“QE3+ is an operation analogous to walking a tightrope over Niagara Falls. Success will be exhilarating, but failure will be ugly.” (John H. Makin. “The Fed Takes a Gamble.” American Enterprise Institute for Public Policy Research. September 2012.)
The last two weeks have been remarkable in this new era of central banking. Developments continue.
The latest move to withdraw more duration from the market is coming from the Bank of Japan (BOJ). The recently announced additional program by the BOJ includes a 50-per cent allocation to the purchase of 10-year Japanese government bonds. The other 50 per cent will buy shorter-term government securities. Thus, the BOJ is applying half of its additional QE stimulus to extracting long duration from the government bond market, denominated in Japanese yen.
In the US, we see the continuing evolution of QE3. The Federal Reserve is now increasing the outright purchase of longer-duration, federally backed mortgage securities. This is an extension of Operation Twist, whereby the Fed replaced short-term Treasury bills with longer-term Treasury notes and bonds.
In the US, the amount of long duration extracted from the market is now estimated to rise to about $85 billion per month. In other words, approximately $1 trillion of long-duration US government securities will be purchased annually. By many estimates, that figure exceeds the amount of new, long-duration US government securities being created.
The deficit of the US is financed by a combination of short-duration and long-duration instruments. Thus, the emphasis on long duration may mean that the total purchased could exceed the amount of actual new issuance of long-duration Treasuries. At the same time, the mortgage finance agencies, Fanny Mae and Freddie Mac, are limited in the amounts of credit they can extend. By some estimates, the Federal Reserve is in the process of becoming the largest government-sponsored enterprise involved in the financing of American housing.
Whether all of this is good or bad, we do not know. The extraction from the market of long duration in this amount could lead to a very bullish outlook for the US stock market. We think that is now the case and will remain the case as long as the Fed policy continues in this direction.
Assume that the short-term interest rate is going to be near zero for the next five to 10 years. Assume that the long-term interest rate, defined by the 10-year Treasury note, is going to be in the vicinity of two per cent for the next five to 10 years. What would you then use as an equity-risk premium so you could calculate the value of the US stock market? Let’s run some numbers to try to predict where the market is headed.
A traditional equity-risk premium calculation would be 300 basis points over the riskless rate. If you apply the calculation to the short-term interest rate, the equity-risk premium would suggest (by traditional standards) an extraordinary price earnings multiple, because the benchmark short-term riskless rate is near zero. If you apply a more conservative approach and use the 10-year yield and a two per cent estimate, you will derive an equity-risk premium comparative interest rate of about five per cent. That is two per cent on the riskless piece plus three per cent on the equity risk premium, for a total of five. This calculation leads you to the basic conclusion that the stock market is priced properly and at an equilibrium level at 20 times earnings. 20 times earnings is not excessive under this set of assumptions. The market would be neither cheap nor richly priced.
Apply the 20 multiple to the earnings estimates that we have for 2013. Many estimates, which suggest that the US economy will slow down and flirt with recession in 2013, centre at about $95 for the S&P 500 Index. Their range may be $90 low, high nineties high. Use $95 for this purpose. Estimates that are derived from the assumption that the US economy will continue with slow growth, a low rate of inflation, and a gradual but consistent recovery lead to an earnings estimate of about $105 for 2013. The wide range could be $90 low and $110 high, for an average of about $100.
For the purpose of this counting exercise, I am going to use $90. 90 times a PE of 20, which we derive from an equity-risk premium of 300 basis points over the 10-year Treasury yield, gives us an $1800 price target on the S&P 500 Index. That is the pricing of the stock market today, if the lower earnings number and a slower-growing economy are assumed and interest rates (as determined by the Federal Reserve in its current policy mode) remain stable. The Fed has essentially said it will hold these interest rates for a long period of time; and the slow-growth economic assumptions, outlined in deriving the value of the stock market, are consistent with the interest rates being so low for so long. Under these assumptions, 1800 on the S&P 500 Index is a fair price today.
On previous occasions, we have written that our price target for the S&P 500 Index was 2000 by the end of this decade. Given the above assumptions, the policy broadcast by the Federal Reserve, and the elements that are in place to achieve it, we are raising that estimate. We think it is quite possible that the S&P 500 Index could be closer to 2300, 2400, or 2500 by the end of this decade. As long as Fed policy stays in its present mode, a little more inflation and a little pick-up in the growth rate during the course of the decade will let us easily achieve these numbers.
Will the Fed stay in its present mode for that long? No one knows. Given the current concentration of intensity, effort, and communication on the employment situation in the US, you can easily guess that it will take four to seven years to achieve an unemployment rate low enough to warrant the Fed changing its policy stance. One Fed president has now called for continuation of this policy until the unemployment rate is 5.5 per cent. Another Fed president has repeatedly called for this policy to continue until the unemployment rate falls below seven per cent. The unemployment rate in the US today is above eight per cent. Other employment statistics reveal that the employment situation in the US is not healthy and is not getting better very fast. For US stock market investors, these facts lead to only one conclusion: the bias has to be toward fully diversified investing in US stocks.
Under the rationale that we will continue seeing the interest rates that we are accustomed to for a number of years, and that the policy will persist until the Fed can say it has achieved the goals established in its mandate to restore a baseline of full employment in the US, Cumberland Advisors’ accounts will remain positioned as described in this commentary.
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