I needed a little time off from writing. What I really needed was some rest from tax season. Then we entertained some friends from out of town for a few days. However, I was in front of my screen and in fact, had the opportunity to appear twice on television, since last publishing.
On April 16 I was on I24News where I spoke about currency manipulation and Netflix (NFLX). I appear at about the 9:30 mark on the video https://www.i24news.tv/en/tv/replay/clearcut/x6hyfah
Then yesterday, I was on ABC Eyewitness News in NY talking about Amazon’s (AMZN) delivery to car service http://abc7ny.com/video/ – search for – Amazon Car – to locate the video as there is no direct URL link
When I last published, I discussed that the markets were beginning to form the right side of a “W” technical formation. All was going well until last week when the markets caught the 3% Flu again. Like Pavlov’s Dog, the stock market sold off (went down in a bull market elevator) when the 10-year US Treasury kissed the 3.00% yield level. Adding insult to injury were sell-on-the-news reactions to strong results from Alphabet (GOOGL) and Caterpillar (CAT).
So, we really need to understand; does a 3% US Treasury Yield really matter, and if so, to what extent? I might get a little theoretical and wonky, however sometimes that is necessary.
According to what is referred to as the Fed model, the implied Price to Earnings Ratio (PE) on the 10-Year US Treasury Note is the inverse of the bond’s yield. Hence at 2.5%, the implied PE would be 40. At 3.0% it is now at 33.3%. This is then compared to the PE for the overall market, as defined by the Standard & Poor’s 500 (SPX). Currently that PE is 16.83, using 2018 earnings estimates (please note that if earnings are better than expected, as is likely the case, the current year PE for the SPX will be even lower). At 18-21 times earnings, the index is considered fairly-valued. Once it gets over 22, valuations are rich. PE can also be considered as a measure of market risk. Higher PEs imply greater risk.
So right now, the risk of the 10-Year US Treasury, using the Fed model is 33.3 versus that of the SPX’s 16.83. Stocks therefore remain cheap and bonds are rich.
We know that after a 35-year bull-market where the yield on the 10-Year US Treasury fell from a peak of nearly 16% in 1981 to just a tad below 1.5% in 2016, that rates would rise. That eventuality is now becoming reality.
This is where the fallacy of bond “safety” begins to fall apart. Let’s say that you buy a 10-Year US Treasury Bond yielding 3% right now. Should you hold that bond to maturity you would indeed receive a 3% annual yield to maturity. However, let’s say that in three years hence, interest rates continue to rise, such that the yield on a 7-year US Treasury would rise to 4%. That is certainly plausible. Should that happen your bond with seven years remaining to maturity would now be valued at (I am rounding) 94 cents on the dollar. You would have lost 6% on your bond, less three years of 3% coupons, resulting in a net gain of 3% in three years’ time. If you factor in inflation, which is currently running at 2.5%, you would have a real loss on your bond investment.
A jump in rates to just 4.5% would, in three years’ time, value that bond at 91 cents on the dollar. The greater the rise in rates, the greater the bond loss. As you can see, you can lose money in bonds
When I look at the stock market, absent a recession, earnings should continue to grow, and the PE ratio will gravitate toward 21. In fact, my expectations are that the next recession might not occur until 2021. On the back of a napkin, between now and then; SPX earnings will rise, conservatively, to about 165. Applying a 21 PE ratio, the index will rise to 3,465, a 31.5% increase. That does not even factor in the annual dividend yield of about 2%.
So, while the 3% yield on the US Treasury has some significance, I believe that the stock market’s reaction is more emotional than quantitively justified. I see more risk to bonds than to stocks over the next three years. The question you must ask yourself is whether you have the intestinal fortitude to ride out the markets adjustment to higher interest rates.
Disclosure: At the time of this commentary Scott Rothbort, his family and/or clients of LakeView AssetManagement, LLC was long CAT, GOOGL, NFLX, SSO & SPXL — although positions can change at any time.
Scott Rothbort is the President & Founder of LakeView Asset Management, LLC, a registered investment advisor specializing in high net worth private wealth management. For more information on investing with LakeView Asset Management, LLC call us at 888-9LAKEVIEW or request more information by clicking on the contact button on the top right hand corner of the website. LakeView Management, LLC is a Nevada LLC, with its principal office located in Henderson, NV and branch office located in Millburn, NJ
Scott Rothbort is also the publisher of the LakeView Restaurant & Food Chain Report, a newsletter focusing in on food, restaurant, beverage and agricultural stocks. An individual subscription to the newsletter can be ordered at www.restaurantstox.com Furthermore; Scott is also a professor at the Seton Hall Stillman School of Business in South Orange, NJ.
– Read Scott’s intra-day thoughts and comments on Scutify for which he is a co-founder of its parent company Wall Street All-Stars, LLC
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