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The chart below presents key trends in the US stock market for the last 40 years:
- The blue line is the S&P 500 index in log scale
- The violet line is the composite earnings of the S&P500 in log scale
- The shaded bars are the official recessions during the period
- The yellow X-factor line is the difference between the actual S&P earnings yield and the S&P earnings yield estimated by a regression on the yield on AAA corporates and the inflation rate.
While the random walk theory is a powerful one, we at Millbrook Advisors nevertheless find the X-factor helpful. When it goes strongly negative, the market seems headed for trouble. For the quarter ended June 30, 2010 the X-factor moved into positive territory (.75) as prices dropped and earnings advanced. Also, both AAA corporate yields and inflation registered modest declines.
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Recent financial news that we, with our contrarian bent, found worthy of note:
- In the Land of the Blind Economists seem to have lost their way, leaving the rest of us to grope for our own answers. Not only did economists fail to predict the US mortgage crisis of 2008 and its global cousins such as Ireland and Spain. Now conventional wisdom on inflation/deflation is seemingly cast to the winds. Jon Hilsenrath of the Wall Street Journal writes that "Here's something else to fret about: After studying more than a decade of deflation in Japan, economists have slowly realized they have no idea how it works." Deflation strategies? Fixed rate pensions and annuities, long term bonds, no debt and not replacing things until they refuse to work.
- Super-low Mortgage Rates Recently mortgage rates dropped to their lowest point in 40 years. Some advisors suggest loading up on this debt and buying more house or stock investments.
 We beg to differ. The mortgage market could be pointing to a Japan style deflation, in which prices drift sideways and down for the next ten years. If inflation is zero, then today's real mortgage rate is at its historical median of 4.6%. If deflation is coming, then mortgage debt is costly. Click on the chart for more detail on rates.
- Long Term Care Insurance - a Crucial Product for the 21st Century. The flip side of the wonder of modern medicine is a significant chance of a prolonged illness. Long term care insurance is an essential tool for containing the financial risk of such an outcome. Click here for our take on this essential but confusing form of insurance.
- Shale Gale. As a result of drilling improvements in shale deposits, proven US natural gas reserves have increased sharply to 100 years or more. As a result, natural gas sells for the equivalent of $30 a barrel of oil, which now trades at $80. It seems hard to overestimate the impact of this change, which only now is seeping into the public consciousness. For one, renewable energies such as solar are way less competitive. Also, the fast way to carbon emission reductions is to replace coal fired electric plants with CCGT. As a consumer, convert to natural gas if you can. In Maine, electric rates will benefit as so much of our generation is already natural gas based.
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Financial planning tip for the day from Shakespeare!