Getting Financial Returns When Everything Seems Maxed Out: Part I

Global markets stand at an important point now, so lets stand back and clarify where we stand and where we seem to be going. The typical approaches to getting returns is by putting savings in stocks, government bonds, corporate bonds, real estate, the money market, and in foreign markets in these same markets.

The relative return between these markets is important to understand because it signals the mood of major market players. When the big players are confident and are hungry for returns, they move away (sell) safe assets and they move into (buy) riskier assets, because expected returns on riskier assets are generally higher than returns on safe assets.

The safest asset around is the 20$ bill in your pocket and all deposits in the “money market” such as your standard bank account, and it has a nominal return of zero and a real return of minus inflation (because it loses purchasing power every year due to the increase in the price of stuff). Since other markets are riskier and less liquid, they generally have higher returns. The difference between riskier-and-less-liquid returns and safe-and-liquid returns is the “yield spread” that we can display as:

yield spread between 2 assets =

riskier-and-less-liquid expected return MINUS safe-and-liquid expected return

What yield spreads are telling us now

Bull markets are generally signalled by falling spreads: big players are piling into risky assets, because they don’t fear a crash in the asset class. Stocks and riskier corporate bonds get capital influx, prices rise in these higher-risk asset classes, making the purchase more and more expensive, hence expected returns lower and lower (because you are buying at a higher and higher price, thus making it less and less interesting).

In the same logic, spreads spike when markets panic, because everyone moves their funds to the money market and sell other assets, making money market returns fall (prices rise and expected returns fall) and riskier asset returns spike due to the selloff making prices drop (you can now buy these at “bargain prices”, so your expected return is now higher — do you have the balls to buy?).

The typical yield spreads are between stocks and government bonds, stocks and corporate bonds, corporate bonds and government bonds, and between comparable asset classes between countries.

Here are a few indicators that I like to look at. I will comment and interpret further below. Take a minute to look at these or skip to my discussion right after…

Price-to-earnings ratio of S&P500 (taken from Macro Trends):

Shiller Cyclically Adjusted PE Ratio (taken from Quandl):

Discussion

1. Stocks are NOT in “extremely overpriced” territory, but they are on the high side based on both price-to-earnings ratios. This signals that either prices could drop a bit (stock market correction) OR earnings could increase going forward. Both would bring down the ratio.
2. Big players are bullish, as signalled by low yield spreads. The risk-taking seems solid and market participants do not see significant risk for now. Some analysts often say that “turnarounds happen when extreme levels are reached” and that makes them freak out about the low yield spreads, because it would mean (according to them) that they will soon spike, hence that a market crash is just around the corner. I will not spend energy and brain CPU resources on explaining why this is broken logic, I will just say that this is overly simplistic and that the whole “picture” of the market must be taken into account to assess market risk and valuation.
3. As I explained at length in a previous post, the lack of convincing inflation is putting a lid on monetary tightening potential, which is generally one major driver of stock market drops. No inflation = no (major) monetary tightening = no recession or market crash…
4. The fall in government bond yields means that markets have discounted some past expected monetary tightening due to 1) Trump policies falling short of bullish expectations and 2) lack of convincing inflation.
5. There is no major buildup of credit, debt or leverage on a massive scale that would pose a systemic risk to the US market or global market.

Markets don’t care about Trump (as long as…)

Trump is a mess. Everything is a mess. But he is not increasing taxes or regulation or launching a major war that could panic everyone (for now). With the absence of Fed tightening risk and the Trump debacle not affecting the bottom line, markets don’t care.

With trade war talk behind (it was all huff and puff), there is war or political meltdown risk that could really move markets. If he launches a war somewhere (you never know with this guy!) or impeachment momentum gains traction, THEN markets will care and it might cause a market correction, but otherwise, it’s all “noise” that nobody of importance in Big Finance or Big Business really cares about.

Yes, there was tax breaks and fiscal stimulus priced in, which may have moved stocks into higher-than-normal levels, but the drop in expected monetary tightening may have counterbalanced the whole thing.

Keep in mind the currency!

If you are invested in a market other than your currency, be careful of currency risk: if a Canadian puts money in the US market, he is at risk of losing on the currency fluctuation if it is not hedged by his investment intermediary. I told my forex students a while ago about the coming drop of the USD versus EUR and CAD and indeed the USD has been losing steam since early 2017:

To me at this point, Canada and Australia seem more attractive, because they both have currency appreciating potential and stocks are less pricey. In Part II we will talk about real estate. Please click the heart if you liked the insights! Regards.