Tag Archives: Federal Reserve

First Fed Hike & Stock Market

Interest RateGuest post by Contributing Editor, David R. Kotok, Cumberland Advisors.

There has been a lot of discussion about the Federal Reserve (Fed) and when it will move its interest rate to something higher than the present 0 to 0.25%. The Fed has been at the zero bound for years. My friend Jeff Saut at Raymond James noted that there are people who have been in this business over eight years and have never experienced a Fed rate hiking cycle. We have to look back more than a decade to recall what sequential hikes were like.

The questions are, when they will do it, by how much, in what sequence, for how long, to what level, and with what effect on the markets?

Bond market pundits think the Fed may raise rates quickly, as they did in other hiking cycles. Others, like our team at Cumberland Advisors, think they will take gradual steps in view of the fact that the US dollar is the strongest currency in the world. It is getting stronger, and worldwide interest rates are low and going lower. Approximately $4 trillion in total sovereign debt worldwide is now trading at negative interest rates. Additionally, the Fed does not see an inflation threat. It does see gradual recovery in the US and healing labor data.  Today’s employment report will add to the list of monthly improvements.  But the labor markets still have a long way to go to get to normal.  The Fed remembers the 1937 experience when they hiked interest rates too soon and dumped a recovering economy back into recession.

All that said, there is one question that remains. What happens to the stock market when the Fed raises interest rates?

Talley Léger is the co-author of our new book, the second (and revised) edition of From Bear to Bull with ETFs. He has published a study entitled “Don’t be too spooked by Fed rate hikes,” dated January 31, 2015. Talley has given us permission to share this Macro Vision Research piece with our readers. The link to his commentary is here.

We do not know what will happen in this particular cycle, since we are now in uncharted waters. We are coming out of the zero-interest-rate regime. We do know that the market has spent a lot of time and energy fretting about the prospect and the timing of rising rates. Our internal view at Cumberland Advisors is that the first rate hike will not trigger a market selloff. Further, we do not expect the bond market to sell off and interest rates to go shooting up when the Fed raises the interest rate from zero by an eighth or a quarter percent. And we expect the first rate hike to take place in the very latter part of this year or in early 2016.  In a few hours we shall see the newest labor data for the US.  We expect that it will validate this gradualist approach in our Fed forecast.

 

Disclosure:

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Cumberland Advisors is not affiliated with FOLIOfn or The Portfolioist.

Related Links:

logo-folioinvesting

The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA and SIPC.

Goodhart’s Law

Goodhart's LawGuest post by Leo Chen, Guest Contributor to Cumberland Advisors.

Goodhart’s Law

“When a measure becomes a target, it ceases to be a good measure.”

-Charles Goodhart

When it was first introduced in 1975, Goodhart’s Law focused mainly on social and economic measures. Since then, many financial market indicators have lost their forecasting power and succumbed to Goodhart’s Law. Nevertheless, Goodhart’s Law in no way depreciates the value and importance of market indicators; it simply means that investors are unlikely to be able to consistently generate abnormal returns over time using popular measures that are publicly available to the entire market. A clear example is what has happened to the CBOE Volatility Index, or VIX.

The Volatility Index

The Volatility Index (VIX) was a groundbreaking product when the Chicago Board Options Exchange (CBOE) released it in 1993. Also referred to as the fear index, VIX measures the expected underlying volatility in the S&P 500 over the next 30-day period on a real-time basis. Using various measures of VIX such as the two-week mean, the 30-day rolling standard deviation, etc., VIX traders and portfolio managers developed strategies that were initially profitable. However, over time it has become extremely difficult to profitably forecast the market by simply observing the movement in VIX.

While the history of the VIX demonstrates how a market gauge lost its predictive power once it caught investors’ attention, the CBOE Low Volatility Index, LOVOL, provides an even better illustration of how an indicator can lose its forward-looking power very quickly. CBOE began calculating the Low Volatility Index on March 21, 2006, and started disseminating LOVOL data on November 30, 2012. The forecasting ability of LOVOL immediately plunged to almost zero within a month. In fact, Goodhart’s Law has captured nearly all of the CBOE volatility indexes as prisoners. These fallen angels are no longer useful tools for forecasting purposes.

Another prominent index, developed in the late 1960s, that uses extremes in its value to signal that a market may soon change direction is the Arms Index (TRIN). As predicted by Goodhart’s Law, while technical indicators such as TRIN were able to successfully predict market returns in the past, their loss of forecasting power was only a matter of time when every technician used these ratios for trading purposes. Even the Federal Reserve was no exception. The pre-FOMC announcement drift was found to explain the equity premium puzzle in 2011. But this 24-hour window disappeared soon after the research was published.

Investors Beware

On one hand, Goodhart’s Law teaches us that a smart investor should not rely on any single factor known by the general public to be “powerful”; on the other hand, it does not negate the significance of any indicator.

The following figure is a ratio brought up by Chairman and Chief Investment Officer David Kotok of Cumberland Advisors. The CBOE SKEW Index measures S&P 500 tail risk, while the VXTH Index hedges “black swan” events such as Black Monday in 1987. Lagging and scaling both indexes by the lagged VIX, we are able to track the daily SPX with a correlation that can top 90%, comparable to the correlation between the S&P 500 and GDP. Nonetheless, a high correlation is not necessarily equivalent to strong forecasting power. While one could use this chart for long-term investing strategy, the accuracy of using these daily ratios to predict the daily market movement is approximately 51%, not economically significant enough for forecasting purpose.

3-5-2015

Figure 1. Correlations between SPX and Volatility Indexes

Conclusion

The list of captives of Goodhart’s Law is clearly longer than just the indicators mentioned above. High-quality research should be able to produce positive abnormal returns as long as there is information that can be exploited; however, superior research alone is no longer synonymous with outperformance – time is also of the essence. Because of technological innovation in financial markets, the time frame in which Goodhart’s law operates today is much shorter than it was in earlier decades. Just as Moore’s Law predicts that chip performance will double every 18 months, investing methodologies must continually evolve in order to remain profitable, due to Goodhart’s Law.

Disclosure:

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Cumberland Advisors is not affiliated with Folio Investing or The Portfolioist.

Related Links:

logo-folioinvesting

The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA and SIPC.

Is the Fed Really “Stealing from Savers”?

Federal ReserveIn a recent article on MarketWatch, Chris Martenson asserts that the Fed’s low interest rate policy and quantitative easing in recent years is deliberately stealing from savers. This article has elicited a big response, with almost 800 comments and almost 2000 likes on Facebook. The key point of the article is that the Fed’s policy of holding down interest rates to stimulate the economy has reduced the income provided by Treasury bonds, savings accounts, and certificates of deposit (CDs) to extremely low levels. In this way, the Fed’s policy can certainly be viewed as harmful to people trying to live on the income from bonds and other very low risk investments. This Fed-bashing rhetoric is far from the whole story, though.

The total impact of very low interest rates on savers and conservative investors is somewhat more complex than the MarketWatch piece suggests. Subdued inflation in recent years, one of the reasons that the Fed cites for keeping interest rates low, also means savers are seeing lower rates of price increase in the goods and services they buy. With very low current inflation, you simply don’t need as much yield as when inflation is higher. It would be wonderful for conservative investors to have low inflation and high yields from risk-free accounts, but that situation is effectively impossible for extended periods of time.  All in all, low inflation is typically a good thing for people living in a fixed income.

Another effect of continued low interest rates is that bond investors have fared very well. The trailing 15-year annualized return of the Vanguard Intermediate bond Index (VBMFX) is 5.4%, as compared to 4.5% for the Vanguard S&P 500 Index (VFINX).  Falling rates over this period have driven bond prices upwards, which has greatly benefitted investors holding bonds over this period.

One interesting related charge leveled by the MarketWatch piece (and also in a recent New York Times article) is that the Fed policy has exacerbated income inequality and that the wealthy are benefitting from low rates while less-wealthy retirees living on fixed incomes are being hurt. Low interest rates have helped the stock market to deliver high returns in recent years and it is wealthier people who benefit most from market gains. In addition, wealthier people are more likely to be able to qualify to refinance their mortgages to take advantage of low rates. The implication here is that less wealthy people cannot afford to take advantage of the benefits of low rates and that these people, implicitly, are probably holding assets in low-yield risk-free assets such as savings accounts or CDs. This is, however, somewhat misleading.  Poorer retired households receive a disproportionate share of their income from Social Security, which provides constant inflation-adjusted income.

While investors in Treasury bonds, savings accounts, and CDs are seeking riskless return, money held in these assets does not help to drive economic growth, and this is precisely why the Fed policy is to make productive assets (in the form of investments in corporate bonds and equity) more attractive than savings accounts and certificates of deposit. So, the Fed is attempting to drive money into productive investments in economic growth that will create jobs and should, ultimately, benefit the economy as a whole. One must remember that the Fed has no mandate to provide investors with a risk-free after-inflation return.

It is certainly understandable that people trying to maintain bond ladders that produce their retirement income are frustrated and concerned by continued low interest rates and the subsequent low yields available from bonds.  Given that inflation is also very low, however, low bond yields are partly offset by more stable prices for goods and services. It is true that the Fed’s policies are intended to get people to do something productive with their wealth like investing in stocks, bonds, or other opportunities. It is also the case that older and more conservative investors world prefer to reap reasonable income from essentially risk-free investments. Substantial yield with low risk is something of a pipe dream, though.  Investors are always trying to determine whether the yield provided by income-generating assets is worth the risk. We may look back and conclude that the Fed’s economic stimulus was too expensive, ineffective, or both, but this will only be clear far down the road.

Related Links:

logo-folioinvesting

The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA and SIPC.

Goldman Sachs Predicts 4.5% 10-year Treasury Yields

Treasury BondGoldman Sachs just came out with a prediction that 10-year Treasury bond yields will rise to 4.5% by 2018 and the S&P 500 will provide 6% annualized returns over that same period.  The driver for this prediction is simply that the Fed is expected to raise the federal funds rate.

Because rising yields correspond to falling prices for bonds, Goldman’s forecast is that equities will substantially outperform bonds over the next several years.  If you are holding a bond yielding 2.5% (the current 10-year Treasury yield) and the Fed raises rates, investors will sell off their holdings of lower-yielding bonds in order to purchase newly-issued higher-yielding bonds.  If Goldman’s forecast plays out, bondholders will suffer over the next several years, while equity investors will enjoy modest gains.

Historical Perspective

This very long-term history of bond yield vs. the dividend yield on the S&P 500 is worth considering in parsing Goldman’s predictions.

Bond Yield vs. Dividend Yield

Source: The Big Picture blog

Prior to the mid 1950’s, the conventional wisdom (according to market guru Peter Bernstein) was that equities should have a dividend yield higher than the yield from bonds because equities were riskier.  From 1958 to 2008, however, the 10-year bond yield was higher than the S&P 500 dividend yield by an average of 3.7%.

Then in 2008, the 10-year Treasury bond yield fell below the S&P 500 dividend yield for the first time in 50 years.  Today, the yield from the S&P 500 is 1.8% and the 10-year Treasury bond yields 2.5%, so we have returned to the conditions that have prevailed for the last half a century. But the spread between bond yield and dividend yields remains very low by historical standards.  If the 10-year Treasury yield increases to 4.5% (as Goldman predicts), we will have a spread that is more consistent with recent decades.

Investors are likely to compare bond yields and dividend yields, with the understanding that bond prices are extremely negatively impacted by inflation (with the result that yields rise with inflation because yield increases as bond prices fall), while dividends can increase with inflation.  During the 1970’s, Treasury bond yields shot up in response to inflation. Companies can increase the prices that they charge for their products in response to inflation, which allows the dividends to increase in response to higher prices across the economy.  The huge spread between dividend yield and bond yield in the late 70’s and early 80’s reflects investors’ rational preference for dividends in a high-inflation environment.

What Has to Happen for Goldman’s Outlook to Play Out?

To end up with a 4.5% 10-year Treasury yield with something like a 2% S&P 500 dividend yield, the U.S. will need to see a sustained economic recovery and evidence of higher prices (inflation) driven by higher employment and wage growth.  In such an environment, investors will be willing to accept the lower dividend yield from equities because dividends grow over time and tend to rise with inflation.  This has been the prevailing state of the U.S. economy over the last fifty years.  Most recently, we had 10-year Treasury yields in the 4%-5% range in the mid 2000’s.  If, however, we continue to see low inflation and stagnant wages in the U.S. economy, bond yields are likely to remain low for longer.

Related Links:

logo-folioinvesting

The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

The Inflation Paradox at the End of 2013

The latest inflation numbers are out from the Bureau of Labor Statistics and they show that consumer prices barely increased over the past twelve months.  The most commonly-cited measure of consumer prices is the CPI-U, the Consumer Price Index for Urban consumers.  The CPI-U is up 1.2% over the twelve months through November, and this is almost identical to the 1% 12-month rise in the data through October.  The other major inflation measure, the Personal Consumption Expenditure index (PCE), is even lower because housing is a smaller component of PCE than CPIContinue reading

The Collapse of the American Net Worth

Many of you are painfully aware of how many friends or family members are out of work, now under-employed, or who have lost their homes. Geoff Considine, a leading contributor to the Portfolioist, provides his take on what we’re calling the “collapse” in household net worth, starting with a recently published report released from the Federal Reserve called the “Survey of Consumer Finances” (SCF).

This study, performed every three years, provides an analysis of household income and wealth across America, and the results will astound you. The SCF is well-worth reading if you want to get a handle on the state of Americans’ finances—especially if you want to see how those same finances have changed dramatically in just three short years. Continue reading