiment, jump-started the Japanese economy, strengthened equities and weakened the yen. On Wednesday, Mr. Abe announced the third arrow of structural reforms, which appears to have missed the target. Japanese equities continued their decline and this is viewed as a sign that the market is turning skeptical about the success of ‘Abenomics’ – the economic policies of the Prime Minister. We have a different view of the Japanese equity market. During the rally from the low in June of last year to the peak in April of this year, the Nikkei 225 gained 98%, an unsustainable pace that caused the equity index to become extremely overbought. The subsequent correction during the past two weeks of 38.2% of the previous gains (Fibonacci level) is consistent with a technical correction in the uptrend. The cycles call for an intermediate low early in the week of June 17 and this overall weakness can last as long as the middle of July. Our maximum target is the 50% retracement (12,040) and then the major uptrend should resume into year-end.
The third-arrow reforms were underwhelming as they didn’t go far enough in strengthening corporate governance, increasing labor flexibility, stimulating the healthcare industry and promoting investment. From a flow of funds standpoint, the important element was loosening the investment rules for the massive public pension plans, allowing them to hold less government debt and invest in other assets, some of which will be offshore. Dollar/yen is tethered to the Nikkei and should decline as well, but we suspect the majority of the correction in dollar/yen has already taken place. Our strategy remains to use any weakness seen into the middle of July to buy dollars for the next leg of the uptrend. There is an initial low due around the end of next week and it can fall as low as 97.85 before bottoming. It should then recover for a week or two before making a further attempt to decline into mid-July. A close below 97.85 means it can fall to the 96.00 area before bottoming, but we strongly doubt it will prove that weak. Following this low, USD/JPY should resume its major uptrend into the end of November or December. A close above the 102.35 to 102.50 area will signal dollar/yen is headed directly higher into August, and will rally to the 105.75 area. Our longer-term objective for the end of the year is 109.00.
By John R. Taylor
Not too hot, not too cold. That is how the porridge must be to satisfy Goldilocks, the young blond interloper in the bear family’s house, and that is how the economic and inflation data must be to satisfy the market and the strategy that Greenspan initiated and Bernanke perfected. Stimulate when the economy looks tepid and threaten to slow money growth when things are percolating too fast. The investing world has caught on, with some hints and winks from Washington. Greenspan praised his discounted valuation model for US equities, which compared their projected future return with the yield on the 10-yr US Treasury Note. This works fine especially when inflation and interest rates are declining over time. There is no way the stock market can’t rally in that situation. Of course, Greenspan’s analytical framework is the same as Friedman’s and Schwartz’s when discussing velocity. They said the money multiplier could be disregarded as a variable because it had not moved since World War II – unfortunately, now it is all over the place and their analysis has its relevance.
Comparing the earnings and dividend returns of the equity market with the interest rate on government securities is fine when inflation is declining, and when Goldilocks’ porridge is neither scalding hot nor stone cold. Declining inflation is the sweet spot but negative inflation tends to become a zero-divide situation – it blows the system. At the extremes the numbers don’t work and today the inflation and interest rate situation seem to be approaching the breaking point. One of two things can happen. Most of the market sees the long, slow decline in interest rates coming to an end and this will put the equity market into a long-term decline, perhaps matching the length of the bond/equity rally from 1984 to now, which would be a 29 year decline. The other possibility is that inflation drops below zero. Considering that core inflation is now at 1.1% and dropping, this is not as outlandish as it seems. Do equities go up to an infinite multiple of their earnings yield? Although Greenspan’s formula would imply some sky-high valuation, history says it won’t happen. Something called Gibson’s Paradox seems to come into play. Although there are many quirks that economists are still arguing about, even though this anomaly was identified by Keynes more than 80 years ago, it implies equity prices will rally when interest rates go up – i.e. interest rates will follow the price level not the opposite. Equity valuations climb while bond yields climb as well. Our conception is that at the point of very low inflation – as we would see under the gold standard (or what we have today) – equity holders become nervous about future earnings or dividend returns when bonds are rallying. In that case, lower interest rates mean a lower stock market. If there are no earnings and many bankruptcies in the future, why buy stocks? All of a sudden the dividend discount model is turned on its head. At some point, the Goldilocks phenomenon comes to an end. Bonds have a bottom limit before Gibson takes over and equities decline, and if interest rates turn higher, equities will decline according to the orthodox calculation. Clearly Bernanke does not want to see deflation and his stimulus means to avoid that, but as the stimulus works, a turn in rates occurs. Rates are moving up now, but if the Fed stops them in a month or so, will the next rally appear as expected? We think so. But the next time around? Maybe not.
Asia Long-Term View Mr. Abe’s Third Arrow
by Jonathan Clark
Japanese Prime Minister Shinzô Abe entered his current term armed with three arrows. First arrow - monetary stimulus comprised of a 2% inflation target, increased asset purchases of extended duration and monetary base doubling. Second arrow – fiscal stimulus comprised of $50 billion in
public works projects and $100 billion of additional government spending. The first two arrows hit the target as they boosted consumer and business sentiment, jump-started the Japanese economy, strengthened equities and weakened the yen. On Wednesday, Mr. Abe announced the third arrow of structural reforms, which appears to have missed the target. Japanese equities continued their decline and this is viewed as a sign that the market is turning skeptical about the success of ‘Abenomics’ – the economic policies of the Prime Minister. We have a different view of the Japanese equity market. During the rally from the low in June of last year to the peak in April of this year, the Nikkei 225 gained 98%, an unsustainable pace that caused the equity index to become extremely overbought. The subsequent correction during the past two weeks of 38.2% of the previous gains (Fibonacci level) is consistent with a technical correction in the uptrend. The cycles call for an intermediate low early in the week of June 17 and this overall weakness can last as long as the middle of July. Our maximum target is the 50% retracement (12,040) and then the major uptrend should resume into year-end.
The third-arrow reforms were underwhelming as they didn’t go far enough in strengthening corporate governance, increasing labor flexibility, stimulating the healthcare industry and promoting investment. From a flow of funds standpoint, the important element was loosening the investment rules for the massive public pension plans, allowing them to hold less government debt and invest in other assets, some of which will be offshore. Dollar/yen is tethered to the Nikkei and should decline as well, but we suspect the majority of the correction in dollar/yen has already taken place. Our strategy remains to use any weakness seen into the middle of July to buy dollars for the next leg of the uptrend. There is an initial low due around the end of next week and it can fall as low as 97.85 before bottoming. It should then recover for a week or two before making a further attempt to decline into mid-July. A close below 97.85 means it can fall to the 96.00 area before bottoming, but we strongly doubt it will prove that weak. Following this low, USD/JPY should resume its major uptrend into the end of November or December. A close above the 102.35 to 102.50 area will signal dollar/yen is headed directly higher into August, and will rally to the 105.75 area. Our longer-term objective for the end of the year is 109.00.
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