It has been a busy two weeks. The Leen’s Lodge gathering added an intense interlude of high-powered conversation and analysis. The Yellen-Summers headlines now have two added mystery names per President Obama. The Fed (Federal Reserve) tapering talk adds the question “What is the policy?” to the question “Who will be making the policy?” Markets are going through gyrations in both bonds and stocks. And we see surprising reactions in foreign currencies, with the Japanese yen strengthening while changes in policy at the Bank of England have resulted in a market reaction opposite to what the BOE expected.
At Cumberland, there have been a number of strategy changes. Clients are aware of these changes by observing the activity in their accounts. We will summarize here the strategy changes and the reasons for them. Expect further commentaries on these matters as we keep you apprised of factors affecting the market and our timely responses to changing conditions.
We have raised cash in both US and international equity accounts. The bottom line is that the risk profile in stock markets is up. There are questions about the pace of economic recovery, some of the sectors such as energy or housing, and the impact of the Fed’s talk of tapering and what it is doing to risk premia and re-pricing in the market. The possibility of a Summers Fed chairmanship, coupled with Elizabeth Duke’s departing, Jerome Powell’s term ending next year, Sarah Bloom Raskin’s leaving for the Treasury, and Janet Yellen’s departing (If she is not appointed chair?) , leads market agents to conclude that an entirely different configuration of the Fed board may soon be at hand.
Add to that the retirements of some of the seasoned presidents (Cleveland Fed president Sandra Pianalto has announced), and the structure of the US central bank may reach a point where the remaining experienced and historically seasoned members of the FOMC (Federal Open Market Committee) are few. New observers and appointees may have seen the financial crisis from the outside; however, they will not have acquired firsthand the knowledge and experience gained only through making decisions under fire. Markets are aware that they face the biggest US central bank transition in many years.
Bond markets have backed up in yields. This is true in the Treasury, municipal and taxable bond markets. We have written about how yields have been distorted and yield spreads have widened enormously. Our example was a trading day in which the 30-year US Treasury obligation (federally taxable) traded at 3.62% yield. In the same 24-hour period, the tax-free New Jersey Turnpike traded at 4.73% yield, and the taxable New Jersey Turnpike traded at 5.15%. In our view, the tax-free turnpike bonds are screaming bargains in the present climate. In fact, Cumberland owns them in clients’ accounts.
Risk management issues loom larger than usual. What do you do when the stock market has reached your next year’s target? Our target was the S&P 500 at 1700 by the end of 2014. We are there. What do you do when the outlook for earnings is starting to deteriorate? We have ratcheted back our S&P 500 estimates for this year by a couple of dollars. We still think that earnings will come in around $110, give or take $2. The picture is trending toward more softness in earnings growth.
What do you do when the outlook for the future earnings growth rate is also deteriorating? We base that assessment on the fact that the profit share of the GDP in the US is at the highest level it has seen in decades and the labor share is at the lowest level. That means productivity seems high and earnings that come from that profit share seem to be strong. Could the profit share go higher? Yes it could. Is that likely now? We think not. Furthermore, the ratio of the value of the entire S&P 500 index to the GDP has reached 100%. History (Ned Davis database) suggests that this is a dangerous level.
We think the profit share of the GDP is rolling over, peaking, and tipping into what might be a long-term decline from this very high level. And the labor share may be bottoming and is positioned now to start a gradual rise over time from this very low level. If this view is correct, then American companies begin to face headwinds that will slow the earnings growth rate. This is not just a day-to-day, week-to-week or month-to-month rate of change. This is strategic. What lies before us is a longer-term stretch in which the tremendous benefit to American business from central bank policy in the post-crisis period will come to an end.
Lastly, there is the issue of demographic headwinds. Rob Arnott, a guest at Leen’s Lodge this year, has offered thoughtful analysis on demographics. He notes, in his serious research, how strongly demographics have contributed, in the past, to accelerating growth rates, and he forecasts significant headwinds that demographic change may introduce into our strategic future.
Put that package together and there emerges a set of circumstances in which stocks, having risen terrifically, now look less appealing at the current price level. Certain sectors of the bond market, by contrast, look more appealing.