Addition by Subtraction or Multiplication by Division?

June 16, 2019


As far as I’m concerned, you can take your pick. After all, it is Fathers’ Day.


There’s a lot of both going around these days, and why not? It’s that kind of world. There are many people, places and things around today for which it can be said that their subtraction from the landscape would be an addition to us all. But, of course (other than a bit of gratuitous name-dropping), I’ve never been one to name names.


So let’s move on to more pertinent matters.


The FOMC meets this week, and there’s significant speculation that the Fed could cut overnight rates during this sequence. The money line on this places it at about a 25% probability. I’ll stick with the odds on this one, and suggest that they’ll instead stand pat. Even so, though, even if we’re right, Vegas is projecting three such reductions this year, which translates into about one every two months. I suppose it could happen, but questions remain.


For instance, can these rate cuts actually cure what ails us? And for that matter, what indeed does ail us?


But if we subtract, say, 75 basis points from the current Fed Effective Rate of 2.37%, a quick check of the math takes the overnight yield down to 1.62%. This, of course would nominally solve the problem of yield curve inversion, as our 10-year notes currently fetch a positively usurious vig of 2.08%.


But what if the rates at the long end of the curve drop in sympathy to its more rapidly expiring brethren? Just saying, we might be looking at some unintended consequences.


After all, rates around the globe continue to plunge to new lows. Our Treasury Department must, at present, pay nearly 50% more than their opposite numbers in Canada for 10-year maturities (1.43%), and over 23x what those fabulous French shell out for the same transactions (0.09%). And the list of countries for which the ratio is incalculable (due to negative yields that render the denominator unusable) include Switzerland, Germany, Japan, The Netherlands, and (perhaps soon) those magnificent Swedes, whose sociological practices so many among us seek to emulate.


So it’s not clear to me that applying any subtraction to Fed Funds will lead to an addition in the spreads levels that one would calculate between, say, domestic overnight rates and those achievable out 10 years in Treasury-land.


But none of this seems to have troubled the equity portion of the capital markets, which, across the globe, sustained the substantial mojo which, after a dismal May, first rematerialized last week. A small portion of this can perhaps be attributed to the secular, merger-drive addition-by-subtraction about which I’ve been bleating for many months. Shortly after last week’s edition went to press, charter Gallant 500 Raytheon (Market Cap $50B) and United Technologies (Market Cap $125B) announced that the two would become one. So we can subtract yet another name from the menu of liquid, large cap marketable securities upon which portfolio managers are able to feast, and add to the scarcity based valuation of the rest. I do fear that we are headed towards a construct where, if one wishes to own Big Tech, the only choice will be GoogleAppleMicrosoftAdvancedMicroFacebookAmazon, discerning financial sector buyers will have a binary choice of long or short JPMorganMorganStanleyGoldmanSachsBankofAmericaWellsFargo (OK; maybe not Wells Fargo), pharmaceutical investors will find their only holdings choice to be PfizerNovartisHoffmanRocheMerckJohnsonandJohnson, and so on. It will be a glorious spectacle to witness -- addition by subtraction at its finest. But will we really be better off? The market, the economy or the average folk on the street? You can decide for yourself.


Equity markets also received a shot in the arm from the withdrawal of our threat to slap tariffs on the Mexicans. This particular addition-by-subtraction was good for about 4% on domestic equity valuations.


But now we must turn to the other half of our theme: multiplication by division. Notably, as our equity indices are surging back towards recent records (ones that might have already been obliterated had we not chosen this point in history to turn up the heat on our China trade war), full-year SPX earnings estimates have been a one-way ticket down. All year:

At the point of this correspondence, the 500 is projecting out $168/unit for all of 2019, and technical analysis suggests that the number could go lower.

I hate to do this to you, but if we’re going to move to multiplication by division, we must extrapolate a current estimated P/E of ~17.2 – pretty elevated by historical standards. But if we flip the numerator and denominator (we do this sometimes), we derive an Earnings Yield in excess of 5.8%, implying that a unit of SPX currently buys 5.8% of earnings.


Now we’ve been higher, MUCH higher. Back in around 1918 (ah, the days of my youth), the Earnings Yield hit nearly 20%. It climbed back to about 16% in 1950 (ah, the days of my middle age). So the number itself is not particularly alarming.


But interest rates were higher during those historical intervals. Much higher. So the question becomes: in a market where Fed Funds yields 2.37%, where 10-year Treasuries throw off a paltry 2.08%, doesn’t the prospect of securing nearly six cents of earnings per dollar of investment in good old American stocks look rather appealing relative to holding Grandma’s Savings Bonds? And couldn’t the appeal spread widen, particularly if rates continue to plunge? As well they might?


And that’s just in the United States, where, astonishingly, government yields are astronomic on a relative basis. And it doesn’t even contemplate the after-tax comparison picture. The average investor in U.S. Treasuries will be required to pay an additional, say, 30% every year, for the privilege of clipping those patriotic coupons, whereas the holders of equities, even at these lofty valuations, will pay only 21%, and need not pay at all for these returns until they decide to sell.


The contrast is even starker in other jurisdictions. Consider Germany for instance. Their Benchmark equity index (which I will heretofore refer to as Herr DAX) currently sports a 15.96 P/E, and thus an Earnings Yield of 6.27%. If one compares this to the prospect of paying 0.25% to Madam Merkel and her crew for allowing them to use your capital until 2029, the selection should be obvious. So I say load the boat Deutschland, On Daimler, Siemens and even the recently-much-maligned Bayer. In Japan, the same story holds (P/E 15.72; Earnings Yield 6.36%).


As such, I have a great deal of sympathy for those, who would actually prefer to generate a positive return on their investment portfolios, if they select Equities over Treasuries. Kon'nichiwa Sony Nintendo and Softbank; Sayōnara JGBs.

And those looking elsewhere, say, the debt of corporations, should be made aware that, alas, they are just a tad late to the party:

Yup, both are approaching five-year lows. And if the Fed follows the smart money and cuts three times in six months, it’s not difficult to extrapolate the forward glide path of these instruments.


So, as a matter of both addition-by-subtraction and multiplication-by-division, all roads appear to point to equities being a pretty good bet.


But it’s not going to be a milk run. However, in the short-term, we have some hopeful catalysts. The decision (announced Saturday) by Chair Xi and his acolytes to back off on their threat to impose unilateral extradition authority on Hong Kong may be a bigger event than some realize. With the Sino economy in the dumpster, and most of the real money in Hong Kong anyway, it’s a bad time for the Party to bring down the hammer on their subjects across the channel. The protests in that jurisdiction have indeed been compelling to observe, but I have a hunch that what really backed the Chinese off was some closed door meetings between the Party and the innumerable corporate enterprises that currently do business in HK, but might not in the future if the entire Island must operate under the threat of extradition to the Mainland. In addition, I suspect that the surprise move tees up a warm, friendly beginning to the pending G20 summit, during which the next episode of the Trump-Xi Game of Thrones should be available for download.


I will admit to being kind of sad that Sarah (Sister Wife) Sanders is exiting, Stage Right. Lots of speculation on this one, but of course, I have my theories. I think that 45 asked her to leave as part of an amping up for the 2020 campaign, the formal announcement of which is scheduled to take place on Tuesday. I’m thinking he figures that all of us Sarah worshipers are already in his camp, and that maybe a new face, perhaps one with more pizzazz, will add an increment of energy. If so, it will offer a clinically perfect environment to test the political aspects of addition-by-subtraction.


And as for multiplication-by-division, well, all I can say is it is Father’s Day. And where would all of us fathers be if our cells didn’t, at one point, divide, in order to subsequently multiply? It’s our day to enjoy the fruits of these blessings, and so I take my leave.


So Happy Father’s Day, y’all. And here’s wishing you many joyous additions and multiplications in the days ahead – whatever route by which they may come your way.





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