Australia’s decision to allow Mutuals to issue capital instruments is credit positive

According to Moody’s, last Wednesday’s  Australian government announcement that it would accept all 11 recommendations of the so-called Hammond Review on regulatory and legislative reforms to improve access to capital for co-operative and mutual enterprises, is credit positive for these entities because it provides an alternative to building capital with retained earnings. In particular in the banking sector, the allowance also shows that the government regards mutual authorized deposit-taking institutions (mutual ADIs) as integral to healthy competition in Australia’s banking system.

Mutual ADIs will be able to build capital in case of need by issuing capital instruments as opposed to relying solely on retained earnings to do so. In theory, the ability to issue capital instruments could facilitate a significant increase in mutual ADI loan growth: we estimate that mutual ADIs could raise up to AUD 1.2 billion through the mutual equity interest framework, supporting AUD 24 billion (or 21%) growth in loans.

Our estimate is based on mutual ADIs’ capital as of 30 June 2017, applying a 15% cap on the inclusion of capital instruments in common equity Tier 1 (CET1) capital, and a current CET1 ratio of around 14%. However, we do not expect such strong CET1 issuance because the mutual ADI sector is already strongly capitalized relative to the broader Australian banking sector.

Yet, some mutual ADIs with smaller capital buffers may issue capital instruments to support housing loan growth. Australia’s larger banks have moderated their residential mortgage lending as a result of macro-prudential measures to slow house price growth and steadily increasing capital requirements for banks that utilize the internal rating-based model for determining risk-weighted assets.

Since capital instruments issued by mutual ADIs would be equivalent to ordinary shares, and require dividend payments, some in the market are concerned that they will affect the traditional mutual business model.

Accordingly, the Australian Prudential Regulatory Authority (APRA) has proposed a 15% cap on the inclusion of such instruments in CET1 capital, and a cap on the distribution of profits to investors at 50% of a mutual ADI’s annual net profit after tax. These caps ensure that mutual ADIs continue to prioritize the interests of their existing members and are not incentivized to unduly increase their risk profile to boost returns to their new equity holders.

The government’s actions last week follow the July 2017 “Report on Reforms for Cooperatives, Mutuals and Member-owned Firms,” led by independent facilitator Greg Hammond. The government’s decision also follows a July 2017 proposal by APRA to allow mutual ADI to issue directly CET1-eligible capital instruments through a mutual equity interest framework.

US Banks’ Net Interest Margins Are Still Increasing

The ANZ Net Interest Margin (NIM), reported last week was 1.99%, and typically banks in Australia are achieving a NIM slightly above this. So, it was interesting to see this note from Moody’s, discussing the NIM of US banks, which has risen to 3.21%, and continues a positive trend over the past year.

Last week, US banks’ reported third-quarter earnings and higher net interest margins (NIM), a credit positive because NIM is a key driver for net interest income, which accounts for more than half of most banks’ net revenue.

Quarter over quarter, the average NIM for the largest US regional banks increased three basis points (Exhibit 1) to 3.21% from 3.18%, continuing a four-quarter positive trend. However, the rate of improvement is slowing. The Federal Funds rate increased 25 basis point (bp) in each of the past three quarters. However, as the bars show, the rate of improvement for listed regional banks’ average NIM has declined each quarter.

Accelerating deposit costs explain why the NIM is not increasing at a consistent rate with each 25 bp increase in the Federal Funds rate. Exhibit 2 shows deposit betas for total deposits (interest-bearing and noninterest-bearing) for each of the past three quarters. Deposit beta is the increase in cost of deposits relative to the increase in the Federal Funds rate. There was a significant step up in beta in the second quarter, which continued in the third quarter. In their earnings calls, most bank managements indicated that retail deposits are not repricing upward, despite the rise in market interest rates. This is not the case with deposits from the banks’ wealth management clients, and especially from their commercial clients, which are both more price sensitive.

Higher Bond Yields Could Depress Share Prices

From Moody’s

Any analysis regarding the appropriate valuation of a long-lived asset must account for the influence of interest rates. All else the same, a rise by the interest rates of lower-risk debt obligations, namely US Treasury debt, will reduce the prices of other financial and real assets. Whenever asset prices defy higher interest rates and rise, a worrisome overvaluation of asset prices may be unfolding. Today’s high price-to-earnings multiples of equities and narrow yield spreads of corporate bonds have increased the vulnerability of financial asset prices to a widely anticipated climb by short- and long-term Treasury yields.

As of 2017’s third quarter, the market value of US common stock was 15.4 times as great as the prospective moving yearlong average of US after tax profits. Third-quarter 2017’s ratio of common equity’s market value to yearlong after-tax profits was the highest since the 16.2:1 of second-quarter 2002. More importantly, the ratio last rose up to 15.4:1 in first-quarter 1998 and would ultimately peak at the 26.0:1 of third-quarter 2000. Stocks may be richly priced relative to after-tax profits, but that does not preclude a further overvaluation of equities vis-a-vis corporate earnings. (Note that the measure of after-tax profits employed in this discussion is from the National Income Product Accounts, excludes changes in the value of inventories and some extraordinary gains and losses, and uses economic depreciation instead of accounting depreciation.)

Today’s equity market differs from that of 1998-2000 for reasons extending beyond 1998-2000’s average aggregate price-to-earnings ratio (P:E) of 21.2:1, which was so much greater than the recent 15.4:1.

In addition, 1998-2000’s equity market seems even more overpriced compared to the current market because the recent 2.43% 10-year Treasury yield was so much lower than its 5.64% average of 1998-2000.

The valuation of equities very much depends on interest rates. Holding everything else constant, priceto-earnings multiples will climb higher as benchmark interest rates decline. If benchmark interest rates fall, the market will be willing to accept a lower earnings yield, or a lower ratio of earnings to the market value of common stock. At some level of corporate earnings, the attainment of a lower earnings yield will be achieved through an increase in share prices. To the contrary, a rise by interest rates will push the earnings yield higher. Barring a sufficient climb by after-tax profits, a higher earnings yield will require lower share prices.

Japanese Banks’ Voluntary Curb on Credit Card Loans

From Moody’s

Last Friday, the Nikkei reported that Bank of Tokyo-Mitsubishi UFJ, Ltd. (BTMU, Sumitomo Mitsui Banking Corporation, and Mizuho Bank, Ltd. (MHBK, the main banking units of Japan’s three megabank groups, Mitsubishi UFJ Financial Group, Inc., Sumitomo Mitsui Financial Group, Inc., and Mizuho Financial Group, Inc., introduced voluntary limits on consumer credit card loans at half or one-third of a borrower’s annual income. The banks’ self-imposed limits are credit negative because they will likely hamper growth in credit card lending, one of few highly profitable domestic businesses for the banking sector.

The restriction responds to growing criticism from lawyers and politicians that excessive credit card lending could lead to a repeat of Asia’s 1997 debt crisis. In Japan, banks’ unsecured lending, including card lending, is not subject to the country’s money lending business law, which was revised in 2010 to restrict consumer finance companies’ unsecured lending to one-third of each customer’s annual income.

Some regional banks in Japan, such as the unrated Akita Bank, Ltd., the 77 Bank, Ltd., and Hyakugo Bank, Ltd., have implemented similar limits on credit card loans, and more banks will likely follow to fend off public criticism. Last Thursday, Nobuyuki Hirano, chairman of the Japanese Bankers Association and president of BTMU’s parent group, MUFG, said at a press conference that while he does not see a need to legally limit banks’ credit card lending, each bank should try to prevent consumer clients from taking on excessive debt.

Banks have benefitted from the 2010 revision to the money lending business law, which led to the rapid growth in banks’ card loans and a sharp decrease in consumer finance companies’ unsecured loans. High margins make card lending an attractive revenue source for Japanese banks and especially domestically focused regional banks as low interest rates and weak credit demand weigh on their profitability. Interest rates on banks’ card loans are 2%-15%, significantly higher than an average loan yield of 1.1% for all Japanese banks in fiscal 2016, which ended in March 2017.

Credit card lending is riskier than secured lending, but because the size of each credit card loan is small, risks from the business are easily  manageable for banks. Also, default rates for banks’ credit card loans have been low.

Canada Reinforces Mortgage Underwriting Guidelines

From Moody’s.

On Tuesday, Canada’s Office of the Superintendent of Financial Institutions (OSFI) published the final version of “Guideline B-20 − Residential Mortgage Underwriting Practices and Procedures,” which mandates more stringent stress-testing for uninsured mortgages. The guideline, which takes effect on 1 January 2018 and applies to all federally regulated financial institutions in the country, is credit positive because it will improve asset quality for Canadian banks.

The guideline sets a new minimum qualifying rate, or stress test, for uninsured mortgages at the higher of the five-year benchmark rate published by the Bank of Canada, the central bank, or the contractual mortgage rate plus 2%. Lenders also will be required to impose and continuously update more effective loan-to-value (LTV) limits and measurements.

A key vulnerability of Canadian banks is the high and rising level of private-sector debt/GDP. Canadian mortgage debt outstanding has more than doubled in the past 10 years (see Exhibit 1) and the index of house prices to disposable income has increased 25% over this period (see Exhibit 2), raising the prospect that real estate overvaluation is driving up overall household debt and overextending borrowers.

OFSI’s action is the latest in a series of macro-prudential measures aimed at slowing house-price appreciation in Canada and moderating the availability of mortgage financing. These measures will address the increasing risk that that growing private-sector debt will weaken Canadian banks’ asset quality. Canada’s growing consumer debt and elevated housing prices threaten to make consumers and Canadian banks more vulnerable to downside risks.

In addition to requiring that all uninsured mortgages be stress-tested against a potential rise in interest rates (high-ratio insured mortgages are already required to meet such tests to qualify for mandatory mortgage insurance), the guideline requires that banks establish and adhere to risk-appropriate LTV limits that keep current with market trends. Additionally, the guideline expressly prohibits banks from arranging with another lender a mortgage, or a combination of a mortgage and other lending products (known as bundled mortgages), in any form that circumvents a bank’s maximum LTV ratio.

Housing prices are at record highs owing to price increases in the urban areas of Toronto, Ontario, and Vancouver, British Columbia. Macro-prudential initiatives dampened volumes and prices in Toronto over the summer, but the effects of similar moves in Vancouver last year appear to be lessening this year as prices regain momentum. We believe that high consumer leverage could result in future asset-quality deterioration in an economic downturn or a housing price correction. Although Canadian banks have demonstrated prudent underwriting standards in the past, this is attributable in part to thoughtful regulatory oversight.

The new guideline follows a consultation period that ended in August. Some industry participants recommended a delay in implementation, cautioning that the combined effect of multiple macro-prudential measures affecting the mortgage market risked unduly depressing the housing market, thereby triggering a severe price correction.

UK Government Plans to Increase Social Housing Grants

From Moody’s

Last Wednesday, UK Prime Minister Theresa May announced that housing associations and local authorities will receive an additional £2 billion in grants for social (i.e., public) housing, including social rented homes. She also announced that rent increases will be set at CPI plus 1% starting in fiscal 2021 (which starts 1 April 2020) for five years. These announcements are credit positive for English housing associations because they signal greater support for the social rented sector.

Increased grant funding will reduce external financing needs and provide incentives to focus on social renting activities, which provide more stable cash flow than markets sales. The rent-setting regime provides clarity about housing associations’ operating environment and signals a shift from the previous government policy, which had negative financial effects on the sector.

The amount of grant funding available under the Affordable Homes programme for housing associations and local authorities will increase by £2 billion to £9.1 billion over the length of the program. Housing associations historically have relied on government grants to finance the production of new social homes, but such grants have significantly dwindled since the financial crisis.

The new grant programme aims to fund the construction of an additional 25,000 homes, and we expect the average subsidy per home to more than double to £80,000 from £32,600 in the last allocation round of the programme in 2016 and from £23,500 in the 2014 round. Although the distribution of the grants will depend on yet-to-be-defined criteria that determines which areas are most in need, we expect the 39 English housing associations that we rate to receive £650-£900 million of new grant funding, which would contribute to financing 8,000-11,250 homes.

The additional grants will reduce housing associations’ external financing needs, and should reduce future borrowing, which we currently expect will reach nearly £4 billion during fiscal 2018-20. However, some housing associations may choose to use the freed-up financial capacity to further increase their production of homes for open market sale rather than to stabilise indebtedness.

The grant programme signals a rebalancing of the government’s position in favour of rented social housing. The social letting business provides more stable cash flows for housing authorities than low-cost home ownership programmes, which had been at the centre of the previous housing policy. The lack of grants for building social rented homes and political pressure had encouraged housing associations to subsidise social homes by building units for open market sale that expose housing associations to the cyclicality of the housing market. The share of such sales to turnover has steadily increased over the past five years, reaching 15% in fiscal 2016 for our rated issuers and more than 40% for a small number of housing associations. Hence, this shift in the availability of funding and the direction of policy is credit positive.

CBA’s Sale of Life Insurance Business is Credit Positive

From Moody’s

Last Thursday, Commonwealth Bank of Australia announced that it had agreed to sell its Australian life insurance business, CommInsure Life,7 and its New Zealand life and health insurance businesses, Sovereign,8 to Hong Kong-based insurer AIA Group Limited for AUD3.8 billion ($3.0 billion). The transaction is credit positive for CBA because it will boost its capital adequacy. The deal also is credit positive for AIA because it will strengthen the insurer’s franchise and distribution in Australia and New Zealand with only a modest increase in financial leverage.

The sale price equals a price/book ratio of approximately 1.7x these businesses’ net tangible asset as of June 2017. The two companies also announced a 20-year bancassurance distribution agreements in both markets.

The announced sale comes at a time when mortgage risk weights and capital requirements are rising for Australian banks. In July 2017, the Australian Prudential Regulation Authority announced stricter capital requirements for Australian banks, including that Australia’s four largest banks, including CBA, raise their common equity Tier 1 (CET1) ratios to 10.5% by 1 January 2020.

These sales will put CBA in a strong position to meet this target. As of June 2017, CBA’s CET1 ratio was 10.1%. CBA estimates that the sale will release approximately AUD3 billion of CET1 capital, raising the bank’s fiscal 2017 (which ended 30 June 2017) CET1 ratio by approximately 70 basis points on a pro forma basis. The bank is currently dealing with allegations of non-compliance with Australia’s Anti-Money Laundering and Counter-Terrorism Financing Act that could result in a financial penalty that, depending on its size, could erode the bank’s capital position.


For AIA, the transaction will strengthen the insurer’s franchise and scale in Australia and New Zealand, where it will become those market’s largest life insurance provider. The 20-year bancassurance distribution agreements with CBA and ASB Bank Limited, which is CBA’s New Zealand subsidiary, will complement AIA’s distribution in these two markets, where AIA has traditionally focused on group business and the independent financial adviser channel.

AIA’s purchase will increase its financial leverage, although it will be small relative to its capitalization. The net cash outlay for the transaction will be only AUD2.1 billion ($1.7 billion), after taking into account reinsurance arrangements, and AIA’s strong capitalization should be able to easily absorb that amount. As of May 2017, AIA reported total equity attributable to shareholders of $38.3 billion and a solvency ratio of 427% at its main operating company, AIA Company Limited (financial strength Aa2 stable). AIA expects the transaction to be earnings accretive in the first year after deal completion.

From a strategic perspective, the transaction aligns AIA and CBA with their respective strengths in insurance product origination and distribution. AIA already has a strong track record in Australia and New Zealand and has strong capabilities in group-wide risk management, claims management and product development, resources on which it can leverage to further enhance its newly acquired businesses

Bond Returns, Lower For Longer?

From Moody’s

A less accommodative US monetary policy may heighten market volatility near term. However, over time, the fundamentals that give direction to business activity and financial markets will prevail. For now, current trends involving demography, technology, regulation, and globalization favor the containment of core price inflation and still relatively low US Treasury bond yields.

Because price deflation is anathema to both profit margins and credit quality, a low enough rate of price inflation will adversely affect both equity prices and systemic financial liquidity. If US core consumer price inflation (which excludes volatile food and energy prices) now eases amid a relatively low and declining unemployment rate, what might become of core consumer prices once unemployment inevitably rises? Today’s already sluggish rate of core consumer price growth increases the risk of outright price deflation if sales volumes endure a recessionary contraction.

US consumer price inflation lacks both the speed and breadth necessary for a lasting stay by a 10-year Treasury yield of at least 2.5%. Because the Fed’s preferred inflation measure — the PCE price index — can be temporarily buffeted about by wide swings in food and energy prices, our focus is on the core PCE price index, which best captures consumer price inflation’s underlying pace.

Pockets of price deflation warn against aggressive tightening

The annual rate of core PCE price index inflation was merely 1.4% in July. The accompanying -2.0% annual rate of consumer durables price deflation underscores the considerable risk of pushing too hard on the monetary brakes. Both persistent consumer durables price deflation and August 2017’s -0.9% annual rate of core consumer goods price deflation (as measured by the CPI) warn that too rapid a rise by interest rates risks even lower prices among businesses already burdened by a loss of pricing power. Prolonged core consumer goods price deflation might yet thin profit margins by enough to necessitate layoffs.

The CPI tells roughly the same story as the PCE price index, where inflation gives way to deflation outside of consumer services. By far the fastest price growth has been posted by consumer services, whose pricing benefits from the category’s relative immunity from global competition. For example, August 2017’s 1.7% annual rate of core CPI inflation consisted of a 2.5% annual rate of consumer service price inflation that differed considerably from the aforementioned -0.9% annual rate of core consumer goods price deflation. Core consumer goods price deflation has held in each month since March 2013 and it posted its worst reading since August 2004’s -1.2% in August 2017.

Moreover, consumer service price inflation has been skewed higher by the relatively rapid growth of shelter costs. After excluding August 2017’s 3.3% yearly increase by the CPI’s shelter cost component, the 1.7% annual rate of core CPI inflation drops to 0.5%, which was the slowest such rate since the 0.5% of January 2004.

Expectations of a 2% to 3% Return from Bonds May Become the Norm

Investment professionals now include expectations of a prolonged containment of price inflation in their long-term outlook for prospective returns. For example, a member of Vanguard Group’s global investment-strategy team reiterated Vanguard’s expectation of expected returns for the next decade of 5% to 8% for equities and 2% to 3% for bonds, according to Bloomberg News.

The expected 2% to 3% return from bonds during the next 10 years is at odds with both the FOMC’s median projection of a 2.75% federal funds rate over the long-term and consensus forecasts of a 3% to 3.5% average for the 10-year Treasury yield during the next 10 years.

The cited Vanguard investment manager claimed that bond yields will be reined in by low price inflation stemming from demographic change, globalization, and technological progress. Aging populations will weigh on household expenditures. An aging population implies less in the way of household formation that otherwise accelerates spending vis-a-vis income and, by doing so, imparts a powerful multiplier effect.

Furthermore, the US workforce now ages in tandem with the overall population. According to the Labor Department’s household survey of employment, the employment of Americans aged at least 55 years surged by a cumulative 31.2% since June 2009’s end to the Great Recession through August 2017. Because the latter was so much faster than the accompanying 9.6% increase by total household-survey employment, the number of employees aged at least 55 years rose to a record 23.2% of household survey employment in August. The unprecedented aging of both the US workforce and population will limit the upsides for household expenditures, core consumer price inflation, benchmark interest rates, corporate earnings growth, and corporate debt growth.

Globalization has weakened the tendency of a tighter US labor market to quicken wage growth and, thereby, stoke consumer price inflation. Globalization exposes US workers to the often cheaper and increasingly skilled workforces of dynamic emerging market countries. Heightened labor-market competition implies that employee compensation will be more closely aligned with a worker’s individual performance. Attractive across-the-board wage hikes are a thing of the past.

Meanwhile, technological progress will facilitate the production of higher quality products at lower costs. Thanks to technology, cost-push deflation may push aside cost-push inflation.

Faster price growth requires the sustenance of faster income growth

A recurring annual rate of consumer price inflation of at least 2% requires that consumers be able to afford such a steady and broadly distributed climb by prices. The atypically slow 2.6% annual rise by wage and salary income of the 12-months-ended July 2017 questions consumer spending’s ability to sustain consumer price inflation at 2% or higher. An improving trend has yet to materialize according to July’s merely 2.5% yearly increase by wages and salaries.

Never before has wage and salary income grown so slowly over a yearlong span more than three years into a business cycle upturn. Yes, it may be true that 2017’s deceleration by wages and salaries reflects an attempt to delay receiving employment income until after possible income tax cuts take effect, but most workers are incapable of timing the receipt of income. Thus, to the extent any slowing of 2017’s wage and salary income reflects a tax-driven postponement of such income, attention is brought to a distribution of income that may be increasingly skewed toward higher income individuals. If true, then any percent increase by wage and salary income will supply less of a boost to household expenditures
and business pricing power compared to the past.

Today’s dearth of personal savings and weakened financial state of America’s lower- and middle-income classes subtract from business pricing power. Less personal savings leaves consumers with less of a buffer with which to absorb widespread price hikes. When savings are low or practically nonexistent, affected consumers may react to broadly distributed price hikes by cutting back on real consumer spending, which, in turn, leads to an accumulation of unwanted inventories and remedial price discounting.

When the core PCE price index averaged a rapid annual advance of 6.6% during 1971-1981, the US personal savings rate averaged 11.6% of disposable personal income. By contrast, since the end of 1995, the 1.7% average annual rate of core PCE price index inflation has been joined by a much lower average personal savings rate of 5.0%, where the personal savings rate was an even skimpier 3.9% during the 12-months-ended July 2017. Moreover, to the degree the distribution of income has become increasingly skewed toward the top, the personal savings rate of middle- to lower-income consumers may now be noticeably lower.

The FOMC now believes that the annual rate of core PCE price index inflation will remain under 2%, but only through 2018. However, core PCE price index inflation is likely to average something less than 2% annually through 2027, especially if employee compensation cannot sustain a pace faster than 4% annually.

Blockchain Prototype Is Credit Positive for P&C Insurers and Reinsurers

The Blockchain Insurance Industry Initiative (B3i) has unveiled a prototype application that streamlines contracts between insurers and reinsurers using blockchain technology according to Moody’s. Once the technology becomes mainstream, they expect that it will significantly reduce policy management expenses and speed up claims settlement for insurers and reinsurers, a credit positive.

B3i’s application gives insurers, reinsurers and brokers a shared view of policy data and documentation in real time.

Blockchain’s shared digital ledger has the potential to increase the speed and reduce the friction costs of reinsurance contract placements. Reinsurers would use the common platform to streamline claims analysis, potentially reducing significantly their administration and management costs.

Blockchain technology is a chain of blocks of encrypted data that form an append-only database of transactions. Each block contains a record of transactions among multiple parties, each of which has real-time access to a shared database. As a block is encrypted with a link to the previous block, it cannot be altered, except by unencrypting and amending all subsequent blocks.

PricewaterhouseCoopers estimates that blockchain technology will reduce reinsurer non-commission expenses by 15%-25%, including data processing efficiencies and reduced chance of overpayment because of data errors. For illustrative purposes, the exhibit below shows the potential effect on annual pre-tax earnings for some of the world’s top reinsurance companies, all of which are included in the B3i consortium. We also expect the technology to decrease the time between primary insurance claim and reinsurance reimbursement, a credit positive for primary insurers.

B3i launched in October 2016 with five original members, including Aegon N.V., Allianz SE, Munich Reinsurance Company, Swiss Reinsurance Company Ltd. and Zurich Insurance Company Ltd. It now has 15 members. Beta testing for B3i’s program is scheduled for October and is open to any insurers, reinsurers or brokers that wish to pilot the technology, regardless of their membership status in the consortium. Although the initial pilot was for property-catastrophe excess-of-loss policies, B3i plans to broaden its application to other types of reinsurance, catastrophe bonds and other insurance- linked securities.

S&P 500 Reaches New Heights (Again)

The US index has reached another high and a 5-year view highlights the strong growth, and momentum since Trump won the election last year.

So, what are the expectations ahead? Well, according to a piece from Moody’s:

An overvalued equity market and an extraordinarily low VIX index offer no assurance of impending doom for US equities. Provided that interest rates do not rocket higher, expectations of corporate earnings growth should be sufficient for the purpose of avoiding a severe equity market correction that would doubtless include the return of corporate bond yield spreads in excess of 700 bp for high yield and above 200 bp for Ba a-rated issues.

For now, the good news is that early September’s Blue Chip consensus expects core profits, or pretax profits from current production, to grow by 4.4% in 2017 and by 4.5% in 2018. Moreover, earnings-sensitive securities should be able to shoulder the 2.5% 10-year Treasury yield projected for 2017’s final quarter. However, the realization of a projected Q4-2018 average of 3.0% for the 10-year Treasury yield could materially reduce US share prices.

Since 1982, there have been seven episodes when the month-long average of the market value of US common stock sank by at least -10% from its then record high. Only two of the seven were not accompanied by at least a -5% drop by core profits’ moving yearlong average from its then record high.

In conclusion, the rich valuation of today’s US equity market very much warns of at least a -10% drop in the market value of US common stock in response to either unexpectedly high interest rates or a contraction of profits. Perhaps, the prudent investor should be braced for at least a -20% plunge in the value of a well-diversified portfolio at some point during the next 18 months.