In 1992, the popular averages failed to beat the 7.92% returns of long treasuries. Over the past three years, 30-year treasury bonds have provided a total return of 35.66%, almost identical with that of the S&P 500, which gained 36.03%. This is one half of the phenomenon we have previously characterized as “bracketing” – stocks are bracketed by interest rates that are too high at the long end to permit shares to rise much and too low at the short end to make a big decline likely. Being bullish on stocks entails being bullish on bonds.
Hemmed in by the steepest yield curve in history (i.e. the difference between short and long rates is the largest ever) and an economic recovery best characterized as lumbering, the market exhibited the lowest volatility on record in 1992, even though individual stocks often gyrated wildly during the year. The difference between the low and high for the year on the S&P 500 was only 12%, compared to an average range between high and low of 29% since 1934. As long as short-term interest rates stay around 3%, and long-term rates around 7.5%, we would expect the market to remain bracketed, and volatility to likewise be restrained. The investment issue, of course, is how long will this abnormal spread between short and long-term rates persist and how will it eventually be resolved?
Opinions are not hard to come by, but all opinions do not have the same epistemic value. We believe most views on this subject can charitably be characterized as mere opinion, and have only the flimsiest of justification. People seem to believe both inflation and interest rates are headed higher over the next twelve months. This is not only the view that anecdotally presents itself most often, it is also the consensus of the 40 economists surveyed semi-annually by the Wall Street Journal. Most importantly, it is the consensus embedded in the current term structure of interest rates.
With short-term interest rates at 3% and the inflation rate at 3%, the pre-tax real return on “riskless” treasury bills is zero, and the after-tax real return is negative. No one willingly accepts guaranteed zero (or negative) returns if an alternative is available unless an imminent change in the returns is expected. Thirty-year treasuries offer among the highest real returns in history, yet trillions of dollars remain parked in bank CDs, money market funds and T-bills. If only 10% of that money moved to 30 years, it would buy up all the long bonds in existence. The only explanation for investors shunning high returns in favor of no returns is they expect inflation will come back, driving down the price of long treasuries and increasing the return on their T-bills. This expectation can be seen in the futures market, where the December 1993 future prices the short-term rate at nearly 5%. Even more revealing is that futures prices imply a steady rise in short-term rates to nearly 8% by 1997. The market clearly expects inflation to come roaring back.
What will be the source of this inflation? The explanation goes like this: as the economy recovers the demand for all of its resources increases. Since demand rises faster than new resources (i.e. land, labor, capital, commodities, etc.) can be created, prices are bid up. Banks raise deposit rates to attract more funds, long-term interest rates rise as demand for credit by government and business clash. Companies raise prices because demand for the products is strong. Wages go up because profits are growing and companies are bidding for new workers. As the economy grows even stronger, upward pressure on prices increases. Inflation turns higher. Soon the economy is in danger of “overheating” and the Fed begins to raise interest rates. And so on.
We can call this view the hydraulic hypothesis. Hydraulics is the study of the forces and effects arising from flows through a system. Using terms such as “under pressure” to describe the stock market suggests an explanation that is hydraulic in nature. A picture of the economy as a vast hydraulic system of pumps and flows, of pressure points and safety valves, is embedded in terms often used to describe the economy. It is “wheezing” or “spurting”, “overheating” or “building up a head of steam”. There is either too much or too little “liquidity” in the system. The Federal Reserve publishes statistics on “the flow of funds”. The hydraulic hypothesis is endemic among those looking for higher rates in 1993. It also seems rife in the thinking of the new administration, some of whose members have referred to new spending programs as “pump priming” to stimulate economic growth.
Just as water seeks its own level (hydraulics again), classical economic theory asserts that the economy seeks equilibrium, actions in one arena set off reactions in another in this Newtonian realm until a stable equilibrium is reached. But the inability of economists to generate reliable predictions about the most basic economic phenomena – about interest rates and inflation rates, GDP growth, the onset of recessions and expansions - suggests serious, if not fatal, flaws in the picture of the economy as a vast hydraulic system, clanking and heaving toward equilibrium, with pumps to be primed and safety valves to let off the steam from overheating. Since the above mentioned Wall Street Journal survey of economists began 10 years ago, in only 7 of the 22 semi-annual periods has the consensus got even the direction, much less the level, of interest rates right.
If engineers could not agree on how to keep buildings from falling down or airplanes up in the air, buildings and airplanes would not get built, and the theories which spawned such faulty results would be discarded. Our social engineers labor under no such difficulties. A social science, economics longs to wear the mantle of hard science, and economic theory is not considered rigorous unless couched in the language of physics. The dreadful record of economists, though, has done little so far to engender skepticism about their ability to diagnose the economy’s ills and prescribe the proper palliative.
Most economists, and most investors, seem to picture the economy as a hydraulic system with the government’s role being to regulate its temperature, pressure and output. If the economy is not performing up to snuff during election time, the incumbent is removed and a new administration is installed that claims to understand how to regulate the system properly.
New economic thinking, instead of new faces with old ideas, seems a more appropriate response to the disappointments so prevalent where economic policy is concerned. Some economists, dissatisfied with classical equilibrium models, such as Brian Arthur at Stanford and Blake LeBaron at Wisconsin, have undertaken such thinking. Instead of looking at the economy as a hydraulic system, or as a system in search of a stable equilibrium, they are exploring the idea that the economy can best be understood as a complex, adaptive system similar to an organism that grows, evolves and adapts to new circumstances. Much of the work is being carried out in conjunction with a broad, interdisciplinary effort underway at the Santa Fe Institute, ably chronicled in a new book, Complexity by Mitchell Waldrop.
We believe this new work holds much promise and we intend to explore whether this research can help us understand and interpret the economy in ways that may improve our ability to manage your funds more effectively.
Whatever way of looking at the economy ultimately proves most useful, we have to make judgments about how to invest effectively. It is clear that the lowest short-term rates in a generation have driven the market to lofty valuations relative to current earnings and current long rates. It is also clear that the market is vulnerable to any rise in short or long rates. It is far from clear that either are in prospect.
The nature of financial markets is such that when the overwhelming consensus is on one side, the investment opportunities usually lie on the other. The term structure of interest rates reflects a powerful consensus for higher short rates and higher inflation, a consensus forged not from facts but from faith in an economic metaphor. If inflation is to return, it must first become visible. There has never been an increase in the inflation rate without it first appearing as a rise in commodities prices. We see no evidence in commodities prices, in wage rates, or in finished goods that inflation will exceed 3% or so in 1993. Slow growth of the labor force, ample global capacity for more products and high debt levels should keep inflation low for several years. If inflation remains subdued, long-term interest rates should move lower and stock prices higher, perhaps substantially so.
The economy is recovering, earnings are moving higher, inflation is dormant, the Fed is accommodative, valuations are high, but not prohibitively so, and many companies are available at attractive prices. The probability of higher rates is no greater than that of lower. Absent external policy shocks, the market should provide returns in 1993 similar to those experienced in 1992. We will work hard to do better.
Read more of Bill's posts about the shifting economic paradigm:
Part I: Time Travel in the Minsky Moment
Part II: The Shifting Paradigm
Part III: “We Have Involved Ourselves in a Colossal Muddle...”
The views expressed are subject to change at any time. LMM disclaims any responsibility to update such views. The presentation should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results, and there is no guarantee the views expressed will turn out to be correct.
©2015 LMM LLC. LMM LLC is owned by Bill Miller and Legg Mason, Inc.
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