Tag Archives: John Coumarianos

Citywire Article: Can You Spot A Bubble? What About Now?

This is my most recent Citywire article on an academic study of bubbles. Despite what Eugene Fama asserts, they have telltale signs.


The return of volatility earlier this month set stock markets on edge, but are we really in bubble territory?

The Dumbest Bet in Finance

In this past weekend’s Real Investment Advice Newsletter, I wrote about financial advisor Larry Swedroe’s excellent article on the “Four Horsemen of the Retirement Apocalypse:”

  • low stock returns,
  • low bond yields.
  • increased longevity; and,
  • higher healthcare expenses.

In his article, Swedroe mentions that high yield (junk) bonds won’t save investors, who haven’t historically been rewarded well for taking on their risk.  Swedroe also says high yield bonds correlate well with stocks, which means they don’t provide much diversification.  Swedroe writes from the point of view of modern portfolio theory, which looks for ways to increase volatility-adjusted returns in a portfolio. In this post, I’ll treat junk bonds a little differently, showing why now is a terrible time to own them. My analysis doesn’t completely contradict Swedroe’s though; it supports his thesis that stocks and junk bonds are highly correlated.

Unlike Swedroe, I don’t dislike junk bonds per se. These loans to decidedly less-than-blue-chip companies are just like any other asset class. They can be priced to deliver good returns, as they were in early 2009, or not.

Right now, they’re not.

Everyone looks at junk bonds initially by observing the starting yield or yield-to-maturity. Right now, the iShares High Yield Corporate Bond ETF (HYG) is yielding 5.53%. That can look attractive to some investors. After all, where else can you get over 5%?

Other people look at the spread to the 10-Year U.S. Treasury. 5.53% is around 2.7 percentage points more than the 2.8% yield of the 10-year U.S. Treasury. That might look find to some too. Of course, a little bit of research shows that spread is lower than the historical average of around 5.7 percentage points.

Still, investors seeking higher yield may be undisturbed by a historically low spread. Some people need the extra yield pick-up over Treasuries, however small it might be by historical standards, and that’s enough for them to make the investment.

Yield Isn’t Total Return

There’s one extra bit of analysis, however, that should make investors think again about owning junk bonds – a loss-adjusted spread. The problem high yield investors often fail to consider is that junk bonds default. And that means the yield spread over Treasuries isn’t an accurate representation of what high yield investors will make in total return over Treasuries. It’s easy to forget about defaults and total return because defaults don’t occur regularly. They tend to happen all at once, giving junk bonds a kind of cycle and encouraging complacency among yield-starved investors during calm parts of the cycle.

Default rates for junk average about 4.2% annually, according to research from Standard & Poor’s. And investors have typically recovered 41% (or lost a total of 59%) of those defaults, according to this Moody’s study from 1981 through 2008. That results in an annual loss rate for an entire portfolio of around 2.5%. So the iShares fund’s 5.53% yield isn’t quite what it seems to be. In fact, if we subtract 2.5 from 5.53, the result is 3.03, meaning investors in junk bonds are likely to make only 20 basis points more than the 2.8% they could capture in a 10-Year U.S Treasury currently.

Now, a more careful analysis should consider an “option-adjusted” spread, which accounts for the fact that issuers can call bonds prior to maturity and lenders or bondholders can sell bonds back to the issuer at prearranged dates. This adjustment usually adds something to the spread, making higher yielding bonds slightly more attractive. So we took the options adjusted spread data, and adjusted it for an annual loss rate of 2.5 percentage points. Remarkably, there have been times such as immediately before the financial crisis when investors weren’t making anything on an options-adjusted basis above Treasuries to own junk bonds. Now at least it’s around 1 percentage point.


Still, even with the option adjustment, one percentage point over Treasuries is still very little, especially considering that the option-adjusted spread we used compares a junk bond index with Treasuries. In other words, the 0.50% expense ratio of most junk bond ETFs isn’t factored into the equation. At a 0.50% or so yield pickup over Treasuries, investors just aren’t making enough from junk bonds to justify owning them. Also, advisors pushing junk bonds on yield-hungry clients aren’t doing much due diligence. The mark of a good advisor is one who can say “No” to a client and bear the risk that the client will go to another advisor doing less due diligence.

Housing Bubble 2.0? Not Yet, But Prices Are High

House prices continue to rise. Yesterday a Bloomberg article reported that home prices jumped to all-time highs in almost two-thirds of U.S. cities in the fourth quarter in the face of limited new supply and an improving job market. Rising home prices have spurred the question: Are we in another housing bubble?

Our quick answer is probably not, but prices are elevated. We constructed a chart of the relationship between median home prices and median household income going back to 1987. We used national numbers, including the S&P/Case Shiller U.S. National Home Price Index and Median National Income. Since the home price index isn’t adjusted for inflation, we used nominal household income.

We went back as far as we could using data on the St. Louis Fed website – 1987 — and we found that for the period up until 2000 the index stayed around 100. And that’s what  you’d expect because prices shouldn’t get radically divorced from income. But then a sharp rise ensued peaking at a whopping 153 in 2006. That was the bubble. We’re at 120 now, which is where the index was in the 2003-2004 period. The standard deviation of the data set is 16. So, at 120, we are beyond it using the early 1990s flat period average. But we are not at two standard deviations (which some people use as the definition of a bubble) from that early flat period.

home prices median income real estate housing debt mortgageData from St. Louis Fed

Our chart doesn’t capture the differences in regions and cities. Home prices on the coasts, for example, may be extravagant again. Indeed the Bloomberg article reports that the most expensive markets were San Jose, San Francisco, Irvine, Honolulu, and San Diego, with San Jose experiencing a whopping 26% increase in prices. So some cities might be in bubble territory, but the relative simplicity of our approach indicates where the national market stands compared to the bubble, and also gives a somewhat longer term perspective. A crash in San Jose and other California cities probably wouldn’t affect the entire country or banking system the way the previous housing crisis did, though it could lead to a recession.

Anecdotally, mortgages aren’t as easy to get as they were during the run-up to the bubble. We’ve heard stories from well-qualified borrowers whom banks have assessed with considerable rigor. Still, it’s likely that very low interest rates have spurred the new price increases. Mortgages may not as easy to get for most people, but they are still available. And because enough of them are still available and rates are so low, house prices continue to levitate.

It’s important to note, however, that there isn’t always a strictly mechanical relationship between interest rates and asset prices. Economist Robert Shiller, who is a student of asset price bubbles, rarely mentions interest rates as primary causes of bubbles, and he’s quick to point out that there have been periods of low rates and low asset prices such as in the 1940s. There are always psychological factors involved when prices elevate beyond reason. Still, nobody should ignore low rates. It’s likely that low rates have facilitated the new rise in home prices as well as other asset prices.

The psychological factors are harder to assess. People aren’t flipping condos for sport the way they were during the bubble when mortgages were available to anyone regardless of whether they had income or assets. Yet t seems there’s a widespread desire to own assets – stocks, bonds, and real estate – regardless of price. It’s not an obviously happy mania, where people are motivated by promises of great wealth. It’s more like a need to be an asset owner in an economy that continues to hurt workers without college degrees and becomes more automated. Nevertheless, the price insensitivity of many buyers is enough to cause concern.

The “Nastiest, Hardest Problem in Finance”

Should retirees own any stocks? It seems ridiculous to ask that question. Of course, they should. People are living longer than ever before and need higher returns on their assets to see them through an extended retirement. And many target date funds are responding by maintaining elevated amounts of stocks through at least the early years of retirement.

How else to get those returns than from stocks?

Not so fast, says economist Allison Schrager who wrote a recent article for Quartz asking the provocative question:

“If you’re about to retire, should you pull out of the stock market?”

After all, weeks such as the last one remind investors that stocks are far from a sure thing, and can vaporize wealth quickly.

It’s true that most people haven’t saved enough to retire easily, and stocks – or the returns they’ve historically provided — may be a way to overcome savings shortfalls. But there are two problems with this argument. First, stocks may not deliver the returns we have grown accustomed to receiving from them. The best indicator of long term – say, future ten-year – returns is the Shiller PE, which is the current price of the market relative to the past decade’s worth of inflation-adjusted average earnings. That metric is over 30, despite last week’s correction. It’s two highest readings previously have been 34 in 1929 and 44 in 2000. And stocks did poorly from those two peaks over the next decade. Basically, it’s very hard for stocks to perform well for the next decade starting from this valuation.

Because of their high valuations, stocks may not outpace bonds. The 10-Year US Treasury is now yielding around 2.8%, and investors can own an index of investment grade corporate bonds that pays nearly 3.6% in the form of the iShares Investment Grade Corporate ETF (LQD). And if investors can get a highly probable return of over 3% from bonds, it’s not clear that domestic stocks will outstrip that by a lot or even at all.

Moreover, the volatility stocks often deliver can destroy retirement plans, even if stocks eke out higher average annual returns than bonds. This is because of something called “sequence of return risk.” That basically means that ,during distribution phase, when and how returns are delivered matters at least as much as the average annual return itself. I did a study of two portfolios – one all domestic stocks, and one balanced – starting in 2000 using the famous “4% retirement rule.” That means the retiree is taking 4% of the portfolio as income in the first year and boosting the first year’s dollar payment by 4% every year thereafter.

Retirement Allocation Chart 4% Retirement Rule

Source: Morningstar, Yahoo!Finance

The results are ugly for the all-stock portfolio, which reduced the account by nearly 80% after 18 years at the end of 2017. The balanced portfolio, by contrast, was reduced by only 20% of the original balance after 18 years of applying the 4% rule. The starting point for the test is admittedly random, and it includes two big stock market drawdowns. But it shows how an unfortunate starting date combined with a lot of stock exposure can hurt a retiree.

None of this is to argue that retirees should eliminate their domestic stock exposure altogether. Stocks may outpace bonds over the next decade, after all; we’re just saying the chances of that happening are low. Also, foreign stocks, especially emerging markets stocks, present better valuations, and their likely future returns are at least somewhat higher than what their domestic counterparts are offering.

Although many mutual fund families have target date funds that contain more than 50% stock exposure at the time of retirement, Schrager says the average target date fund in Morningstar’s database has 40% of its assets in stocks. That’s meaningfully lower than the classic balanced portfolio, which has 60% in stocks.

There’s a big difference between having 60% stock exposure and 40% stock exposure. In 2008, for example, a portfolio that had 60% in the S&P 500 and 40% in the BloombergBarclays U.S. Aggregate Bond Index lost around 20%, but a portfolio that had the reverse exposure – 40% stocks and 60% bonds – lost around 13%. That’s a big difference for retirees taking 4% or more from accounts in income. There are limits to how much stocks can help savings shortfalls in retirement. Don’t put a burden on them they’re not equipped to handle.

As always, your stock exposure depends on your personal risk tolerance (which is much harder to estimate than you might think), your spending needs, and how well funded you are. But Schrager is correct to note that things are different in retirement than they are when investors are saving or accumulating assets. As Bill Sharpe, whom she quotes, says, investing in retirement is the nastiest, hardest problem in finance.

Inverted Curve? Not So Fast, Says Gundlach

While many pundits have been calling for a flat or inverted yield curve – a widely acknowledged recession-predictor – DoubleLine Capital founder, Jeffrey Gundlach, recently argued not so fast. Looking at the difference in yield between the 10-Year and 2-Year U.S Treasuries, Gundlach said in his January 9th, 2018 “Just Markets” webcast, “I’ve noticed that the yield curve has stopped flattening.” Gundlach noted at the time that there are more curve-flattening bets now than at any time since 1995, and said that the crowded trade already wasn’t working.

Normally, creditors demand a higher yield to lend for a longer period of time, making for an upward sloping yield curve. But the curve can flatten or invert if creditors pile into longer term bonds, sending their yields down, if they anticipate a slowing economy and future low rates

Sure enough, after narrowing to 50 basis points on January 4, the difference in yield between the 10-year and the 2-Year has begun to rise again at least for the time being, hitting 62 basis points on February 1.

Gundlach reminded his listeners that the Fed has three rate hikes scheduled for 2018. While that could contribute to flattening or inversion, Gundlach asked listeners to consider the possibility that the long end of the yield curve could steepen. This is in contrast to other asset managers such as Morgan Stanley and T.Rowe Price, who think the Fed’s elevation of short term rates will accompany worldwide central bank balance sheet expansion, buoying demand for long-term debt and leading to a flat yield curve. According to a Bloomberg article, Morgan Stanley strategist, Matthew Hornbach, thinks the U.S. central bank’s plans to shrink its balance sheet is already priced into the market, and that the yield curve will flatten in the third quarter of this year.

Gundlach said leading indictors show no recession for the next six months. From the time of Gundlach’s webcast on January 9th through February 1st, the spread between the 10-Year and 2-year Treasuries has widened from 57 to 62 basis points.

On Friday, Gundlach tweeted about the Federal Reserve Bank of Atlanta’s GDPNow estimate of 5.4% GDP growth for Q1 2018 and average hourly earnings increases. These developments support an inflationary thesis and a steepening curve. Late Saturday, Gundlach also gave an interview to Reuters’ Jennifer Ablan arguing that it was “hard to love bonds at even 3 percent,” given recent GDP growth estimates.

Commenting on the blistering pace of rate increases on parts of the yield curve since September, Gundlach told Reuters that “this is partly caused by the manic mood and partly caused by the falling dollar and related rising commodities.”

While Gundlach doesn’t think bond yields of 3% are attractive given prospective economic growth, PIMCO’s Dan Ivascyn and Mark Kiesel say 3% yield on 10-Year Treasuries might be a signal to buy, according to another Bloomberg article. The article quotes Ivascyn saying “[T]here’ll be buyers of bonds if we back up to 3 percent,”

Not All REITs Are Equal

As an investment concept, I like REITs, and so should small investors. Real estate investment trusts give ordinary investors the ability to own office buildings, apartments, hotels, storage centers, medical facilities, industrial warehouses, malls, movie theaters, gas stations, and even data centers where large computer systems for big online retailers and Internet businesses are stationed. REITs are organized in a way so that there is no tax at the corporate level in exchange for the company distributing 90% or more of its profits as a dividend to shareholders. Dividends from REITs are not qualified, so it helps to hold them in tax-advantaged accounts.

But, as much as they afford small investors the ability to own unique properties, like any investment, REITs can get too expensive. And despite trailing the broader stock market in 2017 and posting losses so far in 2018, most REITs still aren’t priced low enough to deliver big returns in the future. In this article, we’ll show you how to assess REITs, and highlight some possibly cheap ones in an otherwise expensive sector.

Making the assessment

While many investors look at a P/E ratio to appraise a stock, that doesn’t work for REITs. That’s because accounting rules allow real estate investors, including REITs, to take a big depreciation charge every year. So a REITs earnings or “net income” almost always look tepid. Luckily for an investor, that charge doesn’t reflect economic reality well, and the real cash flow the properties inside a REIT are generating is usually significantly higher than stated earnings. That’s why, instead of looking at earnings, knowledgeable REIT investors look at another metric that all REITs publish, but is still poorly reported in the business press, called “funds from operations” or “FFO.”

Basically, FFO takes earnings or net income and adds back the depreciation charge and any profits a company may have made from selling property instead of renting it out or “operating” it, which is its main business. Now, adding back all the depreciation may be too generous because property owners must consistently pour money into properties for upkeep, and, even then, properties get old and obsolete. In other words, FFO isn’t an accurate reflection of reality either. However, FFO is a standardized metric that helps investors compare different companies that own similar or different types of property. And it’s a better starting point than net income, from which investors can subtract their own upkeep estimates.

So instead of a standard Price/Earnings Ratio, we constructed a Price/FFO Ratio for the top-25 REITs in the Vanguard REIT Index ETF (VNQ). The results show that these large REITs are trading at around 18 times FFO. That’s not a cheap price. Investors seeking to by an ETF are buying into an expensive sector. It’s true that REITs have much lower debt burdens than they did before the financial crisis, and the companies are covering their dividends with FFO instead of having to borrow money. But that doesn’t mean future returns will be high.

What looks cheap?

Vornado, a company that owns retail and office property looks like the cheapest stock on our list, with a P/FFO of around 10. But since its one-year FFO number is likely inflated due to one-time rearrangement of its property portfolio, including a spinoff, investors will have to do some digging to arrive at an estimate of “normalized” FFO.

That leaves Host Hotels and Resorts with a P/FFO of around 12. Hotels are, of course, the most economically sensitive property type, with their one-night leases that consumers and businesses slash from their budgets quickly when the economy falters. For that reason, they typically trade at lower multiples than other property types. Still, a multiple of 12 seems compelling, and Host has a good portfolio of 96 hotels with nearly 54,000 rooms encompassing upscale properties including Marriotts, Hyatts, and Westins in major U.S. cities, five Ritz-Carltons, and Le Meridien Piccadilly in London. It also has a few properties of more economy brands, and they are centrally located in cities as well.

Besides a compelling Price/FFO ratio, the next thing investors should want to know is if Host’s 4% dividend yield is safe. The firm pays a quarterly dividend is $0.20 per share, and FFO per share for Q3 2017, the last reported quarter, was $0.33 per share. A dividend soaking up less than two-thirds of FFO shouldn’t be in jeopardy. And while it is of some concern that FFO per share declined in Q3 2017 from $0.37 in Q3 2016, FFO per share held steady for the three quarters before that on a year-over-year basis.

The other stocks that have lower P/FFO ratios are either healthcare companies like Ventas (VTR) or retailers like Simon Property Group (SPG). The companies that own healthcare facilities have not grown dividends in recent years, and the retailers are under pressure from Amazon.