On the “New Neutral”, the Best Performing Stock Market since 1979, and a Plant-Based Diet Reverses Heart Disease!

From: aditya rana
Date: Sat, Aug 2, 2014 at 1:35 PM
Subject: On the "New Neutral", the Best Performing Stock Market since 1979, and a Plant-Based Diet Reverses Heart Disease!

Hi!,

As we head into the final month of summer, the big question which looms ahead for the second-half of the year is the market fallout from the ending of the Fed’s QE program in October and the subsequent signalling of an end of its zero rate policy sometime in 2015. Bill Gross, CIO of Pimco, wrote an important monthly recently which further elucidates their "New Neutral" theme which is likely to have an important bearing on risk assets going forward. To summarise:

-2014 could mark the turning point for markets, with changing demographics, fear of another financial crisis and an income generation focus by institutional investors ushering in an era of income, to replace an era driven by capital gains.

-The markets currently assume long term real neutral policy rates of 1-2% (see chart below) , and if the real neutral fed funds rate over the long term is actually zero as per Pimco’s New Neutral theme, then P/E ratios could be higher, credit spreads tighter and housing prices appear less bubbly.

-For example, the current CAPE (10-year cyclically adjusted P/E ratio) P/E is 25x versus a historical average of 17x (see chart below). However, if the long term real neutral FF rate is closer to zero, then the historical average would need to be adjusted upwards to 20-22x making the current market much less overvalued.

-Ben Bernanke has recently argued that the real neutral rate is lower since growth is expected to be lower. In addition, Pimco views that a highly levered world requires an even lower real rate to keep the financial system from entering into another crisis.

-The real neutral policy rate is the most important element in asset pricing, and over the last 80 years (since Irving Fisher formulates the concept in the 1930s) has historically fluctuated between 0 and 8%. In 1981, the real FF rate was between 7 and 8%, resulting in rock bottom P/E ratios of 6-7x. While the market did not expect the real rates to remain that high, the forward path of rates was still very high compared to historical experience.

-Over the next three decades, real rates headed down to eventually reach a level of -1.25% over the last few years ( 0.25% nominal minus inflation of 1.75%). As Janet Yellen said recently, the real policy rate is evolving to a "not too hot, not too cold" phase to meet the 2% inflation and 3% real growth target of the Fed.

-It is unlikely that real rates are going to remain at the current level for -1.25%, as pressure increases on the Fed to prevent asset price bubbles. At the same time, it is unlikely to be at the 2% historical average as implied by the Taylor rule during decades preceding the crisis, as that was appropriate for a significantly less levered economy than which exists today (the real rate was only at a peak level of 1% in 2006-2007, which was a key factor in precipitating the financial crisis – with the economy currently again levered at the pre-crisis peak level of 350%, a 1 to 2% real rate would be disastrous).

-The San Francisco Fed argues (quite convincingly) that the real neutral policy rate should be -0.25% for the next 5-10 years, thereby capping the nominal FF rate at 1.75%, if the 2% inflation target is to be reached. Rogoff & Reinhart have presented historical data which suggests that real policy rates averaged -0.25% to -1.0% in the aftermath of the Great Depression (until the ’70s) in order to combat the effects of deleveraging and heal the economy.

-If the real neutral policy rate is indeed closer to zero than the historical 2%, then P/Es of 16-17x seem reasonable, as do 10-year US Treasury yields of 2.6%, high yield credit spreads of 350-400 basis points and other alternative assets at current pricing levels. This implies that a bear market is not likely under the New Neutral environment.

-The implications of all this on asset returns are low returns combined with lower volatility than during previous periods, assuming that the globally levered economy (China, Europe-see chart below) does not hit another crisis point caused by either a deflationary or an inflationary scenario. Japan may hold a clue to the future state of the world economy – i.e. manage a debt crisis with even more negative real interest rate debt.

-While the ending of QE by early November will lead to (mild) tightening of credit and significantly slow down the pace of equity market appreciation, it is unlikely to start a bear market under a New Neutral policy rate environment. Bonds (credit) can be expected to return 3-4% and stocks 4-5% over the next 5 years.

An insightful piece, corroborated by recent research by the IMF which also makes the case for a lower level of real rates for the foreseeable future. Their additional point that a highly levered global economy cannot withstand a real rate much higher than zero is important, and the main central banks around the world are likely to keep real rates close to zero. While the UK and the US are likely to start raising rates over the next few years, the pace will be gradual and culminate in a nominal rate around 2%. Under the New Neutral environment, it would be prudent to stay with a diversified portfolio of stocks (EM, Europe, Japan, less US) and credit (Europe, US, EM).

While the ending of QE by early November, and the Fed signaling an end to the zero rate policy in November/December is likely to cause a sharp correction in markets – it should be relatively short-lived as markets eventually begin to focus on a New Neutral world. Therefore reducing risk as we move into the final quarter of the year, and buying steadily on sharp sell-offs may be an appropriate strategy to take advantage of the volatility.

The best performing stock market since 1979?

To add to a June newsletter, which made the long-term structural case for India equities and noted that the Indian stock market has been amongst the top three performing global stocks markets (in $ terms) over the last 10 and 20 years, I present below a fascinating graph (courtesy Asia-Pacific Elliot Wave Financial Forecast) which presents the US$ performance of a wide range of global stock markets since the founding of the Sensex in 1979. Despite a 86% depreciation of the Rupee versus the dollar, the Sensex matched the other best performing stock index – the Hang Seng, both being up 27x! While the two markets have also been the most volatile over this period, for the patient long-term value investor that presents an opportunity rather than risk.

Plant-Based Diet Reverses Heart Disease:

New research by one of the pioneers of advocating a plant based diet to prevent (and even reverse) heart disease – Dr. Caldwell Esselstyn, formerly director of the world renowned Cleveland Clinic.

PRCM July 1, 2014:

-A new research report confirms that heart disease can be dramatically improved—and even reversed—by a plant-based diet.

-Researchers from this study counselled 198 patients with cardiovascular disease on a diet free of fish, meat, dairy, and added oils. Of the 89 percent of participants who followed the diet, 81 percent improved their symptoms and experienced fewer complications from heart disease.

-In addition, those participants lost an average of 18.7 pounds, while 22 percent saw a complete reversal of their condition. This study employed a nutritional training program that eliminated both added oils and animal products.

Esselstyn CB Jr., Gendy G, Doyle J, Golubic M, Roizen MF. A way to reverse CAD? J Fam Pract. 2014;63:356-364b.

http://www.jfponline.com/fileadmin/qhi/jfp/pdfs/6307/JFP_06307_Article1.pdf

I hope my readers have been enjoying a pleasant summer and here’s to keeping a healthy (largely plant based) diet!

Regards,

Aditya

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