Jason Kelly | On the Desk 8/21/13

OVERVIEW

Market Valuation | The Shiller P/E has flashed red for months. Now Jim Swanson at MFS is worried about trailing P/E, too.

Rising Rates | Yields are bouncing around two-year highs. There may be more to it than just a taper tantrum.

Summers or Yellen? | The frontrunners to head the Fed sport very different track records.
His is bad; hers, good.

BRIEFING

1. Market Valuation

I’ve been writing in The Kelly Letter about the P/E10, or Shiller P/E because it was reintroduced to the public in Robert Shiller’s book, Irrational Exuberance, showing the market to be about as overvalued as it was in 2007. The P/E10 provides historical context to current earnings by using a multi-year average of earnings. Shiller focused on a 10-year period, hence P/E10. From last Sunday’s note: “The historical base P/E10 for the S&P 500 is 16.5. It fell to 13.3 at the bottom in March 2009, shot to 24 in February 2011, settled to a range between 20 and 21, and is now back to the 24 area of February 2011. … Returning to just its historical average of 16.5 requires a P/E10 drop of 31 pct.” Remove bank earnings from second-quarter results, and S&P 500 earnings just fell 1.2 pct. Hence, overvaluation is worsening.

Jim Swanson, Chief Investment Strategist at MFS, is now worried about the plain old trailing P/E, too. He wrote, “In the last year, the market’s overall P/E has risen from 14.5 times earnings to more than 16 times earnings. In the last 12 months alone, the S&P 500 has risen 22 pct. While the fundamentals have not disintegrated, the rate of fundamental improvement has slowed as the market has zoomed ahead. This is a yellow flag … the fundamentals will have to show strong improvement before year-end for us to state that this market is on solid ground.”

+ Barry Ritholtz chastises investors who cling to the illusion of clarity, and says there’s no way to know if stocks are expensive or cheap. “If the economy were to accelerate (Sequester ends? China improves? Europe recovers?) then earnings could increase significantly, thereby making stocks ‘suddenly’ look cheap. The opposite of this is a US recession, where earnings fall 20-30 pct, making stocks appear pricey and due for a more significant correction than the 10-19 pct blips we have plowed through the past 5 years. Perhaps a better answer to the question ‘Are stocks cheap or pricey?’ is It depends upon what happens in the future.”

+ Jeremy Siegel thinks the Shiller P/E is overly pessimistic because it’s “based on biased earnings data” and says it should use “the after-tax profit series published in the National Income and Product Accounts (NIPA). … If the price-earnings multiple expands, as I believe is very likely, this bull market is still far from its peak.”

2. Rising Rates

Interest rates have been rising. From Sunday’s Kelly Letter: “Just last May, the 10-year Treasury yielded only 1.6 pct. It’s now up to 2.8 pct after rising 0.25 pct last week, and gunning for 3 pct. On Friday, the yields on longer-term Treasuries grabbed two-year highs and the yield curve steepened with the 2-10-year spread widening to 248 basis points. The 2-year note yields 0.36 pct while the 10-year yields 2.84 pct, a difference (or spread) of 2.48 pct.”

On Monday, the 10-year yield touched 2.90 pct, its highest since late July 2011. Yesterday, it fell to 2.83 pct.

+ Jim Cramer doesn’t “know what else could be responsible for a move up in interest rates like this — other than if the Federal Reserve were dumping Treasurys, instead of buying them. … It’s either artificial, or it is coming from overseas — because no bank, not a single one I deal with, is saying there’s newfound demand for credit.”

+ Along with the rupee and dollar, Treasury yields decoupling from USDJPY forms the new troika.

3. Summers or Yellen?

President Barack Obama will most likely choose either Larry Summers or Janet Yellen this fall as the next chairperson of the Federal Reserve. Both are economists. Summers was the Treasury Secretary from 1999 to 2001 under President Bill Clinton, President of Harvard University from 2001 to 2006, and Director of the White House National Economic Council for Obama from January 2009 to November 2010. Yellen was Chairwoman of the Council of Economic Advisors from February 1997 to August 1999 under Clinton, President of the San Francisco Fed from June 2004 to October 2010, and is currently the Vice Chairperson of the Fed under Ben Bernanke.

The Economist sees basic differences between the two: “For his management of the financial crises of the 1990s Time named [Summers] a member of ‘the committee to save the world.’ Yet his roles have often been marked by blunders. A stint as president of Harvard University ended badly, after missteps prompted a faculty vote of no confidence. … Yellen’s views are an open book. She has written and spoken extensively on monetary policy and the thinking behind the Fed’s current strategy. And she has argued that more could be done to help the jobless given the Fed’s dual mandate: price stability and maximum employment. … Summers’s writing suggests his views are conventionally Keynesian. He reckons the government can help most by boosting demand. But he has sat out the day’s heated monetary debates — save for a mildly skeptical take on QE in remarks at an April conference — and focused instead on fiscal issues. His most recent research argues that fiscal spending could be self-financing if it shortens unemployment spells. Although he is surely more open on monetary policy with Obama, the rest of the world is left guessing his views. … A chairman’s greatest challenge is to anticipate — and react to — surprises. Summers’s backers argue that no one can match his nimble mind. Yellen’s partisans contrast Summers’s past enthusiasm for financial engineering with her prescient forecasting record. She was the most accurate of Fed officials between 2009 and 2012, according to a recent survey.”

One has to wonder who The Economist spoke with on Summers’s behalf. Most who’ve followed his dabbling in the economy can’t spare a kind word for him, “nimble mind” or no.

Typical of the scorn for Summers is an article by Robert Scheer, “The Return of Lawrence Summers, Mr. Spectacular Failure” at The Nation, from which: “Summers has long succeeded spectacularly by failing. Why should his miserable record in the Clinton and Obama administrations hold him back from future disastrous adventures at our expense? With Ben Bernanke set to step down in January, and Obama still in deep denial over the pain and damage his former top economic adviser Summers brought to tens of millions of Americans, this darling of Wall Street has yet another shot to savage the economy. … After all, it was a massive infusion of Wall Street money that helped Obama get elected both times. And Wall Street, which showered Summers with almost $8 million in speaking fees and hedge fund profits during the 2008 campaign while he advised Obama, clearly would approve of this greed enabler as the next Fed chairman.”

Summers’s resume is the very picture of failing upward. He strongly backed two measures that led directly to the subprime mortgage collapse of 2008: the Financial Services Modernization Act and the Commodity Futures Modernization Act, and by “modernization” they meant “meltdown.”

The former smashed the wall created by the 1933 Glass-Steagall Act that had blocked any single company from combining in any way the services of investment banking, commercial banking, and insurance. This prevented them from getting so big that they threatened the financial system, and prevented the conflict of interest when the same entity grants credit through lending and uses it through investing. From Financially Stupid People Are Everywhere: Don’t Be One Of Them: “Unfortunately, the Act passed. At the 1999 signing ceremony with President Clinton that saw the protections of Glass-Steagall fall away, Lawrence Summers called the new legislation ‘a major step forward to the twenty-first century,’ to which he probably should have added ‘and the eventual bankruptcy of our nation in a multitrillion-dollar giveaway of taxpayer money to banks that use this new deregulation to blow up the financial system.’ He left that last part out.”

What’s more, he ignored warnings from Brooksley Born at the Commodity Futures Trading Commission when she warned Congress that the exploding derivatives market “threatens our economy without any federal agency knowing about it.” Summers yelled at her on the phone, and worked with his banking cronies to pass the law that prevented her agency from doing anything as derivatives spun out of control. The subprime mortgage crisis proved her right and the Summers team wrong. Oh, and lest we forget, he “undermined whatever was left of ‘moral hazard’ on Wall Street” when he supported rescuing Long-Term Capital Management in 1998, which Barry Rithholtz described in his book, Bailout Nation as “the predecessor for the great crisis of 2008.”

It’s hard to believe that the utterly invalidated Summers is in contention for the most powerful economic role in the United States, but so it goes. Consensus holds that Summers would direct the Fed toward a more hawkish monetary policy, although Mark Mobius thinks “it’s just the opposite,” that he “would favor a direct stimulus, which means tax cuts for low-income people, direct transfer payments, etc. etc., which could have a very electric impact on at least the US markets.”

Yellen provides a striking contrast and is a superior alternative. She has proved to be a “careful and deliberate thinker who has been mostly right in her assessments over the tumultuous past six years of crisis, recession and grinding recovery,” according to Wonkblog. Her judgment is sound, too. The Wall Street Journal “examined more than 700 predictions made between 2009 and 2012 in speeches and congressional testimony by 14 Fed policy makers — and scored the predictions on growth, jobs and inflation. The most accurate forecasts overall came from Ms. Yellen …” The least accurate? From central bank hawks, which consensus holds Summers to be. One of Yellen’s most memorable calls happened at a December 2007 meeting when she told her Fed colleagues, “The possibilities of a credit crunch developing and of the economy slipping into a recession seem all too real.”

The future is uncertain, but the past has a record. Summers’s is bad, Yellen’s is good. Let’s hope Obama sees the choice this plainly.

+ Another vote against Summers is the desire for a humble chairperson rather than a cocky hothead. Instead of “casting about for a new maestro, we need to return the Fed to dullness and its chairman to obscurity,” according to Amar Bhide of the Fletcher School at Tufts, in a New York Times op-ed.

Back to it. Have a good day,
Jason Kelly