Something I try to stress in these columns is the importance of a valid process. Sure, I have a fondness for behavioral economics, but that’s because I know how cognitive errors can so easily derail our thought processes. Rather than impose a belief system on the reader (“ABC asset class is great!”), I prefer instead to help readers think through their own approaches: the classic “give a fish” versus “teach to fish” test, which dates back (literally) to biblical times.
I very often see market commentary out there failing to meet this simple test. I am compelled to use the error as a teachable moment.
Today’s case in point: the shifting reflation trade and how money managers interpret it. The Wall Street Journal does a nice job summing up the arguments in a column, “Bond market is flashing warning signal on Trump reflation trade”:
“Some money managers and traders believe that a rising Treasury bond market, often seen as a haven for investors, is a warning that valuations of riskier assets – such as stocks, corporate bonds and emerging-market assets – may be stretched. … Others disagree, pointing to factors that remain supportive of riskier assets: improving economic outlooks in the U.S., Europe and China; U.S. corporate earnings rebounding from a recent slump; a gradual approach by the Federal Reserve in raising short-term interest rates and continued bond buying by central banks in the Eurozone and Japan.”
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The column’s poorly written headline overstates the case that it is the bond market that is correctly calling pricey stocks, not vice versa. For the record, I believe stocks are at above-average valuations, but I also understand that they can stay that way for many, many years. And bonds are also pricey, but if Treasuries and other quality debts are held to maturity, you will get exactly what you paid for.
Valuation is never a simple snapshot of a few key metrics. Rather, it is a much more dynamic and complex question involving vectors that are constantly subject to change. The static approaches of merely looking at the price-to-earnings ratio alone for equities or bond yield relative to credit risk and inflation are grossly oversimplified.
To determine which asset class is “flashing a warning signal” – which is pricier – requires us to ask questions about what will happen in the future. These are events that we do not and cannot know – certainly not with the degree of specificity needed to determine which asset class is “right.” These include:
▪ When will the Federal Reserve raise rates and by how much? Will it proceed quickly or slowly?
▪ What will corporate profit growth (or not) be over the next four to eight quarters?
▪ How much inflation is there, and how fast will it rise (or not)?
▪ Will the economy continue its now-seven-year-long expansion, and at what pace?
▪ Will there be a major tax-code revision, and what will it look like? Will there be corporate tax reform and/or income tax cuts?
▪ Will there be a trade war with Mexico or China or whomever?
▪ Is there going to be an overseas profit-tax repatriation? Will a major infrastructure project accompany that?
▪ Will we have a major deregulation push, and what are the positive (short-term) and negative (long-term) consequences of that?
▪ What is the state of the European crisis and Brexit?
▪ And what wild-card events can we expect from the White House?
Thus, what you see from the managers assumes that they have insight into these questions as well as a high degree of confidence that their understanding is probable or even likely. Note that we haven’t even gotten to Japan or the Middle East or any unanticipated externality, let alone a presidential tweet-induced crisis.
To answer the first question posed above – which are pricier, stocks or bonds? – requires you to answer the latter questions. If you cannot do that, then you are making a guess, which if wrong is likely to be quite an expensive mistake.