Category: Chart of the Week

Is Real Estate Overvalued?

The core real estate market has enjoyed a solid run over the last five years. However, outsized returns do not last forever and for this reason investors are starting to question future return prospects for the asset class. There are several metrics to consider when answering such a question and this week’s Chart of the Week looks at one such metric: new supply.

The core real estate market has enjoyed a solid run over the last five years. However, outsized returns do not last forever and for this reason, investors are starting to question future return prospects for the asset class. There are several metrics to consider when answering such a question and this week’s Chart of the Week looks at one such metric: new supply.

The chart above compares new supply as a percentage of existing stock across the four main property sectors. As the chart indicates, current levels of new supply remain below the pre-recession averages for three out of the four sectors. That affords some comfort. However, new supply of apartment properties has exceeded its pre-recession average. Indeed, a lot of the supply in apartments has been driven by an increase in true rental demand, but the data suggests that the apartment sector may come under pressure in the near- to medium-term if new supply continues to rise. According to this metric, opportunity still remains in the retail, office, and industrial sectors. Ultimately, though, new supply is just one metric to consider when gauging the current state of the real estate market. Other important items to monitor include performance, valuation, debt, income, and capital flows. Our recently released newsletter, The State of Real Estate: Is the Run Over?, analyzes these metrics to formulate a view on future return prospects for the asset class.

Has the Drop in Oil Prices Been a Drag on the U.S. Economy?

Over the past few quarters there has been much discussion about how the recent plunge in oil prices would impact the U.S. economy. While there were expectations of both positive and negative effects associated with lower oil prices, the general consensus amongst economists was that this would have a net positive impact on the U.S. economy.

Over the past few quarters, there has been much discussion about how the recent plunge in oil prices would impact the U.S. economy. While there were expectations of both positive and negative effects associated with lower oil prices, the general consensus amongst economists was that this would have a net positive impact on the U.S. economy. Cuts in capital expenditures from U.S. oil producers (which have been a significant contributor to GDP growth for the past several years) were expected to be a drag on economic growth. At the same time, lower energy costs for consumers were expected to result in increased disposable income and thus increased consumer spending, which would boost economic growth. Given that the U.S. is a net importer of oil, the benefit to consumers was expected to more than offset the decrease in capital spending from producers, resulting in a net positive impact.

Since low oil prices have persisted for several months now, we are starting to get an indication of the impact on the economy, and at this point it does not appear to be nearly as positive as expected. It appears as if the economic drag from decreased capital expenditures from oil producers has been greater than the benefit from lower oil prices. While the drop in capital expenditures from oil producers has more or less been in line with expectations, the increase in disposable income has not translated to the increase in consumer spending that was anticipated. Consumers appear to be saving, rather than spending, this increased disposable income. As the chart illustrates, from June 2014, when oil peaked at approximately $115 per barrel, to February 2015 (the most recent date data is available for), annualized household spending on energy has decreased from approximately $645 billion to approximately $533 billion, representing a decrease of approximately $112 billion. Over the same time frame, annualized household saving has increased from approximately $658 billion to $768 billion, an increase of approximately $110 billion.

Thus far, the negative consequences from lower oil prices (reduced capital spending and job cuts from the energy sector) have been a drag on the U.S. economy, while the benefits from lower oil prices (increased consumer spending) have not yet had the positive impact that was expected. This phenomenon may help to explain some of the disappointing economic data observed during the first quarter. Consumers are often slow to adjust spending habits, and that may well be the case here, meaning that consumer spending will likely be one of the most influential economic data points in the coming months.

Which Equity Sectors are Most Sensitive to Rising Interest Rates?

Over the past few years there has been much discussion on the low interest rate environment and what will happen once interest rates begin to rise. Though the Fed has delayed raising its overnight lending rate for far longer than many people initially expected, it seems likely that it will finally begin to raise rates later this year. Coupled with the fact that the 10 yr Treasury yield is once again below 2% and approaching its historical low, an increase in interest rates seems very likely.

Over the past few years, there has been much discussion on the low interest rate environment and what will happen once interest rates begin to rise. Though the Fed has delayed raising its overnight lending rate for far longer than many people initially expected, it seems likely that it will finally begin to raise rates later this year. Coupled with the fact that the 10 yr Treasury yield is once again below 2% and approaching its historical low, an increase in interest rates seems very likely.

This Chart of the Week examines what has happened historically to the sectors of the S&P 500 index when rates on the 10 yr Treasury rise substantially. The chart compares the average monthly returns during seven rising rate periods to the average monthly returns during this entire timeframe. As a whole, the S&P 500 has generally outperformed during these time periods, along with most sectors. Industries that tend to be more cyclical, such as information technology, consumer discretionary, and materials featured the largest outperformance. On the other hand, more conservative sectors failed to beat their averages, with utilities and telecom delivering negative monthly returns. Though it is important to remember that historical results may not always persist in the future, the largely positive returns shown in the chart should help ease the fears of an equity market correction when rates begin to rise.

International Equity Returns vs. Strong Dollar

A major concern for investors over the last year has been the impact of a stronger dollar on international equity returns. Generally speaking, a stronger dollar translates to lower returns for international equity investments, and in 2014 the currency effect on the EAFE index was -10.9%, a sizable reduction to returns for U.S.-based investors.

A major concern for investors over the last year has been the impact of a stronger dollar on international equity returns. Generally speaking, a stronger dollar translates to lower returns for international equity investments, and in 2014 the currency effect on the EAFE index was -10.9%, a sizable reduction to returns for U.S.-based investors. On the other hand, valuations for international equities – especially those in Europe – appear far more attractive relative to levels in the U.S., and suggest higher upside potential, with the ECB’s asset purchase program offering further upside for European equities.

To date, how has this dynamic played out? Have the compelling valuations abroad been more than offset by the currency drag from the dollar’s strength? Our chart this week examines these very questions, looking at year-to-date performance for major markets and regions. Perhaps not surprisingly, Eurozone equities show the largest downward adjustment as a result of exchange rates, while Japan and China show little to no difference between local and dollar-denominated returns. After the first quarter, international equities have outperformed their U.S. counterparts in 2015 and rewarded investors who were patient with their non-U.S. equity allocations. Though it has only been one quarter, this is a theme that may persist for the better part of the year, as the dollar is still stronger than its historical average versus the Euro, and equity valuations are suppressed relative to those in the U.S.

Is the U.S. Equity Market Overvalued?

As U.S. equity indices again touched record highs during the first quarter, the appropriate valuation level for the market continues to be a popular topic in the financial press. Complicating the issue for investors is the tendency of the financial press to use different valuation methods interchangeably (trailing price to earnings, forward price to earnings, cyclically adjusted price to earnings, enterprise value to pre-tax income, etc.).

As U.S. equity indices again touched record highs during the first quarter, the appropriate valuation level for the market continues to be a popular topic in the financial press. Complicating the issue for investors is the tendency of the financial press to use different valuation methods interchangeably (trailing price to earnings, forward price to earnings, cyclically adjusted price to earnings, enterprise value to pre-tax income, etc.). Oftentimes different valuation methods will flash different signals and there is no single method generally accepted as the “correct” indicator. When confusion arises, it is natural to have Warren Buffett weigh in on the issue with his trademark simplicity. In a 2001 article appearing in Fortune Magazine, Mr. Buffett commented that at any given point in the market cycle, market-cap to GDP is likely the best long-term valuation indicator of the market.

In this week’s chart, we plot the market-cap to GDP ratio for the U.S. by dividing the average quarterly market-cap of the Wilshire 5000 index by the quarterly nominal GDP of the U.S. economy. At the end of 2014, this ratio stood at 122%, the highest level seen since the late 1990s and almost 2 standard deviations away from the 43-year average. Although revered by Mr. Buffett, this indicator should not be relied upon for its predictive power. Instead, it should serve as another data point that urges caution to investors considering outsized allocations to U.S. equity.

Yield Compression in the Eurozone

In January, the European Central Bank (ECB) officially announced its much talked about Quantitative Easing (QE) program, which will purchase a total of about €1.1 trillion (€60 billion per month) of bonds through September 2016. As was the reasoning behind QE here in the U.S., the hope in Europe is that QE will lower borrowing costs, which in turn will spur economic growth and inflation. When the rumor mill started buzzing in November about a possible QE program, forward looking investors began snapping up bonds, but what they didn’t count on was the large range of maturities the ECB would be purchasing.

In January, the European Central Bank (ECB) officially announced its much talked about Quantitative Easing (QE) program, which will purchase a total of about €1.1 trillion (€60 billion per month) of bonds through September 2016. As was the reasoning behind QE here in the U.S., the hope in Europe is that QE will lower borrowing costs, which in turn will spur economic growth and inflation. When the rumor mill started buzzing in November about a possible QE program, forward-looking investors began snapping up bonds, but what they didn’t count on was the large range of maturities the ECB would be purchasing.

On March 5th, Mario Draghi, President of the ECB, announced the details of the QE program and surprised markets by stating that purchases would include issues with maturities as far out as 30 years, causing a compression in yields (actual purchases by the ECB and various national banks began on March 9th). As the chart demonstrates, the largest yield compression has occurred in German bonds, where yields on 30-year maturities were 0.633% on Wednesday morning, down from 0.946% on March 5th. The spread between 2 and 30-year German bonds is currently 87 basis points. Yields for some of the riskiest longer-dated European debt (demonstrated here by Spanish and Italian bonds) have also seen compressions, though the spread between 2 and 30-year yields remains around 2%.

What does this mean for investors and the ECB bond buying program? Given the inverse relationship between bond yields and prices, the notable drop in yields has benefitted investors. However, reinvestment risk is a significant concern for investors should they sell their current holdings, as they would then have to purchase newer bonds that feature lower yields and coupons. Unless immediate cash is needed, bond investors will be loath to give up their higher yielding bonds in exchange for lower yields. Some wiggle room will be available as the front runners of QE look to cash in their profits, but others may hold out for a time since the ECB is a large, price indifferent buyer. Eventually, supply will normalize, possibly through a combination of profit taking and the ECB “nudging” those stubborn bondholders to sell.

Fragile Five Now Fragile Four?

In 2013, Brazil, India, Indonesia, South Africa, and Turkey were dubbed the “Fragile Five” due largely to high current account deficits and dependence on foreign capital flows. During the “Taper Tantrum”, these currencies were hardest hit recording double digit losses. This week’s chart provides an update on current account balances for each respective country.

In 2013, Brazil, India, Indonesia, South Africa, and Turkey were dubbed the “Fragile Five” due largely to high current account deficits and dependence on foreign capital flows. During the “Taper Tantrum,” these currencies were hardest hit recording double-digit losses. This week’s chart provides an update on current account balances for each respective country.

While the “Fragile Five” have been famously linked together, India has taken steps to distance itself from the group, improving its current account deficit from -5.1% in March 2013 to -1.3% in September of 2014. In addition, markets have praised the election of Narendra Modi as Prime Minister, given his focus on business confidence, economic growth, and structural reform. In sharp contrast, Brazil’s current account balance has declined and its political turmoil has heightened.

With the U.S. preparing to raise rates, emerging market participants are concerned about the possibility of a “Taper Tantrum” repeat. Relative to 2013, India is in a better position to handle such an environment. India’s contrasts with Brazil exemplify a growing trend of divergence within emerging markets, one that investors should expect to continue. Another tantrum will negatively impact the entire asset class, but some countries are better positioned to navigate the turbulence.

Nasdaq: Then and Now

The NASDAQ Composite recently reached 5,000 for this first time since the days of the “tech bubble” back in March 2000. Given that IPO activity has picked up substantially over the last few years, and Silicon Valley is booming again, investors have begun to wonder whether we are witnessing a “tech bubble 2.0”.

The NASDAQ Composite recently reached 5,000 for the first time since the days of the “Tech Bubble” back in March 2000. Given that IPO activity has picked up substantially over the last few years and Silicon Valley is booming again, investors have begun to wonder whether we are witnessing a “Tech Bubble 2.0”. This week’s chart attempts to answer that question by looking at how the NASDAQ in 2000 compares to the NASDAQ today.

Back in 2000, the NASDAQ Composite included over 4,500 listed companies compared to roughly 2,500 companies today. At the beginning of the millennium, companies were commonly going public with no real business plan and often with no revenue and little cash on the balance sheet. As a result, back in 2000, the NASDAQ index as a whole actually had negative earnings.1  Contrast that market environment with today, when the NASDAQ trades around 30x earnings and most new public companies have both revenue and profits. All in all, we aren’t saying there is no bubble, but this time around the fundamentals look much more sustainable.

1The gap in the P/E ratio line on the chart is due to the negative earnings during this time frame.

Has Oil Been Oversold?

Between June 2014 and the end of January 2015, oil experienced a precipitous fall from $107 per barrel to $45 as reduced demand and excessive supply combined to drive its price significantly lower. During that time, the Credit Suisse High Yield benchmark experienced a -3% total return, as 15% of the index is comprised of energy issuers. In February, oil recovered to $52 and the high yield benchmark rebounded by 3%. Given the wide dispersion of projected oil prices, we attempt to gauge how fairly priced both oil and high yield energy bonds currently are, based on the Baker Hughes North America Rotary Rig Count.

Between June 2014 and the end of January 2015, oil experienced a precipitous fall from $1071 per barrel to $45 as reduced demand and excessive supply combined to drive its price significantly lower. During that time, the Credit Suisse High Yield benchmark experienced a -3% total return, as 15% of the index is comprised of energy issuers. In February, oil recovered to $52 and the high yield benchmark rebounded by 3%. Given the wide dispersion of projected oil prices, we attempt to gauge how fairly priced both oil and high yield energy bonds currently are, based on the Baker Hughes North America Rotary Rig Count.

The Baker Hughes North America Rotary Rig Count is an important business barometer for the oil and gas industry because it tracks active oil drilling rigs and serves as a leading indicator for the demand for oil and gas products and services. The rig count nosedived from 1,931 at the end of September 2014 to 1,267 at the end of February 2015, a period of just five months.

This week’s chart divides the price of oil by the rig count. By doing this, we can see how overpriced or underpriced oil is in the context of active rigs. The blue line shows that oil was generally overpriced over the last six years and is now somewhat cheaply priced as it falls below its average shown by the dotted blue line; the significant reduction in rig count has helped to improve this ratio. The green line shows the spread of energy bonds in the Credit Suisse High Yield benchmark divided by the same rig count. It currently sits above its average, suggesting that perhaps energy high yield bonds have been oversold, and may offer a buying opportunity for value-driven investors.

1As measured by West Texas Intermediate crude, the benchmark for oil prices in the United States.

Emerging Trend in the Labor Force?

As of January 2015, the headline unemployment rate (U-3) stood at 5.7%. Since hitting a recession high of 10% in October 2009, this headline rate has steadily fallen to pre-financial crisis levels. However, headline unemployment is but one of many measures used by the Bureau of Labor Statistics to gauge the health of the labor market since one single measure can’t possibly tell the whole story.

As of January 2015, the headline unemployment rate (U-3) stood at 5.7%. Since hitting a recession high of 10% in October 2009, this headline rate has steadily fallen to pre-financial crisis levels. However, headline unemployment is but one of many measures used by the Bureau of Labor Statistics to gauge the health of the labor market since one single measure can’t possibly tell the whole story.

While the percentage of those officially counted as unemployed has fallen, that decrease also accounts for changes in the amount of those classified as marginally attached to the labor force (those who have stopped looking for work but still want a job) as well as workers employed part-time for economic reasons (those working part-time and unable to find full-time employment). The broadest measure of unemployment (U-6), which includes these two categories, was 11.3% in January.

Part-time workers as a percentage of the labor force have improved slightly over this time period, but not nearly as much as the headline rate has. There is a multitude of possible reasons for the increase and slower decline in part-time workers for economic reasons. Possible reasons include job-seekers lacking the skill sets that employers require, employers being more selective and/or hesitant to add new staff following the Financial Crisis, and the effect of the Affordable Care Act’s 30-hour threshold rule to be considered a full-time employee and receive health coverage. The trend of higher part-time workers as a percentage of the labor force bears watching as this may be part of a secular trend in the labor market.