Investors, journalist, investment strategists and market commentators talk about and analyze the economy as part of their investment decision-making process. They do so on the premise that if the economy is growing, then revenue and profits should grow for they typical company that participate in the economy. This is a top-down approach to investing. If the big picture looks promising, it is generally considered safe to invest in equities and high-yield bonds.
You will notice that we do not talk about the economy very much here at The Options Edge. At the same time, we do not ignore it either. This is because we are bottoms-up investors. This means we look at the performance of individual companies first, then we look at how their sector is performing and finally, we look at the overall economic performance last. We do this for a number of reasons. (1) We search for under or overpriced assets. Analyzing the overall economy is very difficult and there is little connection between the performance of the economy and the value of a particular company. Furthermore, we have not found a reliable method that connects changes in the economy to changes in the performance of a particular company. Individual companies may or may not be in sync with the overall economy. (2) Management’s of companies are changing and adapting to the economy all the time. Good management will be able to profitably grow their companies in any economic environment. Bad management’s, not so much. (3) We like to find and buy companies and sectors that are out of favor with investors, whose stocks trade at discount to the average stock and their historical selves. We like to sell stocks that trade at a premium to the average stock and their historical selves as well.
This does not mean we ignore the macroeconomic picture altogether. It’s much easier to grow a company with the wind at your back. Furthermore, the Federal Reserve focuses on the macro picture when setting monetary policy. Monetary policy can affect the price action of stocks and has a more direct effect on the bond market.So how is the economy doing now? The Federal Reserve of Atlanta makes real-time estimates of economic performance and the picture looks pretty good. Their latest forecast suggests that the economy is growing at 2.9%. This is good for profits and employment and also suggests that we need to be on the lookout for further rate hikes from the Fed. This estimate is consistent with the average forecast of Blue Chip Economists (those who work at banks and advisory firms). This is good news to be sure, but we are always a little leery when everyone agrees.
So how is the economy doing now? The Federal Reserve of Atlanta makes real-time estimates of economic performance and the picture looks pretty good. Their latest forecast suggests that the economy is growing at 2.9%. This is good for corporate profits and employment and also suggests that we need to be on the lookout for further rate hikes from the Fed. This estimate is consistent with the average forecast of Blue Chip Economists (those who work in government, at banks and advisory firms). This is good news to be sure, but we are always a little leery when everyone agrees.
Another way to confirm a growing economy in real time is to examine income tax collection at either the State & Local level and/or the Federal level. If the economy is growing then we can expect income to grow. If incomes are growing, then income tax collections should be growing. The chart to the right shows individual income tax collections at the State and Local levels. As you can see, individuals are paying more income taxes now than they ever have before. The only weakness in this analysis is that it is not adjusted for inflation. But if you believe that the inflation rate is something less than 3% as the government reports, then this is a reasonable real-time indicator that the economy is growing.
One of the ways this consensus is reflected in markets is through risk premiums. Estimating the risk premium in equity markets is difficult as it requires one to use models to estimate the expected return on equities and then compare it to the risk-free rate on long-dated bonds. It is much easier to observe risk premiums in the high yield market, as all one has to do is look at option adjusted spreads. The spread is a direct yield premium designed to provide a higher rate of return for lending money to riskier companies. In my first book, “Quantitative Analytics in Debt Valuation & Management,” I explain why credit risk is simply equity risk in a different form. So observing credit spreads tells us something about equity risk premium investors demand as well.
The chart above shows the credit spread on a BofA ML index of high-yield bonds rated CCC or below. These are the riskiest borrowers in the marketplace. They may be risky because they carry a huge amount of debt or the companies may have fallen on hard times and are struggling to stay in business. This chart tells us that risk premiums are closing in on the post-financial crisis lows and not all that far away from their all time low. Many individual investors have exposure to the credit markets through mutual funds and ETFs. In my portfolio, for example, I have direct exposure to the international, dollar-denominated, high yield market through HYEM the VanEck Vectors Emerging Market High Yield Bond ETF. If you wanted to limit your high yield exposure to the US-based companies, one could invest in HYG, the iShare iBoxx High Yield Corporate Bond ETF. The third alternative for individual investors is to invest in preferred stocks. Preferred stocks are a fixed-income, equity hybrid as they typically pay a fixed dividend and reside near the bottom of a company’s capital structure (just above common stock). I own a few preferred stocks, but I have been lightening up on that exposure over the last month.
The message of the high yield bond market is that everything is a-ok for the economy and for the investment markets. Indeed one could argue that investors are a bit too complacent and may be overconfident in their analysis and expectation of downside risk. It is important to remember that when credit spreads are tight, there is little potential for capital gains and further spread compression is unlikely. But if something goes amiss, such as the conflicts in the Middle East breaking out into a full-fledged war, an economic slowdown due to a miss step by the Fed, etc. credit spreads will widen to reflect those risks and investors will suffer a capital loss. In short, one should expect to simply capture some yield in this environment. So long as the economy chugs along, high yield bond investors should earn 4 or 5% per annum over time.
The chart above is one that is familiar to options traders. The Volatility Index (VIX) which measures the average implied volatility of a basket of near the money 30-day, S&P 500 options are now at all time lows. This tells us investors have little interest in buying put options for protection against a sudden or sharp downturn. Said another way, investors are confident that the economy will continue to perform well and that the risk markets will behave themselves. This is not necessarily a bad outlook to have, but one has to be on guard. Tops are always formed when the outlook is most positive. This is one of the reasons why we have suggested investors actively manage their risk by hedging. Those that do not like to hedge can lighten up and generate some dry powder so they can step in, if and when, lower prices present themselves.
Finally, low volatility is not just a US or developed country phenomenon. The implied volatility
in emerging market equities is at an all time low. In the final analysis, these are the kinds of conditions we see at market tops, but it does not necessarily mean a top is at hand. These conditions can remain in place for years before a top is in. Implied volatility has been low for years in both the developed and emerging markets. As a result, we do see a bear market around the corner. Instead, we see the potential for a shake out. Our investment process looks for price action to signal a trend. We make a judgment about the strength and durability of that trend before taking action.
