Creative Destruction in 2018 and Beyond

December 20, 2017 (Wednesday)

The Great Disruption. The end of one year and start of the next is the perfect time to reflect and resolve to change for the better. At the start of this year, the most popular resolutions involved the typical fare: the desire to get healthy, get organized, live life to the fullest, learn a new hobby, spend less or save more, travel and read more.

Philosophers like to wax poetic about change. Nuggets of wisdom include: “The only thing that is constant is change.” There’s also: “The more things change the more they stay the same.” And for the deep thinkers in the crowd: “No man ever steps in the same river twice, for it’s not the same river and he’s not the same man.” Thank you, Heraclitus.

Change—and the resulting disruption—has buffeted many S&P 500 industries this year. Sometimes, the change began many years ago, but momentum seemed to pick up and reach a tipping point this year. For example, the Internet has been widely used for almost two decades, but this year, hundreds of bricks and mortar retailers shut their doors as competition from Internet and off-price retailers caused the likes of Sears, Macy’s, and others to shrink in bid for survival.

Likewise, the battery has been around since the 1800s, but improvements in energy storage are making solar and wind energy generation viable alternatives to gas- and coal-powered electric plants. Batteries may also be on the verge of driving major changes in transportation. Blockchain, artificial intelligence, and genetic engineering may be new advancements, but there’s no doubting they will shake up the status quo for years to come.

Change isn’t necessarily a bad thing. The stock market is having a banner year. Here’s the performance derby for the S&P 500 sectors ytd through Monday’s close: Tech (39.7%), Health Care (21.7), Consumer Discretionary (21.5), Financials (20.7), Materials (20.4), S&P 500 (20.2), Industrials (17.8), Utilities (12.0), Consumer Staples (10.5), Real Estate (8.6), Telecom Services (-6.0), and Energy (-7.5).

Jackie and I have been writing about the Great Disruption during most of 2017. Let’s review some of this year’s biggest disruptions as we’re about to start a new year:

(1) The Internet. We’ve been surfing the ‘net for almost 20 years now, but people are still figuring out ways to use it to change just about everything. Book, electronic, and clothing retailers have been facing intense competition—and shuttering storefronts—for years. But 2017 will go down as the year store closures accelerated despite a strong economy and competition invaded the grocery aisles.

Deborah Weinswig, an analyst at Fung Global Retail & Technology, tracks announcements of the openings and closures of a set number of US retailers. She reports that closure announcements increased by 229% ytd in 2017, bringing the total number of stores to be closed to 6,985. The most recent casualty: Charming Charlie, which sells inexpensive jewelry and novelty items, filed for bankruptcy protection and announced plans to shut 100 of its roughly 370 stores by yearend.

The biggest store closures in 2017 came from RadioShack (1,470 stores), Payless (700 stores), and rue21 (400 stores). Conversely, announcements of store openings rose 50%, to 3,433 stores, with the largest expansions coming from Dollar General (1,285 stores), Dollar Tree (650 stores), and Aldi (400 stores).

Competition in the grocery business hit a frenzied pitch this year as Amazon acquired Whole Foods in August, following Walmart’s purchase of Jet.com in September 2016. Throw in the US expansion of German grocers Aldi and Lidl, and you’ve got an intensely competitive market that has kept a lid on consumers’ food prices and squeezed margins.

“Higher prices for vegetables, beef and eggs helped push the food portion of the producer-price index up 3.5% annually in November, according to the Labor Department. Meanwhile consumers paid just 0.6% more for groceries that month than a year earlier, the department said on Wednesday. The spread between producer and retail prices is the widest in more than three years,” a 12/17 WSJ article reported, referring to data from Barclays.

The disruption has also put pressure on food companies, leading many of them into marriages. The latest deals were announced this week: Campbell Soup plans a $6.1 billion acquisition of Snyder’s-Lance, and Hershey offered $1.6 billion to buy Amplify Snack Brands.

The market seems to have decided that Amazon, Walmart, and Costco can co-exist. Their shares are up 57.8%, 41.6%, and 20.1% through Monday’s close. They’ve helped power the S&P 500 Internet & Direct Marketing Retail index 49.6% higher ytd and the S&P 500 Hypermarkets & Supercenters index 35.0% higher (Fig. 1 and Fig. 2).

Investors should be aware that both industries have P/E multiples near 15-year highs. The Internet Retail industry, which also contains highflier Netflix, is expected to grow earnings 37.0% over the next 12 months, but boasts a 71.8 forward P/E (Fig. 3 and Fig. 4). The Hypermarkets & Super Centers industry is only expected to grow earnings by 6.9% over the next 12 months, which makes its forward P/E of 23.2 look equally pricy (Fig. 5 and Fig. 6).

Meanwhile, the S&P 500 Food Retail industry, with Kroger its sole constituent, has fallen 0.3% ytd, and the S&P 500 Packaged Foods & Meats industry has lost 0.8% ytd (Fig. 7 and Fig. 8). The Food Retail industry has a much lower forward P/E of 13.5, but its earnings are forecasted to fall by 2.5% over the next 12 months (Fig. 9 and Fig. 10). The Packaged Foods industry’s forward earnings are expected to grow 7.1%; however, its forward P/E is 18.0 (Fig. 11 and Fig. 12). Maybe it’s time to stay away from all of the above until valuations—or growth prospects—look more attractive.

(2) Certainly entertaining. Streaming television shows and movies over the Internet to televisions, computers, and cell phones existed in years past, but 2017 seemed to be the year that hit shows from Netflix and Amazon attracted large enough audiences to make even the industry’s titans take notice.

Disney’s $52.4 billion acquisition of 21st Century Fox’s assets was undoubtedly a reaction to changes in the industry. The deal gives Disney more content to stream directly to customers, instead of relying on Netflix for distribution. The added heft should also help Disney in future negotiations about the distribution of its content with cable and wireless companies now that the Trump administration has rolled back net neutrality.

Change has not been kind to the S&P 500 Movies & Entertainment index, which is up only 5.1% ytd. With Disney, Fox, Time Warner, and Viacom as members, the industry has suffered from downward earnings revisions, and it’s expected to grow earnings by 6.5% over the next 12 months (Fig. 13 and Fig. 14). However, not much enthusiasm is priced into the shares now that the industry’s forward multiple has fallen to 15.3 (Fig. 15).

The S&P 500 Cable & Satellite industry index has fared better, returning 12.8% ytd, while the S&P 500 Broadcasting stock price index has fared worse, falling 5.2% ytd. Despite fears of losing eyeballs, the Broadcasting industry is expected to grow earnings by 10.9% over the next 12 months and has a forward P/E of only 11.4 (Fig. 16 and Fig. 17). Meanwhile, the forward P/E of the S&P 500 Cable & Satellite industry, at 21.6, is lofty relative to its expected forward earnings growth of 12.8% (Fig. 18 and Fig. 19).

(3) Old dog, new tricks. The lowly battery is having a renaissance. The ability to make more powerful batteries that can last longer has meant they can now be used to power cars and trucks and to store vast quantities of power generated by wind and solar farms. The developments have had wide impact on the auto industry, utilities, GE, Siemens, and even commodities.

Elon Musk is, of course, the poster child for the battery’s evolution, renowned for his Gigafactory in the Nevada desert and Tesla cars. Despite the company’s lack of profits, Tesla’s stock is up 58.6% ytd, dwarfing GM’s 21.0% advance and Ford’s 4.4% gain.

The S&P 500 Automobile Manufacturers (Ford and GM) index is up 12.9% ytd, and while it has a forward P/E of only 7.5, earnings are expected to fall by 10.5% over the next 12 months (Fig. 20 and Fig. 21). In this cyclical industry, a low P/E may indicate peak earnings.

The use of batteries to store electricity made by solar and wind farms has reduced the need to build new electric plants. And as we discussed in the 11/28 Morning Briefing, fewer plants has meant less demand for the giant generators produced by GE and Siemens. However, it has also meant increased demand for lithium. One of the largest producers of lithium, Albemarle, has seen its shares climb 53.4% ytd, which has helped push the S&P 500 Specialty Chemicals industry stock index up 31.0% ytd (Fig. 22).

(4) Building on blockchain. While we haven’t been fans of bitcoin or other cryptocurrencies, we have tracked with interest the many new uses that various industries are finding for blockchain, the system that tracks cryptocurrencies transactions. Transactions are monitored by multiple computers so that data can be tracked, verified, and hopefully not hacked. Multiple users can safely access data that is constantly updated.

Cargill is testing blockchain as a way to track turkeys as they move from the farm to the grocery store, a 10/25 WSJ article reports. The food industry hopes using blockchain will help it improve food safety and reduce waste. The real estate industry is evaluating how to use blockchain to record property titles.

Some of the highest hopes for the technology are centered on using it in the financial industry. It could be used to track the clearing and settlement of many different types of loans and securities. “In the US, DTCC is working with IBM, R3 and Axoni to shift post-trade clearing of single-name credit default swaps on to a blockchain system by the end of next year. If this goes well, the plan is to do the same with other derivatives processed by the giant US clearing house,” reported a 10/16 FT article.

Central banks could shift their payments systems onto blockchain or use it as the foundation for their own cryptocurrencies, the FT article continued. Blockchain could be used in trade finance, the verification of customers, and loan syndication. The rollout of this new technology undoubtedly will hurt some businesses, causing layoffs in some areas, but also will cut costs and create new jobs in other areas.

This is by no means an exhaustive list of the changes that we’ve tracked this year or that we expect to follow in the coming months. Artificial intelligence, robots, and genetic engineering appear to be in the first inning of fascinating nine-inning games. May 2018 contain plenty of changes that make all of our lives better and provide many investment opportunities.

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Good Morning, Vietnam

December 19, 2017 (Tuesday)

Vietnam I: Dodging Mopeds in Hanoi. Greetings from Hanoi! I’m just starting a yearend family vacation touring Vietnam, Cambodia, and Thailand. Hanoi is a bustling city with 7.5 million people. Public transportation is minimal. So most of the commuters travel to and from work by mopeds. There are a million of these minimalist vehicles in Hanoi and 44 million in Vietnam.

No one obeys the traffic laws as mopeds drive through red lights and go the wrong way down one-way streets. Our guide told us to look both ways when we cross the street even if it is a one-way road. He also told us to maintain a constant pace when we cross, so the moped drivers can judge whether to proceed behind us or in front of us. No wonder the locals compare the moped traffic to a swarm of dragonflies. While I am dodging mopeds in Hanoi, I asked Sandy Ward to bring us up to speed on Vietnam and Thailand. Here is her report:

Vietnam II: Frontier Dragon. Dragons figure prominently in Vietnamese folklore: Its people are said to be descended from the union of a dragon and a fairy. Dragons symbolize power, prosperity, and nobility. Vietnam is often referred to as the “land of the ascendant dragon” because the slender S-shape of the Southeast Asian country resembles that of the mythological creature rising. “Rising dragon” aptly describes its current economic status as well.

Vietnam is one of the fastest-growing economies in the world, with GDP expanding at an average annual rate of 6.4% since 2000, according to an overview by the World Bank. GDP growth this year is projected to reach 6.7% compared with an expected gain of 2.9% in GDP globally and 5.1% for developing East Asia Pacific countries, excluding China. The Ho Chi Minh Stock Index is up more than 40% ytd in dollar terms compared with a rise of 36.3% in the MSCI Emerging Market Asia share price index through December 15 (Fig. 1).

Despite the strong showing, Vietnam continues to be ranked as a “frontier” market by indexer Morgan Stanley Capital International (MCSI), failing to make the list of countries under consideration for reclassification to emerging market status when it was released this past summer. Hurdles to Vietnam achieving reclassification include ownership limits on foreign investment as well as difficulties converting foreign-exchange accounts and failure to meet English-language disclosure rules; these will need to be cleared before the country’s status is elevated by MSCI, a 7/4 report on 4-traders.com noted.

Still, it’s worthwhile to take a tour of Vietnam and examine the forces behind the current boom, especially as we mark the 50^th anniversary of the Vietnam War:

(1) Roaring GDP growth. The economy surged in Q3, expanding at a rate of 7.5% y/y, the fastest growth since Q1-2008, on strong showings in the services and industrial sectors. Growth in the previous quarter was revised upward to 6.3% y/y. Services, which rose 7.3% y/y in the nine months through September compared to the same period a year ago, is benefiting from increased international tourism and domestic consumption, mainly from China.

Manufacturing rose 12.8% y/y in the first nine months of 2017 as foreign outfits opened more factories in Vietnam. Agriculture rebounded from the worst drought experienced in a century in 2016 and advanced 2.9% y/y in the nine months ended September. Both sectors have contributed to producing the world-leading GDP growth that is much faster than rates seen in Vietnam’s Southeast Asia counterparts (Fig. 2).

Vietnam’s growth is right in line with the central bank’s 2017 target of 6.7% and reduces the need for further stimulus, a 9/28 Bloomberg piece noted, pointing out that Vietnam unexpectedly lowered interest rates in July for the first time in three years. The article noted too that Prime Minister Nguyen Xuan Phuc asked the central bank to bring down bank lending rates to give a lift to businesses. After failing to meet growth targets in 2016, his first year in office, Prime Minister Phuc pulled out all the stops and also pushed for a 21% increase in credit growth, despite concerns about rising debt levels and bad loans.

(2) Samsung exports from here. Double-digit growth in manufacturing translated into a 22.3% y/y jump in exports in Q3. Much of that growth can be explained by the success of South Korea’s Samsung and the popularity of its smartphones, Deloitte Touche Tohmatsu Analyst Lester Gunnion explained in the firm’s 9/28 Asia Pacific Economic Outlook. Samsung represents 20% of Vietnam’s total exports, and 40% of all Samsung’s smartphones are made in Vietnam.

(3) Manufacturing PMI north of 50. The Nikkei Vietnam Manufacturing Purchasing Managers’ Index dipped slightly in November to 51.4 from 51.6 the previous month, as new order growth slowed and production output stayed level. Raw material shortages drove input prices higher and led to higher selling prices for the third straight month. Yet manufacturers continued to add staff, and purchasing activity showed a solid increase, suggesting the latest conditions represent a temporary soft-patch, IHS Market Associate Director Andrew Harker wrote in a 12/1 report.

(4) Thirsty dragon. Bottled and canned beer represents more than 20% of Vietnam’s consumer goods market. The market is growing at a double-digit rate as the economy continues to grow and wages rise, according to an 11/12 FT article. Already, its 92 million people drink more than 4 billion liters a year, making the country the fifth-largest consumer in Asia in per-capita terms.

The government announced plans in late November to sell a majority stake in the country’s largest beer company, the state-owned Saigon Beer Alcohol Beverage Corp., or Sabeco, whose shares were listed publicly a year ago and since have more than doubled in value. Despite strong foreign interest, only one investor, Thai billionaire Charoen Sirivadhanabhakdi, has submitted a bid so far, according to a 12/12 WSJ article. His Vietnam Beverage Co., a unit of Thai Beverage PCL, made a $2.25 billion bid for a 25% stake. The sale is seen as a test of how serious the government is about opening the economy to foreign investment.

Thailand: Land of the White Elephants. In Thailand, white elephants are considered highly auspicious because of their association with Buddha’s birth and are a symbol of divine royal power. The expression “white elephant” derives from when Thai kings would show displeasure with certain subjects by bestowing upon them a white elephant whose expensive upkeep would lead to financial ruin.

Thailand has been one of the best-performing markets this year, and the MSCI Thailand share price index is up 16.7% ytd in baht through December 15 and 28.6% ytd in dollars (Fig. 3). The index hit a record high on December 12 for the first time since July 10, 1995. Thailand’s Q3 GDP expanded at the fastest pace in more than four years—4.3% y/y, on faster growth in agriculture and services, and higher exports—yet continued to lag the growth rates of its Southeast Asia peers.

For the full-year 2017, the government statistics agency projects growth of 3.9%, and for 2018, 3.6%-4.6%. Consumer spending should strengthen following the end of a year-long period of mourning in October for King Bhumibol Adulyadej, and a government plan to spend $46 billion on infrastructure should also provide a boost, according to an 11/19 Bloomberg report.

Still, wages are falling, household debts are high, and the ruling military junta has called for elections next year, creating uncertainty. Trading at a forward P/E of 15.0, near the top of its historical range, while forward earnings growth for the next 12 months is estimated at 7.9% and the forward revenue growth estimate of 6.6% is falling, Thailand appears to be the investment equivalent of a white elephant (Fig. 4, Fig. 5, and Fig. 6).

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Corporate Finance 101

December 18, 2017 (Monday)

Corporate Finance I: Lots of Cash Flow. The Fed released its latest Financial Accounts of the United States on December 7, with updated data through Q3. Today, Melissa and I will focus on the nonfinancial corporations (NFCs) sector. The bottom line is that the NFCs’ bottom line is gushing cash. Yet NFCs continue to borrow lots of money in the bond market. Some of that cash has been used to buy back shares, but capital spending has also been strong. Debt ratios remain manageable. All in all, we think that NFCs are in very good health. Apparently, so do stock investors, who continue to push stock prices to new highs. Let’s have a close look at what’s driving the NFCs’ income statements:

(1) Business sales are booming. The global economy was in a synchronized growth recession during 2015, led by a major bust in the energy and mining industries resulting from plunging commodity prices. Commodity prices recovered in 2016, and so did the global economy. During 2017, the global synchronized recovery turned into a global synchronized boom that is likely to continue in 2018.

US economic growth, as measured by real GDP, scored annualized gains exceeding 3.0% (saar) during Q2 and Q3. The Atlanta Fed’s GDPNow raised the Q4 estimate from 2.9% to 3.3% following last week’s release of the latest retail sales and CPI data for November. That estimate puts nominal GDP up 4.6% y/y. The growth rate in nominal GDP, on a y/y basis, tends to be less volatile than the growth rate in S&P 500 aggregate revenues (Fig. 1).

There’s a much better fit between the growth rates of S&P 500 aggregate revenues and nominal GDP of goods (Fig. 2). The fit is even better with the growth in total business sales of goods (including factory shipments and trade sales), which registered a solid reading of 6.5% during October (Fig. 3).

(2) Profits and cash flow back near record highs. NFCs’ pretax profits rebounded 7.9% y/y during Q3 (Fig. 4). At $1.35 trillion (saar), it is only slightly below the record high during Q3-2014 before the global mini-bust occurred. Corporate cash flow has also rebounded to recent record highs (Fig. 5). Retained earnings, which is after-tax profits less dividends, has hovered below $400 billion since Q1-2015. The NFCs’ depreciation expense deduction (a.k.a. the capital consumption allowance, which is basically a huge tax shelter) rose to $1.38 trillion (saar) during Q3.

(3) Corporate tax rate already low. The Fed’s data on NFCs confirm the work we have been doing on the corporate tax rate. The NFC average effective corporate tax rate was only 21.6% over the four quarters through Q3 (Fig. 6). It has been hovering around 21.0% since early 2010, well below the 35.0% statutory rate! (The actual federal effective tax rate might be lower depending on how much NFCs pay in taxes to other domestic and foreign taxing authorities. On the other hand, NFCs’ profits include the profits of S corporations that pay dividends, which are taxed as individual income.)

The Republicans’ tax plan now aims to lower the statutory rate to 21.0%, while eliminating many deductions that had allowed corporations to lower their effective tax rate. The net effect of the Republicans’ initiative might be to simplify tax accounting for NFCs and to give them a greater incentive to keep their headquarters and operations in the US. However, it might not boost after-tax corporate earnings as much as we and others have assumed.

Corporate Finance II: Plenty of Buybacks & Capital Spending. The widespread view is that US corporate managers have spent too much money on buying back shares rather than investing in capital and labor. That urban legend isn’t supported by the data:

(1) Plenty of capital expenditures. For the NFCs, capital expenditures have stalled over the past couple of years around an annualized $1.7 trillion (Fig. 7). However, that’s a record high. NFCs’ cash flow has also stalled, but also at a record high around $1.9 trillion over the past couple of years. Since the start of the economic expansion in 2010, the financing gap between capital outlays and internal funds has been in surplus (Fig. 8).

The difference between NFCs’ gross fixed investment and their capital consumption allowance has been back near previous cyclical highs in recent years (Fig. 9 and Fig. 10). Previously, we’ve shown that companies may be getting more bang for their buck as they spend more on information technology hardware and software.

(2) Lots of bond issuance. Notwithstanding their abundant cash flow, NFCs have raised lots of money in the bond market. They have a record $5.3 trillion outstanding in bonds (Fig. 11). That’s up $2.3 trillion since Q1-2009.

(3) Lots of buybacks and dividends. Over this same period (from Q1-2009 to Q3-2017), net new issuance of equity by NFCs has been consistently negative in the Fed’s data, totaling $3.3 trillion (Fig. 12). Not surprisingly, this series has had a very close fit with S&P 500 buybacks, which have totaled $3.8 trillion since Q1-2009.

For the NFCs, we can compare the major sources of funds—i.e., internal cash flow plus net new bond issuance—to the major uses of funds, i.e., capital expenditures and buybacks (Fig. 13). Over the past four quarters, they’ve both equaled $2.1 trillion. They’ve tended to be very close for many years.

Corporate Finance III: Taxes One More Time. In recent weeks, Melissa and I have been studying the effective corporate tax rate and have concluded that it is much lower than the 35% statutory rate, and might already be at or below the 20% rate that has been part of the Republicans’ tax reform plan. Here are our latest thoughts on this taxing matter:

(1) Numerator. We feel quite comfortable using the IRS data for corporate tax receipts as the numerator of the effective tax ratio. The NIPA measure of taxes paid by all corporations includes “taxes” paid by the Federal Reserve System as well as taxes paid to other domestic and foreign taxing authorities. (“NIPA” stands for “National Income and Product Accounts,” which are compiled by the Bureau of Economic Analysis to measure GDP.)

(2) Denominator. We’ve been doing more work on the denominator. We’ve been using NIPA pretax profits less the “profits” of the Fed. However, that series still includes the profits of S corporations, which are sole proprietorships. The ones that are profitable tend to pay dividends to their owner. Those dividends are included in personal income. Taxes on those dividends are included in individual rather than corporate tax receipts of the IRS.

There are three quarterly series available to measure dividends (Fig. 14). One is in the NIPA accounts for all corporations. It totaled $990.1 billion over the past four quarters through Q3. The Fed’s measure of dividends for NFCs is based on the NIPA data and totaled $710.8 billion over the same period. The S&P 500 corporations paid out $413.2 billion in dividends.

The IRS compiles annual data for S corporations. The latest available figures are for 2014. Dividends paid by S corporations totaled $409 billion and accounted for 41.5% of corporate dividends (Fig. 15 and Fig. 16).

Our initial inclination was to subtract the dividends paid by S corporations from the denominator, i.e., NIPA pretax profits less taxes paid by the Fed. However, dividends may not be an accurate measure of the actual profits of the S corporations because we also need to account for the S corporations that aren’t paying dividends because they are losing money.

Movie. “Darkest Hour” (+ +) (link) stars Gary Oldman in an all-star performance as Winston Churchill during his first few days as the new prime minster of Great Britain at the outset of World War II. Those were dark days indeed. Most of the country’s army was encircled at Dunkirk by German tanks. Yet Churchill refused to negotiate surrender terms with Hitler. He succeeded in marshalling a civilian boat armada to ferry the troops back home from Dunkirk. He resolutely led the UK throughout the war until the Allies finally defeated Nazi Germany.

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Financials Are Catching Up

December 14, 2017 (Thursday)

Financials I: Digital Tulips? Last week, bitcoin hit an intraday high north of $19,000 per dollar (Fig. 1). This week, the S&P 500 Financials sector stock index hit a post-recession high (Fig. 2). This index is only 8.3% below its record high on February 20, 2007.

It’s a bit odd that these two events occurred simultaneously. Investors buying bitcoin are presumably betting against the viability of the dollar and other currencies, as well as against the current financial system. Conversely, investors buying financial stocks are placing the opposite wager.

Our view is that bitcoin is the first digital tulip bubble. The tulip bubble in Holland during 1636-37 was limited to Holland. Today’s tulip bubble is global thanks to the Internet. The creation of a digital currency that is limited in supply by its algorithm has attracted buyers who are basically “cornering” the market. In the old days, commodities that were deemed to be in short supply were cornered by speculators. They had no interest in ever taking delivery of the commodity or using it. They expected that at some point the buyers would need the commodity that they had cornered and would pay a significantly higher price (than their own purchase price) to buy it from them.

We don’t have any experience with digital bubbles. So it is hard to say how high the price might go for bitcoin. It is also hard to say what will burst the bubble. In the past, high prices stimulated more supply, or a government crackdown on the speculators. A government crackdown on bitcoin and other cryptocurrencies is possible, though that might only send more speculators to the Dark Web, as discussed below. A proliferation of new IPOs of cryptocurrencies might be the supply response that causes the price of bitcoin to take a dive.

Financials II: Vote of Confidence. In theory, bitcoin and the software behind bitcoin have the potential to seriously disrupt the business models of most financial intermediaries. Who needs banks if all our financial transactions can be accomplished easily and quickly using a virtual ledger? This existential question hasn’t slowed the remarkable rally in the stock prices of the Financials so far this year. Let’s have a closer look:

(1) Coming from behind. The Financials sector had a slow start to the year, but it’s finishing strong. As recently as September, the index had returned less than 5% ytd, but in recent weeks investors jumped on board, bringing the ytd return through Tuesday’s close up to 20.8%, behind only Technology (37.0%) and Health Care (21.2) (Fig. 3).

Many of the industries within Financials had a strong 2017 so far. Leading the sector is Asset Management & Custody Banks, up 26.7% ytd through Tuesday’s close, followed by Diversified Banks (21.7%), Investment Banking & Brokerage (20.4), Regional Banks (15.6), and Consumer Finance (15.4) (Fig. 4).

(2) Ac-cent-tchu-ate the positive. Financials benefitted from busy capital markets, strong flows into equity and fixed-income funds, good credit quality, and less regulation under the Trump administration.

Global investment banking revenue was 6% higher ytd than during the same period in 2016, according to Dealogic data on WSJ.com. The total was boosted by a 44% jump in revenue from IPOs and a 50% increase in global high-yield bond underwriting revenue. That was partially offset by a 6% decline in global M&A revenue and a 3% decline in global investment-grade bond underwriting revenue.

Asset managers have been helped by rising markets and positive fund flows. As discussed in Monday’s Morning Briefing, funds are flowing into both equities and fixed-income products. Equity mutual funds and exchange-traded funds (ETFs) had net inflows of $323.9 billion over the past 12 months through October—the best showing since September 2014. ETFs had record net inflows of $375.6 billion, while equity mutual funds had net outflows (Fig. 5). Meanwhile, bond mutual funds and ETFs together recorded net inflows of $415.8 billion, the best flows since March 2013 (Fig. 6).

Banks and brokers also benefitted from the Trump administration’s regulatory rollback of rules put in place under the Obama administration to reduce risk-taking. According to a 12/3 article in the FT: “The likes of Goldman Sachs and Morgan Stanley spent the years since the crisis winnowing their inventories of stocks and bonds held for trading, as new constraints on capital, and new rules such as the Volcker ban on proprietary trades, bit hard. But over the past nine months the trading arsenals of the big six banks have grown by more than $170bn, bringing the total to $1.71tn, the highest level since the end of 2012, according to an FT analysis of public filings.”

The improved regulatory climate under President Trump has boosted their willingness to hold those securities on their balance sheets, the article concludes. And the loosening of regulations is expected to continue as Fed Chair nominee Jay Powell takes over.

(3) Flatter curve. Conversely, the Financials sector was held back by low volatility in the markets, which hurt trading revenues. In addition, the slim difference between the yields of short- and long-term Treasuries didn’t help. The spread between 10-year and two-year Treasuries has fallen to 57bps, its lowest level since 2007 (Fig. 7). The spread has narrowed despite three rate hikes this year, including the Fed’s decision to raise rates by 25bps Wednesday.

(4) Optimism prevails. With looser regulations just starting to have an impact, analysts are optimistic that earnings in the Financials sector will grow 15.6% over the next 12 months (Fig. 8). Those earnings projections are topped only by the 37.7% and 17.9% growth anticipated in the Energy and Materials sectors.

Part of the Financials sector’s earnings strength comes from the Reinsurance and Property & Casualty Insurance industries, where losses from the catastrophes in 2017 are expected to be reversed next year. Forward earnings in those industries are anticipated to jump by 921.7% and 49.5% respectively.

Banks and brokers are forecasted to have respectable results over the next 12 months. Earnings are expected to grow 12.1% at Diversified Banks, 9.7% at Regional Banks, 12.8% at Consumer Finance, 9.4% at Asset Management & Custody Banks, and 10.9% at Investment Banking & Brokerage.

One should certainly keep an eye on the sector’s forward P/E, at 14.9, since it has crept up from below 10.0 during 2009 and 2011 (Fig. 9). But given that Financials spent most of 2017 consolidating, the sector should have more room to run in 2018.

Tails from the Crypt. Pets.com sock puppet commercials from 1999 are always good for a chuckle. Something about the puppet perfectly captured the essence of doginess. Unfortunately, the company spent more on advertising than it generated in revenue and met its untimely demise before the delivery of pet food and products became commonplace.

This trip down memory lane was inspired by CryptoKitties, the latest wrinkle in the world of cryptocurrencies. Consumers can use the cryptocurrency Ethereum to buy cartoon cats, and the platform “has processed more than $12 million in sales,” according to a 12/11 Cointelegraph article. Each cat has a name, biography, “cattributes” and lineage. Owners can breed their cats and sell the kittens.

Cryptocurrencies have come a long way from when they were first used to execute transactions on the Dark Web, the place on the Internet that Google does not go. The Dark Web, which was first established by the Navy, is accessed by the Tor browser and allows users to visit sites anonymously.

The Dark Web is prized by advocates who believe you have the right to privacy on the Internet. You have the right to read things without being monitored by web providers, advertisers, or the government. You have the right to control your own data and information. Newspapers have used the Dark Web to set up sites that whistle blowers can use to pass on information without exposing their identities.

However, the Dark Web is also a place where you can reportedly buy anything from drugs to guns to illegal documents. Here’s a good Ted Talk with some of the basics.

To purchase things anonymously, buyers can’t exactly whip out their AmEx; nor will $100 bills work online. Cryptocurrencies do the job, and bitcoin was among the first to gain traction. However, since bitcoin transactions are recorded on the distributed ledger, criminals reportedly have moved on to currencies like Ethereum and Monero, which hide the name of the sender, the amount, and the receiver.

“Although hard numbers on criminal activity in digital currencies are difficult to pin down, Shone Anstey, co-founder and president of Blockchain Intelligence Group, estimates that illegal transactions in bitcoin have fallen from about half of total volume to about 20 percent last year,” reported an 8/29 CNBC article. The price of Monero has risen to $310, up from almost $13 at the start of the year, and Ethereum trades north of $700 today, up from roughly $8 at the start of the year, according to Coinmarketcap.com.

The authorities are well aware of the nefarious things occurring on the Dark Web. This summer they shut down AlphaBay—a market for drugs, counterfeit credit cards, and other illegal goods. It rang up sales of $600,000 to $800,000 a day, according to a 7/13 WSJ article. But there still seem to be many vendors selling all manner of things on the Dark Web according to a listing of web sites on darkwebnews.com. We’d expect a game of Whac-A-Mole between authorities and criminals to ensue for many years.

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Go With the Flows

December 13, 2017 (Wednesday)

Global Economy: Synchronized Boom. It’s now widely known that one of the main reasons why global stock markets are soaring is that the global economy is booming. That wasn’t as widely recognized during the second half of 2016, when Debbie, Joe, and I spotted more signs the global energy-led economic slowdown and earnings recession were coming to an end. This year, there is mounting evidence of a global synchronized boom. The pace of economic activity has quickened in both the advanced and emerging economies. Consider the following latest developments:

(1) Global PMIs. The JP Morgan global M-PMI has soared from last year’s low of 50.0 during February to 54.0 during November (Fig. 1). Leading the way has been the advanced economies’ M-PMI, which is up from 50.8 to 55.8 over this period. Trailing, but still improving considerably, has been the emerging economies’ M-PMI, up from 48.9 to 51.7 over this period. The global NM-PMI has stalled around 54.0 since the start of the year, but it is up smartly from the recent low of 50.7 during February 2016.

The performance derby among the advanced economies’ M-PMIs is as follows for November: Eurozone (60.1), UK (58.2), US (58.2), and Japan (53.6) (Fig. 2). The M-PMIs for economies within the Eurozone are smoking: Germany (62.5), Italy (58.3), France (57.7), and Spain (56.1) (Fig. 3). Here is a similar rundown for the BRICs’ M-PMIs: Brazil (53.5), India (52.6), China (51.8), and Russia (51.5) (Fig. 4).

(2) China’s trade. Debbie and I also give a lot of weight to China’s merchandise trade data as an indicator of global economic activity. These data are among the most timely of the global economic indicators since they are released about two weeks after the end of each month; for example, November data became available on the 7^th of this month (Fig. 5).

The latest data, in yuan, show that exports are up 10.5% y/y, matching the record high earlier this year. Imports are up 15.2% y/y, nearly matching the record high back during January 2014.

(3) Positive surprises in the US. The Citigroup Economic Surprise Index for the US rose to 69.0 yesterday, the highest since early 2014 (Fig. 6). On the other hand, the Atlanta Fed’s GDPNow model forecast for real GDP growth (seasonally adjusted annual rate) in Q4-2017 was lowered to 2.9% on December 8, down from 3.2%. Oddly, despite the strength of payroll employment, the downward revisions was explained as follows: “The forecasts of real consumer spending growth and real private fixed-investment growth declined from 2.8 percent and 8.1 percent, respectively, to 2.5 percent and 7.0 percent, respectively, after this morning’s employment report from the U.S. Bureau of Labor Statistics.” That’s an odd duck, in our opinion.

(4) Global leading indicators. The OECD leading indicators was unchanged at 100.1 during October; it had been below 100 from September 2015 through February of this year (Fig. 7). That latest reading certainly isn’t showing that a global boom is underway, but it’s an indicator that hasn’t shown much amplitude other than during extreme booms or extreme busts.

Among the strongest economies according to the OECD leading indicators are those of Germany (not surprisingly) and Brazil (surprisingly so) (Fig. 8 and Fig. 9).

US Flow of Funds: Lots of Money. The Fed recently released the latest quarterly Financial Accounts of the United States through Q3. The big story is how much wealth has been accumulated since the financial crisis of 2008. To see this, let’s see how much higher wealth is now than it was during the previous peak, before stock prices and home values crashed:

(1) Total household net worth rose to a record $96.9 trillion, up $29.1 trillion from the Q2-2007 peak (Fig. 10). The ratio of this measure to disposable personal income rose to a record high of 6.7, exceeding the previous high of 6.5 at the start of 2007 (Fig. 11).

(2) Household wealth increases across several asset classes. Households have a record $22.9 trillion in pension fund reserves, up $7.8 trillion from the 2007 peak (Fig. 12). Corporate equities directly held by households rose to a record $17.3 trillion, exceeding the 2007 peak by $6.4 trillion. At $14.1 trillion, owner’s equity in household residential real estate has now fully recovered its losses from the recent housing debacle.

(3) Stock market valuation. The total market capitalization of all equities traded in the US rose to a whopping $43.7 trillion during Q3 (Fig. 13). It’s up $30.3 trillion since the Q1-2009 bottom, and exceeds the 2007 peak by $17.3 trillion. The big holders of equities in the US are households ($17.3 trillion), equity mutual funds and ETFs ($12.9 trillion), foreign investors ($6.6 trillion), and institutional investors ($3.7 trillion) (Fig. 14).

The Buffett Ratio—which is the ratio of the market value of US equities divided by GNP—rose to 1.78 during Q3 (Fig. 15). That nearly matches the record high of 1.80 during Q1-2000. A similar ratio of the S&P 500 market cap to S&P 500 revenues rose to 2.02, slightly exceeding its previous peak of 2.01 during Q4-1999.

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Taxing Matters

December 12, 2017 (Tuesday)

US Corporate Taxes I: Mystery Solved. Melissa and I have been puzzling over the significant difference between the NIPA measure of corporate profits taxes and the revenues actually collected by the IRS from corporations. NIPA stands for “National Income and Product Accounts,” which are compiled by the Bureau of Economic Analysis to measure GDP. NIPA, therefore, has to be comprehensive to capture all components of the economy that add up to GDP. The IRS, on the other hand, is only interested in measuring how much tax revenues are being collected. Let’s see how all this impacts the measurement of corporate tax revenues:

(1) The NIPA’s all-encompassing approach can be seen in the way it measures corporate profits. For example, it includes the profits earned by the Federal Reserve Banks (Fig. 1).They are incorporated entities. There are 12 of them in the Federal Reserve system. Collectively, their profits have soared as the Fed’s balance sheet was loaded up with bonds acquired through QE programs from December 2008 through October 2014 (Fig. 2). Over this period, the Fed’s balance sheet ballooned by $2.4 trillion to $4.4 trillion. That’s after it had ballooned from about $800 million to about $2.0 trillion from September to December 2008 as a result of numerous emergency liquidity facilities that were replaced by QE programs.

(2) The Fed has been earning interest on all those bonds. As a result, the NIPA show that the Fed’s profits jumped from $27 billion (saar) during Q1-2009 to a record $105 billion during Q2-2014. They’ve come down a bit since then to $82 billion during Q3.

(3) The Fed is required to return the profits from its operations, net of expenses, to the Treasury. This item is buried in Table 4 of the Monthly Treasury Statement of Receipts and Outlays as “Miscellaneous Receipts: Deposits of Earnings, Federal Reserve System.” Not surprisingly, the NIPA measure of the Fed’s profits tends to coincide with the 12-month sum of the Table 4 item.

(4) So if we add the 12-month sum of the Fed’s earnings as reported by the IRS to the 12-month sum of the corporate tax revenues reported by the IRS, the result is a series that is closer to the NIPA measure of total corporate tax revenues (Fig. 3).

(5) The remaining difference between the NIPA and IRS series, as adjusted by us, is mostly attributable to state and local taxes on corporations, which are included in the NIPA measure but not in the IRS tally (Fig. 4).

US Corporate Taxes II: Not So Taxing. The obvious conclusion is that measuring the average effective federal corporate tax rate using the NIPA data will overstate it by the amount of “taxes” collected from the Fed and by the amount of taxes paid to taxing authorities other than the IRS.

Nevertheless, the comprehensive NIPA-based effective corporate rate has been below 25.0% since Q1-2008 (Fig. 5). It was 20.7% during the four quarters through Q3 of this year. Even lower is the comparable tax rate based on IRS data on federal corporate tax receipts, excluding the Fed’s contribution. This tax rate has been below 20.0% since Q2-2008, and was just 13.0% over the four quarters through Q3!

That’s well below the current statutory rate of 35.0%. It’s also well below the 20.0% rate that Republicans are aiming to enact as part of their tax reform plan. This raises two relevant questions:

(1) Are we comparing apples and oranges? Melissa and I now feel quite comfortable using the IRS corporate tax revenues measure as the numerator in calculating the effective federal corporate tax rate.

But what about the denominator? Removing the Fed’s profits from the NIPA measure of corporate profits in the denominator doesn’t make much difference. That’s because those profits are a much more significant percentage of corporate tax revenues than corporate profits.

We are investigating the possibility that the treatment of sole proprietorships and LLCs in the NIPA data might be overstating the denominator relative to the numerator of our effective tax calculation. We doubt it since the NIPA include sole proprietors’ income in personal income rather than in profits, as we discussed last Tuesday (Fig. 6). We presume (and are checking whether) the same holds true for the taxes paid by proprietors. We are quite certain they are included in the IRS and NIPA measures of individual income taxes.

(2) Are small corporations paying full fare while large corporations are free-loading? The IRS-based effective federal corporate tax rate suggests that corporations are using all sorts of tax deductions and dodges to very effectively lower their effective tax rate well below the 35.0% statutory rate.

The urban legend is that large multinational corporations have the resources to play this game, and are paying almost nothing in taxes, while smaller corporations are paying something close to 35.0%. I asked Joe to find the amount of taxes paid by the S&P 500 corporations. He found annual data showing that for most years since the late 1990s, taxes paid by these companies actually exceeded the federal corporate tax receipts at the IRS (Fig. 7). Their effective tax rate was 26.4% during 2016 (Fig. 8). That may reflect that the S&P 500 data aren’t strictly comparable because they include taxes paid to other entities, including state and local governments, as well as to overseas taxing authorities.

The bottom line is that getting to the bottom line when it comes to matters of taxation is a very taxing exercise. We’ll keep at it, but our conclusions so far are that corporations, on balance, may actually be paying less than the 20.0% statutory rate that the Republicans are aiming to enact, and large corporations may not be free-loading at the expense of small ones.

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Hot Money

December 11, 2017 (Monday)

Strategy I: Equity ETFs Bubble. As the stock market continues to soar, it is attracting more money into stocks. That’s what usually happens during meltups. Joe and I think the market may be in the early stages of a meltup. We will call it a “meltup” if our 2018 year-end target of 3100 for the S&P 500 is reached within the next 3-6 months rather than the next 12-18 months. To some observers, reaching 3100 by the end of next year may appear to be a meltup since it would mean that the S&P 500 would have risen 51.7% over the three years 2016-2018—i.e., 16.9% from Friday’s close through the end of next year, following the 18.4% gain ytd and 9.5% during 2016 (Fig. 1 and Fig. 2).

Maybe so, but let’s see whether earnings continue to rise rapidly, providing fundamental support for the stock gains so far and in the year ahead. A cut in the corporate tax rate, effective next year, along with continued deregulation should bolster profits. So should a continuation of the global synchronized boom.

Meanwhile, the flow-of-funds case for a meltup is mounting as more hot money pours into equity ETFs. Let’s follow the money:

(1) All equity funds: Mutual & ETFs. Over the past 12 months through October, equity ETFs attracted a record $375.6 billion of net new money (Fig. 3). Admittedly, some of that money might have come out of equity mutual funds, which had net outflows of $51.7 billion over this same period. Collectively, equity mutual funds and ETFs had net inflows of $323.9 billion, the best such pace since September 2014.

(2) All equity funds: Domestic & global. Over the past 12 months through October, the bulk of the inflows into all US-based equity funds went to those that invest globally. They attracted $240.6 billion, while all equity funds that invest domestically attracted $83.3 billion (Fig. 4).

(3) Equity mutual funds: Domestic & global. Interestingly, while $143.9 billion poured out of domestic equity mutual funds, $92.3 billion poured into US-based global mutual funds (Fig. 5).

(4) Equity ETFs: Domestic & global. The hottest hot money flows have been into both domestic ($227.2 billion) and global ($148.4 billion) equity ETFs (Fig. 6). The former was near recent record highs, while the latter made a new record high.

(5) All bond funds: Mutual and ETFs. Remarkably, net inflows into bond funds outpaced inflows into equity funds over the past 12 months. The bond funds attracted $415.8 billion, with $298.0 billion going into bond mutual funds and $117.8 billion going into bond ETFs (Fig. 7). The total inflows into all bond funds was the best since March 2013.

(6) All together. All told, all funds attracted $739.7 billion over the past 12 months through October. That was the best pace on record, going back to mid-2003.

(7) Bottom line. Given these massive inflows, it’s no wonder that bond yields remain remarkably low, despite the strengthening of economic activity, and that stock prices are continuing to rise in record-high territory.

Strategy II: Happy Squiggles. So far, the exuberance for stocks reflected in equity fund inflows is supported by the exuberance of industry analysts about the outlook for S&P 500 revenues and earnings. The weekly “squiggles” data for revenues and earnings show that industry analysts are turning increasingly bullish on the outlook for S&P 500 revenues and earnings:

(1) Revenues. Analysts’ consensus expectations show revenues rising 6.2% this year, 5.6% in 2018, and 4.9% in 2019 (Fig. 8). Forward revenues, which is the time-weighted average of consensus estimates for the current year and next year, exceeds four-quarter-trailing revenues through Q3 by 7.1%.

(2) Earnings. Industry analysts are projecting earnings gains of 10.9% this year, 11.4% next year, and 10.1% in 2019 (Fig. 9). Presumably, these numbers don’t fully reflect the likely big positive impact of a cut in the corporate tax rate next year.

If that happens before the end of this year, analysts may wait until Q4 earnings calls during January to get some guidance from company managements on how tax reform will impact their earnings estimates on balance. These calls are likely to be very bullish, driving stock prices higher early next year. Forward earnings is up to a record $145.06 per share, 13.2% above the four-quarter-trailing sum through Q3.

US Economy: Operating on All Cylinders. What could be more bullish for stocks than solid economic growth with low inflation and a likely cut in the corporate tax rate with the repatriation of lots of corporate cash from abroad? That’s not a trick question. It’s a rhetorical one. I can’t think of a more bullish scenario.

There are two obvious risks in this scenario. One is that too much of a good thing may be too much of a good thing. With the economy operating on all cylinders, there’s a risk that tax cuts might overheat the economy, triggering inflation. A more likely and immediate risk is a stock market meltup, which might set the stage for a meltdown. With so much money pouring into equity ETFs, the potential for a flash crash in these funds can’t be ruled out.

But let’s not dwell on hypothetical bearish scenarios when the unfolding scenario remains very bullish. The global economy is showing more and more signs of booming. So is the US economy. As Debbie discusses below, the labor market continues to run hot for payroll gains, while wage inflation remains cool:

(1) Employment. Payroll employment is up 2.1 million over the past 12 months through November to a record 147.2 million. The household measure of full-time employment rose to a record high of 126.8 million. The adult unemployment rate was unchanged at 3.7%, the lowest since March 2001. The short-term unemployment rate was only 3.1%, while the long-term jobless rate fell to 1.0% (Fig. 10).

(2) Wages. Average hourly earnings rose 2.5% y/y through November. While that remains surprisingly low given the tightness of the labor market, it’s still ahead of the CPI inflation rate of 2.0% y/y through October. Real hourly pay is at an all-time high. It hasn’t stagnated as widely misconceived.

(3) Earned Income Proxy. Our Earned Income Proxy for wages and salaries in the private sector rose solidly by 0.7% m/m and 4.8% y/y, the highest since January 2016 (Fig. 11).

At the same time that the latest consumer data are showing continued strength, so are housing indicators. Furthermore, capital spending indicators are showing more of it over the past year. Record truck tonnage and intermodal railcar traffic confirm that the economy is operating on all cylinders.

Movie: “Lady Bird” (+ +) (link) is a really fine movie about a 17-year-old girl growing up in Sacramento. She is from the wrong side of the tracks, but overcomes her economic disadvantages with poise and smarts. It’s more universal than a typical coming-of-age movie about some confused teenager. It’s all about learning to live in your own skin and being happy about it.

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Tech Fender Bender

December 07, 2017 (Thursday)

Tech: Three Bad Things. “Three’s the charm.” That’s an adage often applied to marriages and other pursuits. Fail at something? Keep trying. You’ll probably succeed by the third time. On the other hand, there’s the old wives’ tale that “bad things come in threes,” especially when it comes to celebrity deaths. While a Google search failed to turn up any credible source for the saying, the notion that famous people die in threes seems to have taken root when Buddy Holly, Ritchie Valens, and The Big Bopper perished in a plane crash together in 1959. At the end of 2016, Alan Thicke, George Michael, and Carrie Fisher all died unexpectedly. Here are a few more morbid threesomes: Michael Jackson, Ed McMahon, and Farrah Fawcett; David Bowie, Alan Rickman, and René Angélil; Prince, Chyna, and Doris Roberts.

The S&P 500 Tech sector hasn’t died, but it has had a tough month after receiving three bad pieces of news. This week, investors seemed to rotate out of Tech upon realizing the Republicans’ tax bill would benefit other S&P 500 sectors more than the Tech sector. Last month, President Trump’s administration announced it would rescind net neutrality, which could mean higher costs for tech companies providing content and services over the web. And finally, old-line retailers and media companies appear to have grown more competitive in recent battles with the tech titans. Crowds flocked to Macy’s on Black Friday, Disney is bidding for 21^st Century Fox, and CVS is buying Aetna before Amazon invades its turf.

Since its recent peak, on November 28, the S&P 500 Information Technology sector has fallen 3.9% through Tuesday’s close, making it the worst-performing sector in the S&P 500 over that period: Telecom Services (3.8%), Financials (3.5), Energy (2.3), Consumer Staples (2.3), Consumer Discretionary (1.4), Industrials (1.2), Materials (0.3), S&P 500 (0.1), Health Care (-0.4), Real Estate (-1.6), Utilities (-1.8), and Tech (-3.9).

With the notable exceptions of Financials and Real Estate, the performance derby ytd is the mirror opposite of the above results: Tech (33.8%), Financials (19.3), Consumer Discretionary (19.2), Health Care (19.0), Materials (18.9), S&P 500 (17.5), Industrials (15.0), Utilities (13.2), Consumer Staples (9.4), Real Estate (6.6), Energy (-7.9), and Telecom Services (-10.9) (Fig. 1).

The good news is that after three bad events, one’s luck is bound to change (if you haven’t been pronounced dead yet). And since the Tech sector still offers some of the market’s fastest growth, with reasonable multiples, we remain optimistic about its future. Let’s take a look at the crystal ball:

(1) Reforming taxes. In recent days, investors have been favoring sectors of the economy that stand to benefit the most from tax reform, and Tech is not one of them. The tax reform bill would bring the federal tax rate down to 20% from the current 35%. Those benefitting the most would be the companies that pay the highest tax rate, and in general companies that generate most of their income domestically have the highest tax bills. Companies with the lowest rates tend to either have operations in countries with low tax rates or they’ve transferred their intellectual property to foreign countries with low tax rates.

Tech had both the lowest five-year median effective tax rate (24%) and the lowest percent of its sales from the US (41%), according to a 12/1 CNBC article citing 2016 data from Compustat and Goldman Sachs Global Investment Research. Here are the tax rates for other sectors: Health Care (26%), Materials (27), Financials (28), Consumer Staples (30), Consumer Discretionary (30), Utilities (31), Industrials (32), Telecom Services (33), and Energy (35).

The Tech sector would certainly be among the largest beneficiaries if cash stashed overseas can be repatriated at a low rate and presumably used for stock buybacks or dividends. Right now, both “House and Senate proposals would impose a one-time levy on (overseas profits)—whether assets are repatriated or not—at 14% on liquid assets under the House proposal and 10% under the Senate’s,” a 12/1 WSJ article reported.

However, the Tech sector wouldn’t fare as well as other sectors if a global minimum tax on foreign income is established to discourage placing operations or intellectual property in countries with low tax rates. The bills would impose a global minimum tax of 10% on the income earned abroad even if it’s not repatriated. In addition, the bill would make some payments between US companies and their foreign units subject to a 20% tax.

Finally, the Senate bill includes a 20% alternative minimum tax (AMT). If the federal tax rate were reduced to 20%, it would mean less use of the research credit by many tech and pharma companies, as using the credit would cause the AMT to kick in.

(2) Real world implications. Since we can’t predict what the final tax law will look like, we decided to examine the 2016 tax bills of Merck, Apple, Home Depot, JPMorgan, and United Technologies. After doing so, it’s clear why so much money is spent on lobbying about taxes—the dollars at stake are huge: Merck had the lowest effective income tax rate, 15.4%, followed by United Technologies (23.8), Apple (25.6), JPMorgan (28.4), and Home Depot (36.3).

The biggest reduction in taxes was typically due to income generated overseas. For example, if Merck’s 2016 income were taxed at 35% with no deductions, it would have paid $1.6 billion in taxes. But because of foreign earnings primarily in Ireland, Switzerland, Singapore, and Puerto Rico, its taxes were lowered by almost $1.6 billion. The tax the company did pay, $718 million, was related to purchase accounting adjustments, state taxes, restructuring, and US health care reform legislation, according to the company’s annual report.

R&D research credits do reduce taxes, but for the companies we examined the impact was far less than the savings from generating income in foreign countries with lower tax rates. For example, if Apple paid the federal income tax rate of 35%, it would have paid $21.5 billion of taxes, according to its 2016 annual report. However, because it had earnings from foreign subsidiaries that were indefinitely reinvested outside the US, its tax bill was reduced by $5.6 billion. The R&D research credit only reduced its taxes by $371 million. At the end of the day, the company paid $15.7 billion in taxes.

It’s not just tech and pharma names that have reduced their taxes by generating income abroad. United Technologies’ tax rate was lowered by 8.1 percentage points because of the “lower tax rates on international earnings for which we intend to permanently reinvest outside the United States,” according to its 2016 annual report.

Conversely, it came as little surprise that Home Depot, with 91.5% of its sales in the US, had a 36.3% tax rate, which amounted to a $4.5 billion tax bill in 2016. Business tax credits lowered JPMorgan’s tax rate by 3.9 percentage points, and tax-exempt income lowered it by another 3.1 percentage points, helping to reduce its tax rate to 28.4% last year.

(3) Neutral no longer. With a new sheriff comes new rules. And in late November, the Federal Communications Commission Chairman Ajit Pai announced plans to reverse the Obama administration’s rules governing Internet traffic. Under net neutrality, companies that sell Internet service aren’t allowed to decide what content flows over the network or at what speed content is transmitted.

Net neutrality was considered important because “most Americans only have one or two options for high-speed internet service at home, which gives internet providers a lot of control,” reported a 11/22 WSJ article. However, new FCC Chairman Pai believes net neutrality stifles innovation and investment. His proposal will be voted on by the FCC on December 14, and it’s expected to pass.

In this new scenario, “internet providers will now be free to negotiate payment deals with websites. In one scenario, your internet provider might speed up Netflix while slowing down Hulu because Netflix has agreed to pay. Chairman Pai says companies will be free to create new business models that could lower costs for consumers or deliver more reliable connections for online services people want,” the Journal noted.

While the new rules could face a legal challenge, or be reversed under future administrations, for now they’re creating a lot of uncertainty for companies delivering content or services over the Internet. Stock investors don’t like uncertainty, and these issues touch a wide array of industries. Amazon and Netflix are in the S&P 500 Internet & Direct Marketing industry, and Disney and Time Warner are in the S&P 500 Movies & Entertainment industry. In the S&P 500 Tech sector, Facebook and Google are in the Internet Software & Services industry, while Microsoft and Apple are in the Systems Software and Technology Hardware, Storage, & Peripherals industries.

(4) The data. Despite all the hand wringing, the Tech sector continues to offer some of the fastest growth at the lowest cost. The sector is expected to have revenue growth of 9.9% over the next 12 months, demonstrably faster than the 11 other S&P 500 sectors: Materials (7.9), Energy (7.8), Consumer Discretionary (5.9), Real Estate (5.9), S&P 500 (5.7), Health Care (5.3), Industrials (5.0), Consumer Staples (3.7), Financials (3.6), Utilities (3.5), and Telecom (2.3).

Tech is also forecasted to have some of the strongest earnings growth over the next year: 13.1%. Its earnings growth is eclipsed by the Energy (43.9%), Materials (19.5) and Financials (15.1) sectors. But Tech still bests the forward earnings growth of the S&P 500 (11.1%), Consumer Discretionary (8.7), Industrials (8.6), Consumer Staples (7.5), Health Care (6.8), Utilities (4.4), Telecom (-0.4), and Real Estate (-10.2) (Fig. 2).

Even though it offers above-average earnings growth, the Tech sector’s forward P/E remains merely average at 18.8. The sectors with multiples higher than the Tech sector include: Real Estate (39.9), Energy (25.1), Consumer Discretionary (20.6), Consumer Staples (19.5), and Industrials (19.0). And those with lower multiples aren’t much below the Tech sector’s multiple: Utilities (18.6), Materials (18.4), S&P 500 (18.4), Health Care (16.7), Financials (14.8), and Telecom (12.7) (Fig. 3, Fig. 4, Fig. 5, and Fig. 6).

As a result, the Tech sector’s market-capitalization share of the S&P 500, at 24.0%, is only slightly higher than its forward earnings contribution to the S&P 500, 23.5%. The rally this year in Tech shares is not a repeat of 1999 (Fig. 7).

South Korea: Make Semis, Not War. The US and South Korea joined forces Monday to conduct large-scale war games, a week after North Korea launched yet another missile, its most powerful yet. Twelve thousand troops and 230 aircraft, including top-of-the-line fifth-generation fighter jets —US F-22 Raptors as well as US F-35 Lightnings—took part in the aerial show of might dubbed “Vigilant Ace.” It marked the largest ever concentration of fighter jets massed in South Korea. Mock strikes on mock missile and nuclear-testing sites were planned.

North Korea warned the combat exercises were leading the countries to the brink of war. You’d never know it by the action in South Korea’s stock market.

Unfazed, South Korea’s benchmark Kospi index has risen sharply since Monday as foreign investors stepped up to buy technology shares, a 12/4 article in Singapore’s Business Times reported. The Kospi is up 23.9% ytd (dollars) through Tuesday at 2510.12, just off its record high of 2557.97 set last month. That compares with a 17.5% advance in the S&P 500 ytd and a 25.6% jump in the Nasdaq.

Neither the threat of nuclear war nor a Chinese boycott of South Korea’s consumer goods in retaliation for deploying a US missile shield has been able to halt the surging South Korea stock market, one of the best performing of the MSCI global stock price indexes ytd, in local currency and US dollar terms. The South Korea MSCI share price index is up 44.5% ytd in dollars and 29.9% ytd in won through Tuesday. In contrast, the Emerging Market MSCI share price index is up 29.6% ytd in dollars and 24.3% ytd in local currency while the Emerging Market Asia MSCI share price index has risen 35.8% ytd in dollars and 29.9% in local currency. Only China has performed better among Asian emerging markets, up 45.4% ytd in dollars and 46.3% ytd in yuan.

Let’s look more closely at the dynamics driving South Korea’s market and economy:

(1) Semi offensive. With demand for memory chips booming amid the data-driven crush of the Internet of Things and AI, South Korea is reaping the benefits. Home to both Samsung, the world’s biggest chipmaker in terms of sales, and No. 3 SK Hynix, South Korea is the world’s second-biggest producer of chips next to the US. Global semiconductor sales continued their torrid strength in October, reaching a record $37.1 billion. The three-month moving average of global sales climbed by 21.9% y/y and 3.2% m/m (Fig. 8).

(2) Quickening GDP growth. South Korea’s economy expanded 1.5% q/q in Q3, revised upward from preliminary estimates, according to an 11/30 article in the Financial Times. On a y/y basis, GDP expanded 3.8%, more than the forecast 3.6%. The quarterly increase was the fastest rate of growth in seven years, as private consumption rose on higher spending on services and durable goods. Construction investment expanded at a 1.5% clip (Fig. 9).

As a result of the strong showing, the Bank of Korea upped its forecast for GDP growth in 2017 to more than 3.0%.

(3) Exports are chipper. Exports, which account for 40% of GDP, jumped 6.1% q/q in Q3 on increased shipments of semiconductors, chemical products, and motor vehicles (Fig. 10). That was in sharp contrast to the 2.9% contraction in Q2 as petrochemical shipments declined. In November, exports rose 9.6% y/y, the 13^th straight month of gains. Exports to China rose 20.5% y/y, suggesting a thaw in the frosty relations between the two countries that existed earlier this year.

(4) Output soaring. Firms reported the fastest expansion of new orders in four and a half years in November, on a pronounced uptick in domestic demand, according to the 12/1 Nikkei-Markit South Korea Manufacturing PMI survey. The PMI increased to 51.2 in November from 50.2 in October, the best pace since April 2013. To meet the order demand, firms boosted production at the fastest rate since February 2015. Optimism among manufacturers jumped to a 19-month high (Fig. 11).

(5) Interest-rate hike. In response to the buoyant economic activity, the Bank of Korea lifted its benchmark interest rate on 11/29 for the first time since 2011, by 0.25% to 1.50%. It was the first time a central bank in Asia raised interest rates since 2014, a 11/29 article in Bloomberg noted (Fig. 12).

(6) Valuation. Trading at a forward P/E of 8.9, the MSCI South Korea share price index looks inexpensive relative to its historical trading levels and compared with estimated earnings growth of 11.7% for 2018. Earnings estimates have been continuing to rise.

Singapore & Taiwan: Semis Boom. The boom in semiconductors is also lifting export-oriented Singapore and Taiwan. The MSCI stock price index of the former is up 30.3% ytd in dollars and 21.7% ytd in local currency, and Taiwan’s index is up 22.6% ytd in dollars and 14.1% ytd in local currency. While we are on our Asian tour, consider the following developments in Singapore and Taiwan:

(1) Singapore Sling. Singapore’s GDP grew at the fastest rate in nearly four years during Q3, notching 5.2% growth y/y, according to an 11/23 release from the Ministry of Trade and Industry, thanks to a synchronized global recovery and strong global electronics demand. Manufacturing gained 18.4% y/y, and finance and insurance expanded 5.9% y/y. Construction activity contracted by 7.6%. The Ministry upgraded its GDP outlook for 2017 to 3.0%-3.5% from 2.0%-3.0%. The Nikkei Singapore PMI rose to 55.4 in November, the highest reading in more than three years, from 54.2 in October.

Taiwan’s economy advanced 3.1% y/y in Q3, beating estimates, on healthy demand for semiconductors. The Nikkei Taiwan Manufacturing PMI rose at the sharpest rate since April 2011, climbing to 56.3 in November from 53.6 in October, driven by the strongest increase in export sales in three years.

(2) Hedge clause. The pace of Singapore’s growth in 2018 is expected to moderate but remain “firm,” based on an expected easing in Eurozone and China demand. Also, the Ministry cautioned that “at this relatively advanced stage of the US’s economic recovery, an upside surprise in inflation cannot be ruled out.” It continued: “Should this happen, monetary policy in the US could normalise faster than expected, thereby causing global financial conditions to tighten more than anticipated.” Still, Singapore’s manufacturing sector is expected to continue to expand and provide support on the back of healthy demand in the global semiconductor and semiconductor equipment markets. The Ministry sees 2018 GDP growth likely to come in the middle of its forecast range of 1.5%-3.5%.

(3) Price inflation. With vendors unable to meet demand, delivery times have lengthened, disrupting the supply chain and driving up prices, according to a 12/1 report by IHS Markit. In Taiwan, increases in raw material prices also drove prices higher, leading to the steepest jump in inflation since early 2011.

(4) Valuation. Trading at a forward P/E of 14.3, the MSCI Singapore share price index looks pricey compared with its estimated earnings growth of 9.0% for 2018 (Fig. 13). Trading at forward P/E of 13.9, the MSCI Taiwan share price index looks fully valued compared with its estimated 2018 earnings growth of 10.7%.

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World Equities & QE

December 06, 2017 (Wednesday)

Strategy I: Equities & Central Banks. Equity investors didn’t get the memo sent by the world’s major central banks a couple of months ago. The growth rate of the assets (priced in dollars) held by the Fed, the ECB, and the BOJ rose 12.9% y/y through November (Fig. 1). However, that’s down from the most recent peak growth rate of 23.7% during August 2016. More interesting is that their combined assets have been flat around $14 trillion for the past four months through November, yet stock markets continue to rally around the world.

Arguably, the bull market in global stock markets has been driven to an important extent by the central bankers. That notion makes sense and has been supported by the relatively close correlation between the combined assets of the three central banks and the All Country World MSCI stock price index (in dollars) (Fig. 2). On the other hand, there was also a seemingly close relationship between the assets held by the Fed and the S&P 500 during the current bull market—until the Fed terminated QE asset purchases at the end of October 2014; the S&P 500 then continued nonetheless to rally to record highs (Fig. 3). Let’s have a look behind the curtain to see what the central banks’ wizards are up to:

(1) Fed. The Fed started to reduce its assets during October by discontinuing purchases of securities to replace maturing ones. It’s hard to describe this as the “Great Unwinding” since the Fed is aiming to trim its portfolio by $10 billion per month. The FOMC’s 9/20 “Implementation Note” to the FRB-NY’s Open Market Desk stated:

“Effective in October 2017, the Committee directs the Desk to roll over at auction the amount of principal payments from the Federal Reserve's holdings of Treasury securities maturing during each calendar month that exceeds $6 billion, and to reinvest in agency mortgage-backed securities the amount of principal payments from the Federal Reserve's holdings of agency debt and agency mortgage-backed securities received during each calendar month that exceeds $4 billion.”

So far, the US stock market hasn’t skipped a beat. The S&P 500 is up 4.8% since the Fed started to shrink its balance sheet at the beginning of October, and 30.8% since the FOMC terminated QE purchases at the end of October 2014.

(2) ECB. The ECB hasn’t skipped a beat either in continuing its program of ultra-easy monetary policy. Focusing on the ECB’s weekly balance sheet priced in euros, we can see that the central bank’s assets rose to a record high of €4.44 trillion at the start of December, up €853 billion y/y and €2.45 trillion since late 2014 (Fig. 4).

But the ECB’s balance sheet is set for a subtle pause, as the bank’s President Mario Draghi revealed during his 10/26 monetary policy press conference. He discussed the bank’s latest decision to continue the asset purchase program (APP) at the current monthly pace of €60 billion until the end of this year. Starting in the new year, the ECB’s net purchases will be reduced to a monthly pace of €30 billion until at least the end of September 2018. Importantly, the ECB will reinvest the principal payments from maturing securities. The reinvestments will be sizable at about €10 billion per month, ECB Vice President Vítor Constâncio said at the press conference.

Draghi didn’t say that the reduction in purchases would be permanent. He added: “If the outlook becomes less favourable, or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation, we stand ready to increase the APP in terms of size and/or duration.” But Draghi also left the door open for purchases to be further reduced or halted.

During the Q&A, Draghi seemed pleased with the results, saying: “[M]y understanding is the market reaction was pretty muted to … our policy announcement in spite of the fact that it's a policy announcement of a certain importance, which seems to say that our communication to the market has been pretty effective.” So it seems that there may be less ECB QE to come. However, the ECB’s tapering will be slow and steady, at least for the first nine months of 2018.

(3) BOJ. In Japan, bank reserves balances at the BOJ have soared since the central bank implemented its QE program during April 2013 (Fig. 5). However, the pace of increases has slowed this year and edged down in November.

In our 9/28/2016 Morning Briefing, Melissa and I suggested that Haruhiko Kuroda, the governor of the Bank of Japan, had “just ditched the BOJ’s QE program” because it wasn’t working. On September 21, the BOJ announced its intention to control the shape of the yield curve by pegging the 10-year JGB yield at zero. To do so, the BOJ altered the quantitative target for its annual JGB purchases simply by adding three words: “more or less” than 80 trillion yen.

This year, in an 11/13 speech, Kuroda mentioned the phrase “reversal rate.” Kuroda defined it as the risk that central banks lower interest rates too far, so that that “the effects of monetary easing on the economy reverse and become contractionary.” Kuroda added: “the Bank will continue to pay attention to this risk.” That could be interpreted as an admission that monetary policy in Japan is now too accommodative.

Two weeks later, Kuroda seemingly attempted to take back the admission that the BOJ is in the process of reversing course. In an 11/30 speech with business leaders, he stated: “At this point in time, the Bank has not reached any decisions on an exit policy.” However, that comment was made in the context of a longer speech in which Kuroda argued that an exit from QQE would not pose any “danger.” Even so, Kuroda said that “it makes perfect sense” to him that Japan’s exit should come after those of central banks in the US and Europe.

(4) PBOC. Meanwhile, China’s central bank has increased its balance sheet by $531 billion over the past seven months from April through October (Fig. 6). That gain reverses most of the decline since this series peaked at a record $5.63 trillion during February 2015.

(5) All told. As a result, the total assets of the Fed, ECB, BOJ, and PBOC rose to a record high of $19.6 trillion during October, up 10% y/y. The bottom line is that the global bull market in stocks continues to be supported by the combined QE expansion of the major central banks. So far, there is no disconnection between what the central banks are collectively doing and the global stock market’s performance.

Strategy II: Looking Forward. Earnings have also been powering the bull market in US equities. Analysts’ consensus expectations for earnings has been remarkably strong since mid-2016, when the energy-led earnings recession ended. There has been a steep upward slope in both S&P 500 forward revenues and forward earnings, both on a 52-week basis, since then (Fig. 7).

Forward revenues is a great coincident indicator of S&P 500 revenues. The former implies that the latter will continue to make record highs in coming quarters. The strength in forward earnings is downright remarkable, outpacing its past correlation with numerous business indicators:

(1) Actual earnings. S&P 500 forward earnings rose to a record $145 a share at the end of November, up 17.2% from last year’s low during the week of March 4 (Fig. 8). Actual S&P 500 operating earnings (using Thomson Reuters data) rose to a record $128 per share over the past four quarters through Q3. Forward earnings tends to be a great year-ahead leading indicator for trailing earnings, and supports our forecast that 2018 earnings could be $147 per share.

(2) Leading indicators. Not surprisingly, forward earnings is highly correlated with the Index of Leading Economic Indicators (LEI) (Fig. 9). What is surprising is that forward earnings seems to have been increasing at a faster pace than the LEI over the past year or so.

(3) World exports. S&P 500 forward earnings has also been highly correlated with the volume of world exports (Fig. 10). The same can be said of its relationship with world industrial production (Fig. 11). In both cases, forward earnings is outpacing the other two indicators.

(4) US business sales. In the past, forward earnings also tracked US manufacturing and trade sales very closely and coincidently (Fig. 12). They’ve both been rising into record-high territory in tandem over the past year. But again, the former is outpacing the latter.

(5) Bottom line. Debbie and I started to detect a significant improvement in global economic growth last fall. Industry analysts apparently started doing the same at about the same time, but have shown much more exuberance for the earnings outlook than suggested by the actual upturns in key global economic indicators. They could be right in anticipating a global boom. In any event, it sure looks like more growth is ahead for the global economy.

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Bountiful Profits

December 05, 2017 (Tuesday)

Profits I: Record Highs. The National Income & Product Accounts (NIPA) reports preliminary quarterly corporate profits along with the second revision of GDP. For Q3, that transpired on November 29, when real GDP was revised to 3.3% from the preliminary 3.0%. That solid gain followed Q2’s solid gain of 3.1%. Both nominal and real GDP continue to rise into record-high territory. Not surprisingly, NIPA profits data are doing the same. Let’s review the cornucopia of corporate earnings data compiled in the NIPA:

(1) Aggregate book profits. Pretax corporate “book” profits, i.e., as reported to the IRS, rose to a record high of $2.34 trillion (saar) during Q3 (Fig. 1). That’s up 7.3% y/y. Corporate profits taxes totaled $476 billion (saar) (Fig. 2). Melissa and I have been noting of late that there is a big difference between the NIPA profits tax series and the actual corporate tax revenues collected by the IRS. The former has been consistently higher than the latter (Fig. 3 and Fig. 4).

We are still looking into the reasons for this divergence. It may be that the NIPA, which are focused on measuring current production, may not reflect all the deductions used by companies to lower their actual tax bill. There may also be some issues with respect to how profits earned abroad are treated.

In any event, after-tax book profits rose to a record high of $1.86 trillion (saar) during Q3, up 10.0% y/y (Fig. 5). That solid gain was foreshadowed by the earlier release of S&P 500 aggregate reported earnings, which rose 11.4% y/y through Q3. By the way, S&P 500 aggregate reported earnings tends to account for roughly 50% of after-tax book profits (Fig. 6).

(2) Aggregate and industry cash profits. Again, the NIPA focus on current production since the accounts are designed to measure GDP, which is the broadest measure of the economy’s current production. Therefore, the NIPA adjust profits to eliminate inventory profits and profits related to the accounting for the historical cost of depreciating capital goods and infrastructure. The inventory valuation adjustment (IVA) accomplishes the former, while the capital consumption adjustment (CCAdj) does the same for the latter (Fig. 7).

These two adjustments haven’t changed the underlying story told by book profits. After-tax profits from current production (i.e., on a cash-flow basis) rose 7.7% y/y through Q3 to $1.74 trillion (saar), matching the previous record high during Q4-2014. This series was depressed during 2015 by the energy-led profits recession.

The NIPA show pretax profits from current production derived from domestic and foreign operations. Domestic nonfinancial and financial industries’ profits remain on uptrends but below recent highs (Fig. 8). On a pretax and current production basis, the NIPA series for net profits from the rest of the world has been stuck around an annualized $400 billion rate since the start of the current economic expansion (Fig. 9). However, gross profits receipts from overseas rose to a record high of $733.3 billion (saar) during Q3.

(3) Dividends and retained earnings. The NIPA data show that dividends paid by all US corporations has been flat at a record high around an annualized $1.0 trillion since Q3-2014 (Fig. 10). Retained earnings (i.e., undistributed corporate profits on a cash flow basis including the IVA and CCAdj) has recovered in recent quarters from the energy-led profits recession (Fig. 11). It totaled $740 billion (saar) during Q3, still 13.0% below the record high during Q3-2010.

(4) Cash flow. Nevertheless, corporate cash flow rose to a record $2.38 trillion (saar) during Q3 (Fig. 12). This series is the sum of retained earnings and tax-reported depreciation, which rose to a record $1.64 trillion last quarter. Previously, Debbie and I have noted that while many corporations have been buying back their shares, there has been plenty of cash flow left over to fund capital spending. Besides, quite a bit of the buybacks seems to have been funded by borrowing in the bond market.

(5) Profit margin. While Thomson Reuters’ measure of the S&P 500 operating profit margin was at a record high of 10.8% during Q3, the comparable NIPA after-tax profit margins relative to GDP remain below cyclical highs, but are still high nonetheless (Fig. 13 and Fig. 14). The Q3 margin was 9.5% based on book profits and 8.9% based on cash profits. In any event, Joe and I have observed that following the Trauma of 2008, corporate managements have seemed to be much more focused than ever before on maintaining as high a profit margin as possible.

(6) Bottom line. The bottom line is that US corporations are in great shape.

Profits II: Proprietors’ Income. Almost always ignored in discussions of corporate profits is proprietors’ income, which is included in personal income on a pretax basis including the IVA and CCAdj. It is up 2.7% y/y and in record-high territory. A comparison with pretax corporate profits, also including IVA and CCAdj, shows that proprietors’ income recently has approximated 60% of corporate profits (Fig. 15 and Fig. 16). Here are some definitions from the NIPA:

(1) “Nonfarm proprietors’ income measures the income, before deducting income taxes, of sole proprietorships, partnerships, and other private nonfarm businesses that are organized for profit but that are not classified as corporations. Sole proprietorships are businesses owned by a single individual. Partnerships include most associations of two or more of: individuals, corporations, noncorporate organizations that are organized for profit, or of other private businesses. Other private businesses are made up of tax-exempt cooperatives, including credit unions, mutual insurance companies, and rural utilities providing utility services and farm marketing and purchasing services.”

(2) “Unincorporated businesses … are able to move assets freely between business and personal accounts with little, if any, reporting requirements, and tax liabilities are not separated between unincorporated businesses and their owners. In fact, the income of unincorporated businesses is generally reported on individual income tax returns; while compensation paid to employees is separately reported, the income of the business is not distinguished from the labor of the business owner and therefore reflects the incomes that accrue as a result of the owner’s own labor and entrepreneurship. Similarly, dividend and interest incomes are separately reported but do not distinguish between business and personal receipts.”

(3) “Reflecting the concepts of national economic accounting, nonfarm proprietors’ income in the NIPAs is defined as that arising from current production.”

Obviously, the wellbeing of small unincorporated businesses is an important contributor to the wellbeing of the overall economy. Corporations, partnerships, and sole proprietorships all are likely to increase their payrolls and expand their capacity when their profits are rising. They are likely to retrench when their profits are falling.

We soon should find out whether the Republicans’ tax reform plans include substantial benefits, not only for corporations but for other businesses as well.

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Market Math

December 04, 2017 (Monday)

Strategy I: Panic Attacks & Milestones. I was on CNBC’s “Power Lunch” on Friday at 1:15 pm. The DJIA had plunged 350 points from Thursday’s close through 11:34 that morning, mostly on an erroneous ABC News report. The report implied that Michael Flynn, after pleading guilty to having lied to the FBI, was ready to accuse President Donald Trump of directing him to talk to the Russians during the campaign, whereas that actually happened after the election, during the transition period. By the time I was on the air, the DJIA was down about 100 points and by the end of the day closed down only 40 points. During my interview, I observed that the bull market since March 9, 2009 has been characterized by frequent panic attacks followed by relief rallies to new high ground. I said that Friday’s action was probably just another panic attack that would soon pass.

CNBC’s Michelle Fox wrote up my comments in an article titled “Despite 58 panic attacks, this market is actually melting up, says Ed Yardeni.” Joe and I have been keeping track of the panic attacks during the current bull market in our S&P 500 Panic Attacks Since 2009. We’ve noticed that the panic attacks have become less frequent and less severe. They’ve gone from lasting many days to several days to a few days to a couple of days. This year, there have been two one-day events (Fig. 1). Last year, there were seven such attacks, by our count (Fig. 2).

The previous “impeachment” panic was a one-day event occurring on May 17. We are holding off on adding Friday’s intraday panic until we see if there is any follow through this week. We doubt that we will have to do so, since we believe that we are in the early phase of a meltup.

Of course, one of the characteristics of a meltup is that the market pays little, if any, attention to bad news. Another characteristic of a meltup is how quickly the DJIA blasts through the 1000-point milestones (Fig. 3 and Fig. 4). It has blasted up by 6807 DJIA points since the start of last year, 5899 points since Election Day, and 4469 points ytd. Of course, that’s getting easier to do, since crossing each 1000-point marker becomes less big of a deal percentage-wise as the market flies higher.

Strategy II: Earnings & the Tax Cut. Melissa and I are still working on sorting out why the effective corporate tax rate for all corporations is higher based on the GDP data than it is based on the IRS data (Fig. 5). Meanwhile, as Joe reminds us, the S&P 500 isn’t the economy. So we take the S&P 500 effective tax rate at face value (Fig. 6).

I asked Joe to update the impact of a cut in the S&P 500’s effective tax rate from 25.0% (our estimate for 2017, down from 26.4% in 2016) to 20.0%, assuming that will be the number in the final GOP tax reform bill. Here are his numbers and our forecasts:

(1) For a baseline, Joe estimates that the S&P 500 earnings per share would rise 7.2% from $131.50 this year to $141.00 next year without a tax cut. He calculates the tax cut will add $6 per share, accounting for some offset for the reduction in the deductibility of interest expense.

(2) So we are using $147.00 per share as the earnings number for 2018, which would be an 11.8% increase versus this year. For 2019, we are estimating a 7.1% growth rate, pushing earnings up to $157.50. That should be the earnings number that the market discounts at the end of 2018. Assuming an 18.0 multiple would put the S&P 500 over 2800 by the end of next year. That’s actually our target for mid-2018. For the end of next year, we are using a meltup multiple of 20.0, putting the S&P 500 at 3150.

(3) Meanwhile, the latest analysts’ consensus numbers show S&P 500 forward revenues and earnings continuing to rise into record territory (Fig. 7). These series tend to lead actual revenues and earnings. The same can be said of the S&P 400 and S&P 600 (Fig. 8 and Fig. 9). The standout development for the S&P 500 is that analysts’ consensus estimates for 2018 revenues and earnings remain steady in record-high territory, while 2019 estimates for both are moving to new highs (Fig. 10).

US Taxes: Compared to Others in OECD. Over the past couple of weeks, Melissa and I have questioned whether US corporations really have a competitive disadvantage because the US corporate tax rate is relatively high compared to other countries. Color us skeptical given that while the statutory rate is relatively high at 35%, the effective rate recently has been 26% for the S&P 500, according to S&P data. For all corporations, it has been 20% and 13%, according to GDP and IRS data. Just by coincidence, the Organisation for Economic Cooperation and Development (OECD) recently published its Revenue Statistics 1965-2016. The annual publication provides information on tax levels and structures in OECD countries.

Most of the written portion of the report focuses on the averages for the 35 countries that are members of the OECD country average over periods of time. What piqued our interest was the supporting data released along with the report on the OECD’s database website. We constructed a few charts comparing US taxes to those in other countries for 2016, the latest available dataset. (See Comparing Tax Burdens Among the OECD Economies, or YRI-OECD.)

The OECD data focuses on the following categories of tax revenues: total, individual, consumption (i.e., both sales and value-added tax, or VAT), property, social security, and corporate. Overall, comparing tax revenue to GDP, the US is relatively competitive with other OECD nations. However, drilling down to the components of tax revenues, we found that the results are mixed. Nevertheless, contrary to popular belief, US corporate income taxes are quite competitive relative to other OECD nations! That is, based on the OECD’s measure of tax revenues to GDP. Let’s have a closer look at these data:

(1) US total taxes low. The 2016 data show that the US has low total tax revenues as a percentage of GDP relative to other OECD nations (YRI-OECD, Fig. 1). The US percentage is 26.0% versus 34.3% for the unweighted OECD average for 33 of the 35 OECD member countries, based on available data. This puts the US at the fifth-lowest ratio of tax revenues to GDP among the OECD.

(2) US corporate taxes low. Comparing income, profits, and capital gains of corporations relative to GDP shows that the US is 10^th lowest among the OECD countries (YRI-OECD, Fig. 2). The ratio is 2.2% versus an unweighted average of 2.9% for the available data for 32 OECD countries. However, three large Eurozone economies have lower ratios: Italy 2.1%, France 2.0%, and Germany 2.0%.

New Zealand holds the top spot at 4.7% in corporate income, profits, and capital gains tax revenues. Even Ireland, known for its favorable corporate tax environment, generates more corporate tax revenues as a percentage of GDP, 2.7%, than the US.

(3) US individual taxes high. On the other hand, the US ranks as the 11^th highest in tax revenues on individual income and profits, excluding capital gains, at 9.6% (YRI-OECD, Fig. 3). That’s above the 8.9% unweighted average of the data available for 27 OECD countries. Among the larger OECD economies, higher tax burdens on consumers are found in Canada (11.6%), Sweden (11.5), Italy (11.1), and Germany (10.0). Lower than the US are France (8.6), Japan (5.7), and Korea (3.8).

(4) No VAT in US. The US generates the lowest consumption tax revenues relative to GDP of all OECD nations at just 4.4% (YRI-OECD, Fig. 4). This compares with an unweighted OECD average of 11.2% (based on the 33 countries with these 2016 data available). A notable difference is that sales taxes are imposed by state and local governments in the US; there is no national VAT as in many other countries.

(5) US social security taxes low. US tax contributions to pay for social welfare spending are also quite low on a relative basis. The US ranks 8^th lowest at 6.2% (YRI-OECD, Fig. 5). That’s well below the unweighted OECD average of 9.6% (for the 32 countries with these 2016 data available). At much higher levels are France (16.7), Netherlands (14.8), Germany (14.1), and Italy (13.0).

(6) US property taxes high. One area where the US tax burden is relatively high is property taxes. Property tax revenues as a percentage of GDP is 2.7% in the US, or the 9^th highest in the OECD (YRI-OECD, Fig. 6). Yet for 20 OECD nations, property taxes represent less than 2.0% of GDP. Notably, homeownership tends to be higher in the US than elsewhere.

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Taxing & Shopping Matters

November 30, 2017 (Thursday)

Corporate Taxes: Facts vs Fiction. In the realm of economics, there are lots of theories. There are also lots of urban legends. Both are often propagated despite lots of facts that question their credibility. Daniel Patrick Moynihan, the former senator from New York, once said, “Everyone is entitled to his own opinion, but not to his own facts.” In today’s world of “fake news,” sorting out fact from fiction is a challenge. In the realm of economics, there’s no shortage of data, which can be very helpful in discerning the difference between information and disinformation.

Which brings me to the subject of the US corporate tax rate, which Republicans are aiming to cut. The widespread view, especially among Republicans, is that the corporate tax rate is too high. They aim to pass a tax reform package before the end of the year that will lower the statutory rate from 35% to 20%. I’m all for tax cuts. However, I’m having a problem with the data:

(1) GDP data. Yesterday’s GDP release for Q3 included corporate pretax and after-tax corporate profits. The data show that corporations paid $472.9 billion in taxes over the past four quarters through Q3 (Fig. 1). This series has been hovering in record-high territory around $500 billion since Q2-2014.

Dividing this tax series by pretax profits of $2281.4 billion over this same period shows that the effective tax rate has been significantly below the statutory rate since the start of the previous decade (Fig. 2). During Q3, it was only 20.7%!

(2) Treasury data. But wait … the plot thickens: Actual corporate tax revenues collected by the IRS have been consistently less than the corporate taxes included in the GDP measure of corporate profits since the start of the former data series in 1972 (Fig. 3). For example, over the past four quarters through Q3, the Treasury reported collecting $297.0 billion in corporate tax revenues, 37% less than the $472.9 billion shown by the GDP measure, on a comparable basis.

The shocking result is that the effective corporate tax rate based on actual tax collections was only 13.0% during Q3, and has been mostly well below 20.0% since the start of the previous decade (Fig. 4).

What gives? Which one of the data series is fake news? Melissa and I are still investigating. However, we would follow the money, which tends to support the story told by the IRS data. If so, then Congress may be about to cut a tax that doesn’t need cutting. Or else, the congressional plan is actually reform aiming to stop US companies from using overseas tax dodges by giving them a lower statutory rate at home. We may not be able to see the devil in the details of the bill until it is actually enacted.

Retailing I: Happy Holidays. The retailing industry is wrapping up a miserable year with a bow. Retail stocks have outperformed the broader market since mid-November as consumers rushed through their Thanksgiving meals to go shopping both online and in stores.

The S&P 500 Consumer Discretionary sector is up 3.1% since November 14 through Tuesday’s close, besting the S&P 500’s return of 1.9% and beaten by only Telecom. Here’s the performance derby among S&P 500 sectors over this period: Telecom (7.1%), Consumer Discretionary (3.1), Financials (2.9), Industrials (2.7), Materials (2.2), S&P 500 (1.9), Tech (1.7), Health Care (1.7), Consumer Staples (0.9), Energy (-0.8), Utilities (-1.2), and Real Estate (-1.3) (Table 1).

The outperformance by S&P 500 industries in the retailing business is even more dramatic over the same time period. Apparel Retail (10.2%), Department Stores (10.2), Housewares & Specialties (9.8), Food Retail (7.0), Footwear (6.4), and Apparel, Accessories & Luxury goods (5.2) all are among the 15 best-performing S&P 500 industries we track (Fig. 5). These industries even outperformed Amazon, which rose 5.0% over the same period.

In the wake of a strong Black Friday, the National Retail Federation predicts sales for November and December will rise 4% compared to last year. If that estimate comes through, this will be the strongest holiday sales season since 2014, an 11/25 WSJ article reported. Bloomberg gave credit to the older Millennials, who were the biggest spenders over the holiday weekend. “Older millennials shelled out $419.52 during the five-day stretch, 25 percent more than the overall average,” its 11/28 article noted.

Retailing II: RVs on the Road Again. More positive news about the consumer arrived Monday night when RV manufacturer Thor Industries reported sales that soared past Wall Street analysts’ estimates. Fiscal Q1 sales rose 30.6%, and net income jumped 63.1%. Diluted EPS also rose 63.1%, to $2.43, beating Wall Street’s $1.84 estimate. As importantly, the company’s backlog of orders rose 69.9% to $3.58 billion. The following day, the shares gained 13.3%, or $18.12, to $154.37. We don’t recommend individual stocks, but Thor’s story provides a good insight into the economy:

(1) General economic conditions are good. Thor attributed its strong quarter to “positive employment, wage trends, and general economic conditions,” according to its press release. It also believes the overall demand for RVs is growing as new consumers adopt the RV “lifestyle.” It did not attribute the surge in sales to the recent hurricanes or forest fires, noting that its backlogs were already at record levels before the natural disasters.

(2) Planning to expand capacity. In response to strong demand, Thor has been expanding its manufacturing plants and in June 2016 acquired Jayco Corp. for $576 million. The company plans further expansion in fiscal 2018, with capital spending rising to $185 million, up from $115 million in fiscal 2017.

(3) Consumers are credit worthy. The company doesn’t do a Q&A with analysts, but offers up a number of questions and answers that it compiles, which provide an interesting read on the economy. Thor noted that credit is available to buyers: “Retail lending standards are also healthy and credit is broadly available to credit-worthy consumers with reasonable down payments and normal length of term options available. The retail RV delinquency rate remains below 1% and is significantly below the average delinquency rate of closed-end consumer loans.”

(4) Labor market is tight, and pricing power is limited. Thor also noted that the labor market is “tight” in Northern Indiana, and the company therefore has expanded into other areas, including Idaho. It has seen “modest” cost increases in certain raw materials, reflecting either a rising price in the underlying commodity or other inputs like labor. However, beyond passing on any increase in input costs, the company feels it has limited pricing power because of competition both from others in the industry and those vying for consumers’ discretionary spending dollars generally.

(5) Outlook is bright. Although the current expansion is the longest in the RV industry’s history, Thor remains optimistic that the good times will continue to roll as new consumers enter the market. In addition, it sees continued growth coming from “improving personal income, higher home values, increasing stock prices driving higher personal wealth, continued strength in light truck and sport utility vehicle sales, and the future potential for tax reform that may provide a boost to consumers. In addition, the demographics are as favorable as they have ever been for our industry, and all indicators are that they will remain so for the foreseeable future.” Sound like items that should benefit investors in the broader markets as well.

(6) Performance is great. The S&P 400 Automobile Manufacturers industry, whose sole member is Thor, has roared higher by 54.3% ytd (Fig. 6). The industry is expected to grow revenue by 9.3% over the next 12 months and increase earnings by 13.9%. As long as the cycle continues, it has a reasonable P/E of 16.1.

Earnings: 2018 Is Coming Soon! December 1 used to be when we’d start shopping for a new calendar for the upcoming year. That was, of course, before the iPhone became the center of our lives and eliminated the need for something so yesterday. But calendars are still a big business. Sales of decorative and other calendars increased by 8% in 2016 to $65 million, according to a 12/29/16 NYT article.

The start of December is still a good time to take a look at the sales and earnings growth Wall Street’s analysts are expecting from S&P 500 companies in the upcoming year. Optimism about future results abounds, even as comparisons to a stellar 2017 are tough. Sales growth is anticipated to slow ever so slightly to 5.5% in 2018 from 6.1% this year. Conversely, earnings growth is estimated to accelerate ever so slightly to 11.4% in 2018 from 10.9% this year.

As is often the case, earnings of the sectors underlying the S&P 500 rarely perform in lock step with the overall index, with some expected to be far stronger and others far weaker. Here’s a quick look at which S&P 500 sectors are expected to pick up steam next year and which are expected to lose it:

(1) Accelerating prospects. Consumers are expected to keep doing what they do best: shop. Earnings growth in the Consumer Discretionary sector is anticipated to pick up to 9.1% in 2018 from 5.9% this year. Likewise, higher interest rates and less regulation are projected to finally help the Financials. That sector is expected to grow earnings by 15.6% next year, almost double the 8.7% forecasted for this year. Analysts are also penciling in nice bounces in earnings for Industrials and Materials. Industrials’ earnings are projected to rise to 9.4% in 2018, well above the 3.4% growth expected this year, while Materials’ earnings are expected to rise 18.5% in 2018 versus 13.3% in 2017.

(2) Growing, but slower. It would be tough for the Energy sector to replicate in 2018 the 355.9% earnings growth expected this year as the sector was coming off a depressed 2016. But analysts do see the sector continuing to rebound in 2018, with earnings projected to grow 37.9%. That growth has been revised upwards by 5% over the past month. The Technology sector’s torrid earnings growth of 16.8% this year is forecast to slow to 13.8% in 2018.

(3) Losers still. The only two sectors that are on course to post earnings declines in 2017—Real Estate and Telecom—are expected to post losses once again next year. The Real Estate sector is expected to see a 15.8% decline in earnings this year followed by a 9.7% drop in 2018. Telecom should see its bottom line contract 2.0% this year, then 0.3% next.

(4) Round up. While these are early days, and expectations are bound to change, it’s always good to know where you’re starting when plotting where you’re headed. In that vein, here’s the performance derby for S&P 500 sector earnings growth in 2018 from best to worst: Energy (37.9%), Materials (18.5), Financials (15.6), Tech (13.8), S&P 500 (11.4), Industrials (9.4), Consumer Discretionary (9.1), Consumer Staples (7.7), Health Care (6.8), Utilities (4.7), Telecom (-0.3), and Real Estate (-9.7).

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Barreling Along

November 29, 2017 (Wednesday)

US Economy I: Full Throttle. The US economy is exceeding the speed limit. That limit was around 2% y/y growth in real GDP from the second half of 2010 through Q3 of this year (Fig. 1). However, on a q/q-saar basis, real GDP growth rose from 1.2% during Q1 to 3.1% during Q2, and 3.0% during Q3. The Atlanta Fed’s GDPNow is currently tracking real GDP growth at an annualized rate of 3.4% during Q4.

Meanwhile, the US transportation indicators that Debbie and I monitor show that the trucking industry has the pedal to the metal and railcars are barreling down the tracks. It’s heady stuff:

(1) Trucking. The ATA truck tonnage index jumped to a record high during October (Fig. 2). It is up a whopping 9.9% y/y, the best growth rate since December 2013 (Fig. 3). This index is volatile on a m/m basis. Smoothing it with a three-month moving average shows that it has tended to be a good leading indicator for real business inventories (Fig. 4). So the recent strength in trucking may reflect lots of optimism on the part of retailers about the holiday selling season. That’s a reasonable expectation given that the unemployment rate fell to a cyclical low of 4.1% during October.

Of course, the bricks-and-mortar retailers are fighting back against the online retailers by slashing prices and providing lots of incentives for consumers to come to shop at the malls. Meanwhile, the rising share of online retail sales might be increasing the demand for trucking services to cart merchandise to fulfillment centers and from those centers to the home shopping crowd.

(2) Railroads. The three-month moving average of the trucking index is highly correlated with the 26-week moving average of railcar loadings of intermodal containers (Fig. 5). The latter is confirming the strength in the former. Intermodal railcar loadings has been chugging along into record-high territory in recent weeks.

US Economy II: Happy Days. The optimism reflected in the transportation indexes is confirmed by November’s consumer optimism surveys, which Debbie discusses below. She also discusses November’s regional business surveys, which are also extremely upbeat. Love him or hate him, there’s no denying that one year after President Donald Trump was elected, the economy’s animal spirits remain in high spirits. Here are a few of the highlights:

(1) Consumer surveys. The Consumer Sentiment Index (CSI) dipped this month, following a strong gain during October (Fig. 6). Debbie and I are bigger fans of the Consumer Confidence Index (CCI), which continued to soar this month to the highest reading since November 2000 (Fig. 7).

The CCI has been more sensitive to labor market conditions than the CSI. We particularly like the CCI series showing whether respondents agree that “jobs are hard to get,” or “available,” or “plentiful” (Fig. 8). During November, only 16.9% of them said that jobs are hard to get, the lowest since August 2001. This series is highly correlated with the unemployment rate (Fig. 9). The jobless rate fell to a cyclical low of 4.1% during October. It might have fallen below 4.0% this month! The CCI was up for all age groups during November, though it soared among those who are 55 years old and older (Fig. 10).

(2) Business surveys. Debbie and I monitor the five monthly business surveys conducted by the Federal Reserve Banks of Dallas, Kansas City, New York, Philadelphia, and Richmond. We focus on the averages of their overall business conditions indexes, their new orders indexes, and their employment indexes (Fig. 11). The overall index dipped this month but remained near previous cyclical highs. The composite orders index jumped back near the cyclical high at the beginning of the year. The employment index edged down, but remained very high.

Helping to boost real GDP growth this year has been the recovery in core nondefense capital goods orders (Fig. 12). This series had been depressed by the global recession in the energy sector. It fell 14.9% from a September 2014 peak to a May 2016 trough. Since then, it is up 10.5% through October. The regional composite index for new orders suggests that business spending on durable goods probably stayed strong in November.

German Economy: No Speed Limit on Autobahn. At the same time that the US economy’s cruise speed is showing signs of improving, so is Germany’s. The country’s IFO business confidence index soared to yet another record high during November (Fig. 13). Needless to say, this is a bullish development for the Germany MSCI stock price index, which is up 9.1% ytd and 19.3% y/y (in euros). It certainly looks like a global synchronized boom and a global bull market in stocks based on the performances of the US and German economies and stock markets.

Both economies have clearly achieved the “escape velocities” long awaited by the Fed and the ECB. This means that the Fed will continue Fed Chair Janet Yellen’s policy of gradually normalizing monetary policy under incoming Fed Chairman Jerome Powell. It also means that the ECB may need to reconsider the continuation of its ultra-easy monetary policy sooner rather than later.

So far, the amazing miracle is that inflation has remained amazingly subdued. Debbie and I aren’t that amazed, since we’ve been predicting this would be the case. Nevertheless, we are impressed. Strong growth with low inflation justify currently high valuation multiples, but risk triggering a stock market meltup.

Movie. “Three Billboards” (+) (link) is a quirky movie with quirky characters. It’s a bit like a Coen Brothers movie, and even stars Frances McDormand, who is married to one of the brothers and has appeared in lots of their movies. Like a Coen-made movie, this one takes place in a rural town with lots of goofy characters caught in tenuous positions of committing, hiding, or dealing with a murder in their midst. Also playing an interesting part is Woody Harrelson.

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Electric Lights-Out Orchestra

November 28, 2017 (Tuesday)

Disruptive Tech I: Decentralizing Power. More and more electric devices are cordless, but you still need a cord for their recharging docks. There certainly are more and more cordless electric-powered devices that must be recharged—phones, tablets, watches, and personal assistants, to say nothing of electric cars. It’s turned the power going into the cord into a hot commodity. Our addiction to these electrified gadgets combined with a growing global economy should mean these are the glory days for companies producing turbines that turn gas and coal into electric power. However, both GE and Siemens recently reported their power turbine divisions have fallen on tough times. So this seems like an opportune time to plug into the current state of the electricity market. I asked Jackie to investigate. Here is her enlightening report:

(1) Shocking results. GE’s new CEO John Flannery hosted an investor day recently to explain why results have been disappointing and to give investors some guidance about what the future under his leadership might hold. One of the company’s problem areas is its Power division, where operating profit is expected to fall by 20% this year and another 25% in 2018. The number of heavy-duty gas turbines it sells in 2018 is expected to drop to 65-70 units, which is down by about 30-40 units from this year, according to a transcript of the company’s 11/14 investor presentation. GE’s business of servicing its installed base of turbines is also under transactional and pricing pressure.

Russell Stokes, president of GE’s power business, laid the blame on the impact renewables have had on the power market. “Look, we understand very clearly that the gas markets are challenged by renewable penetration, but we still believe that gas is going to be an important contributor to the energy mix going forward, even though we believe that we’re going to see some significant declines on the need for gas and the utilization of gas in the short term.”

Siemens recently announced plans to cut 6,100 jobs, or 13% of the workforce in its power and gas unit, which manufactures turbines for utilities. Siemens said that worldwide demand for new, large turbines has fallen to about 110 units a year, while manufacturers have enough capacity to supply 400 turbines. In the fiscal year ended September 30, profits fell in Siemens’ power and gas unit.

Both companies find themselves with large exposure to the turbine market after making major acquisitions in recent years. GE’s purchase of Altsom in November 2015 for $9.5 billion made power its largest division. Meanwhile, Siemens announced in May 2014 the $1.3 billion acquisition of Rolls-Royce’s aeroderivative gas turbine and compressor business, followed by a $7.8 billion deal to acquire the oil and gas equipment supplier Dresser Rand in 2015.

(2) Power glut. An 11/16 article in Handelsblatt came up with two reasons for the glut: “When it comes to big power plants, a hoped-for global transition from dirtier coal to clean gas power plants has yet to materialize (perhaps that’s why Siemens joined other German companies in demanding an end to coal power last week). And when it comes to renewable energy, many companies favor smaller, decentralized power solutions to the massive gas turbines that Siemens once thought were the future.”

An 11/16 WSJ article concurred: “Siemens, like GE, has been caught unprepared for governments’ and companies’ shift away from large, fossil fuel-powered plants to renewables, which make electricity in a decentralized way and without the need to move massive amounts of steam through one of Siemens’s mighty turbines. Meanwhile, gas-powered plants haven’t picked up the slack from embattled coal and nuclear businesses as quickly as both Siemens and GE had anticipated.”

The number of global coal plants that started construction in the 12 months prior to January 2017 fell by 62% compared to the year before, according to a report published by CoalSwarm, The Sierra Club, and Greenpeace. Likewise, the number of announced, pre-permit and permitted coal plants fell 48% in the 12 months prior to January 2017 compared to the year before.

The reduction took place primarily in China and India, which together represented 86% of the coal power built globally from 2006 to 2016. “Over 300 GW of projects in various stages of development were put on hold until after China’s 13th Five Year Plan (2016–2020), including 55 GW of projects that were already under construction. A typical coalfired generating unit is 500 MW, or 0.5 GW, in size, with most power stations having two or more such units. In parallel with China’s government-imposed slowdown, India also experienced a slowdown in coal plant development, driven primarily by the reluctance of banks and other financiers to provide further funds,” the report stated.

(3) Where’s the growth? The overcapacity in the power business is even more notable because it’s occurring as the world’s economy is growing. The US economy picked up steam this year, with Q3 GDP coming in at 3.0% (saar), following a nearly identical 3.1% during Q2 (Fig. 1). Meanwhile, global GDP growth should be 3.7% this year, according to the International Monetary Fund.

Historically, rising GDP growth has led to increased electricity usage as populations grow and generate more goods and services. But that hasn’t been the case in recent years, particularly in developed countries.

The Energy Information Administration (EIA) attributes this new development to developed economies’ shift toward service economies and away from manufacturing, which is more energy-intensive. “As more economic activity shifts from lower-skilled manufacturing to services and higher-skilled advanced manufacturing, additional economic activity can be generated without requiring as much electricity use,” according to an 11/20 EIA report.

Indeed, the energy intensity of US manufacturing has been decreasing, according to a 10/19 EIA report. It states: “From 2010 to 2014, manufacturing fuel consumption increased by 4.7%, while real gross output increased by 9.6%—or more than twice that rate—resulting in a 4.4% decrease in energy intensity. … Although many manufacturing establishments are taking steps to reduce their energy consumption, the energy intensity decrease for total manufacturing is mostly the result of a shift of manufacturing output from energy-intensive industries, such as the manufacture of metals, chemicals, paper, and petroleum and coal products, to less energy-intensive industries. If major industries had maintained the same proportions of the manufacturing sector, the energy intensity decline between 2010 and 2014 would have been 0.7% instead of 4.4%.”

As a result, electric demand among the OECD nations is expected to grow 0.9% annually, while non-OECD countries are expected to show 1.9% annual increases through 2040, the EIA projects.

(4) Not so fast. If electric cars get adopted and go mainstream, this slow-growth prediction could quickly need an upward revision, estimates National Grid, which owns the UK’s national transmission network for electricity and gas. In England, electric cars could reach 9 million by 2030, up from 90,000 in July. If that occurs, it could reverse the UK’s falling electricity demand that resulted from increased efficiency of electric items. Demand could surpass the capacity of the Hinkley Point C nuclear power plant by 2030 if cars aren’t charged at off-peak hours, warned National Grid, in a 7/13 article in The Guardian. GE and Siemens certainly hope so.

(5) Charged up numbers. The S&P 500 Electric Utilities index has had a respectable year, gaining 13.9% ytd (Fig. 2). The industry is expected to enjoy 3% revenue growth and 2.7% earnings growth over the next 12 months (Fig. 3). But despite the slim earnings growth, the industry’s forward P/E has risen to 18.0, which is near the highest levels the industry has seen over the past 20 years (Fig. 4). Perhaps investors are instead focusing on the sector’s dividend yield.

Going forward, the industry’s fate may be determined by which grows faster: the electricity supplied by solar power or the demand for electricity to run electric cars. Had GE bought Tesla instead of Altsom, it would have been able to hedge its bet.

Disruptive Tech II: Lights-Out Factories. Robots should certainly be high on the growing list of items increasing demand for electricity. The number of robots populating factory floors continues to hit new records, as their benefits are hard to ignore. Robots didn’t need to take a nap after Thanksgiving dinner. Nor do they want time off to go shopping on Black Friday. Let’s take a look at some of the latest trends, which have humans both optimistic and fearful:

(1) Record sales. Global sales of industrial robots increased by 18% to $13.1 billion in 2016, according to an industry report by the International Federation of Robotics (IFR). That figure typically doesn’t include the cost of software, peripherals, and systems engineering. If it did, the cost for the entire robotic system would be about three times higher.

Robot unit sales in 2016 increased by 16%, to 294,312, the fourth consecutive, annual record in unit sales. IFR expects sales to remain robust, increasing by at least 18% this year and by at least 15% on average per year from 2018 through 2020.

In 2016, five major markets represented 74% of the total sales volume of robots. The top markets are China, South Korea, Japan, the US, and Germany. Almost a third of all industrial robots are in China, and sales to that nation are far faster, at 27% in 2016, than to other countries. The largest users of robots are the automotive and electronics industries.

(2) Partners, not foes. Robots have become increasingly flexible and able to work alongside humans. Those that do are called collaborative robots, or “cobots,” of course. A 5/5/16 FT article explained: “Traditionally, industrial robots have been locked behind cages, their heavy bulk and rapid movements making them unsafe for human interaction. They have required highly trained programmers to set their tasks and, once installed, were rarely moved.

“Now, a lighter weight, mobile plug and play generation is arriving on the factory floor to collaborate safely with human workers thanks to advances in sensor and vision technology, and computing power. Get in their way and they will stop. Program them with a tablet or simply by moving their arms in the required pattern; no coding is necessary. And if the robot is needed in a different part of the factory—unlike the heavy robotic arms that populate the world’s automotive factories and are bolted to the floor—they can be easily moved.”

These cobots are much less expensive than the larger industrial robots. Their lower price point and greater flexibility may allow smaller companies to purchase cobots and accelerate their deployment.

(3) Internet of Factories. The number of robots deployed is expected to accelerate as factory floors use more sensors to get “smarter.” Right now, sensors are being used for modest functions. For example, a Nokia plant in Finland uses humidity and temperature sensors to maintain the factory’s automation environment, according to a 6/18 column in Forbes. Manufacturers can also place sensors on pallets of goods to track the goods’ location, an 11/1 FT article reported. Sensors can also be placed inside transport vehicles and the final destination factory to track the arrival and departure of goods.

But these are just baby steps compared to the future that’s ultimately envisioned. Some call it “Industry 4.0,” where robots are integrated into factory-wide networks of machines and systems. “Robot manufacturers are already developing and commercializing new service models: these are based on real-time data collected by sensors which are attached to robots. Analysts predict a rapidly growing market for cloud robotics in which data from one robot is compared to data from other robots in the same or different locations. The cloud network allows these connected robots to perform the same activities. This will be used to optimize parameters of the robot’s movement such as speed, angle or force. Ultimately, the advent of big data in manufacturing could redefine the industry boundaries between equipment makers and manufacturers,” concludes a 9/29 article in Robotics Tomorrow.

Today, three people operate the above-mentioned Nokia factory. Ultimately, the company aims to have a “lights out” facility, where no human operators are required—and it can run with the lights off. We have no doubt it’s just a matter of time.

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High Flyers

November 27, 2017 (Moday)

Strategy I: Hard-Charging Bull. Before we left for our Thanksgiving break, Joe and I had a closer look at this year’s bull market through Monday of last week. We wanted to see if the 10 leading industries so far this year are showing frothiness, thus confirming that a meltup might be underway. To cut to the chase, we found that the 15.3% rise in the S&P 500 through 11/20 has been supported by solid fundamentals for both the overall market as well as most of the top 10 hard-charging industries leading this year’s stampede. In other words, so far so good as far as we are concerned. Let’s have a closer look at the market:

(1) Lots of industries advancing. Of the 124 S&P 500 industries we track, 53 have been beating the S&P 500 (Table 1). On the other hand, of the 71 that are underperforming the S&P 500, 38 are actually down for the year. The losers include retailers, energy companies, telecoms, and consumer staples companies. The winners are mostly in the IT, Health Care, Materials, and Consumer Discretionary sectors.

(2) Broad advance. The ratio of the S&P 500 to the S&P 100 stock price indexes has been on a slight uptrend this year, confirming that the market advance is broad-based (Fig. 1). As of the 11/17 week, the percentage of S&P 500 companies with positive y/y comparisons was 74.3% (Fig. 2). The percentage of S&P 500 companies trading above their 200-day moving averages was 66.3% as of the 11/17 week (Fig. 3). The NYSE advance/decline line has been rising to new record highs along with the NYSE composite index (Fig. 4).

(3) Solid fundamentals. Over the past couple of weeks through the 11/16 week, industry analysts have been raising their S&P 500 revenue estimates for both 2018 and 2019 (Fig. 5). They now expect that revenues will grow 6.1% this year, then 5.4% and 4.9% during 2018 and 2019, respectively. As a result, S&P 500 forward revenues continues to set new record highs, and seems to have been doing so at a faster pace over the past couple of weeks. Not surprisingly, the same can be said of S&P 500 earnings, as the forward profit margin rose to a record 11.1% during the 11/16 week. Industry analysts are currently forecasting that S&P 500 earnings will rise 10.8% this year, and 11.3% and 10.1% over the coming two years.

Strategy II: Magnificent 10. And the S&P 500 industry winners are (on a ytd basis, through 11/20): Semiconductor Equipment (75.9%); Casinos & Gaming (65.8); Homebuilding (62.9); Application Software (58.2); Home Entertainment Software (57.5); Health Care Supplies (49.3); Auto Parts & Equipment (45.9); Life Sciences Tools & Services (45.4); Internet & Direct Marketing Retail (43.8); and Technology Hardware, Storage, & Peripherals (43.5). Let’s look at the fundamentals of some of these S&P 500 high-flying industries:

(1) Semiconductor Equipment. The forward earnings of this industry has soared by 64.7% y/y through the 11/16 week (Fig. 6). Industry analysts are expecting earnings to grow 65.7% this year and 24.2% and 7.0% over the next two years. As a result of the remarkable jump in forward earnings yield, the forward P/E remains very reasonable at 14.4 (Fig. 7).

(2) Homebuilding. The forward earnings of this industry is up 22.7% y/y (Fig. 8). The forward P/E was 12.9 during the 11/16 week. Industry analysts are projecting earnings growth rates of 10.3% this year, 26.0% during 2018, and 10.7% during 2019.

(3) Application Software. The forward earnings of this sector remains below its highs of the late 1990s, but it is up 34.0% y/y (Fig. 9). This has been a high-priced industry since 2014, with the forward P/E stable around 35.0. But industry analysts are projecting double-digit earnings growth rates of 21.1% this year, and 25.8% and 22.9% over the next two years.

(4) Internet & Direct Marketing Retail. This industry is in the Consumer Discretionary sector and has several high flyers (AMZN, EXPE, NFLX, PCLN, and TRIP). It’s certainly one of the frothier industries in the S&P 500, as forward earnings has actually stalled, albeit at a record high, while the forward P/E rose from 51.9 a year ago to 72.1 during the 11/16 week (Fig. 10). On the other hand, the industry’s forward revenues has been flying to new highs (Fig. 11). Industry analysts are predicting the following combinations of revenues and earnings growth rates for 2017 (28.3%, 8.7%), 2018 (26.7, 36.8), and 2019 (19.8, 40.5).

(5) Technology Hardware, Storage & Peripherals. The forward earnings of this industry, which includes Apple (AAPL, HPE, HPQ, NTAP, STX, WDC, and XRX), is up 24.9% y/y to a new record high (Fig. 12). Yet it remains relatively cheap, with a forward P/E of 13.9 (Fig. 13).

US Tax Reform: Counting Fence Sitters. Thirteen Republicans voted against the bill. Twelve of them are from states with high taxes, observed the 11/16 WSJ. To pass the Senate’s alternate version of the tax bill in the full Senate, the GOP can’t lose more than two of the potential 52 votes; no Democrats are expected to support the bill.

For now, the Senate bill is moving forward. Members of the Senate Finance Committee voted 14 to 12 in favor of their version of the tax plan also on 11/16. The bill will be brought to a vote in the full Senate as soon as this week. The next step will be to get the bill into a conference committee to reconcile the House and Senate plans sometime in early December, as explained the WSJ’s Gerald Seib in an 11/16 video.

Both the Senate vote and the reconciliation process could prove challenging for the bill’s passage. Any amendments to the Senate plan geared to please those senators who haven’t proclaimed support for the bill yet would require tweaking other parts of the plan. That’s because the budget process set a ceiling of $1.5 trillion in cuts over the next decade. (For more, see our 11/15 Morning Briefing).

In an 11/19 interview with the WSJ, Vice President Mike Pence was asked whether he believed the Senate bill had enough votes to move forward, especially given the uncertainty around the 12/12 Alabama Senate race. Pence responded: “We believe we’ll have the votes. … But we’re taking nothing for granted.”

So far, about a half-dozen GOP senators have taken issue with provisions in the Senate plan. Lots of press stories have hyped these senators’ opposition to the tax bills. But listening closely to some of their comments, Melissa and I think that there’s a decent chance that their concerns will be ironed out through the legislative process. Let’s have a look at what beefs these GOP senators on the fence have with the post-Turkey Day bill:

(1) Sen. Ron Johnson (concern: insufficient pass-through provisions). Johnson was the first GOP senator to voice opposition to the Senate plan, reported the media headlines during mid-November. The Wisconsin senator is primarily concerned that the cuts for small businesses, particularly pass-throughs, aren’t as generous as the earlier White House tax reform framework suggested. However, according to an 11/20 Bloomberg article, Johnson is expected to vote “yes” at the end of the process. Recently, he said: “I’m encouraged by the information and the cooperation I’m getting right now” from the tax writers in the Senate Finance Committee.

(2) Sen. Bob Corker (concern: adding to the debt). Corker technically can vote either way without any political pressure, as he has announced that he is retiring after 2018. The senator from Tennessee told NBC’s Chuck Todd on 10/1 that he wouldn’t support a tax reform plan that adds “one penny to the deficit.” But Corker’s tone was softer on 10/26 when he told CNBC: “If we do it right, and we do the corporate things we're talking about, I'll believe we'll get the dynamic score that is necessary” so as not to balloon the deficit.

(3) Sen. Jeff Flake (concern: adding to the debt). Like Corker, Flake recently announced that he will not seek reelection in the next cycle. And currently, Flake is engaged in a social media feud with the President, but he said that won’t impact his decision, according to Reuters. In an 11/9 statement, Flake said: “I remain concerned over how the current tax reform proposals will grow the already staggering national debt by opting for short-term fixes while ignoring long-term problems for taxpayers and the economy.” But he added: “I look forward to working with my colleagues to deliver on the goal of crafting tax reform in “a fiscally responsible manner.”

(4) Sen. Susan Collins (concern: repealing the healthcare mandate). Maine’s Collins didn’t say she would vote “no” on the Senate bill in an 11/19 interview on CNN. But she did express specific opposition to the late introduction of the provision to repeal the individual healthcare mandate in the Senate bill. Even so, she said she expects the bill to be amended from its current form and hopes that the Senate bill will follow the lead of the House in excluding healthcare as well as a couple of other provisions.

(5) Sen. Lisa Murkowski (concern: repealing the healthcare mandate). CNN covered Murkowski’s interesting position on 11/20 in an article titled: “Lisa Murkowski saved Obamacare. But here's why she may not abandon Republicans on taxes.” Murkowski is not pleased that the debate about the individual mandate has made its way into tax reform. On the other hand, CNN observed that the tax plan will be combined with a bill that is important to the senator from Alaska. It would permit oil and gas drilling in Alaska’s Arctic National Wildlife Refuge (ANWR). Murkowski chairs the committee that was previously chaired, from 1995 to 2001, by her father, who had unsuccessfully tried to open ANWR for drilling.

(6) Sen. John McCain (concern: defense spending). The Arizona senator views the tax bill favorably so far, the 11/17 WSJ observed. But as chairman of the Armed Services Committee, McCain is pushing to ensure that the military gets its fair share for the rest of this year. However, he hasn’t yet “drawn a direct connection between the two issues.”

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Thanksgiving

November 21, 2017 (Tuesday)

Holiday Season: Giving Thanks. This is the time of year we all give thanks to our families for being there for us. We thank our friends for being our friends. We should give thanks to the men and women serving our country as first responders and in the military. We should thank our nation’s Founders for our political system of checks and balances. And of course, we at Yardeni Research thank you for your loyal support of our research service. We wish you all the very best of times with your family and friends during Thanksgiving.

Strategy: Devilish Bull Market. I would also like to thank Ron Howard and Tom Hanks. The former directed “The Da Vinci Code” (2006), and the latter starred in the film as Robert Langdon, a professor of religious iconography and symbology from Harvard University. It was during March 2009 that I morphed from being an investment strategist to being a symbologist. Back then, I was struck by the fact that the S&P 500 made an intraday low of 666 on March 6, 2009. I concluded that we had gone to Hades and would scramble to get the hello out of there.

The number 666 is associated with the Devil. After bottoming at that devilish number, the S&P 500 proceeded to double from there to 1332 by February 14, 2011, and triple from there to 1998 by August 26, 2014. If it quadruples from there, the S&P 500 would rise to 2664. That’s only 3.3% above Friday’s close (Fig. 1). If it gets there, the S&P 500 would be up 300% from the 666 low. It is already the second best bull market since 1928, only bested by the 582% gain from December 4, 1987 to March 24, 2000.

There are no devils in the details of getting to 2664 on the S&P 500. The forward earnings of this index rose to a record high of $144.29 during the week of November 16 (Fig. 2). The index’s forward P/E was 17.9 that week (Fig. 3). Those two numbers put the S&P 500 at 2579. Getting to 2664 would require only a minor increase in the S&P 500 forward P/E.

Given that the holiday season is ahead, Joe and I are already in a festive mood. We are raising our mid-2018 S&P 500 target from 2600-2700 to 2700-2800. The top end of this range is about 8% above the current S&P 500. If the multiple stays at 18.0, the forward earnings would have to rise to $155.67 by mid-2018. That’s realistic given that industry analysts are currently projecting $160.21 by the end of next year.

If the S&P 500 blows through 2700 and then 2800 by the end of this year or early next year with the forward P/E surpassing 20.0, we will be in a meltup most likely triggered by the passage of tax cuts before the end of this year.

US Economy I: Devilish Deficit. There is another devilish number out there. Once again, it is 666. The fiscal 2017 federal budget deficit reached $666 billion during the 12 months through September, before widening to $683 billion in October (Fig. 4). The 12-month sum of federal outlays rose to a record $4.0 trillion in October, while receipts have been relatively flat around $3.3 trillion since early 2016 (Fig. 5). What’s boosting outlays and weighing on receipts? Let’s have a closer look:

(1) Outlays. Federal outlays on goods and services, as measured in the GDP accounts, has been remarkably flat around $1.3 trillion since the start of the current economic expansion during 2009 (Fig. 6). The same cannot be said for federal spending on redistributing income. The sum of such outlays on Medicaid, Medicare, Income Security, and Social Security rose $828 billion since the start of 2009 to a record $2.6 trillion during the 12 months through October of this year.

Federal government outlays on redistributing income now account for 65% of total federal government outlays, up from 43% in early 1987 (Fig. 7).

(2) Receipts. Federal government revenues have flattened out over the past year as individual income tax receipts slowed, while corporate tax receipts declined slightly (Fig. 8). On the other hand, payroll taxes rose to a record high of $1.2 trillion over the past 12 months through October.

By the way, there seems to be a fairly large discrepancy between the National Income and Product Accounts (NIPA) measure of corporate taxes and the taxes actually collected by the IRS (Fig. 9). During Q2-2017, the NIPA number was $479.6 billion (based on the four-quarter average of the saar data), while the 12-month sum (through June) of the Treasury’s data showed $299.4 billion. This implies that the effective tax rate paid by corporations is even lower than the 21.3% shown during Q2-2017 in NIPA and well below the statutory rate (Fig. 10). We calculate that it was 13.3% during Q2-2017 based on the corporate tax receipts actually received by the IRS over the prior four quarters.

Could it be that Congress is about to cut the statutory corporate tax rate from 35% to 20%, which will amount to an effective tax increase on corporations? That’s what the data show!

(3) Deficit. It’s a wee bit unnerving to see that the federal deficit was $666 billion over the past fiscal year. I’m not concerned about that as a symbologist but rather as an investment strategist. Over the past year, the economy has performed very well, with the unemployment rate falling to a cyclical low of 4.1% during October. Arguably, the economy is at full employment. So why are we still running such a huge deficit? Now multiply that number by 10 years and add $1.5 trillion to this deficit if the GOP tax cuts are enacted. The result is another $8 trillion in federal government debt on top of the current $14 trillion. If interest rates ever go up again, watch how fast the debt will compound.

US Economy II: Leading Higher. Let’s be thankful that the Index of Leading Economic Indicators rose 1.2% m/m during October to a new record high (Fig. 11). It is leading the way for the Index of Coincident Economic Indicators (CEI), which rose to another record high last month, as Debbie discusses below. The latter is up 1.9% y/y, confirming that the growth rate in real GDP on a y/y basis is still running around 2% (Fig. 12).

It was back in 2014 that Debbie and I concluded that based on the past five cycles in the CEI, the next recession wouldn’t happen until 2019 (Fig. 13). That wasn’t a forecast. It was a benchmark based on the average length of expansion periods following the recovery back to the previous high in the CEI. The past five post-recovery expansion periods lasted from 30 months to 104 months, averaging 65 months. The CEI rose to a new record high for the first time during the current expansion during February 2014, according to the most recent data. Add 65 months, and the next recession won’t start until July 2019 according to the benchmark model.

Stock investors seem to have come to a similar conclusion recently, namely that the economy has time to keep growing before the next recession hits. Meanwhile, our Weekly Leading Index remains in record-high territory, and bullish for stocks (Fig. 14).

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Giving Thanks

November 20, 2017 (Monday)

US Economy: Thanks for the Jobs. Washington’s politicians like to take credit for creating jobs. Washington’s macroeconomic policymakers like to claim that their policies have moderated the business cycle. I continue to marvel at how well our economy performs despite Washington’s meddling. In our economy, which remains relatively competitive and entrepreneurial, profitable businesses create jobs. Profitable businesses have the resources to grow by hiring more employees and expanding capacity. In our capitalist economy, businesses have a tendency to increase their profits. Washington’s policies can either slow down this natural process or move out of the way and let businesses do what they do best, i.e., grow their businesses.

In this context, Trump’s proposal to cut corporate tax rates and reduce government regulation on business is to be welcomed. We will soon find out whether the former may be harder to accomplish than the latter. Congress is in the midst of the messy process of passing major tax reform legislation that includes corporate tax cuts. Odds are, it will succeed. Large corporations won’t benefit much because they’ve been gaming the tax code to lower their effective tax rate for many years. Smaller corporations, however, should benefit significantly. That’s important, because ADP data show that smaller companies tend to do most of the hiring in the US. Consider the following:

(1) Small business owners survey. Last week, the National Federation of Independent Business released its monthly survey of small business owners. Debbie and I track the less volatile six-month averages of the percentages of them who say that their most important problem is one of the following: poor sales, taxes, government regulation, or credit conditions (Fig. 1). From October 2008 through July 2012, poor sales was the most frequent response in the survey. From 2014 through early 2016, it was a virtual tie between taxes and regulation.

Over the past 12 months through October, the percentage saying that regulation is the biggest problem dropped from 19.5% to 15.7% (Fig. 2). This percentage rose during the late 1980s through mid-1990s. It then mostly fell through 2008. It rose sharply under the Obama administration.

So far, small businesses are confirming that the Trump administration is providing them with regulatory relief. Taxes now show up in the survey as the most frequently cited problem faced by small business. If Congress cuts corporate tax rates, then there won’t be much for small business owners to complain about.

Actually, the NFIB survey shows that the latest problem for small business owners is finding workers. During October, 35.0% of them said that they have job openings, while 52.0% said that they have found few or no qualified applicants for those openings (Fig. 3).

The Small Business Optimism Index soared after Trump was elected, and continues to fluctuate around this year’s cyclical high, which matches the optimism levels of 2003-04 (Fig. 4). It could match or exceed the record high of July 1983 if corporate taxes are cut.

(2) ADP payrolls. Small and medium companies do most of the hiring in our economy. That makes sense, since they aspire to grow their businesses into big ones. ADP has compiled private-sector payroll employment data since the start of 2005 for small (1-49 employees), medium (50-499), and large (over 500) firms. Since then through October of this year, small and medium firms have hired 6.5 million and 5.7 million workers, respectively, while large firms have added just 1.7 million to their payrolls (Fig. 5). During October, small and medium companies accounted for 41.1% and 36.0% of private-sector employment, while large ones accounted for just 22.9% (Fig. 6).

(3) Forward revenues and earnings. S&P 600 SmallCap forward revenues rose to a record high during the 11/9 week (Fig. 7). Industry analysts are forecasting revenues growth of 0.6% this year, 6.1% during 2018, and 5.5% during 2019. Not surprisingly, S&P 600 forward earnings was also at a record high during the 11/9 week. Industry analysts are estimating earnings growth of 4.9%, 18.3%, and 14.1% this year and over the next two years.

Strategy: Thanks for Revenues & Earnings. Joe reports that S&P 500 revenues and earnings data were released last week. On balance, there is much to be thankful for, thank goodness, since Thanksgiving is around the corner. Let’s review the cornucopia of news we should be thankful to receive:

(1) Revenues. S&P 500 revenues per share rose 6.0% y/y to a record high during Q3 (Fig. 8 and Fig. 9). The growth rate in this series on an aggregate (rather than per-share) basis is highly correlated with the comparable growth rate in US manufacturing and trade sales, which was up 6.4% during September. Growth rebounded from the energy-led revenue recession during 2015 (Fig. 10 and Fig. 11).

(2) Earnings & margins. S&P 500 operating earnings per share (Thomson Reuters data) rose 6.8% during Q3 to a record high (Fig. 12 and Fig. 13). The operating profit margin per share remained at a record high of 10.8% during Q3.

(3) Forward revenues & earnings. The weekly time series for S&P 500 forward revenues is a coincident indicator of S&P 500 quarterly revenues (Fig. 14). The former has been climbing on a steep vertical uptrend in record-high territory since early 2016 through the 11/9 week.

S&P 500 forward earnings has been following the same trajectory as forward revenues. The former is usually an excellent year-ahead leading indicator of actual four-quarter trailing operating earnings (Fig. 15). The only exception is that forward earnings never anticipates recessions.

(4) Sectors. Joe reports the following performance derby for the y/y operating earnings growth rates of the S&P 500 sectors (based on Thomson Reuters data): Energy (154.5%), Information Technology (20.5), S&P 500 (6.8), Health Care (6.1), Consumer Discretionary (6.0), Consumer Staples (4.7), Industrials (0.0), Telecom Services (-0.6), Real Estate (-0.9), Utilities (-5.7), Financials (-6.9), and Materials (-11.4). All in all, Q3’s overall performance would have been better but for the hit that property and casualty insurance companies (in the Financials sector) took from a couple of nasty hurricanes.

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Looking a Lot Like Xmas

November 16, 2017 (Thursday)

US Economy: Rolling Along. After yesterday’s retail sales report, the Atlanta Fed’s GDPNow model’s forecast for Q4 real GDP was lowered from 3.3% to 3.2%. That’s still above 3.0%, as were the actual results for the previous two quarters: up 3.1% during Q2 and 3.0% during Q3. There may be a pattern here, one of quickening economic activity following sluggish growth around 2.0% y/y since mid-2010 (Fig. 1). The latest GDPNow estimate implies a 2.6% Q4-to-Q4 growth rate, up from 1.8% last year.

As Debbie and I noted in the 11/7 Morning Briefing, since 2010, there has been a tendency for Q1 to be the weakest quarter of the year (Fig. 2). It was up only 1.2% this year and 0.6% last year. So the first quarter of next year could provide some more insight on whether the pace of growth is improving if it comes in at 2.0% or more, in our opinion. There are mounting signs of this happening in the weekly and monthly indicators:

(1) Transportation indicators. Retailers and other businesses must be expecting a strong holiday season given that both intermodal railcar loadings and trucking tonnage have been soaring to new highs in recent months (Fig. 3).

(2) Business sales. October retail sales data were released yesterday, as Jackie and I discuss below. Total business sales data were also released for September. Business sales includes manufacturing shipments and distributors’ sales. So it includes only goods; all services are excluded. Total business sales soared to new highs both including and excluding petroleum products (Fig. 4). It is up 6.4% and 4.8% y/y including and excluding petroleum. Those are solid revenue gains.

US Retail: Back to the Past? Retailers reported miserable Q3 results. Actually, that’s an understatement. Results were horrific. Most reported negative same-store sales, putting a chunk of blame on the hurricanes and the unseasonably warm fall weather. But a funny thing happened. Despite the awful results, some of the most beleaguered retailers’ shares rallied over the past five days through Tuesday even as the S&P 500 declined.

Could it be a sign that the long-suffering industry has hit bottom? Or are investors just expecting a bounce in Q4, presuming that weather trends return to normal? As we’ve noted before, consumers are healthy and certainly have the ability to spend. They just haven’t been spending at brick-and-mortar retailers, particularly the ones that sell clothing.

The S&P 500 Consumer Discretionary sector has risen 13.9% ytd through Tuesday’s close, dragged down by the S&P 500 Department Stores (-28.7%), Automotive Retail (-20.5), Apparel Retail (-13.2), and Specialty Stores (-9.8) (Fig. 5). But the areas where consumers are spending have performed splendidly, including the S&P 500 Casinos & Gaming index, up 63.3% ytd, Homebuilding (60.7%), Home Improvement Retail (21.5), Auto Parts & Equipment (43.8), Hotels, Resorts, & Cruise Lines (40.3), and Restaurants (19.9) (Fig. 6 and Fig. 7).

However, investors appear to have started bargain-shopping. Over the past week, Department Stores rose 6.1%, Automotive Retail picked up 2.8%, Specialty Stores gained 2.6%, and Apparel Retail added 0.6%, all while the S&P 500 lost -0.5%. I asked Jackie to have a look at whether the shopping spree will continue. Here are her observations:

(1) Healthy consumers. With jobs plentiful and debt service manageable, consumers should have plenty of spare change to fund a trip to the mall or the Internet. After a slow grind down from a peak of 10.0% in October 2009, unemployment was down to 4.1% during October (Fig. 8).

Meanwhile, household debt levels have returned to their pre-recession highs, though the composition of that debt has changed, with mortgage debt and home equity borrowing down sharply while outstanding student loans and auto loans have moved in the opposite direction (Fig. 9 and Fig. 10). Fortunately, the rise in debt still appears manageable. The household debt service ratio—or the ratio of debt service payments to disposable personal income—is at record lows (Fig. 11).

(2) Money to burn. The tougher question is: Where will consumers spend their hard-earned cash? Debbie tracks the three-month average of real retail sales, which was up 1.9% (saar) in October (Fig. 12). Excluding autos, gasoline, building materials, and food service, retail sales contracted 1.0% (saar) but remain at a very high level, showing signs of life with a 0.5% increase in October.

Consumers certainly have been pouring money into their homes. Retail sales of furniture and home furnishings have returned to prerecession highs. Meanwhile, spending on building materials and garden equipment has hit a new high that exceeds the prerecession levels. Not surprisingly, Home Depot reported strong earnings on Tuesday. Same-store sales in Q3 rose 7.7% in the US, and earnings per share jumped 15.0%, helped by hurricane-related sales. Its shares climbed 1.6% Tuesday, bringing its ytd gain to 25.3%.

Consumers aren’t spending in electronics and appliance stores. Nor are they spending in sporting goods, hobby, books, or music stores. The amount being spent at pharmacies and drug stores should be of some concern, as it’s near all-time highs. The more consumers spend on drugs, the less they have to spend on trendy clothing. The same can be said about Apple’s iPhone X. The amount being spent at non-store retailers, i.e., on the Internet, also poses a problem for traditional retailers. And perhaps that explains why sales at department stores have declined so precipitously in recent years (Fig. 13 and Fig. 14).

Sales at department stores have fallen 31% since 2005; however, they appear to have bottomed at a very low level over the past year. So while Q3 same-store-sales fell 4.0% at Macys and rose only 0.1% at Kohl’s, shares of the former jumped more than 12% over the past five trading days and shares of the latter added 3.7%. At Dick’s Sporting Goods, Q3 same-store sales dropped 0.9%, but the shares rose 4.9% over the past five trading days.

There’s no denying that many of these unloved retail areas are cheap. Earnings for the S&P 500 Department Stores industry is expected to drop 8.6% over the next 12 months, but the industry’s forward P/E has fallen to only 9.2, close to the lows of the recession (Fig. 15 and Fig. 16). The forward P/Es of Specialty Stores, 17.3, and Apparel Retail, 15.4, aren’t quite as attractive relative to these industries’ forward earnings growth rates of 9.6% and 6.0%.

While there’s no guarantee that the one-week rotation into unloved areas of retail will continue, a Q4 rebound from a miserable Q3 would certainly make a nice holiday present.

Batteries: Charging Ahead. Most of the ink that is spilt on Tesla concerns the company’s battery-powered cars. But the company also sells batteries for grid energy storage, and, thanks to the company’s 2016 acquisition of SolarCity, it is a major producer of solar panels. This year, Tesla has had an opportunity to show off its non-auto capabilities by helping two nations with power problems: Australia and Puerto Rico. While the situation in each country is unique, both provide a wider picture of Tesla’s product offerings and how electric generation and storage may change in the future. Here’s Jackie’s report on this disruptive technology:

(1) Energy Down Under. In Australia. they call it the “Climate Wars.” The country, which is largely dependent on coal-fired electric plants, has had a rocky experience trying to go green. Coal is used to produce 60% of Australia’s energy, down from 80% a decade ago. The nation had made a big push to use more renewable energy and shut down coal-fired electric plants. South Australia and Queensland aimed to get half of their electricity from renewable sources, with gas-powered plants used as a backup.

But then in February, a blackout hit 90,000 homes in Southern Australia in the midst of a heat wave. “As temperatures rose above 105 degrees Fahrenheit, a local power plant couldn’t get enough gas to meet the additional demand, and sources such as wind and solar couldn’t fill the gap,” a 10/17 WSJ article reported. The inability to access natural gas in Australia is ironic since the country is one of the largest exporters of liquefied natural gas, or LNG. “In the week that Adelaide’s February blackout cut power to 90,000 homes, five ships left Gladstone carrying out 314,000 tons of LNG altogether, according to the port operator. That’s enough to generate electricity for roughly 750,000 Australian homes for a year, according to calculations for the Journal by the Australian Bureau of Statistics,” a 7/10 WSJ article noted.

The February blackout wasn’t an isolated event. “In March, Australia’s largest aluminum smelter cut production and laid off workers because it said it couldn’t secure enough cheap energy. During one blackout last year, some families lost embryos in an in-vitro-fertilization clinic with no backup generation, according to a government-commissioned report. In February, some tuna fishermen watched catches rot because freezers shut off,” the 7/10 WSJ reported. In addition to poor service, Australia’s electricity is among the most expensive in the world.

Since the blackout, more natural gas has been retained in Australia, and more land has been made available for drilling for gas. In addition, Tesla agreed to build the world’s largest lithium-ion battery system. The 100-megawatt system stores energy from a wind farm. Elon Musk offered to build the battery installation in 100 days or deliver it for free. The clock started on September 29, when a grid agreement was signed, DailyMail.com reported on 10/2. South Australia is counting on the storage capacity to be in place by December, when summer’s hot temperatures mean electricity demand surges. Tesla will either enjoy a PR coup or face a PR disaster.

(2) Caribbean sunshine. Hurricane Maria wiped out Puerto Rico’s electric grid on September 20, and not much has been done to repair it since. As of November 9, the country’s only utility, Prepa, has brought a little more than 40% of its generating capacity back online, according to an 11/11 article in Quartz. Prepa was in bankruptcy protection prior to the storm and generates more than 40% of its electricity using oil-fueled generators. The lack of infrastructure and perpetually sunny skies could make Puerto Rico a prime candidate for the mass adoption of solar power.

The Quartz article explains, “Solar power companies are moving just as quickly to set up micro-grids: local power systems with battery storage, which can operate independently from the main grid. Houston-based Sunnova, which already has some 10,000 customers with solar panels on the island, is sending them batteries. Tesla switched power back on at the children’s hospital in San Juan, ‘the first of many solar+storage projects’ in the island, the company tweeted. Sonnen, a German manufacturer of solar energy-storage equipment, has also donated 15 micro-grids. Such setups could help ease the power shortages while Prepa is still busy rehanging power lines, but once the grid is back up they’ll also serve to eat away at its monopoly on generation.”

Not everyone is in the solar camp. Some contend that Puerto Rico should build an LNG terminal and use natural gas to power more of its electric plants. However, by the time a decision to do so could be made and facilities built, solar panels might already be supplying much of the country’s electricity.

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Sausage for the Holidays?

November 15, 2017 (Wednesday)

Tax Reform I: Taxing Chronology. Melissa and I have been watching legislators make sausage in Washington, DC’s sausage factory. It’s not pleasant to watch. It can be a little nauseating and make one’s head spin. Sausage tends to include lots of mystery meat. There is certainly lots of mystery meat going into producing tax reform in Washington currently.

Yesterday morning, we thought that the House and Senate Republicans were likely to deliver the sausage before the end of the year. By the end of the day, we weren’t so sure. Senate Republicans proposed to add a repeal of Obamacare’s individual mandate to their tax legislation. That could seriously complicate achieving tax reform at all.

If the Republicans still manage to push it through both houses of Congress, there would be individual tax reform that mostly benefits the middle class, with some taxpayers paying more and some less in taxes on balance. The corporate tax rate would probably get cut to 20%, which would be very positive for corporations that have actually been paying the current statutory rate of 35%.

However, NIPA data show that the effective tax rate on all corporations averaged 21.3% during Q2-2017 (Fig. 1)! The S&P 500 companies had an effective tax rate of 26.4% last year (Fig. 2).

There would likely to be a significant tax cut for repatriated earnings without any restrictions in how the after-tax proceeds are used. If so, then significant sums of corporate cash could come back to the US and used to buy back more shares, increase dividends, pay for M&A deals, boost capital spending, and even increase workers’ pay.

Yesterday morning, we wrote, “Investors certainly aren’t worrying about a fiscal-cliff meltdown this year as they did in late 2012. Maybe we should all be worried about a fiscal-led meltup this time.” Now, who knows? There are lots of good reasons for staying away from sausage factories. If tax reform is now less likely to happen, we are sticking with our view that the strength in the global economy and earnings will keep the bull market going with or without tax cuts. A meltup becomes less likely without tax reform, which is alright with us too.

To better understand where US tax reform stood prior to the turn of events late yesterday, I asked Melissa to do a short chronology of the major related events over the past few months.

To track the stock market’s reaction to those events, Joe charted the respective dates against the S&P 500 price index (Fig. 3). We are also monitoring the S&P 600 SmallCaps stock price index, which has been especially sensitive to the changing prospects for tax reform (Fig. 4). Since tax reform officially kicked off on 9/27, the S&P 500 price index has increased 3.5% through Monday. However, it is up 20.8% since last year’s Election Day, partly on expectations of tax reform. Here are the important happenings since then and a look at what lies ahead:

(1) September 27 (S&P 500 up 3.5% since the day before): Unified framework released. On 9/27, the Trump administration, the House Committee on Ways and Means, and the Senate Committee on Finance announced a “Unified Framework for Fixing Our Broken Tax Code.” The intent of the framework was to serve “as a template for the tax-writing committees” in the House and Senate. (It followed the much less detailed White House one-pager, which had been released on 4/26.)

Given that it was just an outline, the framework was not officially scored by the Joint Committee on Taxation (JCT), which is a bipartisan group that aids members of Congress with scoring tax changes. However, the Tax Policy Center (TPC) provided an unofficial preliminary estimate of a loss of $2.4 trillion in net revenue impact over the next 10 years. The TPC turned around the estimates on the same day that the framework was released.

That estimate was significantly lower than the TPC’s $6.2 trillion estimate of the cost of the then presidential candidate Trump’s tax proposals back in October 2016.

(2) October 19 (S&P 500 up 0.9% since the day before): Budget Resolution passed. On 10/19, the Senate approved by a slim 51-49 vote the FY 2018 Budget Resolution, officially titled: “Concurrent resolution establishing the congressional budget for the United States Government for fiscal year 2018 and setting forth the appropriate budgetary levels for fiscal years 2019 through 2027.”

In addition to other non-tax-related items, the resolution included reconciliation instructions to the House Ways and Means Committee and to the Senate Finance Committee to provide for changes in laws, specifically comprehensive tax reform, that will add no more than $1.5 trillion to the deficit over the next 10 years.

(3) November 2 (S&P 500 up 0.2% since the day before): House proposes TCJA. On 11/2, the House Ways and Means Committee released its first draft of the legislation, titled the “Tax Cuts and Jobs Act” (TCJA). The JCT’s estimate for the tax changes totaled just under the $1.5 trillion over the next 10 years—no surprise there.

(4) November 9 (S&P 500 down 0.4% since the day before): Committee on Ways & Means passes TCJA. Just a couple of amendments proposed during the House Ways & Means markup sessions made it into the House’s final version of the legislation. The Committee approved it on 11/9 with a vote of 24-16 on party lines, reported The Hill. The full House is expected to vote on it this week.

(5) November 9: Senate version released. On the same day, 11/9, the Senate Finance Committee released its version of the tax reform legislation. As per the budget reconciliation instructions, the Committee’s proposal totals just under $1.5 trillion in net revenue cuts over the next decade as scored by the JCT. Although the versions arrive at more or less the same grand total, the Senate version differs from the House version in a number of ways, as detailed below.

(6) November 13: Senate markup sessions held. Upon release of the Senate version of the tax plan on 11/9, Senate Finance Committee Chairman Orrin Hatch (R-UT) announced in a press release that the committee will examine and debate the proposal known as the “Chairman’s mark.” Those sessions kicked off on Monday 11/13 at 3pm.

“The Senate Finance Committee traditionally holds conceptual markups, meaning the legislation is debated and examined as a detailed narrative, rather than actual bill text. The proposal released today is a conceptual mark,” stated the 11/9 press release.

Hatch stated: “This is just the start of the legislative process in the Senate. We expect robust committee debate on the policies in this bill, will have an open amendment process, and hope to report legislation by the end of next week. I’m confident that if we continue to allow each chamber the opportunity to work its will, we can easily reconcile our differences.”

Any way you slice it and dice it, federal deficits will be larger, and so will the amount of federal government debt. With the economy at full employment, the FY 2017 deficit was $665.7 billion (Fig. 5). Now multiply that by 10 and add $1.5 trillion for the tax cuts (maybe). The result is lots more publicly held debt added to the record $14.8 trillion during October (Fig. 6).

Tax Reform II: Splitting Hairs. “Far apart” is how the media has characterized the Senate and House tax plans. Melissa and I disagree, because both plans aim to achieve the same overriding goals. Many of the details on which they disagree seemed reconcilable yesterday morning. We’re not sure how yesterday afternoon’s monkey wrench will change the outcome. In any event, we did the work on comparing the two.

Both plans were based on the joint framework previously released by the Trump administration. Both the Senate and the House plans arrive at the same prescribed target of $1.5 trillion in cuts in accordance with the FY 2018 Budget Resolution’s reconciliation instructions. Both target individual tax cuts, focusing on the middle class while simplifying the tax code and eliminating many deductions. Both aim to reduce corporate and business taxes.

Both would repeal the alternative minimum tax, repeal personal exemptions, and nearly double the standard deduction. Both would impose a “transition” tax on offshore profits. Both would permit immediate write-offs for business qualified investments, a benefit that would expire after five years.

In an interview on Fox Business Network on Friday, Treasury Secretary Steven Mnuchin said that the tax-reform efforts are on track to be completed by December. “There are some minor differences between the bills,” he said. Mnuchin added: “So, we’ll reconcile the differences. As I said, I am very comfortable that we have the same objectives.”

On Thursday, House Speaker Paul Ryan (R-WI) told reporters: “The House will pass its bill, the Senate will pass its bill and then we will get together and reconcile the differences, which is the legislative process,“ according to the WSJ. According to the Washington Examiner, House Ways and Means Chairman Kevin Brady (R-TX) told Politico on Friday: “I actually believe having slightly different—or maybe even substantially different—designs to hit [the] target, that’s part of the process.”

Nevertheless, let’s touch on a few of the areas that are up for debate (other than repealing the Obamacare mandate):

(1) State and local taxes. Perhaps the biggest sticking point at this point is that the House will not accept the Senate tax plan to eliminate the federal deduction for all state and local taxes (SALT) including income or sales taxes and property taxes, Bloomberg reported. That’s according to comments by Kevin Brady on Fox News Sunday.

Even so, it isn’t the entire SALT deduction that is up for debate—just property taxes. Unlike the Senate, the House would maintain a property tax deduction capped at $10,000. However, the Senate would eliminate the deduction for SALTs altogether.

Perhaps this is an issue on which the Senate will bend. The property tax debate puts Republicans in states with high property taxes in a tough spot, because the voters who benefit from the deduction will want to keep it. Brady said: “What we’ve worked [on] so carefully with our lawmakers from New York and California and New Jersey is to make sure we deliver this relief.” According to Bloomberg, they pushed Brady to keep the property-tax deduction in the House bill.

(2) Individual rates. Just four individual tax brackets are included in the House tax plan, down from the current seven. For the Senate plan, seven tax brackets would be maintained, but the rates would be changed. For wealthy individuals, the top tax rate in the House plan is maintained at 39.6%, while the Senate plan would reduce it to 38.5%. That would offset some of the deductions that would be eliminated for higher-income individuals under both plans.

(3) Corporate-rate-cut timing. Both the Senate and the House propose reducing the corporate rate to a flat 20% from the current maximum 35%. However, the Senate would delay a cut in the corporate tax rate until 2019, while the House would cut it effective for 2018. That would help to pay for some of the cuts in the near term but make it tough to comply with the Senate rule that tax changes can’t add to the deficit beyond the 10-year budget window, as discussed below.

(4) Pass-through benefits. Pass-through business income would be entitled to a 17.4% deduction for non-wage income in the Senate plan, excluding professional service businesses (with some exceptions). The House would apply a formula to derive the rate based on the nature of the pass-throughs. Ultimately, both plans might be different ways to get to about the same place.

(5) Other individual deductions and credits. In the House plan, the cap is on mortgage loans of up to $500,000 (as compared to the $1 million that is allowed now), whereas in the Senate plan, the mortgage interest deduction is preserved on loans up to $1 million, including for second homes.

The House would eliminate both the deduction for medical expenses and student loans, while the Senate would preserve both. In the Senate, the Child Tax Credit would be slightly higher than in the House. However, the Senate would phase out the credit.

(6) Estate tax. The Senate would not repeal the estate tax, while the House would do so starting in 2025. Both the Senate and the House, however, would double the current $5.49 million estate tax exemption. Senate rules may ultimately dictate what happens here, because the House plan could add more to the deficit than the Senate rules would allow beyond a decade, again as discussed below.

(7) International tax reform. In accordance with the Senate plan, multinational offshore earnings would be taxed at 10% and 5% for cash and non-cash holdings, respectively. In the House plan, such earnings would be taxed at 14% and 7% for cash and non-cash holdings.

Tax Reform III: Rule Book. Neither the House nor the Senate plan appears to satisfy the Senate rule that the tax changes cannot increase the deficit beyond 10 years. The problem is that the budget projections include significant negative hits to revenue in the later years within the 10-year estimate period including 2027. (See the latest estimates here.) That could mean that the revenue hits from the tax plans might carry over beyond 2027.

The WSJ reported that Senator Hatch said that Republicans are “aware of this problem” and are trying to address it in his opening statement at Monday’s Senate Committee on Finance session. “There’s no real cause for concern at this point,” he said, adding that Republicans “have every intention” of making the bill’s business-tax cuts “permanent,” which implies that some individual tax cuts might be made temporary.

However, the estimates are static (although they do include micro-dynamic behavioral effects) and not dynamic, meaning that they don’t include the economic benefits of the proposals, which theoretically would pay for the cuts. Static is the way tax reform has traditionally been scored by the JCT. It’s also necessary that the estimates be static to assess whether they fall in line with the Republicans’ self-imposed static $1.5 trillion in cuts approved as a part of the FY 2018 Budget Resolution. Even though the Senate and House tax plans are not precisely in agreement, it’s no coincidence that both plans arrived at the same bottom line.

To gain a better understanding of this convoluted process, let’s brush up on some complicated political concepts and procedures:

(1) Magic number. The budget resolution establishes a framework for the budget of the US government for the year ahead. Set forth in the form of legislation, the budget resolution provides for budget totals, and divides the spending into functional categories. It may also include reconciliation instructions to committees in the House or Senate.

Such instructions direct the named committees to draft legislation that would change the current law for the purpose of bringing it into alignment with the budget resolution. Generally, only a simple majority is needed to pass new legislation as long as it follows the instructions of the budget reconciliation.

The passage of FY 2018 Budget Resolution was significant because it set the Republicans’ self-imposed $1.5 trillion in headroom for tax cuts on a static basis. Specifically, the FY 2018 Budget Resolution stated: “The Committee on Ways and Means of the House of Representatives shall submit changes in laws within its jurisdiction that increase the deficit by not more than [$1.5 trillion] for the period of fiscal years 2018 through 2027.” The same language was used for the Senate Committee on Finance. If you’re wondering where that figure came from, it seems to have been the brainchild of Senators Bob Corker and Pat Toomey, according to a 9/19 statement from Toomey’s office.

(2) Invoking rules. “Passing [the FY 2018 Budget Resolution] is not a requirement for passing tax reform,” said Senator Gary Peters, according to the 10/19 NYT. “Passing this budget is only a requirement to pass a tax bill with as few votes as possible.” Why so?

The Congressional Budget Act set forth certain codes of conduct for the Senate in developing a budget. See a summary of the rules here. Senators can raise points of order if they believe that a Senate rule has been violated. If sustained, the outcome of the point of order is to strike the offending piece of the legislature. Many points of order may be waived by a 3/5ths (60) vote in the Senate. But such a waiver wouldn’t be easy to achieve in the current slim-majority Congress.

One important point of order that may be raised is the Byrd rule. Its purpose is to keep extraneous subject matter out of the budget process. That would include raising “deficits in any year after the period covered by the reconciliation instructions unless other provisions recommended by the same committee fully offset those ‘out-year’ costs,” according to the Center on Budget Policy and Priorities. During the Senate Committee session to review the latest legislation, Senator Hatch proposed an amendment that indicated there would be “proposals designed to ensure compliance with” the Byrd rule without any specifics.

By the way, the Byrd rule only applies to the Senate and not the House. However, the rule “can deter the House from including provisions in its reconciliation bill that are likely to violate the rule and be struck from the legislation in the Senate,” according to a note by the Peter G. Peterson Foundation.

So since the FY 2018 Budget Resolution sets forth the budgetary levels for FY 2019-2027, provisions cannot impact the budget beyond that 10-year period. That could be a problem for the passage of the House bill as it stands in the Senate. For what it’s worth, the reconciliation instructions don’t have to cover 10 years. For example, the FY 2001 Budget Resolution covered only five fiscal years, according to a 2016 Congressional Research Service paper.

(3) Keeping score. Dynamic scoring in the context of tax reform is the process of accounting for the macroeconomic effects of potential changes in the law. Static models, on the other hand, keep economic growth in accordance with existing laws.

It is the JCT’s standard practice to use Congressional Budget Office (CBO) projections as a baseline for economic growth. According to the CBO’s website: “CBO’s economic forecasts are based on current laws governing federal taxes and spending.” According to the FY 2018 Budget Resolution summary, the CBO’s June 2017 baseline is the baseline of choice for tax reform within the budget window.

The JCT website notes that conventional estimates are sometimes referred to as “static.” It states: “The starting point for a revenue estimate prepared by the Joint Committee staff is the Congressional Budget Office (‘CBO’) 10-year projection of Federal receipts, referred to as the ‘revenue baseline.’ The revenue baseline serves as the benchmark for measuring the effects of proposed tax law changes. The baseline assumes that present law remains unchanged during the 10-year budget period. Thus, the revenue baseline is an estimate of the Federal revenues that will be collected over the next 10 years in the absence of statutory changes … In providing conventional estimates, the Joint Committee staff assumes that a proposal will not change total income and therefore holds Gross National Product (‘GNP’) fixed.”

Accordingly, the House Ways and Means estimates for the “Tax Cuts & Jobs Act” are indeed static, a fact confirmed by an 11/3 Tax Foundation analysis. While the JCT estimates stopped at 2027, the Tax Foundation analysts estimate that federal revenues would decrease by $1.6 trillion over 2028-2036 on a static basis.

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Commodity Currents

November 14, 2017 (Tuesday)

Commodity Markets: Mixed Signals. Since early last year, commodity markets have signaled a rebound in global economic growth following the recession that rolled through the global energy industry during 2015. While oil prices have remained strong this year, industrial commodity prices have stalled (Fig. 1). The price of a barrel of Brent crude oil is up 127.8% from its cyclical low on January 20, 2016. The CRB raw industrials spot price index is up 25.4% from its cyclical low on November 23, 2015. This year so far through Friday’s close, the former is up 11.8%, while the latter is up only 1.2%.

Debbie and I generally give the CRB more weight as an indicator of global economic activity than we give the price of oil. That’s because the price of oil often is a function of unique supply and demand factors that don’t reflect global economic activity. These factors tend to be geopolitical in nature. In addition, while we and others have suggested that OPEC’s days are numbered, the cartel continues to have an impact on the price of oil.

Nevertheless, we continue to monitor our homebrewed YRI Global Growth Barometer, which is the average of the CRB raw industrials spot price index and the price of oil (Fig. 2). Admittedly, that gives oil equal weight, which is more weight than we reckon it deserves. Our YRI-GGB is up 49% from its low of 54.9 on January 20, 2016 to its new cyclical high of 81.8 last Thursday. That’s the highest it’s been since December 11, 2014, but still 26.0% below its June 20, 2014 high.

To cut to the chase, the YRI-GGB confirms that the global economy is rebounding. Now let’s have a look at the details:

(1) Baltic Dry Index. The fundamental basis of the improvement in industrial commodity prices is confirmed by the uptrend in the Baltic Dry Index since early last year (Fig. 3). It is up 405% since February 11, 2016 through the end of last week. This can be a funky indicator of global trade since it is very sensitive not only to the demand for dry bulk commodities but also the supply of freighters. It soared during 2006 and 2007 when global demand for commodities, especially Chinese demand, overwhelmed the availability of freighters (Fig. 4). It crashed when the global financial crisis unfolded during 2008, and remained relatively low during the subsequent global recovery as shipyards completed a large fleet of new freighters that had been ordered during the boom.

(2) Dr. Copper. Professor Copper is widely deemed to be the commodity with a PhD in economics. It is very sensitive to global economic activity, especially in China. It may soon also become a very sensitive indicator of the global transition from motor vehicles powered by fossil fuels to those running on electricity. Electric cars require more copper because that is an essential element for producing electric motors. The CRB raw industrials includes the price of copper. However, while the CRB has stalled this year, the price of copper is up 23% ytd (Fig. 5).

Interestingly, the strength in the price of copper this year suggests that the strength in the price of oil this year might reflect rebounding economic activity, and not just OPEC’s apparently successful efforts to keep a lid on the production. The price of oil is highly correlated with the price of copper (Fig. 6).

(3) Fracking USA. Also confirming that this year’s strength in oil prices reflects better global economic activity is the fact that US oil field production rose to 9.6mbd in early November, rebounding back to its high of 2014, before the price of oil took a dive (Fig. 7). Despite all this US output, the price of oil is still rising. Furthermore, US stocks of crude oil and petroleum products dropped below last year’s readings in early July, and just dropped below 2015’s levels (Fig. 8).

(4) S&P 500 Materials & Energy. In the past, there has been a good correlation between the CRB raw industrials spot price index and the ratio of the S&P 500 Materials stock price index relative to the S&P 500 (Fig. 9). While the Materials index has outperformed the S&P 500 recently, it has been mostly a market performer (neither leading nor lagging the market) since the spring of 2016. The ratio has been fairly flat and range-bound since then despite last year’s rebound in the CRB. The ratio has been more consistent with the CRB’s stalling this year.

By the way, as Jackie explained last Thursday, much of the recent strength in the Materials sector has been related to the outperformance of Materials companies that produce lithium and stand to benefit from the greater demand for this element in the production of batteries for electric cars.

Also lagging behind the rebound in the oil price is the ratio of the S&P 500 Energy stock price index to the S&P 500 (Fig. 10). Seems that stock investors aren’t convinced that the rise in the oil price is sustainable. They might be wrong if the price is reflecting better global demand combined with recent geopolitical concerns about the stability of the Saudi regime.

(5) Global production. Global industrial production data are available through August (Fig. 11 and Fig. 12). They show that production rose to a record high with a y/y growth rate of 3.8%, following a growth dip during the second half of 2014 and all of 2015.

Interestingly, that dip was concentrated among the advanced economies, while the emerging economies barely skipped a beat (Fig. 13 and Fig. 14).

(6) Emerging markets. The performance of the Emerging Markets MSCI stock price index is showing more and more signs that emerging economies are finally emerging from their dependence on commodities. In the past, this stock price index was highly correlated with the CRB raw industrials spot price index (Fig. 15). But they’ve clearly diverged as the stock index (in local currency) has soared 27% ytd. They’ve also broken free of their correlation with the trade-weighted US dollar (Fig. 16). In the past, a strong dollar weighed on the Emerging Markets MSCI. That’s no longer the case, as the latter has soared to new record highs this year.

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Meltup Medley

November 13, 2017 (Monday)

Strategy: Early Christmas. Have you noticed? It isn’t even Thanksgiving yet, and yet stores are already decorated for the Christmas holiday and radio stations are starting to play Christmas songs. Hearing too much Christmas music can be bad for your mental health, research shows; psychologist Linda Blair told Sky News: “It might make us feel that we’re trapped—it’s a reminder that we have to buy presents, cater for people, and organize celebrations.”

On the other hand, the stock market often tends to do well after Thanksgiving through Christmas and into the first day of the New Year. This recurring phenomenon has been dubbed the “Santa Claus rally.” The weakness in the stock market late last week was caused by concerns about whether the Republicans can get a tax reform deal done before Christmas, as promised by President Donald Trump. Nevertheless, there’s already some chatter that the Santa Claus rally could start earlier than usual this year. That’s certainly likely to be the case if Republicans make some progress toward completing a deal.

Last year’s Santa Claus rally has morphed into this year’s meltup. The S&P 500 is up 17.1% since Thanksgiving of last year through Friday. It’s been rising into record territory all this year (Fig. 1). It’s up 20.7% since Trump won the election on November 8 of last year. The latest record high was hit on November 8 when the S&P 500 closed at 2594.38. It is down only 0.5% since then.

Joe and I have been observing since the summer of 2016 that earnings are improving because the energy-led earnings recession is over. Starting late last year, Debbie and I have been noting that the global economy is showing mounting signs of strength. In other words, the market has been boosted by solid fundamentals. Trump’s victory and potential corporate tax cuts were icing on the Yule log cake. In other words, if the Republicans fail to do a deal, that won’t turn us bearish. If they do a deal, we will be concerned about a Santa Claus meltup. Now let’s sit by the fire and play a medley of meltup songs:

(1) Jingle bull rock. The bulls are all coming home for the holidays. Investors Intelligence’s Bull/Bear Ratio (BBR) soared to 4.47 last week (Fig. 2). That’s the highest reading since March 1987. The 52-week average was 3.17 last week. Readings above 3.0 for this moving average are rare.

Are there too many bulls? Contrarians might think so, but the BBR works better as a contrary buy signal when the ratio is at 1.0 or less than as a sell signal when it is at 3.0 or more (Fig. 3).

The percentage of bears in the Investors Intelligence survey remained at 14.4% last week, the lowest since May 2015 (Fig. 4).

(2) LTEG: Do you fear what I fear? Joe and I are getting a sense of déjà vu all over again as we watch S&P 500 long-term consensus earnings growth expectations (LTEG) going vertical since early last year (Fig. 5). Thomson Reuters compiles this series based on analysts’ consensus expectations for the earnings growth of the S&P 500 companies over the next five years. LTEG has jumped from last year’s low of 9.6% during March to 13.8% last month, the highest reading since April 2002. Leading the way recently is the LTEG for the S&P 500 Information Technology sector at 16.2% during October (Fig. 6).

(3) Valuation: You’d better watch out. The good news is that rising LTEG expectations are making stocks look more attractive based on the ratio of the S&P 500 stock price index to its LTEG (Fig. 7). This PEG ratio for the S&P 500 has declined from a record high (starting in 1995 for this series) of 1.7 during the week of January 28, 2016 to 1.3 at the start of November.

That’s great as long as those LTEG estimates make sense, which they don’t. They are too high, though not as high as their 2000 peaks of 18.7% for the S&P 500 and 28.7% for the index’s IT sector. They seem to be heading in that direction again, which could fuel a meltup by investors driven by FOMO (i.e., fear of missing out).

The more traditional measure of valuation is elevated, but not excessively so. We are referring to the S&P 500 forward P/E, which rose to a cyclical high of 18.0 in early November, the highest since March 2004 but well below the July 1999 peak of 25.3 (Fig. 8). That’s not cheap, but valuation metrics that account for inflation, like the real earnings yield and the Rule of 20, show that the market is fairly valued (Fig. 9) and (Fig. 10).

(4) All I want for Christmas is an ETF. Data available on equity mutual funds and ETFs, compiled by the Investment Company Institute, are available through September (Fig. 11). Collectively, over the past 12 months, these funds attracted $275.2 billion, up sharply from $21.6 billion a year ago and the best such inflow since July 2015. On a 12-month basis, equity mutual funds have had net outflows since March 2016, though the pace has been slowing. The big story is the big inflows into equity ETFs totaling $349.6 billion over the past 12 months.

Investors seem to be especially interested in exposure to foreign equities. The outflows from equity mutual funds have been all among domestic equity mutual funds, which lost $154.6 billion over the past 12 months (Fig. 12). Meanwhile, over the same period, US mutual funds investing globally attracted $80.3 billion.

A similar analysis of equity ETFs over the past 12 months shows that domestic ETFs attracted $210.3 billion, which was slightly below June’s record pace (Fig. 13). While net inflows into global/international equity ETFs was less than for the domestic ETFs at $139.3 billion, that was a record amount.

Movie. “LBJ” (+ + +) (link) is a very well crafted movie about Lyndon B. Johnson before and after John F. Kennedy was assassinated. Woody Harrelson provides a great performance as LBJ, who had a great need to be loved but was certainly hated by Bobbie Kennedy. Director Rob Reiner is one of Hollywood’s more liberal denizens, so the movie focuses on LBJ’s achievement in passing the Civil Rights Act of 1964 rather than his role in widening the war in Vietnam.

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Chips & Chile

November 09, 2017 (Thursday)

Technology: Driverless Semiconductors. Waymo announced on Tuesday that its minivans soon will start picking up passengers without anyone in the driver’s seat. It’s a pilot program in a Phoenix suburb that marks a major leap on the road toward a world filled with autonomous cars. Passengers will hail Waymo’s car with a mobile app, like those used by Uber and Lyft, and sit in the back seat. A video in this 11/7 Bloomberg article shows what the future may hold.

While it’s unclear how quickly Waymo’s driverless cars will be rolled out, the news is welcome to the semiconductor industry, as chips galore are needed to process the reams of data involved with safely propelling driverless cars. It’s just one of the technologies—along with cloud computing and the Internet of Things—that have helped the S&P 500 Semiconductors and Semi Equipment industries remain the hottest of the industries we track.

The S&P 500 Semiconductor Equipment stock price index has posted a 73.7% ytd return, and not far behind is the S&P 500 Semiconductors industry, up 38.0% ytd (Fig. 1 and Fig. 2). The semis have had a banner year thanks to strong earnings and a surge of M&A, which culminated in last week’s news that Broadcom has offered to acquire Qualcomm for an eye-popping $105 billion. I asked Jackie to take us for a drive down the road of driverless chips. Here is her guided tour:

(1) Surging sales. It all starts with strong sales. Worldwide semiconductor sales hit a quarterly record of $107.9 billion in Q3, marking a 10.2% q/q gain, according to a 10/30 Semiconductor Industry Association press release. The three-month moving average for sales in the month of September was $36.0 billion, up 22.2% y/y. And ytd sales through September are up more than 20% compared to last year (Fig. 3).

The strong revenues have supported the industries’ earnings. The consensus of industry analysts currently expects S&P 500 Semiconductor Equipment 2017 revenue and earnings to grow by 32.2% and 64.6%. Revenue and earnings in the S&P 500 Semiconductors industry are expected to increase by 14.7% and 38.1% this year.

The future is bright, but less so than this year. In August, World Semiconductor Trade Statistics forecast that global semiconductor sales will increase by 17.0% this year and 4.3% in 2018. Wall Street’s analysts also predict results will moderate. Over the next 12 months, the Semiconductor Equipment industry’s revenues are expected to grow 12.1% and earnings are expected to expand 16.8%. Results in the Semiconductors industry are also expected to moderate over the next 12 months, but revenue should still grow a healthy 6.3% and earnings should increase by 7.4% (Fig. 4).

Earnings have grown so rapidly that the valuations on the two indexes still don’t look stretched. The forward P/E for the Semiconductor Equipment industry is 14.5, and the forward P/E on the Semiconductors industry is 16.0 (Fig. 5 and Fig. 6).

(2) Surging M&A. Broadcom’s massive offer for Qualcomm is just the latest in a record year for M&A deals in the semiconductor industry. According to an 11/6 WSJ article, semiconductor deals announced so far this year globally amount to $167 billion, up from $130 billion for all of 2016 and only $38 billion in 2014.

Broadcom itself is the result of Avago Technologies’ 2015 acquisition of the former Broadcom for $37 billion. “The company sells a diverse line of equipment for networking and communications. Its products include chips for Wi-Fi and Bluetooth technology that connect devices that are closer together—technologies that some analysts say are likely to grow less quickly than 5G,” the 11/6 WSJ article reports.

Separately, Qualcomm is in the midst of acquiring NXP Semiconductors for $39 billion, the second-largest deal ever announced in the semiconductor industry. Like Broadcom, Qualcomm is a leader in Wi-Fi and Bluetooth technology, but it also supplies chips in cell phones and owns patents used in cell phones.

“Should the deal be completed, Broadcom would take on Qualcomm’s leadership in developing the next wave of cellular technology, known as 5G, which is expected to roll out over the coming two years. That could give Broadcom a new growth engine, as 5G is expected to dramatically accelerate the speed and responsiveness of cellular communications necessary for applications like self-driving cars,” the WSJ explained.

Elsewhere in the semi world, Marvell Technology Group is reported to be in talks to acquire Cavium for roughly $14 billion, according to an 11/3 WSJ article. Marvell’s chips are typically used in storage devices, printers, wireless products, and cars. Cavium’s chips are used in networking, data-center, and wireless products.

Intel and Advanced Micro Devices teamed up to develop a chip that combines an Intel processor and AMD’s graphics unit to be used in laptops that are thin, but powerful enough to run high-end video games, noted a 11/6 WSJ article. The intention is to take share from Nvidia, which sells graphics chips that go into laptops used for gaming.

Media: Not So Entertaining. Cord-cutting and Netflix continue to create drama in the entertainment industry. With subscriber and advertising numbers hurting, industry leaders are considering mergers and acquisitions as a way to move from defense to offense. Below, Jackie takes a look at this moving picture:

(1) Subs down. Cord-cutting seems to be accelerating. Comcast’s video customers were down 125,000 in Q3 to 22.4 million. There were 100,000 subscribers lost to competition and 25,000 customers lost due to the hurricanes, said CEO Brian Roberts in a 10/26 interview on CNBC. At AT&T, Q3 losses were even worse, with 385,000 paying TV subscribers leaving the company. AT&T attributed the decline to competition, its implementation of stricter credit standards, and hurricane disruptions, according to a 10/24 Business Insider article. At Discovery Communications’ US Networks, subscribers declined 5% last quarter.

Conversely, Netflix added in Q3 850,000 subscribers in the US and another 4.5 million subscribers internationally, bringing its total to 109.3 million globally.

(2) Turning off the tube. While we may all still be couch potatoes, we seem to be watching things beyond television channels. In the first nine months of fiscal 2017, Disney’s cable and TV revenue was flat and operating income fell 11% to $6 billion. At CBS, advertising revenue dropped 4.8% in Q3. Comcast’s NBCUniversal Broadcast Television division’s revenue was the exception, increasing by 12.3% in Q3, excluding revenue related to last year’s Olympics.

(3) Awakening giants. CBS was among the first to respond to the cord-cutting/Netflix threat. It created CBS All Access in 2014. Last quarter, CBS’s affiliate and subscription fees jumped 52.0% thanks to the All Access platform and the Floyd Mayweather/Connor McGregor pay-per-view event on Showtime.

Disney announced in August that it will pull all its movies from Netflix starting in 2019 and jump into the streaming business itself. It plans to launch an ESPN video streaming service and a Disney direct-to-consumer streaming service in 2019. “In pulling its movies from Netflix in 2019, Disney gave up an estimated $300 million-plus a year, people with knowledge of the arrangement said. And while it currently produces Marvel superhero series like ‘Daredevil’ for Netflix, new Marvel shows in the future are expected to live on the company’s own streaming service,” an 11/8 WSJ article reported.

The need for content to feed that new streaming service may have been behind Disney’s talks to buy 21^st Century Fox. The above-mentioned WSJ article noted that 21^st Century Fox has a 30% stake in streaming TV company Hulu, a television studio, and the rights to various Marvel characters, like X-Men. The talks reportedly have concluded with no deal resulting. But had they succeeded and had Disney decided to remove Fox’s content from Netflix too, the results would have been painful for Netflix. “Fox made up 17 percent of Netflix’s top-rated shows by IMDb as of June, while Disney made up 7 percent, according to MoffettNathanson and YipitData,” an 11/7 Reuters article reported.

The push for more content may also be driving AT&T’s $85.4 billion acquisition of Time Warner. Time Warner boasts ownership of HBO, CNN, and film studio Warner Brothers. That deal may also be hitting a wall as the US Department of Justice is asking for “structural remedies” to satisfy its antitrust concerns, reported an 11/8 Reuters article.

With the giants rustling, Netflix will continue its hefty spending to create new content. Next year, it plans to spend $7 billion to $8 billion on content, following a $7 billion budget this year.

(4) The numbers. It’s an interesting exercise to compare the four industries in which the entertainment players reside. Comcast is in the S&P 500 Cable & Satellite industry, which has forward earnings growth of 14.0% and a forward P/E of 20.6, down from a peak of 24.4 in February. CBS is a member of the S&P 500 Broadcasting industry, which has expected forward earnings growth of 10.3% and a forward P/E of 11.4, down sharply from 19.6 in 2014. Lastly, Disney is a member of the S&P 500 Movies & Entertainment industry, with forward earnings growth of 7.7% and a forward P/E of 14.2.

Chile I: Red Hot Stocks. Chile, up 4.4%, outperformed China, up 3.9%, for the month of October in the MSCI Global Stock Indexes performance derbies (in local currency). The two are not as disparate as they may appear. Copper connects the two—China needs it, and Chile has it. As the world’s biggest copper producer, the metal represents 50% of Chile’s exports. The country is also high on lithium, which is another element necessary for producing electric cars. I asked Sandra to have a look. Here is her report:

(1) Electric motors need copper. After a prolonged slump, copper prices have been hitting three-year highs lately amid tighter supplies and bullish economic data out of China, where real GDP expanded at a 6.8% y/y rate during Q3. Demand for battery-powered electric vehicles, which use up to four times more copper than vehicles with internal combustion engines, is also powering the run-up in prices, according to a 9/26 article in TheStreet.com. A 9/25 Reuters story quoted BHP Billiton’s chief commercial officer saying 2017 is the “tipping point” for the coming revolution that will see 140 million electric cars on the roads by 2035, up from about one million today. “And copper is the metal of the future,” said BHP’s Arnold Balhuizen.

(2) Batteries need lithium. Lithium is a key resource used to power electric cars, and, again, Chile is a top producer, boasts the world’s biggest reserves, and is part of the so-called “Lithium Triangle” along with Argentina and Bolivia. Demand for lithium has been the driving force behind the big gains in the S&P 500 Materials and Specialty Chemicals sectors ytd, as Jackie pointed out in the 11/2 Morning Briefing “High on Lithium & Paint.” Indeed, Charlotte, NC-based Albemarle is one of just two companies allowed to mine lithium in Chile under a contract signed in the 1980s, according to a report in the 6/15 Economist, which also noted that Chile’s Economic Development Agency extended Albemarle’s mining lease to 2044 and added to its quota. Albemarle’s stock is up 68.8% ytd.

(3) Regime change? Also contributing to the optimism surrounding Chilean stocks are elections scheduled for November 19 in which billionaire rightwing candidate and former president Sebastian Pinera is widely expected to prevail and return Chile to a growth trajectory. Though he’s deeply unpopular, Chile enjoyed average annual economic growth of 5% under his previous tenure compared with the under 2% on average delivered by the current president, Michelle Bachelet. In late summer, Bachelet’s entire economic team quit, frustrated by their inability to persuade her to pursue policies that would have resulted in increased and more diversified growth, according to an 8/31 FT article.

(4) By the numbers. Through Tuesday, Chile is up 27.8% ytd in the MSCI global stock price index performance derby (in local currency) (Fig. 7).

Chile’s market performance may be getting ahead of itself, already factoring in projected economic growth and hopefulness surrounding the coming elections and the likelihood of a new pro-growth government. Its near-record-high forward P/E of 20.1 is out of whack with its forward earnings growth estimate of 13.3% and revenue growth of 5.2%, and, all the while, revisions have been to the downside (Fig. 8, Fig. 9, Fig. 10, Fig. 11, Fig. 12, and Fig. 13). This is a country that narrowly missed slipping into recession in Q2. Let’s look more closely at the economy.

Chile II: Not So Hot Economy. Chile’s economy isn’t all about copper. While mining output has increased sharply since July following a strike, other economic activity has been weak, particularly in the construction industry. As noted above, the current government’s economic policies have weighed on growth, and stock investors may be hoping that a new government might deliver better numbers than the following:

(1) GDP growth. Chile’s economy managed to avoid slipping into recession during Q2, though growing at only 0.9% y/y, worse than expected. That result was a big improvement over the 0.1% y/y gain eked out in Q1, which was the worst showing since 2009 during the global financial crisis. A 43-day strike earlier in the year at the world’s largest copper mine—Escondida, operated by majority owner BHP Billiton—continued to impact economic growth. The strike reflected workers’ reaction to production cuts amid soft copper prices in Q2, and production came back on line only gradually. It was the country’s longest mine strike since a 74-day strike at the El Teniente mine in 1973, and is expected to reduce annual GDP by 0.2%. The mine produces 5.0% of the world’s copper and represents 20% of Chile’s total production and 2.0% of its GDP.

A 9/7 Reuters article reported that Chile’s central bank revised its forecast for full-year economic growth to 1.75%-2.75% from a previous range of 2.0%-3.0%. “On the domestic front, the main concern has to do with the low growth the Chilean economy is facing,” Central Bank President Rodrigo Vergara told Reuters. “If this scenario (the bank is projecting) comes true, it will mark four straight years of annual growth of around 2.0 percent.” The Central Bank forecasts 2018 GDP growth of 2.5%-3.5%.

(2) Inflation. Chile’s Central Bank kept its benchmark rate unchanged at 2.50% at its 10/19 meeting, despite September’s sharp drop in inflation to 1.5%, according to a 10/31 piece in Focus Economics. Central bankers justified standing pat due to slightly stronger underlying inflation in September and more optimistic business and consumer sentiment.

(3) Government spending. Higher copper prices and improving sentiment led President Bachelet to announce a 3.9% increase in budget spending, to widen access to free higher education, raise teachers’ salaries, and continue to build new hospitals. Higher tax revenues from rising copper prices are expected to offset the spending.

Higher copper prices go a long way toward improving Chile’s fortunes, but they’re not enough to get the overall economy humming again.

Mexico: Heading South. Earthquakes and hurricanes took a toll on Mexico’s economy during Q3 as real GDP shrank for the first time in more than four years, according to official estimates quoted by Reuters in a 10/31 story.

Real GDP contracted about 0.2% q/q (sa) during Q3, the national statistics agency said, following an expansion of 0.6% in Q2. If confirmed when official data is released on November 24, the result would mark the country’s first quarterly contraction since Q2-2013.

The preliminary data showed the industrial sector likely shrank by 0.5% in Q3 compared with Q2, while services slipped 0.1%. Agriculture expanded 0.5% q/q. The economy is expected to bounce back as reconstruction efforts gain momentum. The National Statistics Institute also introduced a new base year of 2013 for GDP data, replacing data based on 2008 and leading to upward revisions in previous quarters. Mining now is assigned a lower weight than services.

More bad news came in the form of the October IHS Markit M-PMI data for Mexico, which showed a decline to 49.2 from 52.8 in September as output, new orders, and employment contracted. Business sentiment was the weakest since March.

As its economy has shrunk, so have the gains in the Mexico MSCI stock price index since we last wrote about the country in the 8/23 Morning Briefing (Fig. 14). The index is up 7.3% ytd through Tuesday (in local currency) compared with an advance of 11.8% then. Its forward P/E has retreated to 16.1 from the 17.2 of August, and forward earnings growth is estimated at 6.1% compared with 14.2% in August. That’s a wide enough gap to give us pause, but it remains to be seen whether the weakness reflects the natural disasters or deeper uncertainties plaguing the economy. NAFTA, anyone?

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Global Warming

November 08, 2017 (Wednesday)

Global Economy I: Rogoff’s Thesis. Yesterday, Debbie and I reviewed the indicators suggesting that the US economy might be on the verge of booming after a long period of subpar growth from 2011-2016. The same can be said of the global economy outside the US, and particularly the Eurozone. Lots of good reasons have been proffered for what was widely described as “secular stagnation.” We added to the list with our focus on aging demographic trends around the world. Other observers focused on high debt-to-GDP ratios. Everyone was surprised by how little bang per buck/euro/yen the major central banks were getting for their ultra-easy monetary policies.

In any event, there has been a raging debate between economists who’ve argued that stagnation is secular and those who’ve believed it would pass. The data are starting to support the latter camp. Before we review the latest global stats, here is a brief profile of the academic leaders of the two camps:

(1) Larry Summers, a Harvard professor, first stirred up the big debate on whether the United States is mired in a protracted period of secular stagnation in an off-the-cuff presentation at an IMF forum on November 8, 2013. He followed it up with an op-ed in the 12/15/13 FT titled “Why Stagnation May Prove to Be the New Normal.” He concluded that “the presumption that normal economic and policy conditions will return at some point cannot be maintained.”

He based that mostly on the subpar performance of the US economy during the current economic recovery. He noted that economic growth has been weak despite near-zero interest rates. He also worried about deflationary pressures in wages and prices that could cause consumers to delay spending. Worsening the situation was income inequality, in his opinion. Summers has argued on numerous occasions over the past couple of years that the world has a glut of savings and shortage of investment demand. His solution is a typically Keynesian one: the government should borrow to fund public investment.

(2) Kenneth Rogoff, who is also a professor at Harvard, explained that history shows that slow growth is common following severe financial crises. He predicted that secular stagnation would turn out to be a temporary phenomenon.

Rogoff posted an April 22, 2015 article on this subject, fittingly titled “Debt Supercycle, Not Secular Stagnation.” He rejected the view that the world is experiencing secular stagnation “with a long future of much lower per capita income growth driven significantly by a chronic deficiency in global demand.” Instead, he argued that weak global economic activity since 2008 reflected “the post-financial crisis phase of a debt supercycle where, after deleveraging and borrowing headwinds subside, expected growth trends might prove higher than simple extrapolations of recent performance might suggest.”

He concluded that in this situation, debt-financed fiscal spending is counterproductive: “[O]ne has to worry whether higher government debt will perpetuate the political economy of policies that are helping the government finance debt, but making it more difficult for small businesses and the middle class to obtain credit.” In his opinion, time heals all wounds: “Unlike secular stagnation, the debt supercycle is not forever. As the economy recovers, the economy will be in position for a new rising phase of the leverage cycle.”

Global Economy II: Getting Hotter. The data suggest that Rogoff is turning out to be right after all. Nevertheless, we still see some specific explanations for the global economy’s warming trend, other than “time heals all wounds.” We’ve focused on the stimulative impacts of lower oil prices, ongoing monetary easing (on balance) by the major central banks, a record increase in Chinese bank loans, mass migration into Europe, and the wealth effect from soaring stock prices.

Today, let’s review the latest batch of global economic indicators:

(1) Global M-PMIs. The global M-PMI has been very strong over the past few months, rising to 53.5 during October, led by the M-PMI for the advanced economies, which rose to 55.2 last month (Fig. 1). Leading the way higher among the advanced economies has been the Eurozone’s M-PMI, which jumped to 58.5 last month (Fig. 2). Leading the way in the Eurozone has been Germany’s M-PMI, which was red hot at 60.6 during October (Fig. 3). Not far behind were Spain (55.8), Italy (57.8), and France (56.1).

By way of comparison, here at home in the US, the M-PMI edged down to a still solid 58.7 during October with impressive readings for its three major subcomponents: new orders (63.4), production (61.0), and employment (59.8) (Fig. 4).

(2) German factory orders. Confirming the strength in Germany’s M-PMI are the country’s new factory orders during September (Fig. 5). They rose to a record high led by strength in foreign orders, particularly capital goods orders. That’s a sure sign of better global economic growth.

(3) Eurozone retail sales. The volume of Eurozone retail sales excluding motor vehicles has been on a steepening upward trend since 2013 (Fig. 6). It rose to a new record high during October 2016, and has continued to move into record-high territory since then. It jumped 0.7% m/m during September (3.7% y/y) through September. This time, Germany isn’t leading the way higher but rather France, with a y/y increase of 4.6% (Fig. 7).

(4) Forward revenues. Since the S&P 500 companies get almost 50% of their sales from overseas, Debbie and I view S&P 500 forward revenues as a great weekly proxy for global economic activity (Fig. 8). It has been on a steep uptrend since early 2016. Consensus revenue estimates for 2018 and 2019 have been edging higher recently. The same can be said of the forward revenues for the All Country World ex-US MSCI stock composite (Fig. 9).

Global Stock Markets: On Fire. While President Trump’s tweets often imply that he deserves most of the credit for the record highs in US stock price indexes since Election Day, he can’t take credit for the global bull market in stocks. Joe and I believe that credit belongs to the strength of the global economy. Joe and I believe that credit belongs to the strength of the global economy. Here is the performance derby through Monday of the major global MSCI stock price indexes (in local currencies) since November 8, 2016: Japan (30.0%), Emerging Markets (24.7), EMU (23.1), United States (21.1), All Country World (21.0), and the United Kingdom (10.2).

Since late last year, we’ve ventured forth from our Stay Home investment strategy to the Go Global alternative. In local currencies, much of the outperformance of the All Country World ex-US stock price index occurred late last year relative to the US MSCI stock price index (Fig. 10). So far this year, the former is up 15.4% through Monday, while the latter is up 15.9% (Fig. 11). The EMU MSCI in euros is up 14.1% ytd (Fig. 12). On the other hand, the Emerging Markets MSCI stock price index has been on a tear, rising 27.3% and 31.2% ytd in local currencies and in dollars (Fig. 13).

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Animal Spirits Revisited

November 07, 2017 (Tuesday)

US Economy: Roaring. Late last year and early this year, there was lots of chatter about the disconnect between soaring measures of “animal spirits” after Trump won the presidential race and lackluster economic indicators in the US. The chatter has died down because “hard” economic indicators have turned stronger, while “soft” ones (i.e., mostly surveys of confidence) remain highly spirited. Have you noticed that since Election Day, there’s been less and less chatter about a “New Normal” and “secular stagnation?”

It may be time to consider the possibility that the US economy is finally entering a boom phase. We aren’t there yet, but there is evidence that the pace of real economic activity is quickening. On the other hand, there’s no evidence that inflationary pressures are starting to build. This is a Nirvana scenario for the stock market. The only risk might be that investors become overly exuberant and cause a Meltup scenario. On October 9, I raised my subjective odds of such an event to 55% from 50% on August 2, 40% on March 6, and 30% on January 24, 2013. (See our 10/9 Morning Briefing.) In other words, it is now actually my most likely scenario, with the Nirvana scenario at 20% and the Meltdown scenario at 25%.

The test of my boom hypothesis might be the performance of the economy during Q1-2018. The first quarter has been a clunker since the start of the current expansion. Here are the averages for the growth rates (saar) of real GDP for each of the four quarters since 2009: Q1 (0.5%), Q2 (2.4), Q3 (2.3), and Q4 (2.4). There’s definitely a strange pattern of weakness during Q1 even though the data are seasonally adjusted (Fig. 1). This year matches the pattern but with stronger growth rates as follows: 1.2%, 3.1%, 3.0%, and 3.3%. That last number is the latest forecast of the Atlanta Fed’s GDPNow Model for Q4-2017.

Debbie and I will be monitoring the hard data during Q1 to see whether the first-quarter curse disappears, as we expect it might given the mounting signs of an economic boom. We will also be tracking the daily Citigroup Economic Surprise Index (CESI), which has exhibited a similar pattern. From 2010-2017 it has tended to peak during Q1, falling during the quarter and immediately afterwards before moving higher over the rest of the year (Fig. 2). This year, the CESI plunged from a peak of 57.9 during March 15 to a low of -78.6 on June 16. It has recovered since then, and soared in recent days to 40.9 at the end of last week. The hard data are turning harder in the US, while the soft data remain strong. Consider the following:

(1) Consumer confidence & Earned Income Proxy. As Debbie and I noted last week, the Consumer Optimism Index (COI) soared during October to the highest level since December 2000 (Fig. 3). We calculate this index by averaging the Consumer Confidence Index (CCI) and the Consumer Sentiment Index (CSI). Leading the way last month was the COI’s current conditions component, which rose to the highest reading since March 2001.

The heady optimism in the COI reflects the continuing improvement of labor market conditions, which are boosting incomes. Indeed, our Earned Income Proxy for private-sector wages and salaries rose 0.2% m/m and 4.1% y/y during October to a new record high (Fig. 4).

(2) Renters vs. owner-occupiers. Last month, the CCI for 35- to 54-year-old consumers jumped to the highest level since October 2000 (Fig. 5). This age group tends to be married, have kids, and trade up to bigger homes. In other words, they are among the economy’s most reliable spenders.

More of them along with the younger cohort of Millennials (aged 21-36 this year) seem to be buying rather than renting their homes. Census data released last week show that over the past year through Q3, the number of households who are renters fell 49,000, based on the four-quarter average, the first decline in this series since Q1-2005 (Fig. 6). Owner-occupiers increased 834,000 over this same period, the most since Q3-2006.

(3) Job surveys & unemployment rate. The CCI’s “jobs-hard-to-get” series continues to closely track the unemployment rate (Fig. 7). During October, the former fell to 17.5%, the lowest since August 2001, while the latter dropped to 4.1%, the lowest since December 2000. The jobless rate for adults fell to 3.7% last month, the lowest since March 2001. It dropped to just 2.0% for adults with a college education. The short-term unemployment rate (for those unemployed for less than 27 weeks) declined to just 3.1%, the lowest since October 1953 (Fig. 8).

(4) CEO confidence and capital spending. The quarterly CEO Outlook survey conducted by the Business Roundtable found that 94.5% of top executives were upbeat (Fig. 9). That’s up from 69.6% a year ago before the presidential election. This series tends to be a good coincident indicator of the growth rate of capital spending in real GDP on a y/y basis, especially for equipment spending. Real capital spending is up 4.4% y/y, with spending on equipment and structures up 5.9% and 3.3% respectively.

Nondefense capital goods orders excluding aircraft is up 8.3% y/y through September (Fig. 10). It has been staging a solid recovery from the energy-led recession during 2015. Over the past three months through September, it is up 11.9% (saar), the best such growth rate since August 2014.

(5) Transportation stocks & indicators. The Dow Jones Transportation Average has been rising into record territory along with the Dow Jones Industrials Average this year, providing a bullish Dow Theory signal (Fig. 11). Both railcar loadings of intermodal containers and truck tonnage have been making new highs recently (Fig. 12).

(6) Regional business surveys & M-PMI. Remarkably, the average of the five composite business conditions indexes compiled by the FRBs for the districts of NY, Philly, Richmond, KC, and Dallas rose to 24.1, the highest since July 2004 (Fig. 13). Leading the way was the employment component (18.8), with a solid reading for the orders index (21.3). The regional composites are highly correlated with the comparable national M-PMI indexes. The overall M-PMI edged down from 60.8 during September to a still-robust reading of 58.7 during October.

(7) Stock prices & forward earnings. Our Boom-Bust Barometer rebounded from the hurricanes to a new record high during the week of October 28 (Fig. 14). Also having risen to yet another new record high is S&P 500 forward earnings (Fig. 15). Both these series are highly correlated with the S&P 500, which also happens to have been rising in record-high territory.

(8) Too many bulls? Animal spirits are soaring, according to the Bull/Bear Ratio (BBR) compiled by Investors Intelligence (Fig. 16). Debbie reports that the BBR jumped to 4.41 during the last week of October. That’s the highest reading since early 1987, which was a year that included a nasty flash crash on Black Monday, October 19. According to the sentiment survey, the bullish percentage was 63.5%, the bearish percentage was 14.4%, with the remaining 22.1% in the correction camp. So perhaps we have nothing to fear but nothing to fear.

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TGI . . . TCJA?

November 06, 2017 (Monday)

Tax Reform I: Sausage Factory. House Republicans released their massive tax reform bill last Thursday. It is 429 pages long. The new bill, known as the “Tax Cuts and Jobs Act“ (TCJA), proposes a radical overhaul of the tax system. Now comes the hard part. Getting it passed through both houses of Congress will be challenging, especially in the Senate. To get it passed, Republicans may have to alter it in significant ways, which makes it hard to predict what the ultimate bill will look like. Of course, it might not pass. Consider the following:

(1) Losers. As currently proposed, the TCJA hits wealthy individuals in states with high income and property taxes the hardest. That’s because the plan eliminates the itemized deduction for state and local income or sales taxes (SALT) for individuals and caps the real property tax deduction at $10,000. (Currently, there is no cap on the SALT deduction.) It also caps the amount of deductible mortgage interest expense on new loans that are no larger than $500,000. (The current limit is for loans up to $1 million.) That may be too much simplification for wealthy people to bear without putting up a political fight, given that their top marginal tax rate won’t be cut and might actually go up.

The top rate stays at 39.6% for both joint and single filers. However, it would apply to fewer people—joint filers with annual incomes of $1 million or more rather than $470,701 as now and single filers with annual incomes of $500,001 or more rather than $418,401 or more. For joint filers, incomes between $260,001 and up to $1 million would have a marginal tax rate of 35%, combining the 33% and 35% rates that previously applied to income in this bracket. For single filers, the 35% applies to incomes between $200,001 and up to $500,000. (For more, see Business Insider’s helpful chart found in an 11/2 article.)

In an 11/2 article, Politico discussed a hidden 46% tax bracket in the November bill. It noted: “[A] little-noticed provision effectively creates a new band in which income is taxed at over 45 percent. Thanks to a quirky proposed surcharge, Americans who earn more than $1 million in taxable income would trigger an extra 6 percent tax on the next $200,000 they earn—a complicated change that effectively creates a new, unannounced tax bracket of 45.6 percent.” That means that “the top marginal tax rate would rise above 40 percent for the first time since 1986.”

The new code could be bad news for real estate values, especially for large homes since the mortgage interest deduction has been cut in half. It’s bad news for states with high income taxes like California, Connecticut, Illinois, New Jersey, and New York. They’ve been seeing net population outflows to states with no income taxes like Florida, Tennessee, and Texas. The new tax plan will only exacerbate these outflows from SALT to SALT-free states. That would depress real estate prices in the SALT states too, and force them to raise property taxes and/or cut spending.

Now that there is a detailed bill with specific measures, the special interest groups are marshalling their resources and lobbyists to fight the measures they don’t like. The housing-related special interest groups are already up in arms. Republican senators from the high-tax states are threatening not to support the bill.

(2) Winners. The big winners are corporations. They are projected to get a tax cut of $1.5 trillion over the next 10 years from lower corporate rates alone (which is somewhat offset by other reforms). The corporate statutory tax falls from up to 35% to a flat 20% rate starting next year. (A different rate applies to personal service corporations.)

Interestingly, the effective tax rate during Q2-2017 for all corporations was down to 21.3%, according to National Income & Product Accounts data (Fig. 1). For the S&P 500 (LargeCaps), the effective tax rate was 26.4% during 2016 (Fig. 2). Part of the reason that those rates are lower than the 35% top statutory rate is because of offsetting deductions. Additionally, corporate tax rates are currently based on a rate schedule, so some smaller corporations do not incur the 35% statutory rate; accordingly, lowering the statutory rate to 20% may not matter that much to them.

Since Election Day (November 8, 2016), S&P 500/400/600 are up 21.0%, 21.3%, and 24.1% partly on expectations of lower corporate tax rates (Fig. 3).

Tax Reform II: The Byrd Rule. Any changes that are made to TCJA risk violating the Byrd Rule. Passed in 1985, it requires any bill going through the budget reconciliation process not to contain any “extraneous matter” or something “merely incidental” to the federal budget. The budget-reconciliation maneuver through which the GOP hopes to move the TCJA allows a bill that adjusts the federal budget to pass through the Senate with a simple 50-vote majority to avoid a filibuster. Any other legislation needs 60 votes to avoid a filibuster.

One of the provisions of the Byrd Rule is that any bill going through the reconciliation process can't add to the federal deficit outside of 10 years, which is the length of a budget resolution. According to an 11/3 Business Insider analysis: “The most likely way leaders could cut down on the deficit increase in the second decade would be to make its planned corporate tax cut temporary.”

The key will be whether dynamic scoring, i.e., factoring in faster economic growth from tax reform, will boost revenues enough to satisfy another provision of the fast-track reconciliation process: “Procedurally, the economic impact is important—because under the reconciliation rules, it can only add $1.5 trillion to deficit over 10 years. If the economic growth projection slips, however, this could change, putting it outside of that $1.5 trillion window.”

The bottom line is that the bill might change a lot to achieve enactment, or it might die.

Tax Reform III: Favoring Business. The TCJA is weighted more toward benefiting corporations and small businesses than individuals. To demonstrate this, it is helpful to step away from the minutia of the specific tax changes. Here are the major bottom lines based on the Joint Committee on Taxation’s (JCT) table of the estimated revenue effects of the tax bill:

(1) On balance, revenue effects seem equally split between individuals and businesses. JCT estimates that the net effects of the proposed tax changes will result in a $1.5 trillion overall tax cut from 2018 through 2027. According to the JCT breakdown, that is composed of cuts of $929.2 billion for individuals and $846.5 billion for businesses. To arrive at the balance, there are offsetting increases for tax changes for foreign income and foreign persons of $285.4 billion and $3.2 billion for exempt organizations. So on the surface, according to the JCT, it appears that the cuts are more or less balanced for individuals and businesses.

(2) Pass-through businesses are businesses. Notice, however, that the JCT version includes the treatment of pass-through business income in the total of the section for “individuals.” Many pass-through businesses will enjoy a reduced tax rate under the bill, which is estimated to result in tax cuts of $448 billion. If we simply shift that to the business side of the ledger from the individual side, it’s obvious that the bill favors businesses.

We aren’t the only ones who think this classification makes sense. When the Tax Policy Center (TPC) analyzed the Trump administration’s September preliminary tax framework that preceded the November bill, the analysts included the treatment of pass-through business income as a provision for businesses (see Table 1 on page 7 of the TPC’s preliminary analysis of the framework). Further, the policy highlights for the November bill from the House Ways & Means committee don’t discuss pass-through provisions under “individuals and families” but under “job creators of all sizes.”

(3) The bottom lines. Even without pass-throughs, corporate cuts are bigger than individual cuts. The rate reductions for individuals are expected to result in cuts of $1.1 trillion, offset by other adjustments that will increase tax revenues by $608 billion, for a net effect of $481 billion in cuts. Lower corporate tax rates are estimated to result in tax cuts of $1.5 trillion offset by increases from other reforms of $616 billion, for a net effect of $846 billion in cuts. (For more details on the bill, see the House Ways & Means committee’s section-by-section summary of the “Tax Cuts and Job Act.”)

Tax Reform IV: Good for Stocks. Politically speaking, the Trump administration never would blatantly admit that the goal of tax reform is to benefit the stock market. However, Steve Mnuchin did recently indicate as much. In a mid-October interview with Politico, Mnuchin said: “To the extent we get the tax deal done, the stock market will go up higher. But there’s no question in my mind that if we don’t get it done you’re going to see a reversal of a significant amount.”

So far, the market has reacted positively to the release of the detailed tax bill on 11/2. The S&P 500 has risen 0.3% since 11/1 and 3.2% since the White House released an outline of the plan on 9/27. So it held the gains since late September despite the news that the tax bill would result in a lower dollar amount of tax cuts than preliminary estimates suggested. Based on the September framework, the TPC estimated the net effect of the tax cuts would be $2.4 trillion versus the JCT’s recent $1.5 trillion estimate. Nevertheless, the market’s upbeat reaction could simply demonstrate that the investors are starting to believe more in the tax cuts now than they did before, even though the effects might not be as great.

Tax Reform V: Reagan’s Cuts Favored the Wealthy. Unlike TCJA, President Ronald Reagan’s tax cuts significantly favored reducing taxes for individuals over those for corporations. Corporate rates were consolidated and reduced, but corporate deductions were reduced too, as discussed in a 1986 NYT article “The Tax Bill of 1986: Lower Corporate Rate, But Fewer Deductions; Numerous Changes Would Raise Burden on Business.”

The 1990 Budget of the United States Government includes a table on page 4-4 that shows the net effect on tax receipts of major enacted legislation during the 1980s. At the bottom of the table, an addendum breaks the effects down by source. For all periods shown, the largest reduction in tax receipts by far is for individuals.

For example, the net effect of tax receipts expected for the farthest year out shown, 1992, is a reduction of $258.3 billion. Included in that figure, individual tax reductions totaled a whopping $326.9 billion, while corporate income taxes and social insurance taxes and contributions were among the offsetting increases totaling $43.7 billion and $27.8 billion. (Increases to excise taxes and reductions to estate and gift taxes as well as miscellaneous receipts made up the difference to arrive at the overall net tax cut.)

Pre-Reagan, the top tax rate was 70%, which was slashed to 28% by the time Reagan was done, according to a record of tax facts found in a 2006 US Department of Treasury analysis. The current top tax rate stands at 39.5% and could rise to 45.6% for some high-income taxpayers, as noted above.

Tax Reform VI: Raising Taxes to Cut Taxes. The GOP tax reform plan is likely to reduce the percentage of Americans paying income taxes, placing a greater burden on wealthy individuals. Nothing in it is likely to broaden the tax base, in our opinion, other than the faith-based notion that the plan will boost growth enough to create more wealthy people, who will pay more taxes.

The key concept of the plan seems to be to raise taxes on the wealthy to pay for some tax cuts for the middle class and a big cut for business owners, with a key assumption being that they will pay their workers more and spend on capital to boost productivity.

Just for the record, IRS data available for 2014 show that 35.0% of income tax return filers paid no taxes (Fig. 4). The IRS reports that during 2014, there were around 400,000 millionaires. Collectively, they accounted for 17.2% of total taxable income and paid 27.6% of all income taxes (Fig. 5).

The media has actually hyped the opposite: that wealthy taxpayers stand to get a windfall from the tax cuts. That’s because the owners of pass-through entities, which are essentially small businesses that file through individual tax returns, mostly fall into the higher income tax brackets. However, the catch is that it all depends on how that income is earned, i.e., either actively or passively.

There are strict guidelines via a formula that’s intended to prevent the new lower rates on pass-throughs from being applied to personal labor income. So, for example, accountants, lawyers, and doctors who do their work through their own practices might not get much of a benefit. The rule is intended as a “give” for small business owners who are creating lots of jobs, rather than those who are practicing their trade solo through pass-through entities. While many might not like it, it’s an important rule because it should help to prevent taxpayers from fraudulently shifting personal income to pass-through income. Such fraud was a key concern that came out of the previous framework, which had assumed more aggressive rate cuts for pass-throughs than the latest bill.

Movie. “The Florida Project” (+ +) (link) is a movie that all rich people should see, especially if they are depressed by what the GOP is planning to do to them under TCJA. The film is about Moonee, a precocious and mischievous six-year-old girl growing up with a single mom in a welfare motel, which is next to Disney World. She certainly makes the best of tough living conditions. Perhaps the rich would feel better about paying more in taxes if they actually benefited kids like Moonee.

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High on Lithium & Paint

November 02, 2017 (Thursday)

Sectors I: Materials Improvement. As 2017 enters the homestretch, the S&P 500 Materials sector has surged ahead and become the second-best-performing sector in the S&P 500. Up 18.4% ytd, Materials still trails the Tech sector, but it has broken away from the other S&P 500 sectors, even edging past Health Care.

Here’s the performance derby for the S&P 500 sectors ytd through Tuesday’s close: Tech (35.7%), Materials (18.4), Health Care (17.7), S&P 500 (15.0), Financials (14.1), Utilities (13.2), Consumer Discretionary (13.0), Industrials (12.5), Real Estate (5.4), Consumer Staples (2.8), Energy (-9.3), and Telecom Services (-16.1) (Fig. 1).

The outperformance of Materials owes much to the expected surge in demand for lithium, related to the anticipated move to electric vehicles from those run by the gasoline-fueled combustion engine. Here’s a quick look at what’s pushing this sector materially higher:

(1) Summer surge. The Materials sector’s acceleration started in late summer. From August 15 through Tuesday’s close, the sector returned 9.4%, on par with the Tech sector’s market-leading 9.91% return.

Ironically, the Materials sector isn’t being driven by companies selling raw materials. After a strong rally from mid-2015 to mid-2016, the CRB raw industrials index has flat-lined in recent months, albeit near its highest levels. It’s up only 0.6% ytd (Fig. 2). Accordingly, the S&P 500 Steel industry index has fallen 2.8% ytd, while Copper (6.0%) and Gold (6.1%) are up by mid-single-digit levels. Instead, the Materials sector is being propelled higher by Specialty Chemicals, up 29.0% ytd, Diversified Chemicals (24.9%), Industrial Gases (18.0), and Fertilizers & Agricultural Chemicals (15.3) (Fig. 3).

(2) Thank the chemicals. Within the Specialty Chemicals industry, the standout performer is Albemarle, which gets roughly a third of its revenue from the production and sale of lithium. Its shares are up 63.7% ytd through Tuesday’s close, propelled by hopes that electric cars will become commonplace and the demand for lithium batteries will soar.

The second-best-performer in the Specialty Chemicals industry is Sherwin-Williams, up 47.0% ytd. It has benefitted from the boom in housing and its acquisition of Valspar. The deal helped Sherwin report a Q3 37.4% jump in sales y/y to $4.5 billion. Earnings per share in Q3 fell to $3.33 from $4.08 a year earlier; however, that includes a $1.42 a share charge for acquisition-related costs and 27 cents of expenses and lost sales related to the hurricanes. PPG Industries—another industry member that also produces paint in addition to coatings and specialty materials for industries like automobiles and aerospace—is up 22.7% ytd.

Since the start of the year, analysts have been boosting their expectations for revenue and earnings growth in the Specialty Chemicals industry. It’s now expected to grow revenue by 8.7% and earnings by 14.5% over the next 12 months (Fig. 4). The industry’s forward P/E also has climbed, to 22.5 from a low of 18.0 in January 2016 (Fig. 5).

(3) More lithium. The S&P 500 Fertilizer & Agricultural Chemicals industry stock price index has helped the Materials sector move ahead as well. Momentum comes less from the farm and more from the need for batteries. The shares of fertilizer producers CF Industries and Mosaic are up 20.7% and down 23.8%. Meanwhile, the shares of Monsanto, which sells seeds and herbicides to farmers, have climbed 15.1%.

But that pales in comparison to the 64.2% ytd gain in FMC’s shares. Like Monsanto, FMC produces herbicides and other products for the agricultural market. That segment kicked in $583 million in Q2, or 88.7% of total revenue. The lithium segment generated $74 million of revenue, or 11.3% of the total, but that may be where investors are focused. Last year, FMC announced plans to triple its lithium production by 2019 in response to the “rapid growth of electric vehicle sales and strong demand for FMC’s battery grade lithium hydroxide.”

Analysts expect FMC’s earnings will jump to $5.15 a share in 2018, up from $2.43 this year. Because of the major jump expected in earnings, FMC shares trade at 18.0 times 2018’s estimated EPS despite their strong run. Earnings growth is expected to slow sharply in 2019, to 13.6%.

The S&P 500 Fertilizer & Agricultural Chemicals industry is expected to see revenues grow by 9.8% and earnings jump by 20.3% over the next 12 months (Fig. 6). And its forward P/E, at a recent 23.4, looks reasonable compared to prior booms (Fig. 7). Just remember that developments with electric vehicles may affect this industry more than events down on the farm.

Sectors II: Energized. The S&P 500 Energy sector is still in negative territory ytd, down 9.3%, but it too has enjoyed a healthy rally since late summer. Since August 15, the sector has gained 7.9%, right behind Materials and Tech. The Energy sector has been propelled by the Oil & Gas Drilling industry, up 19.2% since August 15, Oil & Gas Exploration & Production (13.7%), and Oil & Gas Refining & Marketing (13.3). Let’s take a quick look at what’s going on in the energy patch:

(1) Production cuts working. The price of oil has climbed over that period on expectations that OPEC would extend its current deal to cut crude output. At a recent $61.37 per barrel, Brent crude oil has risen 36.9% from its June 21, 2017 low of $44.82 (Fig. 8).

“The higher-than-expected compliance with the deal has been a major factor behind the upswing in prices, analysts say. OPEC’s compliance in the first three quarters of 2017 was close to 90%, J.P. Morgan analysts estimate, adding that Saudi Arabia was ‘clearly doing whatever it takes to balance the markets’ with a cut that was 20% above their required target,” reported a 11/1 WSJ article. Wall Street analysts surveyed by the Journal now expect Brent crude to average $54 a barrel next year, up $1 from their estimate in September. As of March, world production has been flattish, helped by cutbacks by Saudi Arabia and Russia (Fig. 9 and Fig. 10).

(2) Swing factor. In addition to OPEC, US production will be a wildcard. Shale producers are often profitable when the price of a barrel of oil tops $50; since that’s the case again, producers are expected to bring capacity back into the market.

US crude output in August dipped slightly to 9.203 mbd from 9.234 mbd in July, according to the latest report from the US Energy Information Administration. The amount of gasoline the US produced dipped over the past year, while the amount of distillate has continued to climb (Fig. 11 and Fig. 12). The US rig count and crude oil stocks have also come off their recent peaks (Fig. 13 and Fig. 14).

(3) Important chart. In addition to the supply side of the equation, investors would be wise to watch demand for crude and gasoline as well. In the US, consumers have been driving more miles using less gas (Fig. 15). More efficient gasoline-powered cars as well as the onset of electric cars may be reducing the amount of gasoline used even as miles traveled keeps increasing. Perhaps the higher the price of lithium goes, the more nervous investors in crude should get.

Bitcoin: More than Chump Change? Bitcoin surged past the $6,000 marker last week after receiving an implicit endorsement by the CME Group, which announced plans to introduce bitcoin futures by yearend (Fig. 16). The contract will bet on the value of bitcoin, but it will trade and settle in dollars. The CBOE Global Markets indicated earlier this year that it too plans to introduce a bitcoin futures contract.

A futures market may make traditional institutional investors more willing to invest in bitcoin. A 10/31 Bloomberg article explained: “A functioning derivatives market could help professional traders and investors access the incredible volatility inherent in bitcoin without having to trade on unfamiliar venues that may risk anti-money laundering and know-your-customer rules. It will also allow traders to hedge their cash positions in the digital currency, which to date has been difficult to do.”

Another Bloomberg article on 10/31 speculated that the development of a derivatives market for bitcoin would ease the way to creating exchange-traded funds (ETFs) that purchased bitcoin futures. So far, the Securities and Exchange Commission has denied a bitcoin ETF proposed by Tyler and Cameron Winklevoss “saying necessary surveillance-sharing agreements were too difficult given that “significant markets for bitcoin are unregulated.’” However, the CME and CBOE are both closely regulated, so an ETF based on bitcoin futures stands a better chance. Ledger X won approval by the Commodity Futures Trading Commission to sell swaps and options based on bitcoin.

From our perspective, the creation of swaps, futures, and ETFs based on the price of bitcoin doesn’t validate the price of bitcoin. It just means that a $1 increase or decrease in bitcoin will be leveraged and affect far more investors than ever before.

We still don’t see what gives bitcoin its value, beyond being worth what the next guy is willing to pay for it. Bitcoin isn’t issued by a government that can raise money from taxes. Nor does bitcoin produce anything that creates earnings. It can’t be used to power an engine, like nature gas. And it’s not even pretty to wear, like gold. We’ve never seen an article that tries to justify the price of bitcoin using some valuation metric. Even during the 2000 Internet bubble, there were eyeballs to count.

One last thought arises in the wake of recent headlines about fake news from Russia on our elections distributed via Facebook and other Internet sites. Much of the news about bitcoin and other cryptocurrencies is distributed by Internet sites devoted to the subject. They are not owned by large media outlets. One site lists an address in Oslo, Norway. Another is owned by a US firm that also owns a brokerage that trades bitcoin. Some sites have no way to contact the owners. Many of the writers don’t have traditional journalism backgrounds—which many readers may consider a positive, not a negative. But taken all together, these points at the very least raise an eyebrow and perhaps deserve further consideration.

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AC vs DC

November 01, 2017 (Wednesday)

Strategy I: Alternating Currents. “DC” is the acronym for “the District of Columbia.” In engineering, it stands for “direct current.” In Washington, DC, everything runs on “AC,” i.e., “alternating current.”

The stock market stumbled on Monday after receiving a jolt from DC. The day before Halloween, Bloomberg spooked the market by reporting that the Republicans are talking about slowly phasing in their proposed cut in the corporate tax rate:

“House tax writers are discussing a gradual phase-in for President Donald Trump and Republican leaders’ proposed corporate tax-rate cut—on a schedule that would put the rate at 20 percent in 2022, according to a member of the chamber’s tax-writing committee and a person familiar with the discussions.” Under discussion is a cut of 3ppts per year from 35% to 20%. Trump wants the full cut upfront.

Meanwhile, our good friends at Capital Alpha Partners observe that phase-ins are the norm in DC. James Lucier wrote on Monday: “As a general rule, significant changes in the corporate and individual rate structures are always phased in to minimize the distortions and disruptions that can result from too sudden a revision. We expect that almost every major change in corporate tax provisions in the reform bill will be subject to some phase-in or other, including for example changes in the tax treatment of interest expense.”

Also on Monday, special counsel Robert Mueller, who is investigating Russian meddling in the 2016 elections, accused two former Trump campaign officials of not paying taxes on millions of dollars in income and obtained a guilty plea from a third, who admitted that he had lied to federal authorities about contacts with Russian go-betweens. This is a significant distraction for the Trump administration at a time when the Republicans must move quickly to achieve tax reform before next year’s midterm elections.

Trump’s tax reform agenda seemed dead in the water following the repeated failures of the Republicans to repeal and replace Obamacare. However, last Thursday, the House of Representatives narrowly passed a budget resolution that clears the way for Congress to fast-track tax reform legislation. The budget includes reconciliation rules that will allow the Senate to pass tax reform with only a simple majority rather than the usual 60 to overcome a filibuster.

A significant hurdle for the Republicans is to come up with some tax revenues to pay for the tax cuts. Read that sentence again. Raising taxes to lower taxes is the AC way that DC operates. The current Republican plan would eliminate deductions for state and local taxes (SALT), which would raise more than a trillion dollars over the next 10 years. The CNN report on this subject observed that eliminating SALT would make “it a huge source of revenue for their overall plan to reform the tax code.” The story didn’t comment on the irony of this proposal.

Melissa and I wrote about the importance of eliminating the SALT deduction in the 10/4 Morning Briefing titled “Taxing Tax Reform.” We observed that the Trump administration needs the $1.3 trillion from the elimination of SALT because the fast-track reconciliation process allows for only $1.5 trillion in tax cuts. We wrote: “That’s a really big sticking point for Republicans from high-tax states who want to keep that tax break.”

The bottom line, it seems, is that the big tax cut that the administration would like can’t be sold with only the money-back guarantee that it will pay for itself. So the administration has to raise taxes to cut taxes. That became obvious once the decision was made not to cut spending in any significant way. To get a revenue-neutral tax cut requires a big assumption that growth will pay for the tax cut or additional tax revenues from other sources …or both.

Strategy II: Earnings Power. While DC continues to be powered by alternating currents, earnings remain charged up on direct current. Joe and I may have to revise our earnings estimates for next year depending on how tax reform plays out. However, we believe that there’s plenty of power in earnings without tax reform.

Forward earnings rose to fresh record highs at the end of October for the S&P 500/400/600 (Fig. 1). The forward earnings for the S&P 500 has been rising in record territory since the week of October 7, 2016. That’s when the Energy-led earnings recession ended. We started to write about that last summer. And here we are with S&P 500 forward earnings up 9.7% y/y (Fig. 2). It’s the same story for forward revenues, with the S&P 500 composite up 5.3% y/y (Fig. 3).

Also remarkable is that the forward profit margin of the S&P 500 rose to a record high of 11.1% during the 10/19 week (Fig. 4). This has certainly frustrated the many bears who’ve been warning that the profit margin is at a cyclical high and vulnerable to reverting to its mean. Here is the performance derby for the profit margins of the S&P 500 sectors through mid-October: IT (20.7%, record high), Real Estate (17.3), Financials (16.3), Telecom Services (11.8), Utilities (11.3), record high), S&P 500 (11.1), Health Care (10.7), Materials (10.6, record high), Industrials (9.5), Consumer Discretionary (7.6), Consumer Staples (6.8), and Energy (4.9).

US Consumer: Happy Days. We live in happy times. How can that be given all the unhappy happenings in DC these days? Apparently, we are all tuning out the political static and focusing on what matters most: jobs. While our politicians continue to promise policies that will create more jobs, we are doing just that despite Washington. As a result, consumer confidence is soaring. Consider the following happy developments:

(1) Consumer confidence. Both the Consumer Sentiment Index (CSI) and the Consumer Confidence Index (CCI) jumped in October (Fig. 5). Debbie and I focus on the average of the two, which we call the “Consumer Optimism Index” (COI) (Fig. 6). During October, the overall COI jumped to 113.3, the highest since December 2000. Its current conditions component rose to 133.8, the highest since March 2001, while its expectations component rose to 99.8, the best reading since January 2004.

(2) Availability of jobs. Among the plethora of series included in the CSI and CCI surveys of consumer confidence, our favorites are the jobs plentiful, jobs hard to get, and jobs available series from the latter source (Fig. 7). During October, 36.3% of respondents agreed that jobs are plentiful, the highest reading since June 2001. The jobs-hard-to-get percentage fell to 17.5%, the lowest since August 2001. It tends to be highly correlated with the unemployment rate, and suggests that the jobless rate is still falling (Fig. 8).

(3) Wages. In the past, there was a reasonably good correlation between wage inflation and the jobs plentiful series (Fig. 9 and Fig. 10). This was so using the yearly percent change in either average hourly earnings or the Employment Cost Index (ECI). The latest data show that average hourly earnings for production and nonsupervisory workers rose 2.5% y/y during September, while wages and salaries in the ECI rose 2.6% during Q3. Both remain surprisingly low given the plentitude of jobs.

So why are consumers so happy? Jobs are plentiful and wages rising faster than prices. The PCED rose 1.6% y/y during September.

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Is Everybody Happy?

October 31, 2017 (Tuesday)

Global Economy: Upbeat Goes On. “Is everybody happy?” was the catchphrase made famous by Ted Lewis, a multitalented entertainer who was popular before and after World War II. The answer to that question today is “Yessir!” That was another one of his well known catchphrases. Everybody seems to be happy in the US and Europe. Stock investors are joyous around the world. Consider the following happy stuff:

(1) US consumer confidence. The Consumer Sentiment Index, compiled by the University of Michigan Survey Research Center, jumped 5.6 points during October to 100.7, the highest reading since January 2004 (Fig. 1). Its two major components rose sharply too: The current conditions index rose 4.8 points to 116.5, the best level since November 2000, while the expectations index rose 6.1 points to 90.5 (Fig. 2).

(2) US regional surveys. The average of the business conditions indexes for the available five Fed regional surveys (New York, Philadelphia, Richmond, Kansas City, and Dallas) jumped from 14.0 in July to 24.1 this month—the highest reading since July 2004 (Fig. 3). The average of the new orders indexes showed billings rose from 11.9 to 21.3 over the same period, back near March’s record high of 24.5. The average of the employment indexes jumped from 10.2 during July to 18.8 this month, the best jobs rate in the history of this series going back to June 2004. No wonder consumers are so happy!

(3) European consumer & business confidence. Everybody is very happy in Europe. That’s according to the Economic Sentiment Index (ESI) for the European Union, which jumped this month to 114.2, the highest since June 2007 (Fig. 4). The Eurozone ESI kept pace, rising to 114.0, the highest since January 2001, suggesting that real GDP growth is continuing to improve in the region (Fig. 5). Leading the pack is Germany, where the ESI rose to 114.5, the highest reading since April 2011 (Fig. 6). Germany’s Industrial ESI has been especially strong in recent months (Fig. 7).

(4) Flash M-PMIs. Markit’s October flash M-PMI for the Eurozone rose to 58.6 this month, well above its reading of 53.5 a year ago (Fig. 8). October’s flash for the region’s NM-PMI has been hovering at an elevated range around 55.0 all year.

For the US, Markit also reported solid increases to solid levels in both the M-PMI (from 53.1 to 54.5) and NM-PMI (from 55.3 to 55.9) (Fig. 9).

(5) Exports in GDP. Boosting the Eurozone’s growth is exports of goods and services (as measured in the region’s real GDP), which rose 4.4% y/y during Q2 to a new record high (Fig. 10). This measure is up 19.9% over the past four years (since Q2-2013). US exports of goods and services in real GDP edged up to a record high during Q3-2017, but is only up 8.0% over the past four years (Fig. 11).

(6) World stock markets. Are you getting a warm fuzzy feeling about the global economy? You should be. Debbie and I have been since last fall. Over the same period, Joe and I have embraced a more Go Global investment posture with less commitment to our long-held Stay Home investment strategy. It’s been working this year. Here is the performance derby (in dollars) for the major MSCI stock price indexes so far ytd through last Friday: Emerging Markets (28.8%), EMU (24.1), Japan (17.8), All Country (17.5), US (15.4), and UK (11.1) (Fig. 12).

Doesn’t all this make you want to have a Coke? Blissed-out investors worldwide are swaying to the bubbly soda’s theme song in celebration of the global synchronized boom:

I'd like to build the world a home,
And furnish it with love,
Grow apple trees and honey bees
And snow white turtle doves.
I'd like to teach the world to sing
In perfect harmony.
I'd like to hold it in my arms,
And keep it company.

US Consumers: Getting Personal. The Bureau of Economic Analysis in the Commerce Department released September data on personal income yesterday. It was all good news, though Fed officials must be depressed to see that the core PCED inflation rate at 1.3% y/y remains depressed below their 2% target (Fig. 13). The good news: Such a low inflation rate and lots of jobs are boosting consumer confidence and spending. We guess that means that everyone is happy except Fed officials. Consider the following happy developments:

(1) Wages & salaries. Wages and salaries in the private sector rose 3.4% y/y to a record high during September (Fig. 14). Inflation-adjusted average hourly earnings for production and nonsupervisory workers remained unchanged at a record high during September, and up 0.9% y/y (Fig. 15). It is up 19.5% since January 1999, belying the widely held notion that real incomes have stagnated for the past 18 years.

(2) Proprietors’ income. One of the most neglected economic series of them all is the proprietors’ income component of personal income (Fig. 16). It reflects the profits of small business owners, and tends to be about three-quarters as large as pre-tax corporate profits. As Debbie and I have observed in the past, small businesses account for lots of jobs in our economy. So it was good to see September’s proprietors’ income holding onto recent record highs. If Trump’s tax reform agenda happens and it benefits proprietors’ after-tax income, the result is likely to be greater demand for labor.

(3) Standard of living. Everybody is happy because most Americans have been enjoying increases in their standard of living (SOL) to record levels. You wouldn’t know that based on the widely followed Census series on real median household income, which was up just 0.6% during 2016 compared to 1999 (Fig. 17). Much more accurate and comprehensive measures of the SOL are real mean household personal income and consumption. Both are at record highs, with the former up 25.8% since the start of 2000 and the latter up 28.2% over the same period. No wonder everybody is happy!

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Everything’s Just Rosy

October 30, 2017 (Monday)

Strategy I: Earning-Led Meltup. If Ethel Merman were singing about the US economy today, she’d undoubtedly belt out her classic “Everything’s Coming Up Roses” from the 1959 Broadway musical Gypsy. That’s because all signs indicate that things are just swell for the US economy.

Q3 GDP rose 3.0% (saar), with solid gains led by both consumer spending on goods and services as well as business spending on capital equipment. (See Debbie’s analysis below.) New orders for nondefense capital goods excluding aircraft rose 1.3% in September, the latest in a string of gains. And a string of positive earnings reports over the past few weeks confirms that business has picked up. Strength is no longer confined mostly to the S&P 500 Tech sector. Other cyclical industries are enjoying strong demand from customers in the US oil patch and in construction, as well as from China and other international customers.

The stock market started to anticipate the improvement in late summer when the S&P 500 Energy, Materials, and Industrials sectors joined the Tech sector in outperforming the broader market. Here’s how the 11 S&P 500 sectors have performed since August 31: Financials (8.8%), Energy (8.2), Materials (7.5), Tech (7.5), Industrials (5.2), S&P 500 (4.4), Consumer Discretionary (3.2), Health Care (1.3), Utilities (0.7), Real Estate (-2.1), Consumer Staples (-2.6), and Telecom Services (-4.5) (Fig. 1).

There is mounting chatter about a stock market meltup. Joe and I have been chattering about that possibility since early 2013. We first assigned a 30% subjective probability to this scenario on May 9, 2013. This year, we raised the odds to 40% on March 6, and again to 55% on October 9. The good news is that some of the meltup in stock prices since last year’s low on February 11 has been attributable to earnings, as shown by our Blue Angels analysis (Fig. 2). Consider the following metrics since last year’s low:

(1) The S&P 500 index is up 41.1%, with forward earnings up 15.3% and the forward P/E up 22.3% from 14.8 to 18.1.

(2) The S&P 400 index is up 48.5%, with forward earnings up 20.3% and the forward P/E up 23.4% from 14.8 to 18.3.

(3) The S&P 600 index is up 55.8%, with forward earnings up 18.9% and the forward P/E up 31.0% from 15.2 to 20.0.

Here’s the performance derby of the forward earnings of the S&P 500 sectors’ forward earnings over this same period: Energy (87.3%), Information Technology (25.4), Materials (19.8), Consumer Staples (13.3), Industrials (10.8), Financials (8.7), Health Care (8.7), Consumer Discretionary (7.6), Utilities (6.5), Real Estate (2.8), and Telecommunication Services (2.1) (Fig. 3).

Of course, an earnings-led meltup isn’t really a meltup. It’s a great bull market. The big gain since February 11, 2016 has been roughly half earnings-led and half P/E-led. It could turn into a full-fledged meltup, if P/Es continue to soar from current highly elevated levels. Then again, maybe earnings will lead the way over the rest of this year and next year.

Strategy II: Capital Improvements. The data continue to belie the widely held notion that corporate America isn’t investing enough to expand capacity and to increase productivity. The widespread myth is that companies have been using most of their cash flow to buy back their shares. Quarterly data compiled by the Fed show that during 2016 and the first half of this year, both the internal cash flow of nonfinancial corporations and their capital expenditures were at record highs (Fig. 4).

That’s impressive considering that the world-wide recession in the energy industry depressed nondefense capital goods orders excluding aircraft during 2015 and most of 2016 (Fig. 5). Those orders have rebounded smartly, with a y/y gain of 7.8% through September. Also impressive is that inflation-adjusted capital spending in real GDP rose 4.4% y/y through Q3 to a record high (Fig. 6). Let’s drill down some more into the real GDP data on capital spending:

(1) Weakness in structures. Capital spending on structures rose to a cyclical high during Q2-2015, which was below the previous four cyclical highs (Fig. 7). It dropped sharply during second half of 2015, led by a plunge in energy-related structures, which have rebounded this year (Fig. 8). Also down sharply, by 26.7% from its cyclical high during Q2-2015, and yet to rebound is spending on manufacturing structures (Fig. 9).

(2) Strength in equipment. Despite the weakness in manufacturing structures, spending on industrial equipment is up 7.6% y/y to a new record high (Fig. 10). Even more impressive is the increase in spending on information processing equipment, which is up 8.6% y/y to a record high.

(3) Strength in intellectual property products. Software is included in the intellectual property products category of capital spending in real GDP. Not surprisingly, it is highly correlated with spending on information procession equipment (Fig. 11). Inflation-adjusted spending by businesses on software is up 5.1% y/y to a record high. By the way, spending on research and development, which is a component of intellectual property products too, rose 1.7% y/y, also to a record high.

Strategy III: Hot & Cold Industrials. I asked Jackie to have a look at some of the strong earnings reported by a few of the major companies in the S&P 500 Industrials sector in recent days. Here is her report:

(1) Digging it. Caterpillar’s Q3 revenue jumped almost 25% y/y to $11.4 billion and, showing the power of leverage, profit climbed to $1.95 a share excluding restructuring costs, up from 85 cents a year ago. Results blew past estimates of $1.11 of earnings per share.

CEO Jim Umpleby credited the results to strength in China’s construction market, North America’s onshore oil and gas industry, and the construction market, along with increased orders from mining customers in all geographic regions. All four geographic regions saw sales and revenue increases ranging from 20% to 29% y/y. The only area of remaining weakness is the energy and transportation unit outside of North America.

Caterpillar expects the good times to continue, and the company upped its full-year EPS outlook to $6.25 from $5.00. “The increase in the profit outlook is largely a result of a higher estimate for sales combined with a favorable mix, improved price realization, and the slower ramp of period cost spend for targeted investments,” explained CFO Bradley Halverson. “These positives are slightly offset by an increase in short-term incentive compensation expense and higher material cost.” One of the few clouds on the horizon is the rising price of steel. Another concern is how quickly suppliers will be able to bring on additional capacity to meet demand.

Lots of good news is priced into the S&P 500 Construction Machinery & Heavy Trucks stock price index, which is up 112.5% since January 25, 2016 (Fig. 12). Revenue is expected to grow 7.2% over the next 12 months, and earnings are estimated to increase 20.5% over the same time period (Fig. 13). However, the forward P/E for the industry at 18.5 is historically high (Fig. 14).

(2) Chugging along. The Q3 earnings report from Union Pacific—the railroad that transverses the western half of the US—was a mixed bag, with most industries shipping fewer products, including autos, crude oil, chemicals, coal, and agriculture.

The one area that did have a huge increase in business: industrial products. Revenue in the division was up 26% due to a 15% increase in volume and a 10% jump in average revenue per car. The area benefitted from a 120% jump in sand shipments to the fracking business it services, a 22% increase in waste due to West Coast remediation projects, and a 130% increase in military shipments due to more deployments and rotations, according to Beth Whited, UNP’s chief marketing officer.

Overall, revenue increased 4.6% to $5.4 billion, operating income edged up 3%, and EPS jumped 10.3% to $1.50—one cent above analysts’ estimates—helped by stock repurchases.

Railroads have been chugging along nicely since early 2016. Railcar loadings are up sharply from early 2016 (Fig. 15). The industry’s stock index is up 22.6% ytd, with analysts optimistically calling for a 4.3% revenue increase over the next 12 months and a 14.2% jump in earnings (Fig. 16). The industry’s P/E ratio has also climbed from 12.4 during January 2016 to a recent 18.5 (Fig. 17).

(3) Stumbling along. Holding back the performance of the S&P 500 Industrials sector—and clouding many of its performance stats—is General Electric. And nothing in its first quarterly report under new CEO John Flannery indicated that the company’s problems would end soon. Excluding restructuring charges and other bad stuff, GE reported EPS of 29 cents, below the 32 cents earned a year ago and almost half the 49 cents Wall Street consensus, according to a 10/20 WSJ article.

The company’s plans to restructure, and questions about whether it will be able to maintain its dividend have sent GE shares down 12.8% over the last five trading days and 34.2% ytd. The shares now trade at 16.9 times 2018’s expected earnings of $1.23 a share. Were GE excluded, the S&P 500 Industrials stock price index would be up an additional 8 ppts ytd.

Largely because of GE, the S&P 500 Industrials sector is only expected to show a 4.7% revenue gain and a 10.0% increase in earnings over the next 12 months (Fig. 18). Yet the industry sports a forward P/E of 18.4, which is higher than usual during the past 20 years or so, except for one period early in the century when the P/E reached a peak of 22.7 (Fig. 19).

Movie. “The Foreigner” (+ +) (link) is an action-packed thriller produced by and starring Jackie Chan, who is a movie producer and a martial arts actor. He has appeared in over 150 films. However, this is the first of his work that I’ve seen, and I really enjoyed it. The movie is set mostly in London, where a small cell of terrorists is trying to revive the IRA despite the opposition of one of their elders, played by Pierce Brosnan, who has turned from terrorist to statesman. Chan, seeking revenge for the death of his daughter resulting from the terrorists’ bombing of a bank, plays a one-man special forces unit.

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Birth Dearth

October 26, 2017 (Thursday)

Staples: Cry Babies. It’s not often you hear executives admit not knowing why their products aren’t selling well, but that’s what P&G’s CFO Jon Moeller did in the company’s earnings conference call last week. P&G reported 1% y/y increase in organic sales for its fiscal Q1-2018, down from 3% growth a year ago. When asked what was driving US sales deceleration, Moeller said, “We’ve been unable to put our finger on [it].” No change in consumption levels has been noticed, no move to private labels. Intrigued, I asked Jackie to investigate. Here’s what she discovered:

(1) Blaming babies. P&G is not the only consumer products company having a tough time. At Kimberly-Clark, a 1% y/y increase in Q3 sales volume was offset by a 1% decline in net price, leaving organic sales flat y/y. At Kimberly-Clark, however, executives blamed the babies—or rather the lack thereof. The US birthrate was down about 3% y/y in Q1, and South Korea’s birthrate was down 7%-9% ytd. The decline in the birthrate is expected to be an ongoing problem. “Those babies aren’t born this year, and they won’t be in the category next year or the year after that. So category weakness is certainly there in a couple of big markets,” said Kimberly’s CEO Thomas Falk during the conference call.

Indeed, a look at quarterly data from the Centers for Disease Control and Prevention shows that in Q1 the general fertility rate—the total number of births per 1,000 women aged 15-44—was 57.7. That’s down 3.8% from Q1-2016, when the fertility rate was 60.0, and it’s the only time the quarterly figure has dropped below 60.0 looking back to Q1-2015.

Baby care, which includes diapers and wipes, kicked in 14% of P&G’s $65.1 billion of total sales in FY-2017. Kimberly-Clark doesn’t break out its product lines as finely; however, it reports that its personal care unit—which includes diapers, wipes, feminine products, and incontinence care products—contributed $9.0 billion, or about half of the company’s sales last year.

(2) Diaper wars. While there may be fewer babies in the US, the amount of competition doesn’t appear to have declined at all. And many of the players are competing on price, according to our admittedly unscientific research on the matter. We searched on Amazon for the best-selling size 5 diapers, and the top brand was P&G’s low-cost brand Luvs. Its 140-count box was selling for $22.06, or 16 cents a diaper. P&G’s premium (and presumably higher-margin) Pampers size 5 box is the 12^th most popular seller, but its 152-count box retails for $52.39, or 35 cents a diaper.

At Target.com, the best-selling size 5 diaper is the Target brand, Up & Up. Its 128-diaper box retails for $21.99, 17 cents a diaper. P&G’s Pampers is the third product listed, and its 92-diaper box sells for $31.49, 34 cents a diaper. Kimberly’s Huggies brand 96-diaper box sells for $24.29, and it’s the 13^th product listed. There were also two brands, Honest Company (59 cents per diaper) and Seventh Generation (42 cents per diaper), pitched to buyers who want a more natural alternative or have kids with allergies.

(3) Dry cleaning for hair. The other theory P&G discounted was that consumers were spending more on services, like their mobile phone service, and therefore spending less on staples. “I want a cell phone, so I am not going to wash my hair; it doesn’t make a lot of sense to me,” said Moeller.

Again, we turned to Amazon for answers. Amazon listed the top three shampoo sellers: Nizoral, an anti-dandruff shampoo owned by Johnson & Johnson; PURA D’OR, an anti-hair loss shampoo that’s independently owned; and Art Naturals Organic Moroccan Argan Oil shampoo, which also appears to be independent. Maybe people haven’t stopped buying shampoos, just the major brands’ offerings—choosing products pitched as more natural that come from boutique manufacturers instead?

In fifth place on Amazon’s best-selling shampoos list was Batiste Dry Shampoo, owned by Church & Dwight. For the gentlemen in the audience, dry shampoo is a product used to “clean” dry hair instead of washing hair with shampoo. It has grown in popularity as women have gotten busier and as pin-straight hair has gained in popularity. Women don’t want to get their hair blown out by a professional every day, so they’ll do it on a Monday and use dry shampoo for a few days to make the blowout last. (Once hair is washed, it won’t stay perfectly straight anymore.) The trend started a few years ago. Perhaps it suggests that women are indeed washing their hair less often?

P&G has offerings in the dry shampoo category. However, the top sellers on Amazon’s list are Church & Dwight’s Batiste and independent brands Amika and Not Your Mother’s.

(4) Costlier pulp. Another interesting takeaway from both conference calls was the mention of higher commodity prices. P&G’s Moeller explained: “Following the natural disasters we’re now estimating about a $300 million profit hit from higher commodity costs. We knew we’d see higher pulp cost going into year, these costs have continued to increase beyond initial forecast ranges. Ethylene, propylene, kerosene, and the polyethylene and polypropylene resins have increased recently primarily as a result of the hurricanes in the Gulf.”

Kimberly-Clark also called out higher prices for pulp, which is used in tissues, paper towels, and diapers. The company’s CFO Maria Henry reported: “Commodities were $115 million drag in the quarter, and we now expect full year inflation will be slightly above our previous estimate of $200 million to $300 million. This outlook includes somewhat higher cost estimates for pulp and polymer resin.”

(5) By the numbers. As the year enters its final stretch, the Consumer Staples sector finds itself far behind in the derby race among S&P 500 sectors. Here’s where things stand ytd as of Tuesday’s close: Tech (30.8%), Health Care (20.6), Materials (18.3), Financials (15.1), Industrials (14.9), S&P 500 (14.8), Utilities (12.9), Consumer Discretionary (11.8), Real Estate (5.1), Consumer Staples (3.9), Energy (-9.7), and Telecom Services (-13.7) (Fig. 1).

The Staples sector is expected to see revenues jump 3.4% and earnings gain 7.4% over the next 12 months (Fig. 2). The pace of earnings growth has decelerated over the years, yet the sector’s forward P/E has climbed steadily to 19.2 since bottoming at 11.2 in March 2009 (Fig. 3). As a result, the sector’s P/E-to-growth ratio has jumped to 2.4, up from 1.5-2.0 in years past (Fig. 4).

Some industries in the Staples sector have managed to buck the trend and turn in strong stock performances so far this year. The S&P 500 Distillers & Vintners is up 35.4% ytd, and Personal Products, which is solely Estee Lauder, has gained 23.9%. Hypermarkets & Super Centers jumped 18.6% thanks to the gains in Walmart stock, and Soft Drinks (9.2%) and Tobacco (7.1) enjoyed smaller gains.

P&G and Kimberly are both members of the S&P Household Products industry, which has added 4.0% ytd (Fig. 5). The industry is expected to grow revenues by 3.1% and earnings by 6.7% over the next 12 months (Fig. 6). Even though the industry is growing earnings at a much slower pace than the S&P 500, Household Products has a much higher forward P/E, 21.7, than does the broader index.

The above-market P/E is one of the reasons that we haven’t favored the sector. Another has been the Food Retail segment, which is down 20.7% ytd due to the decline in Kroger shares (Fig. 7). We thought the industry would face tough times as Amazon grew more aggressive and as German discounters expanded in the US. Indeed, forward earnings estimates have fallen precipitously, and are now expected to decline 3.1% (Fig. 8). In just the past year, the industry’s forward P/E has compressed to 10.6 from 14.7 (Fig. 9).

Times may remain tough. P&G’s Moeller noted that the sales you see in stores aren’t being funded by his company: “[R]etailers, particularly in the US, are choosing to make investments in price as they compete with each other. And that shows up in the scanner data as a promotion, but it’s not one that’s been funded by the manufacturer.”

Japan: Abe Wants Babies. Riding the tide of the strongest economic growth in two years, Prime Minister Shinzo Abe and his ruling Liberal Democratic Party won a resounding victory in Sunday’s election in Japan.

Stocks rallied to the highest level in 21 years and posted 16 straight sessions of gains, on renewed hopes that the economic reforms first introduced in 2013 to halt three decades of deflation and known as “Abenomics” will continue. Hallmarks of Abenomics include an easy monetary policy to achieve 2.0% inflation, fiscal stimulus, and growth initiatives to promote private investment.

This fresh victory emboldens Abe to move forward with his plan to amend Japan’s 70-year-old post-war Constitution to include language legitimizing the Japanese military known as the “Self-Defense Forces,” an action that requires a two-thirds majority of both houses of the Diet, Japan’s parliament, a 10/22 article in the NYT explained. Majority approval from the public also is required. With North Korea launching missiles and trading threats of war with the US, Abe hopes his plan will resonate with voters, though pacifism runs deep in the culture and opinion polls show the public is divided on the issue, according to a 10/23 report on the Wire. As currently written, the Constitution renounces war and prohibits an army. He is likely to use the occasion of a visit by President Trump on November 5 to bolster his case. Indeed, Trump and Abe agreed to work together to ratchet up the pressure on North Korea, as we noted yesterday.

Topping Abe’s agenda, too, is the need to tackle Japan’s biggest problem: an aging population and low birth rate (Fig. 10 and Fig. 11). Abe plans to increase the sales tax in 2019 to 10% from 8.0%, taking advantage of improving consumer confidence, and use a portion of the proceeds to fund child care and free college tuition (Fig. 12). The rest will be used to reduce national debt, more than twice Japan’s $4.94 trillion GDP, ranking it highest among advanced nations in terms of debt-to-GDP (Fig. 13). The tax hike has been postponed numerous times in the past on concerns that the economy was too weak; yet this time Abe has vowed to push ahead, barring a financial crisis on a par with 2008. A tax hike in 2014 to 8.0% from 5.0% threw the country into recession.

The victory was all the sweeter for Abe coming on the heels of two domestic scandals that drove his approval ratings below 30%, a level that has proven fatal to past prime ministers, according to a 7/25 report in The Guardian. Abe’s decision to call for snap elections a year early caught the opposition off guard and poorly prepared.

The MSCI Japan Index is up 16.8% in dollars and 14.2% in yen ytd through Tuesday, with much of those gains coming since September (Fig. 14). With the market valued at a forward P/E of 14.3 and earnings growth estimated at 16.8% this year and 5.7% next year and estimates rising, there’s room for more gains. I asked Sandra to have a look at the data that has driven the stock market enthusiasm and underpins Abe’s win. Here is what she reports:

(1) Quickening GDP growth. The economy grew at the fastest pace in two years in Q2, the sixth straight quarter of economic growth, on strengthening domestic demand. On an annualized basis, real GDP expanded by 2.5% in the April-June period, the biggest jump since Q1 2015 (Fig. 15). The growth rate was revised significantly downward from a preliminary estimate of 4.0%, following a slowdown in private non-residential investment, but continues to represent a healthy clip.

Domestic demand rose a powerful 3.8% (saar) from the previous quarter. Household consumption, representing 60% of GDP, increased by 3.4% (saar) q/q, and capital spending accelerated by 7.1% (saar) q/q.

There has also been a pickup in industrial production, up 2.0% in August, as machinery orders rebounded in July and August (Fig. 16).

(2) Exports surging. Exports expanded at the fastest pace in nearly four years in August, rising 18.0% y/y, well ahead of forecasts of 14.3% growth and the biggest increase since November 2013, according to a 9/19 Bloomberg piece. It was the ninth monthly increase. Autos and semiconductors led the growth, which were helped by a weaker yen. Exports to China, Japan’s biggest trading partner, rose 25.8% y/y. US shipments increased 21.8% y/y, and those to the European Union rose 13.7% y/y.

(3) Imports rising. Strengthening domestic demand—mainly for coal, liquefied natural gas, and crude oil—lifted imports 15.2% y/y in August versus a projected 11.6%. It was the eighth month in a row of increases.

(4) Inflation dormant. Still, for all Japan’s progress, inflation remains near zero, far from Abe’s 2.0% target. Despite a tight labor market, wages remain stagnant, as firms are reluctant to boost salaries on concerns that they won’t be able to pass price hikes onto customers (Fig. 17). To break the logjam, the government now is considering expanding tax incentives to encourage companies to raise wages, according to a 10/24 NYT story.

(5) Demographic implosion. It’s been called “the ticking time bomb” threatening Japan and its economy: Japan’s population is now expected to shrink by close to a third by 2065, to 88 million from 127 million in 2015, according to figures updated in April by the health ministry and detailed in a 4/11 story in The Telegraph. By 2065, people aged 65 and older will make up 38% of the population compared with 10% for those aged 14 and under. That suggests there will be only 1.2 working people to support every person over 65 by 2065, compared with 2.1 in 2015. This has serious negative implications for the country’s healthcare system, pension system, tax revenue, and labor productivity.

Japan just broke its own record for the number of people living beyond 100 years: There are 67,824 centenarians, according to data released in September by the health ministry, compared with 339 in 1971, notes a 9/15 report in Business Insider.

The government is focusing on providing more child care in an effort to attract more women into the workforce as a way of stemming the declining population growth. And it’s redefining “elderly” to age 75 and up from 65 as a way of keeping more people in the workforce. Robotics and artificial intelligence are also a priority.

One sure way to address the problem is to allow large-scale immigration. Health ministry forecasters reckon that if the number of foreigners were to increase by 250,000 every year, it would add significantly to the population and raise the total to 100.7 million by 2065. Yet Japan is a homogeneous society that has historically been reluctant to embrace immigration, which remains an unpopular subject. Quietly, though, Japan’s resident foreign worker population has risen 40% since 2013, according to a 3/28 report by the Migration Policy Institute.

The sun will come out tomorrow in the Land of the Rising Sun. But for Japanese stocks to keep rising over the long term, Abe and his ruling party will have to find the answer to the population problem.

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Fearless

October 25, 2017 (Wednesday)

Strategy I: White Swans. Pete Seeger’s song asks, “Where have all the flowers gone?” Today, the question is, “Where have all the black swans gone?” Is it really possible that we have nothing to fear but fear itself? It’s not that hard to come up with more substantial fears. For example, as I observed yesterday, many of our accounts are asking me, “Won’t the stock market take a dive if the Republicans fail to pass tax reform including tax cuts?” My answer, “What if they succeed in doing so?” That white swan seems to be driving stock prices to new record highs since the Trump administration presented its 9/27 Unified Framework for Fixing Our Broken Tax Code.

Another white swan for stock prices is earnings. Let’s review the latest data:

(1) Q3. The Q3 earnings season is showing that the blended estimated/actual earnings for S&P 500/400/600 are down sharply through the 10/19 week (Fig. 1). Some of the weakness reflects the hit from hurricanes Harvey and Irma. The traditional upside hook is showing up in the S&P 500’s Q3 earnings series. The stock market is obviously ignoring that y/y earnings growth rates are down for S&P 500 (from 10.0% during Q2 to 3.5% during Q1), S&P 400 (12.3% to 3.4%), and S&P 600 (6.1% to 0.9%) (Fig. 2).

(2) Q4. Analysts must believe that the Q3 weakness is temporary, because their earnings estimates for Q4 have been remarkably stable since the start of the year. They are expecting Q4 rebounds in earnings growth rates back into the double digits for the S&P 500 (12.0%), S&P 400 (13.0), and S&P 600 (18.1).

(3) 2018. Also holding up remarkably well are analysts’ consensus earnings expectations for the three market-cap categories in 2018 (Fig. 3). They are currently predicting solid growth rates for next year for the S&P 500 (11.6%), S&P 400 (15.2%), and S&P 600 (22.2%).

(4) 2019. Joe and I are now starting to track weekly consensus expectations for 2019 earnings. Analysts currently estimate that S&P 500 earnings will rise from $130.70 this year to $145.91 next year and $159.30 in 2019. The 2019 growth rates for the S&P 500/400/600 are 9.2%, 3.9%, and 5.7%.

(5) Forward earnings. Since they are time-weighted averages, forward earnings of the three S&P 500 stock market indexes are rapidly converging toward their 2018 consensus estimates. Next year, they will increasingly give more weight to their estimates for 2019 and less to those for 2018. In other words, company results being reported now for Q3 and to be reported in January for Q4 are mostly irrelevant to stock market investors at this point, except in cases suggesting significantly altered earnings outlooks for 2018 and 2019.

(6) Forward revenues. Driving earnings estimates higher are solid projected growth rates in revenues (Fig. 4). For 2018, they are estimating 5.1%, 5.0%, and 5.3% for the S&P 500/400/600. For 2019, their estimate revenues growth rates are 4.9%, 3.9%, and 4.3%. The march to record highs of the S&P 500 forward revenues since early this year has been particularly impressive.

Strategy II: Gray Swans. With so many white swans swimming in the stock market, it’s hard to see any black ones. Our worst-case scenarios currently are more like gray swans:

(1) 1987 all over again. The stock market melts up through early next year. Then something bad happens, which isn’t so bad but is bad enough to cause an ETF-led flash crash. Neither the bad event nor the crash are wicked enough to cause a recession. So it would be reminiscent of 1987, when the S&P 500 plunged 20.5% on Black Monday, October 19. The closing price of that day turned out to be a great buying opportunity. The S&P 500 retested this low on December 4 before starting a new bull market. The bad event in this scenario might be the failure of the Republicans to achieve their tax reform agenda.

(2) New Fed sheriffs. Another event that might trigger a meltdown, or cap a meltup, might be a more hawkish Fed. Under the leadership of newly appointed governors to replace Fed Chair Janet Yellen and Fed Vice Chair Stanley Fischer, the Fed might be more inclined to see a stock market meltup as a potentially worrisome bubble. If so, the FOMC might be more willing to employ either monetary policy and/or so-called macroprudential policies to take some air out of the bubble.

(3) QE termination. Another gray swan might be the termination of QE programs by the major central banks. The perma-bears (remember them?) growled that the current bull market was driven mostly by the Fed’s QE programs. They showed a chart with the S&P 500 compared to the balance-sheet assets of the Fed (Fig. 5). The two series were highly correlated until the Fed terminated QE at the end of October 2014. Since then, the Fed’s assets have been flat around $4.3 trillion, while the S&P 500 is up 27.1%!

This month, the Fed started to let its balance sheet shrink as its bonds mature. Yet there’s no fear showing in the stock market, or even the bond market for that matter. Perhaps the gray swan will make an appearance when the European Central Bank (ECB) and the Bank of Japan (BOJ) announce that they are terminating their QE programs. The S&P 500 may be hooked on the combined QE programs of the Fed, the ECB, and the BOJ (Fig. 6).

(4) Little Kim. Perhaps something bad will soon happen between the United States and North Korea. This past weekend, Japanese Prime Minister Shinzo Abe was re-elected with a decisive win. He is one of President Donald Trump’s strongest allies in Asia as both Washington and Tokyo grapple with how to handle Pyongyang. CNN reported: “Abe, a conservative hawk, has long been a supporter of Trump’s more aggressive North Korea policy, which has coincided with his attempts to rewrite Japan’s post-war pacifist constitution.

“Following Sunday’s vote, Japanese Defense Minister Itsunori Onodera warned the threat from North Korea—which has repeatedly fired missiles over Japan in recent months—had reached an ‘unprecedented, critical and imminent’ level.”

The question is, “Why don’t the Chinese remove Kim Jong Un, the belligerent nuke-obsessed leader of North Korea?” Thanks to him, Abe was basically given a mandate to upgrade Japan’s military capabilities, not a welcome development in Beijing. The Chinese know where all of North Korea’s nukes are located since they trained all of the country’s rocket scientists. They can always de-Kim and de-nuke North Korea. So what are they waiting for?

They may be hoping to use their obvious leverage to change North Korea’s regime to get recognition of their sovereignty over the South China Sea resulting from their man-made islands. It’s a dangerous game, but it isn’t likely to end with a military confrontation. That seems to be the widespread assumption among stock investors. I agree. However, that elusive black swan we’ve been looking out for just could be swimming in the South China Sea.

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Halloween Is Coming

October 24, 2017 (Tuesday)

Strategy: Whistling Along. This is the time of the year when most of us—especially the older folks among us—express amazement at how fast the year has gone. Halloween is next Tuesday. Less than three weeks later is Thanksgiving. Shortly thereafter come Hanukah and Christmas celebrations. Before you know it: Happy New Year, 2018!

September is long gone. It is supposed to be the scariest month of the year for stock investors, perhaps in anticipation of Halloween. During the Septembers from 1928-2017, the S&P 500 has managed to lose 1.0% on average (Fig. 1). October has a history of some harrowing selloffs too, though on average it’s been up 0.5%. This year, the S&P 500 rose 1.9% during September, and October is up 2.2% through the end of last week. So now we can look past Halloween to November and December, which tend to be among the best months of the year on average, with gains of 0.7% and 1.4%, respectively.

In recent meetings with some of our accounts in NYC, I’ve been asked whether the stock market might take a dive if the Republicans fail to pass tax reform. This admittedly very small survey of investors’ psyches suggests to me that there’s still plenty of fear that the Republicans will screw it up despite their majority status in Congress. The fear is that the Republicans will deliver more tricks than treats.

Meantime, the stock market has continued to forge ahead to new highs ever since the Trump administration presented its 9/27 Unified Framework for Fixing Our Broken Tax Code. The S&P 500 is up 3.1% since the day before it was released through the end of last week. On 10/4, Melissa and I noted that the framework is an outline that “is leaving it up to Congress to fill in the details that will make it a plan. The Republicans need to make tax reform the law of the land to hold onto their slim majorities in both houses of Congress come next year’s mid-term elections. They might fail as miserably on this challenge as they did on repealing and reforming Obamacare, when their majority splintered and not one Democrat in either the House or the Senate supported their effort.”

As we noted yesterday: “Also driving the market higher recently are rising expectations that there will be tax reform by early next year that will include a cut in the corporate tax rate. On Thursday, the Senate passed a budget resolution that may expedite tax legislation. The budget proposal includes $1.5 trillion in tax reductions over the next 10 years. It might be possible to pass it with a simple 51-vote majority in the Senate, without a conference committee with the House of Representatives.”

So the question now may be: “What if tax reform happens?” rather than “What if it doesn’t happen?”!

The Republicans might actually deliver a treat rather than another lame trick. There’s increasing chatter that this might happen by the end of this year or early next year. That provides an upbeat path for the stock market bulls to continue charging ahead. If it turns into a stampede, then the resulting meltup could set the stage for a correction when tax reform is actually enacted. Of course, the selloff would be more severe if the Republicans screw it all up. Let’s review the recent chatter, as provided by a 10/13 CNBC article on the subject:

(1) President Donald Trump, top White House officials, and House Speaker Paul Ryan all aim to approve a tax bill before the end of this year. Ryan said on Thursday, October 12 that he would keep the House in session through Christmas if necessary.

(2) Texas Republican Senator Ted Cruz told CNBC on Friday, October 13 that it will take “at least a couple months” to iron out differences within the GOP, which has a narrow majority in the Senate. “I do think virtually every Republican wants to get to yes” on overhauling the tax system he said. He expects tax reform to get done “late this year or early next year.”

(3) The GOP is running into political dissent within the party. Some GOP lawmakers, such as Senator Bob Corker, have expressed concerns about the potential budget deficits the tax cuts would generate. Republican lawmakers in high-tax blue states have started to push back on a proposal to get rid of state and local tax deductions.

US Economy I: Faith-Based Economics. There are lots of good reasons for overhauling our tax system. However, while the Republicans might succeed in pushing for some tax cuts, I doubt that the tax code will be shorter or much simpler than before their reforms. I wish I was kidding, but the reality is that we have the best tax code money can buy. Billions of dollars have been spent on lobbyists and by lobbyists to fashion the tax code to meet the special interests of special interest groups. It’s hard to imagine that Trump will be signing a tax reform package that will significantly reduce the complexity of the tax code. I hope I am wrong, but I’ll believe it when I see it.

I would love to believe that reducing marginal personal income tax rates and cutting the corporate tax rate will boost economic growth sufficiently so that the reforms “will pay for themselves,” as is the mantra of supply-side economists. To prove their point, they often point to the pickup in US economic growth following the tax cuts implemented by the Kennedy, Reagan, and Bush administrations. Reagan cut the top marginal income tax rate from 70% to 28%. He reduced the top corporate tax rate from 46% to 40%. That helped boost the economy out of severe recession at the start of the 1980s. President Bush also used supply-side economics to cut taxes in 2001 and again in 2003. The economy grew, and revenues increased. Supply-siders give tax cuts all the credit for better growth. The problem is that it’s hard to separate out the impact of other variables such as easy monetary policies and bubbles in stocks and real estate.

Supply-siders favor “dynamic scoring” of their tax-cutting proposals over the coming 10 years. The exercise requires using an econometric model that allows for a feedback loop from lower tax rates to better economic growth, which generates more tax revenues, which “pay” for the tax cut. They might be right. I hope they are. But lots can happen over a 10-year period. I would feel better about it all if there were more efforts made to slow the growth of government spending on entitlements at the same time. The problem is that progressives can counter that if the supply-siders can have tax cuts, they should get to keep their entitlements. If the tax cuts can pay for themselves, maybe they can also pay for more entitlements. It’s all faith-based economics to me. Let’s review what the facts show:

(1) Federal government receipts as a percentage of nominal GDP has tended to fluctuate in a flat trend (Fig. 2). Since 1948, it has ranged between a high of 20.4% and a low of 13.4%, averaging 17.6%. It is very procyclical, rising during economic expansions and falling sharply during recessions.

According to supply-side theory, cutting tax rates will boost the growth rate of nominal GDP. On a static scoring basis, the Revenues-to-GDP Ratio (RGR) should fall initially, especially if GDP growth responds rapidly to the tax cut. But in time, better GDP growth will generate more revenues.

The extreme procyclicality of the RGR since 1948 suggests that no matter what the individual tax rate might be, revenues outpace GDP during expansions. The ratio has almost always risen to a new cyclical high during expansions, peaking just before recessions.

This suggests that the best fiscal and monetary policies for the RGR are the ones that prolong the business cycle.

(2) Federal government outlays as a percentage of nominal GDP is countercyclical (Fig. 3). It tends to rise during recessions, peaking at the end of these downturns. It then falls during expansions, tending to trough just as the economy falls back into another recession.

This ratio has had an upward drift since the mid-1960s, when the Johnson administration expanded the New Deal entitlements programs through the Great Society social welfare programs.

(3) Don’t get me wrong: As an entrepreneur running a small business, I certainly would be happy to see lower tax rates. They might boost economic growth, and at least partly pay for themselves. But I’m skeptical that faster growth can be achieved given the demographic outlook for the US. There is room for growth in productivity, which might get a boost if lower taxes boost final demand. After all, productivity has a demand side in addition to a supply side. You can have the most efficient widgets factory in the world, but if no one wants widgets, your productivity will be zero. Ironically, supply-side tax cuts might work by stimulating demand, boosting productivity and GDP growth.

US Economy II: Chugging Along. While we are all waiting to see whether tax cuts are coming, the economy continues to grow at a slow but steady pace. The Atlanta Fed’s GDPNow model is currently forecasting 2.7% real GDP growth for Q3. The data are hard to interpret for September and October as a result of the direct impacts on the economy of hurricanes Harvey and Irma and their consequences. September’s auto sales rose sharply, perhaps reflecting demand to replace flooded vehicles (Fig. 4 and Fig 5).

The October regional surveys conducted by the New York and Philly Feds showed quite a bit of strength. The average of their composite indexes jumped from 24.1 during September to 29.1 this month, just shy of February’s 31.0—which was the highest reading since July 2004 (Fig. 6). The average of their new orders dipped, from 27.2 to 18.8, but remains high. The big surprise was the big jump in the average employment index from 8.6 to 23.1, the highest since May 2011.

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From Seinfeld to Sinatra

October 23, 2017 (Monday)

Strategy: Bull’s Theme Song. The last significant correction during the current bull market occurred from November 11, 2015 through February 11, 2016, when the S&P 500 fell 13.3% to bottom at 1829.08 (Fig. 1). The S&P 500 is up 40.8% since then, which in normal times would be a decent bull market all by itself. It is up 22.7% y/y, near the best readings since the beginning of 2013 (Fig. 2).

Last year on May 23, when the S&P 500 was back up to 2048.04, Joe and I observed that it still had failed to take out the previous record high 2130.82 reached on May 21, 2015. We wrote: “While these flat market trends suggest that it has been a ‘Seinfeld market’—i.e., nothing much happening over the past year—there has been significant volatility on occasions, which could certainly recur.” When the S&P 500 broke to record highs during the summer of 2016, we amended our spin as follows on July 12: “The rally in stock prices to new record highs is somewhat reminiscent of a Seinfeld episode. It is happening because not much is happening other than interest rates are at record lows.”

This year on May 3, we elaborated on our theme as follows: “‘The Pitch’ is the 43rd episode of the TV sitcom Seinfeld. It is the third episode of the fourth season. It aired on September 16, 1992. In it, NBC executives ask Jerry Seinfeld to pitch them an idea for a TV series. His friend George Costanza decides he can be a sitcom writer and comes up with the idea of “a show about nothing.” The bull market in stocks since March 2009 has had a fairly simple script too. As a result of the Trauma of 2008, investors have been prone to recurring panic attacks. They feared that something bad was about to happen again, so they sold stocks. When their fears weren’t realized, the selloffs were followed by relief rallies to new cyclical highs and to new record highs since March 28, 2013.”

With nothing bad happening, the path of least resistance for the stock market has been up to new record highs. Perhaps it is time to move on from the Seinfeld analogy. Instead, consider the possibility that the bull market has a theme song now, namely “Fly Me to the Moon,” sung by Frank Sinatra:

Fly me to the moon
Let me play among the stars
Let me see what spring is like
On Jupiter and Mars ….

Stock investors are certainly singing along:

Fill my life with song
And let me sing for ever more
You are all I long for
All I worship and adore
In other words, please be true
In other words, I love you.

Until this year, the bull market had been widely described as the most hated bull market in history. Now it seems to be one of the most beloved. Go figure! The bull continues to return the love to his adoring fan base, which seems to be growing rapidly. Consider the following:

(1) Bull-Bear Ratio. The bull market has plenty of supporters, as is obvious by its unidirectional move to the upside since late last year. Investors Intelligence reports that the Bull-Bear Ratio rose to 4.00 during the week of October 10 and remained elevated at 3.95 last week (Fig. 3). The percentage of bears is just north of 15.0 over the past two weeks.

(2) Leading the way. This year, investors have certainly fallen in love with Information Technology, Industrials, Financials, and Materials. Joe and I gauge the momentum of the S&P 500 sectors by tracking their 200-day moving averages (Fig. 4, Fig. 5, and Fig. 6). Here are their 200-dma ytd performance derbies: Information Technology (23.9%), Financials (23.4), Industrials (14.7), Materials (12.9), S&P 500 (12.9), Consumer Discretionary (11.2), Health Care (8.5), Utilities (6.0), Consumer Staples (3.4), Real Estate (0.3), Energy (-1.7), and Telecommunication Services (-5.1). Lagging, but with admirable gains, are Consumer Discretionary and Health Care. The focus on cyclical stocks suggests that investors are expecting that the economic expansion may last for a while.

(3) Fed heads. The question of who will replace Fed Chair Janet Yellen should be troubling the stock market. It seems to have gotten the attention of the US Treasury 10-year bond yield, which is up from this year’s low of 2.05% on September 7 to 2.39% on Friday (Fig. 7). That’s largely on anticipation that Stanford University Professor John Taylor is leading the pack of candidates for the Fed’s top job. He is deemed to be more hawkish than some of the other ones under consideration. This might be why he won’t get the job after all. In any event, the prospect of higher bond yields has been a big positive for the Financials, much more so than it has been a negative for the other sectors.

The WSJ quoted President Trump late last week on this subject as follows: “Most people are saying it’s down to two: Mr. Taylor, Mr. Powell. I also met with Janet Yellen, who I like a lot. I really like her a lot. So, I have three people I’m looking at, and there are a couple of others.” Federal Reserve Governor Jerome Powell is widely viewed as a clone for Yellen on monetary policy.

(4) Trump card. Also driving the market higher recently are rising expectations that there will be tax reform by early next year that will include a cut in the corporate tax rate. On Thursday, the Senate passed a budget resolution that may expedite tax legislation. The budget proposal includes $1.5 trillion in tax reductions over the next 10 years. It might be possible to pass it with a simple 51-vote majority in the Senate, without a conference committee with the House of Representatives.

(5) The four phases. While we are all singing Sinatra’s happy go-lucky song, let’s not forget the always relevant observation of Sir John Templeton: “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”

American Demographics: Slicing & Dicing. Every now and then, Melissa and I like to update our analysis of demographic trends in the US. These trends change slowly, but they do change, and they certainly do have an impact on the economy. The obvious conclusion is that the profile of American households has changed dramatically since the 1950s. Let’s review some of the more important trends focusing on the characteristics of total households:

(1) Families and nonfamilies. Family households as a percentage of total households has declined from 89.4% during 1947 to 65.3% during 2016 (Fig. 8). The percentage of nonfamily households has increased from 10.6% to 34.7% over this same period. These trends reflect that Americans are living longer, so there are more seniors who live in nonfamily arrangements. Millennials are staying single longer than previous generations.

(2) Married couples. Married couples as a percentage of total households has fallen from 78.3% during 1947 to 47.9% during 2016 (Fig. 9). Over the same period, all other (households excluding married couples) rose from 21.7% to 52.1%.

The percentage of family households with a father only or mother only has increased from 11.1% to 17.4% (Fig. 10).

(3) Children. Most of the drop in the percentage of households that are families has been attributable to families with children. The percentage of families with children has declined 46.7% to 27.6% of total households from 1950 through 2016 (Fig. 11). Married couples with children as a percentage of total households has fallen from 43.2% to 18.9% over this same period (Fig. 12). The percentage of other families with children has risen from 3.4% to 8.7%. The percentage of married-couple households without children has been relatively flat around 30% since the 1950s (Fig. 13).

(4) Average size. The percentage of households with only one person has increased from 13.1% during 1960 to 28.1% during 2016 (Fig. 14). The percentage with two persons rose from 27.8% to 34.0% over this period. The percentage with three or more persons dropped from 59.1% to 37.9%.

There was a big drop in the average number of children per family from about 2.3 in the early 1970s to about 1.8 in the late 1980s. It’s been ranging between 1.8-1.9 since then (Fig. 15).

The conclusion is that in the decades since the 1950s, the profile of the average American household has changed dramatically. At the start of the 1950s, families accounted for 90% of all households, with close to 80% of all households having married couples. Today, families are down to 65% of households and married couples are down to 48% of households.

Children have been going out of fashion. Families with them dropped from 47% to 28% of all households since the early 1950s. Married couples with children fell from about 43% to 19%.

Smaller households, fewer kids, and fewer married couples: That’s the profile of Americans today. Most of these trends can be explained by the rising percentage of the working-age population that is single, which has increased from 38% at the start of the data during 1976 to about 50% since 2013.

Movie. “Blade Runner 2049” (+) (link) is a sequel to the 1982 flick starring Harrison Ford. This one stars Ryan Gosling. In both movies, the world is full of “replicants,” which are biorobotic androids. They are virtually identical to adult humans, but are stronger, speedier, more agile, and more resilient. They come in different models with varying degrees of intelligence. The only way to recognize them is by their lack of emotional responsiveness. Yet, just as I found myself rooting for the apes in the “Planet of the Apes” movies, I found myself rooting for the replicants.

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Path of Least Resistance

October 19, 2017 (Thursday)

Strategy: Slow Motion Melt-Up. The S&P 500 closed at 2139.56 on Election Day, November 8, 2016. On December 12, Joe and I predicted that the S&P 500 would rise to 2400-2500 by the end of 2017. On July 31 of this year, we wrote: “Our yearend target of 2400-2500 has been achieved way ahead of schedule. Now, as strategists, we are aiming for 2700 by the middle of next year, a four-fold increase since March 2009. Assuming a forward P/E of 18, we would need to see forward earnings climb to $150 per share by the middle of next year, up about 7.4% from the latest reading in late July. That’s realistic, in our estimation.”

Here we are in late 2017 with the S&P 500 at 2559.36. It is up 19.6% since Election Day. Last week, S&P 500 forward earnings rose to a new record high of $142.36 per share (Fig. 1). That’s impressive considering that industry analysts have been slashing their earnings estimates for Q3-2017, which was hard hit by the hurricanes (Fig. 2). However, all of 2017 is increasingly irrelevant as forward earnings per share is rapidly converging to the consensus earnings estimate for next year, which is currently $145.55. The 2018 consensus will become increasingly irrelevant next year as forward earnings converges with the estimate for 2019, which is currently $159.09.

Meanwhile, the S&P 500 forward P/E is currently at 18.0 (Fig. 3). Our Blue Angels analysis shows stocks flying as forward earnings continues to climb to record highs almost every week since Election Day (Fig. 4). No wonder the market is up almost every day since then. There hasn’t been one significant correction since early 2016.

Industry Focus: Pharma and Biotech. Earlier this week, President Donald Trump repeated his dissatisfaction with the high price of prescription drugs. It’s one of the few subjects that can unify both Democrats and Republicans. The President certainly didn’t mince his words.

According to a 10/16 Bloomberg video, the President said: “Prescription drug prices are out of control. … If you look at the same exact drug, by the same exact company, made in the same exact box and sold someplace else, sometimes it’s a fraction of what we pay in this country. Meaning, as usual, the world is taking advantage of the United States. They are setting prices in other countries and we’re not. The drug companies, frankly, are getting away with murder. And we want to bring our prices down to what other countries are paying. Or at least close and let the other countries pay more because they’re setting such low prices that we’re actually subsidizing other countries and that’s just not going to happen anymore.”

While it’s hard not to sympathize with his outrage, it’s also tough to pinpoint a solution unless the FDA wants to get into the business of setting prices. The President can pontificate, but there’s no use in investors’ panicking about drug price legislation until a credible plan is put forth. Indeed, the government may not have to get directly involved since the commentary from the ultimate bully pulpit may already be having the desired effect. Consumer prices for prescription drugs have been rising much more modestly in recent months. The September CPI for prescription drug prices rose 1.4% y/y, the lowest rate since January 2014 (Fig. 5).

The pharmaceutical and biotech stock indexes barely flinched at President Trump’s latest attack. The S&P 500 Biotechnology index is up 28.1% ytd through Tuesday’s close (Fig. 6). The shares are down 2.1% relative to their all-time high hit in 2015. The gains in the S&P Pharmaceuticals index aren’t quite as exuberant, at 13.2% ytd, but the index is also near all-time high levels that it has tried to top twice before over the past two years. If the index succeeds on its third attempt, it would be breaking out after more than two years of consolidation (Fig. 7). I asked Jackie to have a deeper look at some of the developments on the state and federal levels that may affect drug prices going forward. Here is her report:

(1) FDA on the case. New FDA Commissioner Scott Gottlieb—a Trump appointee—declared high drug prices a “public health concern” that the FDA should address. He is approaching the matter by fostering increased competition by speeding up the approval process for complex generic drugs. The goal is to make a more efficient generic drug development, review, and approval process.

Gottlieb appears ready to make other changes as well. In a 7/24 Bloomberg interview he said, “There are situations where … branded drug companies are taking advantage of certain rules to prolong monopolies beyond the point in which Congress intended, and that’s what I’ve called the ‘gaming.’ We want to have more generic drugs approved on the first cycle. That’s not only going to get more competition into the market, it’s also going to end what I call the opportunity for regulatory arbitrage where you see speculators come into the market and pick off a generic drug that might not face a lot of competition. Now they have a monopoly for themselves and they’re able to jack up the price because our process itself isn’t efficient. So, we’re going to try to target those products.”

We noted in the 9/7 Morning Briefing that the pace of FDA new drug approvals has picked up this year, helping biotech stocks. Turns out, the FDA has also been speedier with generic drugs, approving an average of 763 applications in its fiscal year ending September, up from 651 last year and 494 in fiscal 2015. Already, those efforts may be having an effect: “Counterintuitively, that has served as an overall headwind for generic drug manufacturers. Speedier approvals boost competition and restrain manufacturers’ pricing power. Shares of many generic drug makers have struggled this year, despite an overall strong market for stocks,” a 10/6 WSJ article explained.

(2) States taking action. Instead of waiting for the federal government to bring down drug prices, a number of states are jumping into the fray. Earlier this month, California passed a law that requires drug companies to explain large price increases. “The law requires pharmaceutical companies to notify insurers and government health plans at least 60 days before a planned price increase of more than 16 percent during a two-year period, and to explain the rationale for the increase. The information will be available on a government website,” reported a 10/9 Bloomberg article. The practice will begin in January 2019. The industry is expected to attempt to block the legislation in the state courts.

California isn’t alone. Nevada passed a law that “requires pharmacy benefit managers to reveal rebates they receive from insulin makers, how much of those rebates are passed on to insurers and what they keep for themselves,” a 9/13 Bloomberg piece explained. The price of Eli Lilly’s Humalog insulin cost $21 a vial when introduced in 1996, and today its list price is $275. The Biotechnology Innovation Organization and the Pharmaceutical Research and Manufacturers of America responded by suing Nevada, saying the law “violates patent rights and jeopardizes trade secrets.”

Maryland has a law on its books to penalize drug companies that price-gouge. The state will investigate reports of “unconscionable” price increases for essential off-patent or generic drugs. The law doesn’t apply to drugs that still have patent protection. Violators will be fined up to $10,000. The state “can also require a manufacturer or distributor to show its records and justify a price increase,” a Reuters article reported on 9/29. The law survived the generic drug industry trade group’s initial request for an injunction, but the trade group plans to appeal the court’s decision.

In New York, a law passed this year will limit what the state’s Medicaid program will pay for drugs. If companies don’t discount a drug’s price enough, the state will review whether the price is out of line with its value. Meanwhile in Vermont, officials are allowed to scrutinize up to 15 drugs with rising prices on which the state spends “significant healthcare dollars,” noted a 9/29 Washington Post article.

(3) Could Amazon cure all? If there ever was an industry ripe for disruption, it’s pharmaceuticals. Its pricing is opaque, its distribution often involves multiple layers, and going to a drug store when you’re sick to pick up medicine seems so 1950s.

Have no fear: Amazon reportedly plans to jump into the market of selling drugs by 2019. David Larsen, a Leerink Partners analyst, said his calls with “industry experts suggest that Amazon ‘is in active discussions’ with midsize pharmacy benefit managers and possibly a larger player,” reported a 10/6 Bloomberg article. Meanwhile, CNBC disclosed on 10/6 that an email from Amazon said it would decide before Thanksgiving whether to move into selling prescription drugs online. Needless to say, that hasn’t been good news for drug store retailers CVS and Walgreens. The S&P 500 Drug Retail stock price index has fallen 6.7% since 10/6 and is down 33.8% from its July 29, 2015 peak (Fig. 8). Its forward P/E has tumbled to 12.0 from 20.8 in July 2015, not far from the depressed levels of the recession (Fig. 9).

(4) No fever here. As noted above, despite the bluster from the White House, the rapid FDA generic drug approvals, and the approaching shadow of Amazon, biotech and pharma stocks continue to rally. The S&P Pharma industry is expected to grow earnings by 8.1% over the next 12 months, and the net earnings revisions have been increasingly positive over the last three months (Fig. 10 and Fig. 11). Meanwhile, its forward P/E of 15.9 is below the broader market and low relative to the industry’s history (Fig. 12).

The S&P 500 Biotech industry has similar patterns. It’s expected to grow earnings by 5.4% over the next 12 months. Industry analysts see the bottom line accelerating, from a decline of 0.1% this year, to 6.5% growth in 2018 and 10.5% in 2019 (Fig. 13). Granted, that’s looking far into the future, but at least the future looks bright. Here too, net earnings revisions from analysts have been increasingly positive (Fig. 14). And with a forward P/E of 15.5, the industry remains less expensive now than it has been during most periods over the last 20 years (Fig. 15).

Managed Health Care: Negotiations Ongoing. Beware the tweet. Just when it looked like the President and Congress were inching toward a temporary fix to the Affordable Care Act (ACA), the President sent out a tweet on Wednesday that said he “can never support bailing out (insurance companies) who have made a fortune with O’Care.” The implication: He won’t support the bipartisan deal struck on Tuesday, supposedly with the President’s encouragement.

Confused? Let’s take a step back. Things heated up last week when President Trump announced his administration would immediately end billions in payments to insurance companies under the ACA. Congress never appropriated funds for the ACA payments and therefore, he contended, making the payments was unlawful.

At the same time, however, President Trump reportedly let it be known that he would support preserving the payments if a bipartisan deal being negotiated by Republican Senator Lamar Alexander and Democratic Senator Patty Murray could be struck. And—wouldn’t you know?—less than a week later, the two senators reached a short-term deal that could be taken up by Congress.

Here’s the 10/17 WSJ explanation of the plan: “Under the deal, Republicans would get changes that let states get speedier and more flexible federal waivers to the health law, as well as the ability of more people to sign up for bare-bone health plans with low premiums. Democrats would get restored funding for billions of dollars in insurer subsidies, funds that Mr. Trump proposed cutting this month.” The funding would be set for two years. The deal would also make it easier for states to get federal waivers from the ACA law, granting them a faster review period and more room to experiment with different health care models.

President Trump reportedly called Senator Alexander on Wednesday morning. “’He called me to say that, number one, he wanted to be encouraging about the bipartisan agreement that Sen. Murray and I announced yesterday. Number two, he intends to review it carefully to see if he wants to add anything to it. Number three, he is still for block grants sometime later, but he will focus on tax reform this year,” according to a 10/18 WSJ account.

And then the tweet happened. Despite the uncertainty and confusion, S&P 500 Managed Health Care stock index remains near all-time highs, albeit with a bit of whiplash in recent days (Fig. 16). The index climbed 3.7% Monday and Tuesday, making up for a 3.6% loss late last week. Industry shares were also bolstered by news Tuesday that member UnitedHealth Group was increasing its 2017 earnings-per-share expectation to $10 up from a previous range of $9.75 to $9.90, even after its decision to exit the ACA market. It also announced that next year’s earnings could grow by 13% to 16% if the ACA tax on health plans does not return next year. If the tax does return, it would reduce EPS by 75 cents.

The Managed Health Care industry has been amazingly resilient despite all the political haranguing. The industry’s revenues are expected to climb 7.0% over the next 12 months, while earnings are thought to increase by 10.8% (Fig. 17). Net earnings revisions by analysts have been decidedly positive, and profit margins have improved after bottoming in early 2016 (Fig. 18 and Fig. 19). The industry’s forward P/E, at 17.3, is at the upper end of its traditional range, but it doesn’t look overly stretched (Fig. 20). That said, the market has a glimpse of how the industry’s shares will react without a deal. Let the horse-trading continue.

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Yellen Sees Rational Exuberance

October 18, 2017 (Wednesday)

The Fed I: Yellen Reviving Fed’s Stock Valuation Model. The world’s major central bankers met on Sunday at the Group of 30 International Banking Seminar in Washington, DC. Fed Chair Janet Yellen spoke. Her prepared remarks were a rehash of her recent pronouncements. Nothing new here, so move along, folks. More interesting were her impromptu remarks as reported by the 10/15 WSJ: “While asset valuations today are ‘high in historical terms,’ that may reflect investors’ expectations of a ‘new normal’ of lower interest rates for the foreseeable future than in the earlier decades, she said, adding that financial stability risks remain ‘at a moderate level.’”

Could it be that Yellen is reviving the Fed’s Stock Valuation Model? Sure seems that way. It all brings back lots of nostalgic memories for me:

(1) Greenspan’s question. The valuation question isn’t as existential as Hamlet’s “To be or not to be” soliloquy. The question is: “How can we judge whether stocks are overvalued or undervalued?” I’ve been working on answering this question for many years. I started thinking more about it after Alan Greenspan, former chairman of the Federal Reserve Board, famously asked the valuation question near the end of a 12/5/96 speech, “The Challenge of Central Banking in a Democratic Society.”

This was the first time any Fed chairman had ever mused publicly about the impact of monetary policy on the interaction of the inflation rate for goods and services and the valuation of equities. Notice that he asked a question rather than making a statement on valuation: “Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”

(2) Greenspan’s answer. After Greenspan famously worried out loud for the first time about irrational exuberance, his staff apparently examined various stock market valuation models to help him evaluate the extent of the market’s exuberance. One such model was made public, albeit buried in the Fed’s 7/22/97 Monetary Policy Report to the Congress that accompanied Greenspan’s Humphrey–Hawkins testimony. It included a chart showing a strong correlation between the US Treasury 10-year bond yield and the S&P 500 forward earnings yield—i.e., the ratio of the year-ahead forward consensus expected operating earnings to the price index for the S&P 500 companies (Fig. 1). The monthly chart compared the two series starting in 1982 and extending through July 1997.

This model was first developed in the mid-1980s by Dirk van Dijk at I/B/E/S, which had started compiling the forward earnings series on a monthly basis during September 1978. I first wrote about my discovery of the “Fed’s Stock Valuation Model,” as I dubbed it at the time, in my 8/25/97 commentary, a week after noticing it in the 7/22 report to Congress. In his testimony, as so often in the past, Greenspan played the role of a “two-handed economist.” I pointed out, though, that he was clearly inclined to be bullish: “Without question, the exceptional economic situation reflects some temporary factors that have been restraining inflation rates. In addition, however, important pieces of information, while suggestive at this point, could be read as indicating basic improvements in the longer-term efficiencies of the economy.”

(3) Long-term earnings growth. The Fed’s Model showed that stocks were fairly valued at the end of 1996, but 17.8% overvalued during July 1997 (Fig. 2). By June 1999, stocks were 42.5% overvalued relative to bonds. Along the way, in a 9/5/97 speech at Stamford University, Greenspan explained: “And the equity market itself has been the subject of analysis as we attempt to assess the implications for financial and economic stability of the extraordinary rise in equity prices—a rise based apparently on continuing upward revisions in estimates of our corporations’ already robust long-term earnings prospects.”

The Fed II: LTEG All Over Again. While he never said so specifically and it wasn’t a variable in the simple version of the Fed’s Model, Greenspan obviously was tracking a data series collected by I/B/E/S on consensus annual long-term earnings growth (LTEG) for the S&P 500, because it is the only one available for such expectations (Fig. 3). The monthly data start in January 1985 and are based on industry analysts’ annualized growth projections for the next three to five years. In July 1997, the consensus LTEG forecast was 13.5%, the highest recorded since the start of the data.

The LTEG series rose even higher during the next few years, peaking at a record 18.7% during August 2000. That was mostly because technology analysts in the late 1990s were under the influence of extreme irrational exuberance. Their LTEG expectations for the S&P 500 Information Technology sector soared to a record 28.7% during October 2000 (Fig. 4).

What’s the latest with the valuation question that Yellen says isn’t a problem? Consider the following:

(1) The Fed’s Model has been signaling that stocks are cheap relative to bonds since 2003. Since the beginning of the current bull market, stocks have been relatively cheap by 50% or more.

(2) Greenspan suggested that the Fed’s Model needs to account for LTEG. This measure of long-term expected earnings growth jumped from 9.6% during January 2016 to 13.7% during September for the S&P 500. That’s the highest since May 2002. In a sign of déjà vu all over again, the S&P 500 Technology sector’s LTEG is back up to 15.7%, the highest since June 2008.

(3) It seems that the election of President Donald Trump has boosted LTEG. Joe tracks the weekly data for the 11 sectors of the S&P 500. Here is where they are now during the first week of October versus the first week in November, just before the election: Energy (25.6% from 29.6%), Consumer Discretionary (20.1, 18.9), Information Technology (15.9, 14.4), S&P 500 (13.6, 12.5), Financials (13.2, 7.7), Real Estate (12.3, 13.4), Materials (12.0, 7.2), Industrials (11.2, 8.2), Health Care (10.3, 10.6), Consumer Staples (8.0, 8.5), Utilities (3.9, 4.1), and Telecommunication Services (2.5, 1.9) (Fig. 5).

This suggests that the run-up in stock prices since Trump’s election reflects expectations that a more pro-business administration (compared to the previous one), by providing deregulation and corporate tax cuts, should boost earnings growth over the next three to five years.

The Fed III: Taylor’s Rule? As Melissa and I noted yesterday, what Yellen says or thinks may be irrelevant if she is replaced by President Trump when her term as Fed chair expires on February 3, 2018. Monday’s Bloomberg reported that the president “gushed” about Stanford University professor John Taylor after their one-hour meeting last week. The 10/12 WSJ included an article, “What You Need to Know About John Taylor.” Here are some of the key excerpts:

(1) “Mr. Taylor is perhaps best known for his ‘Taylor Rule,’ first spelled out in 1993, that he says provides a mathematical formula to set the proper level of interest rates. The rule relies on the gap between actual inflation and output and their targeted levels as well as on the interest rates that would perfectly match the supply of and demand for credit.”

(2) “During the long recovery from the financial crisis and the recession, the rule would have called for considerably higher interest rates than the Fed put in place. Fed officials say higher rates during that period would have harmed the economy. Mr. Taylor, though, has spent the past few years calling for higher interest rates. By some economists’ estimates, his rule would currently prescribe the Fed’s benchmark federal-funds rate to be 3.5%, well above its current range between 1% and 1.25%.”

(3) “Mr. Taylor backs Mr. Trump’s claim that he can raise annual U.S. economic growth to a sustained 3%. In an essay co-authored with Stanford colleagues Kevin Warsh and John Cogan as well as with Glenn Hubbard of Columbia University, Mr. Taylor argued that tax cuts, deregulation and government spending cuts could boost private sector investment and productivity.”

Taylor spoke on Friday, October 13 at an economic conference hosted by the Federal Reserve Bank of Boston. The 10/15 WSJ provided a transcript. He reiterated that he believes that the Fed should adopt a rules-based approach to running monetary policy. In his opinion, the choice isn’t rules vs. discretion, but rather versus “chaos.”

He believes that the FRB/US econometric model used by the Fed is too complicated and favors a rule that is “relatively simple that would not create shocks and could react to shocks well.” He isn’t dogmatic: “I don’t think rules should be viewed as ways to tie central bankers’ hands. They are meant to help policy makers make better decisions ...”

The Fed’s 7/7 Monetary Policy Report, which accompanied Yellen’s congressional testimony, included a section titled “Monetary Policy Rules and Their Role in the Federal Reserve’s Policy Process.” The basic message was that the FOMC does pay attention to models such as the Taylor Rule, which prescribe the level of the federal funds rate. However, the Fed’s policymakers believe that these models ignore too many “considerations” that require their judgment when setting the federal funds rate. In the “rules versus discretion” debate, they clearly favor the latter approach.

For Fed watchers like me, discretion means that we will continue to find gainful employment as profilers of Fed officials. If Taylor turns out to be the next Fed chair, though, all bets are off.

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Addictions

October 17, 2017 (Tuesday)

Global Economy: Hooked on Central Bank Money. Joe and I have some good news and some bad news. The good news is that the global economy continues to show signs of solid economic growth, as evidenced by data we monitor on the forward revenues of the major MSCI stock market indexes. Over the past couple of weeks, we’ve focused on five reasons why this is happening: (1) Global monetary policy remains ultra-easy. (2) Chinese bank lending is at a record high. (3) The 50% cut in oil prices since mid-2014 is a big windfall. (4) Mass immigration into Europe is boosting the region’s economic growth. (5) The global bull market in stocks is having a very positive wealth effect on economic growth.

The first two are all about monetary conditions. As Melissa and I noted yesterday, while the Fed remains on course to gradually normalize monetary policy, the minutes of the 9/19-20 FOMC meeting and subsequent speeches by several Fed officials suggest that they are turning more dovish, i.e., less inclined to raise the federal funds rate, especially as the Fed is starting to trim its balance sheet. Meanwhile, the ECB continues to expand its balance sheet at a rapid rate, and Japan’s “Peter Pan,” BOJ Governor Haruhiko Kuroda, said this past Sunday that the central bank would continue its expansive monetary policy in an effort to boost inflation. Here are the latest central banks stats and global forward revenues:

(1) High-powered money. The sum of the balance sheets of the Fed, ECB, and BOJ rose to a record $14.2 trillion during September (Fig. 1 and Fig. 2). It’s up $1.4 trillion y/y, or 11.3% (Fig. 3 and Fig. 4).

(2) High-powered revenues. This cornucopia of liquidity has certainly helped to revive global economic growth following the energy-led slowdown from the second half of 2014 through the first half of 2016. That’s quite visible in revenues growth. Joe and I track year-ahead forward consensus expected short-term revenues growth (STRG) for all the major MSCI stock price indexes.

The All Country World growth rate is up from last year’s low of 2.7% during the week of March 17 to 5.4% during the first week of October (Fig. 5). By the way, both short-term and long-term earnings growth expectations have also picked up significantly over this period. STRG has improved across all the major MSCI indexes over this period: Asia ex-Japan (8.8% from 5.7%), Emerging Markets (8.6, 5.6), United States (5.4, 3.2), United Kingdom (4.9, 0.3), Europe (4.1, 1.4), and Japan (3.2, 0.9) (Fig. 6).

So what’s the bad news? Much of the world’s growth is being driven by China. Nothing wrong with that other than the fact that China is on an unnatural high attributable to record-high injections of debt, which is the Chinese government’s drug of choice.

China: Debt Overdose. The problem with drugs that provide a high is that more must be taken over time to maintain the high. In other words, they lose their effectiveness. The abuser is forced to take more drugs or suffer the painful consequences of the inevitable lows. China is the world’s greatest abuser of the drug called “debt.” China keeps using more of it to sustain economic growth, which is slowing nonetheless. The government has talked about putting the country in a rehab program, but it has been all talk, which is a common characteristic of junkies. Withdrawal is hard to do.

Yesterday, the Chinese reported September data for “social financing,” which includes lending by banks and the so-called “shadow banking system.” Debbie and I derive the latter stats by subtracting bank lending from the total. Here are the latest data documenting the extent of China’s debt addiction:

(1) Social financing is up $2.9 trillion over the past 12 months through September (Fig. 7). In yuan terms, the y/y pace reached was a record high.

(2) Bank loans rose $2.0 trillion over the past 12 months through September, matching August’s record high (Fig. 8).

(3) Shadow banking is mostly unregulated, as implied by its name. The government was concerned about its lending activities during 2013, when the 12-month pace rose to a record $1.65 trillion during May (Fig. 9). Some measures were implemented to squelch such activity. Nevertheless, over the past 12 months through September, the shadowy lenders lent out almost $1 trillion.

While China’s debt dealers are providing record amounts of it “on the street,” the country’s debt junkies are getting less of a high. The ratio of China’s bank loans outstanding to industrial production rose to a record 173.7 during August, up from 100 near the end of 2008 (Fig. 10). The Chinese are clearly getting less output bang per yuan of bank debt. The good news is that the Chinese bank debt is all internally financed, i.e., they owe it to themselves. China’s M2 is up $2.5 trillion y/y to a record high of $25.2. trillion during September (Fig. 11 and Fig. 12).

Bernanke: One More Toke. Former Fed Chairman Ben Bernanke is currently a Distinguished Fellow at the Brookings Institution and the Hutchins Center on Fiscal and Monetary Policy in Washington, DC. He remains very actively involved in the academic realm of monetary policy-making. He recently wrote a long paper, Monetary Policy in a New Era, that he presented at the Peterson Institute’s conference on Rethinking Macroeconomic Policy in Washington, DC, during October 12-13, 2017.

One section was focused on inflation targeting, a subject about which Bernanke literally wrote the book. When Bernanke was an academic economist focusing his research on monetary policy, he became intrigued by inflation targeting and went on to co-author the book Inflation Targeting: Lessons from the International Experience (2006) as well as write several articles about this approach.

Under Bernanke, the Fed on January 25, 2012 issued a statement adopting an explicit inflation target: “The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.”

In his recent paper, Bernanke wrote: “I have proposed for consideration a ‘temporary price-level targeting’ approach, which applies only at times at which policy rates are at or very close to zero; at other times, standard inflation targeting would prevail. Under this approach, monetary policymakers would commit in advance not to raise rates from zero at least until 1) average inflation over the entire ZLB period is at target, and 2) unemployment has returned to normal ranges.” (ZLB = the zero lower bound for the federal funds rate.)

In other words, the Fed should keep the federal funds rate near zero until the 2% inflation target has been achieved for a while. Fed Governor Lael Brainard in a 10/12 speech strongly endorsed the concept: “His proposed temporary price-level target would delay the liftoff of the policy rate from the lower bound until the average inflation over the entire lower bound episode has reached 2 percent and full employment is achieved. This type of policy, which would result in temporary overshooting of the inflation target in order to make up for the previous period of undershooting, is designed to, in Bernanke's words, ‘calibrate the vigor of the policy response ... to the severity of the episode.’”

Melissa and I concluded yesterday that this idea provides the Fed’s doves with more ammo to hold off on raising interest rates. What are they smoking? Here are a few of our objections:

(1) They just don’t get it! Current and former Fed officials refuse to admit that perhaps monetary policy plays a small part in the inflation process. So targeting inflation is pointless.

(2) They really should move forward with raising the federal funds rate. They should do it while the markets aren’t having any tightening tantrums. They should do it so that they will have more room to lower rates when bad times come again.

(3) If they don’t proceed with normalizing monetary policy because of their obsession with “lowflation,” then the result is likely to be a huge asset bubble. As we wrote yesterday: “Let the melt-up begin!”

Of course, all this could be irrelevant depending on who President Donald Trump picks to replace Fed Chair Janet Yellen and Fed Vice Chair Stanley Fischer. We have the same clues as everyone else does about who they might be. But we will wait until we know who they are with certainty before we guess what they’ll do.

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Bitdollars

October 16, 2017 (Monday)

Global Economy: Happy Days. Our friends at Lazard Asset Management ran a cool chart showing how the global synchronized recovery is lifting earnings estimates among the major MSCI stock price indexes around the world (Fig. 1). It was featured in the 10/13 The Daily Shot Brief. The data are time series for analysts’ consensus expectations for earnings growth over the next 12 months. Debbie and I have been tracking lots of other indicators from around the world that have been pointing in the same upbeat direction since late last year. Here is a quick update:

(1) Forward earnings. The global synchronized upturn is also very visible in forward earnings for the MSCI stock indexes for the US, Developed World ex- US, and Emerging Markets (Fig. 2). The US is at a record high, while the other two broad measures of forward earnings have been in cyclical rebounds since late 2016.

(2) Asia. August’s industrial production in Malaysia jumped 1.2% m/m and 6.8% y/y to a new record high (Fig. 3). Indonesian output has stalled at a record high for the past three months, with a gain of 2.3% y/y through August. Also showing strength are China’s September imports and exports, up 18.7% and 8.1% y/y through September (Fig. 4).

(3) US. The Atlanta Fed’s GDPNow model raised its forecast for Q3 real GDP growth from 2.5% to 2.7% on Friday following the release of a stronger-than-expected retail sales report and a weaker-than-expected core CPI, both for September. On a three-month basis, adjusted for inflation, Debbie reports that the retail sales report was mixed: up 2.6% (saar) for the total, 2.0% excluding building materials, and just 1.5% for core retail sales (excluding autos, gasoline, and building materials) (Fig. 5).

The headline CPI rose 0.5% m/m during September as a result of a temporary spike in gasoline prices, and just 0.1% on a core basis. On a y/y basis, the former was up 2.2%, while the latter rose 1.7%, remaining below the Fed’s 2% target (Fig. 6). Excluding food, energy, and shelter, the CPI inflation rate is just 0.6% (Fig. 7).

The Fed: Stargazing. Fed officials remain puzzled and concerned that inflation remains so low. Participants of the September FOMC meeting were split on solving the inflation puzzle: Why has inflation been so stubbornly low despite historically low levels of unemployment and incredibly accommodative monetary policy? The minutes demonstrated the debate: “In their review of the recent data and the outlook for inflation, participants discussed a number of factors that could be contributing to the low readings on consumer prices this year and weighed the extent to which those factors might be transitory or could prove more persistent.”

Melissa and I are in the latter camp that believes structural forces are likely to continue to weigh on inflation. FRB-ATL Fed President Raphael Bostic pointed out in a 10/12 speech that “abstracting from those transitory factors still leaves the inflation trend running a bit below the FOMC’s target.” The minutes stated that “many” participants are concerned “that the low inflation readings this year might reflect not only transitory factors, but also the influence of developments that could prove more persistent.”

If the low rate of inflation persists, it is safe to say that the Fed isn’t going to raise interest rates very quickly or much, if at all, from where they are now. It was noted in the minutes that “some patience in removing policy accommodation while assessing trends in inflation was warranted.” A “few” participants thought that “no further increases in the federal funds rate were called for in the near term or that the upward trajectory of the federal funds rate might appropriately be quite shallow.” In contrast to the view of the “many,” just “some” participants worried about upside risks to inflation from an “unduly slow pace” of rate hikes. Here’s more on the subject from the Fed’s talking heads:

(1) Big bang theory. In a speech on 10/12, Fed Governor Lael Brainard described the relationships that once guided monetary policymakers as currently “tenuous.” She was referring to the breakdown in the expected relationship between unemployment and inflation. That is, when unemployment is low as it is now, inflation should pick up. Specifically, Brainard highlighted that the Phillips curve, which is like the big bang of monetary policymaking theory, is now “very flat.” Former Fed Governor Daniel Tarullo said in a 10/4 speech at the Brookings Institution: “The substantive point is that we do not, at present, have a theory of inflation dynamics that works sufficiently well to be of use for the business of real-time monetary policymaking.”

(2) Constellation of factors. Three “common global factors” were citied in the FOMC minutes as the root causes of the breakdown in inflation theory: the change in workforce demographics (as baby boomers retire and are replaced by younger and presumably lower-paid workers), low productivity growth, and competitive pressures. In a 10/13 interview with Business Insider, FRB-SL President James Bullard added a fourth; he sees technology as a disinflationary force as well.

In a 10/11 speech, FRB-SF President John Williams reported that his staff identified several transitory factors weighing on inflation: prescription drug and other healthcare costs, mobile phone plan prices, and airline tickets. Nevertheless, Williams concluded that the “stars are aligned. They all point to a new normal for interest rates.” According to Williams, the new normal for interest rates isn’t very much higher than rates are now. Similarly, Bullard said: “Interest rates probably don’t have to change much from where they are today.”

(3) Shooting stars. In her recent speech, Brainard repeatedly cautioned against being “preemptive” or “premature” in raising rates. She referred to a paper by former Fed Chair Ben Bernanke, Monetary Policy in a New Era, in which Bernanke suggests explicitly overshooting the FOMC’s inflation goal for the “new era.” Specifically, Bernanke proposes “a temporary price-level target” that “would delay the liftoff of the policy rate from the lower bound until the average inflation over the entire lower bound episode has reached 2% and full employment is achieved.”

Though Brainard clarified that she was not talking about current policy, she seemed to be saying that Bernanke’s logic makes sense for today’s “new normal” environment, in which the old theories no longer do make sense. The proposal wouldn’t be without its risks, she cautioned; for example, the market might question how serious the Fed was about its inflation target, and the central bank might lose its nerve to overshoot its inflation target for a prolonged period of time. But it’s obvious that she’s taking Bernanke’s idea seriously.

(4) Escape velocity. Brainard also said that she is concerned about not escaping the zero lower bound soon enough. Moving interest rates higher would provide room for monetary policy maneuvers in the event of a future crisis. The minutes indicated that other participants share her angst “that the persistence of low inflation might result in the federal funds rate staying uncomfortably close to its effective lower bound.” But unless inflation speeds up soon, the Fed might have no easy way to get away from zero for now.

(5) Financial stability. It appears that more Fed officials are turning more dovish. According to the latest FOMC minutes, “only a couple” of participants “expressed concern that the persistence of highly accommodative financial conditions could, over time, pose risks to financial stability.” Brainard did mention near the end of her dovish speech that persistently low interest rates risked raising asset valuations, which might lead to “financial imbalances.”

She lamely concluded: “Macroprudential tools are the preferred first line of defense to address such financial imbalances, which should in principle enable monetary policy to focus on price stability and macroeconomic stabilization. But the development and deployment of macroprudential tools is still relatively untested in the U.S. context, and the toolkit is limited.”

Melissa and I conclude: “Let the Melt-Up begin!”

Central Banks: Chomping at the Bits. Global banking organizations are actively discussing the possible proliferation of central bank backed cryptocurrencies (CBCs). It isn’t easy to say that three times fast. And it isn’t easy to explain how the technology would work. In a nutshell, CBCs would leverage distributed ledger technology (DLT) like blockchain, which supports bitcoin. But unlike bitcoin, CBCs would have the backing of governments. In other words, there would be bitdollars, biteuros, bityen, bityuan, and so forth.

Why would central banks want to get behind a cryptocurrency? There are all sorts of reasons why not to do so. By nature, DLTs are not centralized and are hard to control and to audit for accuracy. CBCs might pose lots of systemic risks if the technology’s stability and its susceptibility to cyberattacks came under question. The implementation of CBCs also could cause all sorts of havoc for the banking industry at large. Financial intermediaries could be rendered useless if central banks were to directly open access to CBCs to retail customers. It’s no wonder that Jamie Dimon called bitcoin a fraud. DLT could be a big threat to his business. “We’re not going to call it banking—we’re going to call it something else,” FRB-SL President James Bullard told Business Insider about the future of the industry.

I asked Melissa to mine the section in the September BIS Quarterly Review on the topic titled “Central bank cryptocurrencies” for answers to “why.” One sentence about mid-way through the 16 pages piqued her interest. It stated: “Fedcoin has the potential to relieve the zero lower bound [ZLB] constraint on monetary policy.” Beyond that, the section is worth a read for those interested in a deep dive on a CBC’s potential properties in relationship to bitcoin and other existing alternative-coins. For now, let’s focus on the ZLB tidbit in the BIS study:

(1) Bitcoin, Fedcoin, and bitdollars. Global banking organizations are just starting to take the concept of CBC seriously now. But the idea is at least several years old. In the footnotes, the authors of the BIS section credit two 2014 works with having originated the concept of CBCs. Both are thought pieces from the blogosphere that introduce the concept of “Fedcoin” and “bitdollars” interchangeably as a Federal Reserve backed cryptocurrency.

(2) Cryptocurrencies as real money? In 7/21/2014 blog post referenced by the BIS, Sina Motamedi outlined a scenario in which a reputable private entity—Google, for example—implements a bitcoin-like currency backed by the promise that it could be exchanged for dollars at any time. But what if, for some reason or another, Google were not able to meet its promises in an unforeseen bank-run-type event? The author concludes that that’s why central banks need to understand cryptocurrencies as they develop. “If central banks wait too long, there will be risks of bank runs and financial instability from privately issued crypto-currencies.” Bitcoin banking startups could face a similar fate.

(3) A central bank for DLTs. “Bitcoin needs a central bank. And BitDollar would be the answer to that,” supposes Motamedi. Central banks could create their own cryptocurrencies and outlaw the use of any others. While the proliferation of CBCs currently is far from here, the PBOC already has cracked down on cryptocurrency transactions, reported the South China Morning Post (SCMP) just last month. In addition, the PBOC is enthusiastic about creating its own digital currency, says the SCMP.

(4) Bye-bye, Benjamins. The distinction between dollars and Fedcoin could be wiped out if the Fed were to establish a fixed 1-to-1 relationship between them. “Just think of dollars as an abstraction which can be manifested in traditional paper form and now digital form. And like original gold-backed currency, we eventually won’t even need regular dollars to back BitDollars, as long as the network effects of BitDollars exist to justify their value,” he wrote.

Inspired by Motamedi’s thoughts, JP Koning explored the concept of Fedcoin in a 10/19/14 blog post also cited by the recent BIS report. If Fedcoin were to be widely adopted, the Fed might have “a good case for entirely canceling larger denominations like the $100 and $50,” said Koning.

(5) Fear not the ZLB. If cash were to become obsolete, that could effectively free the Fed from the dreaded ZLB, i.e., the zero lower bound. The ZLB is feared by monetary policy makers because it’s the point at which interest-rate tools become ineffective at creating stimulus. Cash can become a nuisance for monetary policy if the Fed needs to implement a negative interest rate policy (NIRP) in order to meet its goals for employment and inflation. Under NIRP, cash would be in higher demand as it would be cheaper to hold onto cash than to deposit it in a savings account with a negative interest rate.

To get around that problem, Koning hypothesizes that interest could be paid on each Fedcoin at a rate determined by the Fed. “After all, if the Fed wished to reduce the rate on reserves to -2 or -3% in order to deal with a crisis, and reserve owners began to bolt into Fedcoin so as to avoid the penalty, the Fed would be able to forestall this run by simultaneously reducing the interest rate on Fedcoin to -2 or -3%. Nor could reserve owners race into cash, with only low denomination and expensive-to-store” bills available, Koning theorized. So just as interest could be earned on Fedcoin, a negative rate could be imposed on Fedcoin.

(6) More ammo for bankers. Currently, the Fed’s goal of maximum employment generally has been met and inflation remains stable, though below the Fed’s 2% target. So the Fed’s main reason for raising rates now is to be able to provide additional stimulus should it be needed in the event of a future crisis. It’s possible that more stimulus would be available in a Fedcoin world. So the prospect of untapped monetary stimulus could allow the Fed to keep interest rates lower for longer.

(7) Ready or not. Who knows when the Fed might seriously explore and implement its own CBC? For now, bankers around the world are paying more attention to the idea. In a 9/29 speech, IMF head Christine Lagarde focused on central banking and fintech. She argued that CBCs “could be fully transparent, governed by a credible, pre-defined rule, an algorithm that can be monitored … that might reflect changing macroeconomic circumstances.”

Lots of financial press articles translated her words into IMF support for CBCs. Some joked about the potential for “IMFcoin.” Lagarde added: “So in many ways, virtual currencies might just give existing currencies and monetary policy a run for their money.” In other words, central banks might be forced into CBCs, ready or not.

Looks like the Fed is quickly coming to that realization. Just last week, a “faster payments” team of 27 industry leaders was announced by the Federal Reserve Board. The interim collaboration work group, now formally the “work group,” was established by the Fed’s Faster Payments Task Force.

In an introductory report, the Faster Payments Task force stated: “Non-bank providers such as technology companies have begun to enter the market and develop innovative new solutions to meet the changing expectations of consumers and businesses for faster payment methods. Although innovation is taking place, faster payments solutions are being developed in a fragmented way without collaboration across the payment industry or broad adoption across the market as a whole.”

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2018 Is Coming

October 12, 2017 (Thursday)

Strategy: Another Happy Year Ahead? On July 1, analysts thought S&P 500 earnings would rise by 8.6% y/y during Q3. Now they expect earnings to increase by only 4.3%. Blame it on the terrible hurricane season? Some insurance, energy, and transportation companies were hit hard. Then again, cutting earnings estimates is just what analysts usually do prior to earnings seasons. Two sectors have weighed most heavily on the results: Financials and Energy. On July 1, the S&P 500 Financial Services sector’s Q3 earnings were forecast to rise by 6.4%, and now they are expected to fall 9.1%. Likewise, S&P 500 Energy sector earnings are expected to jump 140.4%, down from the July 1 estimate of 186.5%.

Despite the gloomier outlook for Q3, the S&P 500’s streak of new record highs has continued in October, implying that Q3 earnings results, whatever they might be, are yesterday’s news, as long as they don’t significantly alter expectations for next year. That’s even truer for Q4 results since we won’t have them until early next year. Investors are clearly looking ahead to 2018, when bottom-up analysts are calling for strong revenue growth, margin improvement, and even stronger earnings growth. Here’s a look at what all the excitement is about:

(1) Solid sales. What instantly jumps out about 2018 is the strength of expected S&P 500 companies’ sales. They are forecasted to rise 5.0% next year, after climbing an estimated 5.8% this year. Results are strong even if the contribution from the Energy or Financials sectors is backed out, 5.0% and 5.2%. The strength is also broad-based: Seven of 11 S&P 500 sectors are expected to have revenue growth north of 4%.

Here’s how analysts see revenue growing in 2018 for the S&P 500 sectors: Tech (8.9%), Materials (6.4), Energy (5.4), Consumer Discretionary (5.4), Health Care (5.3), Real Estate (5.1), S&P 500 (5.0), Industrials (4.8), Consumer Staples (3.4), Financials (3.4), Utilities (2.4), and Telecom Services (0.6). These forecasts have been inching up over the past month. The overall S&P 500 sales estimate has increased by 0.1% over the past month, and estimates for nine of the 11 sectors’ revenue growth have increased or stayed flat. The exceptions: Financials, for which 2018 revenue estimates have declined by 0.1%, and Energy, for which they’ve declined by 0.3%.

(2) Good earnings. Solid sales growth is expected to result in even stronger earnings growth next year—if analysts are on target. They expect the S&P 500 to generate 11.5% earnings growth in 2018, a nice improvement from the 10.3% growth forecast for this year. Again, 2018’s results are strong even if the Energy or Financials sectors are excluded, 10.7% and 11.0%.

As is often the case, the average masks a wide range of outcomes. The S&P 500 Energy sector is expected to produce 35.7% earnings growth in 2018, while analysts forecast a 1.5% drop in earnings for the Real Estate sector. Here’s the performance derby for the S&P 500 sectors’ 2018 earnings: Energy (35.7%), Materials (18.0), Financials (13.6), Tech (13.1), S&P 500 (11.5), Industrials (10.8), Consumer Discretionary (10.4), Health Care (8.4), Consumer Staples (7.8), Utilities (5.0), Telecom Services (1.7), and Real Estate (-1.5).

The S&P 500 earnings estimate for 2018 has been trimmed by 0.1% over the past month. Minor downward revisions occurred in Financials, Telecom Services, and Utilities. More substantial trimming occurred in the estimates for Industrials’ earnings (-1.1%), Materials (-0.9), Energy (-0.8), and Real Estate (-0.8). Those downward revisions were almost entirely offset by the 1.1% upward revision in the Tech sector. Despite the trimming, industries in the Energy sector are forecasted to generate the strongest earnings among all of the S&P 500 industries we track. Top industry earnings in 2018 are expected to come from Oil & Gas Exploration & Production (382.8%) and Oil & Gas Equipment & Services (69.9).

The Materials sector is also home to some of the industries with the fastest-growing earnings next year. For example, the Copper industry, with 48.7% estimated earnings growth in 2018, and Construction Materials (37.1%) are among the top eight S&P 500 industries ranked by projected earnings growth next year (Table 1).

(3) Record margins. Investors looking for a reason to be cautious on the stock market should consider that S&P 500 earnings estimates for 2018 assume that operating margins will continue to expand from current record levels. Analysts’ consensus earnings and revenue estimates imply that the S&P 500 operating profit margin will improve from 10.1% in 2016 and an estimated 10.5% this year to 11.2% in 2018 (Fig. 1).

The Tech sector pulls up the S&P 500’s operating profit market average, with a 20.8% operating margin forecasted for 2018 (Fig. 2). However, the Tech sector’s margin is currently in record territory, and the 2018 earnings forecasts depends on margin improvement continuing, up from an expected 20.0% this year and 19.2% in 2016.

Optimists can counter that there’s room for margin improvement in Financials and Energy. Analysts forecast that the Financial sector’s margin will widen to 16.6% in 2018, up from 15.1% this year and 14.3% in 2016 (Fig. 3). That improvement seems plausible given that it’s still off from the record-high forward profit margin of 17.8% posted in August 2007. The Energy sector also may help bolster the S&P 500’s margins in the future. The downtrodden sector’s operating profit margin is expected to recover to 5.0% in 2018, up from 3.9% this year and 1.1% in 2016; however it’s far from the double-digit levels enjoyed earlier in the decade (Fig. 4).

Here’s how the estimated 2018 operating profit margins stack up for the S&P 500’s 11 sectors: Tech (20.8%), Real Estate (17.1), Financials (16.6), Telecom Services (11.4), Utilities (11.4), S&P 500 (11.2), Health Care (10.8), Materials (10.7), Industrials (9.6), Consumer Discretionary (7.7), Consumer Staples (6.8), and Energy (5.0) (Table 2).

Spain I: Breaking Up Is Hard To Do. Defusing a tense showdown Tuesday between Catalan separatists and Spain’s central government in Madrid, Catalonia’s President Carles Puigdemont softened his stance and pulled back from declaring independence, Reuters reported in a 10/10 story. Instead, the separatist leader said he would suspend the results of the 10/1 referendum on independence—known as “1-O”—and pursue talks with the central government that would include representatives from the European Union.

The move came two days after hundreds of thousands of anti-secessionists demonstrated in Barcelona on Sunday, a 10/8 article in the NYT reported. In addition, a host of companies prepared to move their legal domains out of the region, one of Spain’s most prosperous, representing 20% of the country’s GDP and 25% of exports, a 10/9 Bloomberg piece explained. Among others, CaixaBank SA, the region’s largest lender and the country’s third largest in terms of global assets, said it would move its base beyond Catalonia to Valencia. Banco Sabadell SA, the nation’s fifth-largest bank based on assets, is moving to Alicante. The only remaining Catalan company in the benchmark IBEX 35 index is the drug maker Grifols.

Moreover, the European Commission announced that a separate Catalan government would find itself outside the European Union and would have to reapply for membership, creating onerous trade barriers. France, too, said it wouldn’t recognize Catalonia separately from Spain, according to a 10/9 Guardian article. Barcelona is the preferred Spanish city for foreign companies, with one-third of them choosing the regional capital for their base of operations.

Spain’s Prime Minister Mariano Rajoy took a hard line in attempting to quash the separatist movement, noted a 10/9 piece by Independent. After declaring the referendum on the region’s independence illegal, his government took control of the region’s finances and sent thousands of military police to Barcelona to prevent voting, an action that erupted in violence as police fired rubber bullets at the crowds and beat voters with batons. Rajoy then upped the ante by threatening to take control of the autonomous region, an extreme action reminiscent of the days before democracy when the military dictator Francisco Franco ruled. On Wednesday, he moved forward with his threat by initiating a request to invoke Article 155 of the Constitution, the tool that would give him those broad powers, the NYT reported in a 10/11story.

The political uncertainty that has escalated in the past month pressured financial markets and threatened to undercut Spain’s powerful economic momentum. Investor worries drove the MSCI Spain Share Price Index down 2.6% in dollars this month through Tuesday’s close, bringing its ytd gain to 23.9%. That compares with the 29.3% advance the index had delivered this year through August 1, as cited in our 8/3 Morning Briefing, “Sangria Summer.”

In the days leading up to the 10/1 referendum, yields on Catalan bonds rose to their highest levels of the year on concerns of redenomination. The spread between Spanish and German 10-year notes widened following the referendum but tightened amid this week’s developments, with yields hitting their lowest level since before the vote (Fig. 5).

Spain II: United We Stand. Manufacturing and services data released in the days following the referendum revealed an economy that continues to strengthen despite the unsettled politics (Fig. 6). Consider the latest good news on the Spanish economy:

(1) Services PMI. The seasonally adjusted Business Activity Index rose to 56.7 in September from 56.0 in August, according to a 10/4 report by data tracker IHS Markit, noting the “sharp and accelerated increase.” The number confounded economists who had been expecting a slowdown to 55.5. It was the 47^th straight month of increased business activity at Spanish service companies, reflecting better market conditions and rising numbers of customers. Activity was broad-based, but the Post & Telecommunications sector saw the fastest growth as well as the biggest increase in new business.

(2) New orders. New orders in September expanded across the services sector at the fastest rate since August 2015. It was the 50^th consecutive month that the services sector saw new orders increase. Stronger client demand led to higher output prices, with prices rising at one of the fastest rates in a decade. Price increases occurred in all sectors, led by Hotels & Restaurants.

(3) Staffing. A jump in workloads led to more hiring in September, with the Financial Intermediation sector logging the sharpest rise in employment. As a result, input prices rose, though at a rate that was the weakest in a year. A 10/6 country focus by the International Monetary Fund notes that one-quarter of all jobs created in the Eurozone over the past year were in Spain, mainly in the services sector, in which 79% of all Spaniards work.

(4) Manufacturing. Spain’s manufacturing purchase managers index rose to 54.3 in September from 52.4 the previous month, on stronger demand and new export business as new orders from overseas jumped sharply, IHS Markit revealed in a 10/2 report. Production increased for the 46^th straight month, with the intermediate goods sector marking the fastest growth. New orders, output, and employment increased sharply during the month.

(5) Supply chains. Raw materials shortages continue to extend delivery times and contribute to price inflation. The pace of inflation growth last month was the fastest since April, with steel prices particularly strong.

(6) Business Climate. Confidence soared among Spanish businesses in September, supporting sentiment expressed to IHS Markit that conditions will further strengthen in the coming year (Fig. 7).

With a P/E of 13.1, Spain’s MSCI index continues to represent value as earnings growth now stands at (recently revised upward) 12.3% for 2017 and 9.3% for 2018 (Fig. 8). In contrast, earnings for Europe MSCI companies are estimated at 12.7% for this year and 8.5% for 2018, and the index is trading at a 14.5 P/E.

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Blue Skies for Blue Angels

October 11, 2017 (Wednesday)

Strategy I: Good Jobs, Bad Returns? There’s a chart floating in cyberspace showing that five-year annualized returns for the S&P 500 tend to be subpar or even negative following periods when the unemployment rate is below 5.0% (Fig. 1 and Fig. 2). The jobless rate has been below that level for the past 17 months since May 2016. Over the past 60 months through September, the S&P 500 has generated an average annualized gain of 14.5%. So are returns doomed to be subpar over the next five years?

Not necessarily. In the investment business, hedge clauses always include the following disclaimer: “Past performance is not a guarantee of future performance.” However, just because performance was good in the past doesn’t mean that future performance must be bad. Much depends on the time frame. The DJIA was around 1000 in the late 1970s. Now it is up over 22-fold. Over the past 40 years, stocks have been great performers, though the disclaimer was relevant a few times along the way over five-year periods.

The wannabe rule of thumb that a jobless rate of less than 5% is bad for stock returns implicitly assumes that low unemployment leads to high inflation and interest rates. In the past, the booms inevitably led to busts, which have always been bad for stocks. So five-year periods following cyclically low unemployment were bound to include a recession and a bear market, which is why returns had been bad after a period when the labor market is good.

However, we have to consider the possibility that a tight labor market might not be as inflationary as it had been in the past. It hasn’t been so far for numerous reasons that Debbie, Melissa, and I have discussed for quite some time. They include globalization, technological innovation, and aging demographics. If there’s no boom, there isn’t likely to be a bust. Consider the following:

(1) Unemployment cycle. Amazingly, the cyclical low in the jobless rate always occurs right before the start of recessions (Fig. 3). We are just testing you to see if you are paying attention: Of course, that’s a tautology. There have been plenty of times when the unemployment rate has dropped below the previous cyclical low and continued to fall lower as stock prices continued to gain.

Nevertheless, it is true that bear markets begin at about the same time as the unemployment rate bottoms (Fig. 4). So calling the bottom in the unemployment rate would be a good call. Call us when you are sure it has bottomed. We think it could go lower.

(2) Misery Index. A related rule of thumb is based on the Misery Index, which is the sum of the unemployment rate and the CPI inflation rate on a y/y basis (Fig. 5). It seems to give a bit more warning ahead of bear markets. That’s because in the past, cyclical lows in the unemployment rate were increasingly offset by rising inflation. The Misery Index has had a tendency to peak during recessions as both unemployment and inflation peaked.

However, none of the above is science. Tell us when the next recession starts using the jobless rate, the Misery Index, or any other forecasting tool, and we’ll tell you when the next bear market will be underway.

(3) Misery-adjusted forward P/E. While we are on the subject, we’ve previously concocted a misery-adjusted forward P/E (MAPE) by simply summing the S&P 500 forward P/E and the Misery Index (Fig. 6). Its average value since September 1978 has been 23.9. It was 24.0 during August, suggesting that the market is fairly valued. Of course, there are plenty of other valuation metrics—such as traditional P/Es, CAPEs, and Buffett-style ratios—showing that stocks are extremely overvalued. We’ve recently favored the S&P 500 real earnings yield, which agrees with the fair-value assessment of our MAPE.

Strategy II: Wild Blue Yonder. While some measures of stock market valuations are flying into the wild blue yonder, so are revenues and earnings. For now, it still looks like a Nirvana scenario for stock investors. That should remain the case as long as valuations don’t continue to outpace earnings. Valuations recently have been outpacing earnings, however, which is why Joe and I raised our subjective probability of a Melt-Up scenario from 50% to 55% on Monday. The reason we gave was that a melt-up seemed to be unfolding: “melting up seems to be what stocks continue to do.”

We also raised the odds of a Meltdown scenario from 20% to 25%, simply because melt-ups tend to be followed by meltdowns in the stock market. By default, that forced us to lower the odds of Nirvana from 30% to 20%.

Right now, Nirvana is where we are in real time. Looking ahead, too much of a good thing may be too much of a good thing. We much prefer Nirvana to a Melt-Up/Meltdown, and we hope that we can raise the odds of Nirvana soon. Either way, the odds of stock prices continuing to rise either at a leisurely slow pace or at an irrationally fast pace add up to 75% currently, in our estimation. Now consider the following:

(1) Forward revenues. In recent weeks through the end of September, forward revenues for the S&P 500/400/600 all have been rising in record-high territory (Fig. 7). Just as impressive is that revenue estimates for this year and next year have remained steady for the S&P 500 and have been rising for the S&P 400/600.

Currently, S&P 500 revenues are expected to rise 5.7% this year and 5.0% next. Those solid growth rates undoubtedly reflect the improving outlook for the global economy, as we have been discussing since late last year. The IMF, which has been forced to lower its estimates for global growth during most of the years since the 2008 financial crisis, has been raising its numbers.

Yesterday, the IMF raised its estimates for global economic growth in 2017 and 2018, citing stronger expansion in the first half of the year in the Eurozone, Japan, and some emerging markets. Globally, the IMF upped its growth forecasts to 3.6% in 2017 and 3.7% in 2018, both 0.1% higher than projections in July. Global growth in 2016 was 3.2%.

(2) Forward earnings. As Joe reported yesterday, the forward earnings of the S&P 500/400/600 all rose to record highs during the first week of October (Fig. 8). On the other hand, industry analysts are doing what they typically do at the start of earnings seasons; they lower their estimates (Fig. 9). As a result, they are estimating a weak 4.0% y/y increase for Q3-2017 (Fig. 10). Joe and I expect that this will turn out to be another setup for the usual earnings hook as reported earnings beat reduced expectations. Gee, what a surprise!

(3) Blue Angels. Our Blue Angels analysis of the S&P 500/400/600 shows that all three indexes are flying high along with both forward earnings and forward P/Es (Fig. 11).

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On a Winning Streak

October 10, 2017 (Tuesday)

Germany: Another Happy Canary. Germany and South Korea stand out as two countries that are especially sensitive to global trade. Last week, Debbie and I observed that South Korea’s exports soared 17.1% m/m during September to a record high of $691 billion (saar) (Fig. 1). The data are seasonally adjusted by our data vendor, Haver Analytics. At first, our reaction was that perhaps the seasonal adjustment program has a glitch. However, the y/y growth rate in the unadjusted data was 35.0%, the fastest since January 2011 (Fig. 2). This strongly suggests that the pace of global economic growth may be accelerating.

Sure enough, now Germany’s August data for new orders and production are corroborating this thesis:

(1) New orders. The German new orders index jumped 3.6% m/m during August to a record high (Fig. 3). Leading the way were foreign orders, which rose 4.3% m/m and 9.1% y/y—also to a record high.

Especially strong were foreign orders outside of the Eurozone. They soared 7.7% m/m and 14.2% y/y (Fig. 4).

(2) Industrial production. Also blasting off to new record highs was German industrial production during August, as Debbie discusses below. The total (excluding construction) was up 3.0% m/m and 4.7% y/y (Fig. 5). Manufacturing output jumped 3.2% m/m and 5.3% y/y.

The question is why now? Last Tuesday, I reviewed five explanations for the acceleration in global economic growth. In brief: (1) Global monetary policy remains ultra-easy. (2) Chinese bank lending is at a record high. (3) The 50% cut in oil prices since mid-2014 is a big windfall. (4) Mass immigration into Europe is boosting the region’s economic growth. (5) The global bull market in stocks is having a very positive wealth effect on economic growth.

The German data confirm the global boom. They also support the notion that the wave of migration that occurred into Germany during 2015 and 2016 might have boosted domestic demand. Domestic consumer goods orders jumped 5.9% m/m during August to the highest level since December 2008. Industrial production of consumer goods has been remarkably strong, with a gain of 3.8 y/y (Fig. 6).

Global Strategy: ‘Go Global’ Is Winning. Late last year, I noticed that our accounts were getting more interested in putting more of their equity weightings in foreign stocks, mostly because foreign stocks looked cheaper than US ones. Furthermore, the fundamentals seemed to be improving overseas, while US economic growth remained relatively subdued. So Joe and I warmed up to the Go Global investment style after having been quite adamantly in the Stay Home camp since early in the current bull market. Let’s review some of the recent valuation metrics and performance stats:

(1) Valuation. At the end of September, the US MSCI stock price index stood out as the most expensive of the major equity indexes based on forward earnings: US (18.1), EMU (14.4), UK (14.3), Japan (14.3), and Emerging Markets (12.4) (Fig. 7). The US has been the priciest of these indexes since the start of 2014.

The US MSCI has tended to have a higher forward P/E than the All Country World P/E since the start of the available data in 2001 (Fig. 8). However, the current divergence is relatively large, with the former at 18.1 and the latter at 14.2.

The major EMU indexes look especially cheap relative to the US: France (14.9), EMU (14.4), Germany (13.4), Italy (13.4), and Spain (13.1) (Fig. 9).

Among the Emerging Markets MSCI indexes, the valuation pecking order is as follows for the major regions: Latin America (14.1), Asia (12.6), Emerging Markets (12.4), and Eastern Europe (7.6). There is a fair amount of dispersion particularly among the Emerging Markets in Asia: India (18.2), Indonesia (15.8), Taiwan (13.4), China (13.3), Korea (8.9), and Turkey (7.9) (Fig. 10).

Based on the fundamentals, Germany and South Korea seem especially cheap.

(2) Performance in dollars. So far this year, in dollars, the US MSCI has been among the underperformers: Emerging Markets (27.9% ytd), EMU (23.7), All Country (16.4), US (14.0), Japan (13.3), and UK (11.6) (Fig. 11).

(3) Performance in local currency. The ytd performance picture changes significantly in local currencies. The US has outperformed all of the major MSCI indexes with the exception of the Emerging Markets: Emerging Markets (24.0% ytd), US (14.0), All Country (13.2), EMU (11.3), Japan (9.4), and UK (5.0) (Fig. 12).

If there is a melt-up coming in global stock markets, Joe and I won’t be surprised if it is led by the US in both dollars and local currencies. Helping the US to outperform the rest of the world would be any sign that the Trump administration might succeed in lowering the corporate tax rate and in stimulating the repatriation of overseas earnings. Then again, the rest of the world may continue to attract buyers seeking improving fundamentals and relatively low valuations.

In any case, the Emerging Markets story is looking solid. In the past, their stock markets and currencies usually plunged when the Fed was tightening US monetary policy. That’s not happening this time. Could it be that they are finally actually emerging?

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FOMO & MAMU

October 9, 2017 (Monday)

Strategy I: Melt-Up Musings. I visited our accounts deep in the heart of Texas last week, specifically in Austin, Dallas, Fort Worth, and Houston. They all wanted to talk about the potential for a stock market melt-up. They also asked me what could go wrong for the market. I said that I am most concerned about a melt-up followed by a meltdown. I’ve been raising the odds of a melt-up this year. And I am doing it again today. Consider the following:

(1) 60/30/10. On January 24, 2013, I first suggested that if we all just keep calm and carry on, “then maybe the cyclical bull market will morph into a secular bull market.” The S&P 500 rose to a new record high on March 28, 2013 for the first time since October 9, 2007. Also in early 2013, I detected “anxiety fatigue” among many of our accounts. After the widely dreaded “fiscal cliff” scare turned out to be a non-event at the start of 2013, they were tired of being anxious that the bull would get tripped by a bear.

On May 9, 2013, I first assigned subjective probabilities of 60/30/10% to Nirvana, Melt-Up, and Meltdown scenarios. On May 16, I observed, “In other words, we have nothing to fear other than an absence of fear. … Perhaps now that investors are no longer fearful that the end is near, all the liquidity pumped into the financial markets by the major central banks over the past four years to avert the Endgame scenario is about to cause the Mother of All Melt-Ups (MAMU).”

(2) 40/40/20. This year, on March 6, I lowered the odds of the Nirvana scenario (from 60% to 40%), and raised the odds of the Melt-Up one (from 30% to 40%) because stocks were doing just that, melting up. Increased Melt-Up odds implied that I should raise the odds of a Meltdown (from 10% to 20%), since the former scenario tend to lead to the latter one the way that booms lead to busts.

(3) 30/50/20. Then, on August 2, I wrote: “Today, we are raising the odds of the Melt-Up scenario from 40% to 50%. The Meltdown scenario remains at 20%, while the Nirvana scenario gets cut from 40% to 30%. By the way, a melt-up followed by a meltdown won’t necessarily cause a recession. It might be more like 1987, creating a great buying opportunity, assuming that we raise some cash at the top of the melt-up’s ascent. Our animal instincts will have to overcome our animal spirits.”

(4) 20/55/25. Today, I’m raising the odds of the Melt-Up scenario to 55% mostly because melting up seems to be what stocks continue to do. I’m also raising the Meltdown odds to 25%. As a result, Nirvana is down to 20%.

The extraordinary rally to multiple record highs this year has been driven by several solid fundamental factors. Earnings have continued to rebound from the energy-led earnings recession during 2015 and the first half of 2016. The pace of global economic growth started to quicken late last year. President Donald Trump’s administration is moving rapidly on deregulation, and more slowly on enforcing current regulations. He has yet to deliver on cutting taxes and bringing back overseas earnings, but both remain possible. Inflation and interest rates remain low, which justifies historically high valuation multiples.

However, this Nirvana scenario seems to be rapidly morphing into the Melt-Up scenario. As one of our NY accounts observed last week in an email exchange with me: It’s “a case of FOMO, as the youngsters call it these days—Fear Of Missing Out.”

Strategy II: The Fourth Phase. In 1725, Antonio Vivaldi composed The Four Seasons, a set of four violin concertos. The sounds of each concerto resemble its respective season. So for example, “Winter” is punctuated with pizzicato notes from the high strings, suggesting icy rain. “Summer” sounds like a thunderstorm in its final movement, which is often called “Storm.”

One of the great virtuosos of the investment business was Sir John Templeton. He observed that bull markets experience four phases: pessimism, skepticism, optimism, and euphoria. Similarly, my friend Laszlo Birinyi has also identified four phases: reluctance, digestion, acceptance, and exuberance. Where are we now in the current bull market? See if you agree with the following phase demarcations as I see them for the current bull market:

(1) First and second. The first phase started on March 9, 2009 and ended after the second and worst correction of the bull market, on October 3, 2011 (Fig. 1).The second phase included three minor corrections, with the last one ending on November 15, 2012.

(2) Third and fourth. On July 8, 2014, I wrote that the S&P 500 was moving from the third to the fourth phase. Now I’m thinking that the third phase was extended by the energy-led earnings recession. Instead, the third phase might have ended on February 11, 2016, when the S&P 500 fell to the lowest reading since April 11, 2014, taking out some of the optimism that had been building during the third phase. During the fourth phase since then, there have been no significant corrections, which certainly must be contributing to the mounting euphoria/exuberance about stocks.

(3) P/E phase profile. The S&P 500’s forward P/E also can be used to identify these four phases (Fig. 2). It mostly fell during the first phase, when earnings caught up with the initial bull market euphoria. During the second phase, it rose slightly but remained relatively low as investors continued to fret about another financial crisis and a renewed recession. During the third phase, the forward P/E trended higher, rising to a cyclical peak of 17.2 on February 24, 2015. It was back down to 14.7 on January 20, 2016. It has been above 17.0 ever since January 24, 2017, and was at 18.0 at the end of last week.

This is all still Nirvana territory but bordering on Melt-Up terrain, in my opinion. If the P/E rises over 20.0, that would suggest to me that the exuberance phase of the bull market is well underway.

Strategy III: Front-Cover Curse. The melt-up is making headlines. Randy Forsyth’s column in Barron’s this week is titled “The Meltup Before the Storm?” He notes: “‘The bull market in everything’ is how the current issue of the Economist sums up the state of affairs. The magazine’s subhead does ask, ‘Are asset prices too high?’ which implies that the inevitable correction is at hand. The cover illustration also features a bull, a redoubtable contrarian indicator of trouble ahead.”

Randy also observes: “On the CNN Fear & Greed Index, fear was nowhere in evidence on Thursday. The index closed at 95 on a scale of zero to 100, a score deemed to be ‘extreme greed.’” Apparently, the so-called “most hated” bull market in stocks is now loved. Let’s review some more loving indicators:

(1) Corrections are MIA. The S&P 500 hasn’t had a significant panic attack or correction since early 2016 (Fig. 3). The index’s level has been above its rising 200-day moving average since May 26, 2016 (Fig. 4).

(2) Sentiment is bullish. The Bull/Bear Ratio (BBR) compiled by Investors Intelligence rose back above 3.00 over the past two weeks as the percentage of bears fell below 18.0% (Fig. 5).

(3) VIX is comatose. The S&P 500 VIX remains in record-low territory, falling to a record low of 9.2 on Thursday and edging up to 9.7 on Friday (Fig. 6). It is highly correlated with the bearish component of the BBR. It tends to spike in response to panic attacks. The previous spike peaked at 16.0 as a result of a short-lived North Korean crisis (Fig. 7).

(4) Dow Theory is smoking. Both the DJIA and DJTA rose to record highs last week (Fig. 8). The latter seems to be breaking out of a trading range that started last year.

(5) P/E multiples are elevated. On Friday, the S&P 500/400/600 forward P/Es rose to 18.0, 18.2, and 20.2 (Fig. 9). Daily data since 1999 show that the S&P 500 multiple remains well below its 1999/2000 bubble peaks around 24.0. However, both the S&P 400 and S&P 600 are back to levels that previously marked their cyclical tops.

The Russell 2000 P/E is especially rich at 27.0 at the end of September (Fig. 10). Even richer is the 34.8 multiple for Russell 2000 Growth (Fig. 11). Then again, if Trump delivers on deregulation and on tax cuts, smaller corporations might benefit more than larger ones.

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Gushing Over Global Growth

October 5, 2017 (Thursday)

Global Economy: Sunny Barometric Readings. Debbie and I have observed in recent weeks mounting evidence of a global synchronized economic boom. On Tuesday, we listed five good reasons why this is happening: (1) Global monetary policy remains ultra-easy. (2) Chinese bank lending is at a record high. (3) The 50% cut in oil prices since mid-2014 is a big windfall. (4) Mass immigration into Europe is boosting the region’s economic growth. (5) The global bull market in stocks is having a very positive wealth effect on economic growth.

While these factors have been in play for a while, it wasn’t until early last year that they came together to collectively exert a stimulative effect on the global economy. This is most evident in the CRB raw industrials spot price index, which fell to a cyclical low of 398 on November 23 in reaction to the global recession in the energy business during 2015 (Fig. 1). This index was up 28% through Tuesday to 509. Not surprisingly, the index, which includes no oil commodities, is highly correlated with the price of a barrel of Brent crude oil, which has also made a big comeback from last year’s low of $27.88 on January 20 to $59.00 on Tuesday.

We combine these two commodity prices to derive our Global Growth Barometer (Fig. 2). It is up from its low of 55 on January 20, 2016 to 79 on Tuesday.

Oil Industry: Back in Business. Given that our Global Growth Barometer is signaling good weather ahead for the world’s economy, Jackie and I decided to have a look at how this might be impacting the S&P 500 Energy sector. Worldwide demand for oil has been stronger than expected of late, and excess inventories have slowly been draining. Can this continue? Perhaps in the short term. Long term, however, that may depend on whether higher prices lure more US frackers into the market and on how popular the electric automobile becomes. Let’s take a look:

(1) Demand is improving. With world economies strengthening nicely as 2017 progresses, it should come as little surprise that demand for black gold also has been stronger than anticipated. In its latest outlooks, the International Monetary Fund (IMF) projects that world real GDP will rise 3.5% y/y this year and 3.6% next year, matching the IMF’s April projections. The International Energy Agency now expects oil consumption in 2017 to increase by 1.6 mbd to 97.7 bd, according to its 9/13 report—just the latest in a series of gradually rising demand forecasts by the agency (up from a 1.4 mbd increase in July and 1.5 mbd in August).

Some of the projected demand increase is coming from the US, where crude consumption is expected to jump from 19.63 mbd last year to 19.87 mbd this year. European demand is expected to go from 14.05 mbd last year to 14.25 mbd this year, and China’s consumption should jump from 11.86 mbd last year to 12.38 mbd this year.

(2) Supply remains ample. Forecasting the amount of crude oil that will be produced is a much tougher endeavor. Total world supply is estimated to have increased to 97.0 mbd in Q2-2017, up from 96.1 mbd a year earlier (Fig. 3). Most of that supply came from the Americas, where production jumped by 0.8 mbd to 19.8 mbd (Fig. 4). Meanwhile, OPEC has successfully kept supply flat overall at 32.3 mbd in Q2, down ever so slightly y/y from 32.5 mbd in Q2-2016. Recently, the cartel’s efforts to reduce supply were aided by the unrest in Libya that caused the nation’s output to ease in August, reversing some of the increases from earlier in the year. Increased production by Nigeria has been offset by production cuts in Saudi Arabia and some other nations.

So with demand running slightly ahead of supply, the market has started to draw down some of the vast amount of oil supplies in storage. Commercial oil stockpiles were unchanged in July at just over 3 billion barrels, which was less than expected because stockpiles normally increase this time of year, a 9/13 FT article reported. Yesterday, the Energy Information Administration reported that crude oil being held in US storage fell by 6 million barrels last week, more than expected, due to a jump in US crude exports.

(3) Geopolitical matters can matter. The future of oil prices will have as much to do with politics around the world as with the industry’s fundamentals. A 10/3 Business Insider article highlighted three risky spots to watch.

In Iraq, Kurds’ vote in favor of independence in a non-binding referendum has the potential to disrupt supplies. Iraq and Turkey responded to the Kurdish vote by announcing joint military drills to be held in an area of Turkey bordering the Kurdish region of Iraq. “Turkey’s President Recep Tayyip Erdogan described the vote as ‘unacceptable’, and threatened to close his country’s sole border crossing and the Iraqi Kurds’ vital oil export pipeline,” a 9/25 BBC article noted.

Investors should also keep an eye on the US nuclear deal with Iran, described by President Trump as “one of the worst deals ever negotiated.” He has pledged to rip up the agreement and has the opportunity to do so on October 15. If he does, Congress could reinstate the sanctions that prohibited investment in Iran’s oil sector and reduced demand for Iran’s crude exports. The Trump administration has also warned that it could increase the economic pressure on Venezuela’s government, which could make it more difficult for that country to export oil as well.

(4) US frackers are wild card. One of the reasons that oil prices enjoyed a nice rally in late summer was the sudden decline in the amount of drilling rigs being used domestically. The Baker Hughes land rig count peaked at 937 on August 4. It proceeded to fall for most of the next seven weeks to a low of 916 on September 22. Last week, however, the industry watcher reported that two more land rigs were put into use. That spooked investors who feared increased production by US frackers, enticed by the recent jump in crude prices (Fig. 5). And suddenly, the price of two-year Brent crude oil futures dropped below the spot price of Brent crude oil (Fig. 6).

(5) Back to the future. It seems to us that the true threat to the price of oil is the advent of the electric car. If consumers decide they like plugging in their automobiles, then a huge source of demand for oil will gradually disappear. Almost half of world oil was consumed by drivers in 2015, according to an International Energy Agency 2017 report.

A number of countries recently have announced aggressive sales targets for electric cars and in some cases their intention to ban gas-powered automobiles. China hopes 1.5 million electric cars will be sold annually by 2025. On Thursday, the country “said it would require foreign auto companies manufacturing in China to start making new-energy vehicles in the country by 2019,” noted a 10/2 WSJ article.

Paris is banning the driving of cars built before 1997 and motorcycles built before 2000 within city limits during weekdays and daylight hours. The goal: to lower pollution. By 2040, France will end sales of gas-fueled vehicles. And Norway aims to sell only electric or hybrid cars by 2025. India is considering not selling petrol or diesel cars by 2030.

Some industry watchers believe the switch to electric cars will be so fast that there won’t be a need to ban gas-powered cars in the future because no one will be using them. A 7/6 article in The Guardian reported: “Tony Seba, a Stanford University economist who has published research predicting electric cars will even more rapidly take over from conventional cars, said of France’s plan: ‘Banning sales of diesel and gasoline vehicles by 2040 is a bit like banning sales of horses for road transportation by 2040: there won’t be any to ban.’”

The same article noted that: “Electric vehicles will make up 54% of all light-duty vehicle sales by 2040, up from the 35% share Bloomberg was forecasting just last year, according to a new report by the research group. Bloomberg said such a widespread uptake of electric vehicles would globally reduce oil demand by 8m barrels a day and increase electricity consumption by 5% to charge all the new cars.”

Sector Focus: Strong Performers. As we enter the home stretch of 2017, the leading S&P 500 sectors—Technology and Health Care—remain unchanged in ytd performance rank, but some interesting reshuffling among other sectors has been happening in recent weeks. Notably, Utilities has lost momentum, having dropped now to seventh place among the 11 S&P 500 sectors from third in early September. Conversely, Financials have come back strong, moving up to fifth place from ninth in early September (Fig. 7).

Here’s where the S&P 500 sector performance derby stands ytd through Tuesday’s close: Tech (26.4%), Health Care (19.9), Materials (15.8), Industrials (13.7), S&P 500 (13.2), Financials (12.3), Consumer Discretionary (11.4), Utilities (8.8), Consumer Staples (4.3), Real Estate (4.2), Telecom Services (-7.2), and Energy (-8.7).

The Tech sector has been fueled by the rocket-like performance of the Home Entertainment Software industry, up 63.0% ytd, and the Semiconductor Equipment industry, up 58.7% (Fig. 8). But industries from other sectors also appear in the top performance quartile among S&P 500 industries.

For example, Consumer Discretionary members Casinos & Gaming and Hotels, Resorts & Cruise Lines are up 54.7% and 32.7% respectively ytd. Also from that sector are high-performers Auto Parts & Equipment (42.9%) and Homebuilding (41.1). Representing the Health Care sector are Health Care Technology (52.1), Life Sciences Tools & Services (40.9), Managed Health Care (29.8), and Biotechnology (28.1). Utilities have the Independent Power Producers & Energy Trading (34.6) as a top performer. And Industrials can boast about Aerospace & Defense (30.4) and Construction Machinery & Heavy Trucks (28.6) (Table 1).

Industries: High Flyer. We’ve been optimistic about the fortunes of the Aerospace and Defense industry for a while, and it hasn’t disappointed. After trading sideways for much of 2014 and 2015, the industry has rocketed higher (Fig. 9). The industry has much to like. Revenue growth has accelerated—from a drop of 1.9% in 2016 to expected increases of 2.4% in 2017 and 4.4% in 2018. Profit margins have improved, and earnings growth has picked up too, from only 4.8% in 2016 to an expected growth rate of 8.5% this year and 9.1% in 2018 (Fig. 10 and Fig. 11).

The only point of concern would be the industry’s forward P/E, which has risen to 20.9 from roughly 15 a year ago (Fig. 12). With all the saber-rattling going on in the world (North Korea comes to mind), it’s tough to imagine anything but increases in the US defense budget. However, one area that might see softness is the industry’s exposure to airlines.

A slew of new, low-cost airlines has sprung up in Europe’s market in recent years, and a shakeout appears underway. Earlier this week, Britain’s Monarch Airlines declared bankruptcy, leaving 110,000 passengers stranded. A 10/2 WSJ article explained: “Monarch Airlines, owned by private-equity firm Greybull Capital LLP, was a British tourist airline that tried to remake itself as a budget carrier. Its failure comes after Italian flag carrier Alitalia and Germany’s No. 2 airline by passengers, Air Berlin PLC, ran out of money this year. Strong competition from budget airlines such as Ryanair Holdings PLC, Europe’s biggest airline by passengers, and rival easyJet PLC have forced down prices, crimping the prospects of carriers that can’t compete on cost. These European airline failures have implications as far away as the U.S. Air Berlin, though principally a European carrier, had to close trans-Atlantic routes.”

Monarch had placed orders for 32 of Boeing’s new 737 Max jetliners, and its rented planes were being returned to lessors, the article reported. Boeing’s shares are up 93.2% over the past year, and Monarch’s 32-plane order won’t break the bank at Boeing. But the change in the European airline market certainly could cause turbulence.

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Taxing Tax Reform

October 4, 2017 (Wednesday)

US Tax Reform: Retooled. The Trump administration’s 9/27 Unified Framework for Fixing Our Broken Tax Code is essentially an outline. The President is leaving it up to Congress to fill in the details that will make it a plan. The Republicans need to make tax reform the law of the land to hold onto their slim majorities in both houses of Congress come next year’s mid-term elections. They might fail as miserably on this challenge as they did on repealing and reforming Obamacare, when their majority splintered and not one Democrat in either the House or the Senate supported their effort.

In this case, the President might have to reach out to “Nancy and Chuck” to formulate a bipartisan tax reform bill. What are the odds that the Democrats would give the Republicans any tax reform that they could tout as their own during the upcoming election? Slim to none is the obvious answer.

Politics aside, let’s look at the latest White House framework. How does it differ from Trump’s tax-related campaign promises? Are there any key changes that might affect how investors reshuffle portfolios? That’s hard to say, given the scant details in the latest framework; for now, let’s work with the big-picture numbers that we do have.

The upshot is that the new framework is far less costly to the government than the one proposed during the campaign. Let’s compare:

(1) Lighter revenue hit. The non-partisan Tax Policy Center (TPC) estimated the revenue effects over the next 10 years of the Trump campaign’s October 2016 proposal in a published analysis and did a similar preliminary analysis of the new White House framework. It’s important to caveat that the analyses, the latter one especially, are based on a lot of assumptions given the lack of details. That said, the bottom line came in approximately $3.7 trillion less costly for the White House framework than Trump’s campaign proposal over the next 10 years.

To trace that figure to its source documents, see the bottom of Table 1 in the TPC’s updated analysis (reducing revenues by about $2.4 trillion) and compare that to the older analysis Table 2 (costing $6.2 trillion). Another caveat: These figures are based on different 10-year periods, specifically 2018-2027, for the updated analysis and 2016-2026 for the older one.

(By the way, another often-cited analysis, done by the Committee for a Responsible Federal Budget, pegged the net cost of the framework at $2.2 trillion, not far from the TPC’s bottom line.)

(2) State of individuals. Melissa prepared an updated table comparing the estimated revenue impacts of the latest White House framework with those of the Trump campaign proposal using TPC estimates (Table 1). Taxes changes are skewed toward individuals more than pass-through entities and corporations.

The new White House framework has nearly $1.7 trillion in additional revenue from individuals. Much of it appears to come from repealing the state and local tax deduction, which adds about $1.3 trillion to revenue (offset by changes to estimates for other itemized deductions), according to the TPC’s latest analysis.

The state and local tax deduction isn’t specifically mentioned in the White House framework. The TPC likely culled it from the White House framework, which states: “In order to simplify the tax code, the framework eliminates most itemized deductions, but retains tax incentives for home mortgage interest and charitable contributions.” In other words, the state and local tax deduction is not retained.

That’s a really big sticking point for Republicans from high-tax states who want to keep that tax break, observed a 9/29 Bloomberg article. Bloomberg reported that President Trump is open to negotiating on this matter. Another hot topic that Congress will surely debate is eliminating the medical expense deduction, as discussed in a 9/29 WSJ article, “A Big Tax Question: What Happens to the Medical-Expense Deduction?”

(3) Bones for progressives. In addition to eliminating the state and local deduction, there was a sizable giveback for individual tax rates on high-income earners. In the new White House framework, the tax rate for top earners was increased to 35.0%, generating more revenues than the 33.0% proposed in the original Trump campaign’s tax plan. Even so, the move still benefits high-income earners, as the top marginal income tax rate currently stands at 39.6%.

The change clearly was a bone tossed to Democrats who argued that Trump’s campaign proposal overly and overtly favored the wealthy. Perhaps in a futile gesture to get some Democratic support, the framework provides for a top fourth bracket: “An additional top rate may apply to the highest-income taxpayers to ensure that the reformed tax code is at least as progressive as the existing tax code and does not shift the tax burden from high-income to lower- and middle-income taxpayers.” Meanwhile, the tax rates for the two lowest of the three income brackets were kept the same in the framework as in the campaign proposal at 12.0% and 25.0%. But how much income will determine each bracket is unknown, as Business Insider pointed out in a 9/27 article.

(4) Pass-through loops. Pass-through entities wouldn’t benefit as much from the White House framework as they would have under the Trump campaign proposal. A hallmark of the Trump campaign’s tax proposal was the flat 15.0% tax rate for pass-throughs. The latest framework earmarks the pass-through rate at 25.0%. The current framework would cost the government $1.4 trillion less than the campaign proposal for the treatment of pass-through entities, according to the TPC.

About half of the $1.4 trillion reflects the higher pass-through rate, including the TPC’s estimates of the potential recharacterization of income. The source of the other half of the difference is less clear. From the TPC’s analyses, the other half seems to come from no longer allowing a line item for investments and equipment to be expensed (as opposed to capitalized). Expensing of capital investments for businesses is mentioned in the new White House framework, but is not specifically tied to pass-through entities, so that’s probably why the TPC opted to exclude it in the new analysis.

Though the rate for pass-throughs was increased for the framework, “[t]he real fight [in Congress] is going to be over what income qualifies for the rate reduction and what income doesn’t,” said a former House GOP aide quoted in a 9/24 Fox Business article. The TPC included in its analyses assumptions that individuals would seek to recharacterize wages (fairly or unfairly) as “pass-through income” to qualify for the lower rate.

The new framework suggests that the White House would adopt rules to prevent unfair recharacterization of income. Earlier in September, Steve Mnuchin specified: “If you’re an accountant firm and that’s clearly income, you’ll be taxed an income rate, you won’t be taxed a pass-through rate. If you’re a business that’s creating manufacturing jobs, you’re going to get the benefit of that rate because that’s going to be passed through to help create jobs and better wages.”

So small businesses that create jobs stand to significantly benefit from the latest White House framework. Juanita Duggan, the NFIB President and CEO, was right on 9/19 when she told the Senate Finance Committee: “If the purpose of tax reform is to jump-start the economy and create jobs, then tax reform must start with small business.”

Indeed, small and medium-sized companies are disproportionately big employers, according to ADP’s monthly tally of payrolls, as we discussed in our 6/14 Morning Briefing. Recently, small business owners have reported that they have lots more jobs to fill but can’t find enough qualified workers to fill them. It’s possible that the pending tax reform will help to free up some capital for small businesses to raise wages and better afford qualified workers, assuming they’re out there.

(5) New corporate rate target. Overall, the change from the campaign proposal to the framework isn’t as significant for corporations as for individuals and pass-throughs. The statutory federal rate stands at 35.0% now, was 15.0% in the Trump’s campaign proposal, and has been increased to 20.0% for the framework. Trump reportedly will not negotiate any further on it, according to Gary Cohen, reported Bloomberg. Trump also recently called 20.0% a “perfect number.”

The change could add back about $400 billion in revenue, per the TPC analysis. But that can’t be very exact, since the new framework lacks sufficient details on how corporate deductions would impact effective corporate tax rates. Further, there’s another $400 billion or so addback in the latest TPC analysis related to less aggressive allowances for business expensing of capital investments.

(6) Macro feedback MIA. Melissa and I aren’t surprised that the “Big 6” fiscal policymakers who developed the framework found several trillions of dollars to add back to revenue from Trump’s campaign dreams. Before Trump came on the political scene, members of the GOP had introduced a similar blueprint for tax reform to Congress. Melissa and I reviewed the earlier proposal in our 5/1 Morning Briefing, highlighting that the TPC estimated the cost of the original blueprint at around $2.5 trillion, close to the recently released framework’s level (Table 2).

So it appears that the Big 6, the group of high-profile tax policymakers who are fully backed by President Trump, had that top-level figure in mind when developing the framework. The group, named in a 7/27 joint statement, includes: House Speaker Paul Ryan (R-WI), Senate Majority Leader Mitch McConnell (R-KY), Treasury Secretary Steven Mnuchin, National Economic Council Director Gary Cohn, Senate Finance Committee Chairman Orrin Hatch (R-UT), and House Ways and Means Committee Chairman Kevin Brady (R-TX).

Steve Mnuchin recently said that the framework should more than pay for itself. According to a 9/28 Dow Jones Newswire posted on Fox Business, he “argued that any measure of the tax cut should disregard about $500 billion in expired and expiring tax breaks that Congress was going to extend anyway. That would make the total cut smaller, at approximately $1 trillion, he said. A $1 trillion tax cut generating $2 trillion in revenue, would leave an extra $1 trillion to help pay down the debt, Mr. Mnuchin concluded.”

Mnuchin’s calling out of a $1 trillion cut could be important. Connecting the dots to a fact found in a 9/27 Forbes article, the reconciliation process—which would streamline the Trump administration’s tax reform pursuit in Congress—allows for only $1.5 trillion in tax cuts.

Whatever the targeted number might be, Mnuchin’s cuts don’t reconcile with the TPC’s analysis. Neither do his estimated economic effects. In the TPC’s analysis, the effects were miniscule compared to the cuts. The TPC does not have a new “Macro Feedback” estimate for President Trump’s latest proposal, but notes in its report that it is forthcoming.

Who knows who is right about the framework’s economic impacts? If the framework materializes into law, the impacts will be tough to estimate going forward and even more difficult to prove 10 years from now.

(7) Forced repatriation. Beyond that, Melissa and I particularly want to better understand the potential effects of the repatriation tax on the financial markets. Investors seem to be betting that it will turn out to be quite bullish for domestic equities. In a 10/1 interview with Maria Bartiromo, Gary Cohn said that the White House is looking to bring back nearly $3 trillion in profits stashed overseas.

The questionable new news in the new framework is that it implies that such repatriation will not be optional. It states: “To transition to this new system, the framework treats foreign earnings that have accumulated overseas under the old system as repatriated.” Melissa and I don’t recall the initial discussions on repatriation as having been focused on forcing the issue.

Going forward, the framework notes: “To prevent companies from shifting profits to tax havens, the framework includes rules to protect the U.S. tax base by taxing at a reduced rate and on a global basis the foreign profits of U.S. multinational corporations.” US multinational corporate lobbyists, according to a 10/2 Bloomberg article, see that as an “appalling” new tax on US companies foreign profits.

But it isn’t all bad news. Don’t forget that the repatriation tax should be offset by the lower corporate tax rates discussed above. What’s more, the existing overseas profits would be taxed at a much lower, one-time retroactive tax rate payable over a period of time. The framework didn’t specify the rate. Neither did Cohn in his interview. In its latest analysis, the TPC estimated the one-time rates to be the same as in the 2014 proposal of former House Ways and Means Chairman Dave Camp, i.e., 8.75% on accumulated foreign earnings in cash and 3.5% for non-cash, payable over eight years.

However, Cohn did say that the rate would be bifurcated—a different rate for liquid assets offshore and another for those that have turned earnings into bricks-and-mortar or investments offshore. He said: “We will give [companies] some period of time to pay it, but [they] will incur the tax liability the minute the tax referendum goes through.”

(8) Border tax axed. By the way, the controversial concept of a border tax was dropped prior to the release of the White House’s September framework. On July 27, in the previously referenced joint statement, the Big 6 concluded: “While we have debated the pro-growth benefits of border adjustability, we appreciate that there are many unknowns associated with it and have decided to set this policy aside in order to advance tax reform.” (For more, see the 7/27 NYT article on the subject.)

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Thanks a Trillion!

October 3, 2017 (Tuesday)

Global Economy I: Booming? The global economy is showing more signs of booming, as Debbie and I review in the next section. Why might that be happening? Several explanations come to mind. They are not mutually exclusive. Consider the following:

(1) Global monetary policy remains ultra-easy. While the Fed has started to unwind its balance sheet in a very gradual fashion, the ECB and BOJ are continuing to load up on securities through their respective QE programs. Over the past 12 months through August, the Fed’s assets were unchanged at $4.4 trillion. The ECB’s assets soared $1.3 trillion to a record-high $5.1 trillion. The BOJ’s assets also hit a record high during August of $4.7 trillion, up $184 billion y/y. Altogether, the balance sheets of the Three Sisters rose $1.5 trillion y/y to a record $14.1 trillion (Fig. 1 and Fig. 2).

(2) Chinese bank lending is at a record high. No piker in this central bank monetary extravaganza is the People’s Bank of China, with assets of $5.2 trillion during August (Fig. 3). That’s actually down slightly by $178 billion y/y. On the other hand, China’s bank loans have increased by a record $2.0 trillion over the past 12 months through August to a record high of $17.5 trillion (Fig. 4).

(3) The 50% cut in oil prices since mid-2014 is a big windfall. We estimate that the drop in oil prices since mid-2014 through mid-2017 has saved $1.8 trillion for global oil consumers (Fig. 5). The initial plunge in oil prices seemed to depress global economic activity as the oil industry retrenched quickly. The rebound in the price of a barrel of Brent from a low of $27.88 on January 20, 2016 to $56.09 currently has revived the oil industry. US oil field production is back at the highs of early 2015 (Fig. 6). However, there remains a substantial windfall for consumers at current prices, which remain much lower than they were during H1-2014.

(4) Mass immigration into Europe is boosting the region’s growth. The number of people with an immigrant background in Germany rose 8.5% to a record 18.6 million in 2016, largely due to an increase in refugees, the Federal Statistics Office said last Tuesday. Germany took in more than a million migrants, many fleeing war and poverty in the Middle East and Africa in 2015 and 2016.

Chancellor Angela Merkel’s decision to open borders initially hit her popularity and boosted the anti-immigrant Alternative for Germany (AfD) party, though she won a fourth term as chancellor in elections last month. In any case, the surge in immigrants might also explain the faster pace of growth in Germany.

(5) The global bull market in stocks is having a very positive wealth effect on growth. The value of all equities traded just in the US alone soared $23.4 trillion since the start of the current bull market from a low of $10.9 trillion during Q1-2009 to a record $34.3 trillion during Q2-2017 (Fig. 7). It’s up 62% since the previous bull market high during Q2-2007!

Global Economy: Booming! A trillion here, a trillion there: It’s all adding up to serious money. Any one of the stimulative developments mentioned above could contribute to better global economic activity. Put them altogether, and the result could be a global boom. Consider the following:

(1) South Korean exports soaring. Our focus on the global economy today was inspired by South Korea’s September exports data released yesterday (Fig. 8). They mostly meandered sideways at record highs from 2011-2014. Then they fell during 2015. They recovered to their record highs by early 2017. During September, they went vertical, jumping by 17% m/m and 38% y/y. It will be interesting to see if September data for any of the other major Asian economies outside of China confirm that something big is up in the global economy (Fig. 9).

(2) Economic Sentiment & M-PMIs very strong in Europe. Another notable sign of a global boom is September’s Economic Sentiment Indicator (ESI) for the Eurozone (Fig. 10). It rose to 113.0, the highest reading since June 2007. It is very highly correlated with the y/y growth in the region’s real GDP. Leading the way is Germany’s industrial component of the ESI (Fig. 11).

Germany’s M-PMI led the pack of rising indexes among the major European countries (Fig. 12). It rose to 60.6 last month, confirming the strength in Germany’s industrial ESI and in the German Ifo business confidence index. Solid M-PMI readings were also registered last month in France (56.1), Italy (56.3), Spain (54.3), and the UK (55.9).

(3) German unemployment at record low. German unemployment slid to a record low in September. The jobless rate dropped to 5.6% in September, down from 5.7%. That’s impressive considering the migration inflow over the past two years.

(4) US M-PMI in the 60s. In the US, the national M-PMI rose to 60.8 during September (Fig. 13). That’s the best reading since May 2004. The composite’s three major components had readings exceeding 60.0: New Orders (64.6), Production (62.2), and Employment (60.3). That trifecta is a very unusual occurrence.

(5) Global M-PMI. The global M-PMI remained relatively high at 53.2 last month, as Debbie discusses below (Fig. 14). While the M-PMI for emerging economies dipped to 51.3, the index for advanced economies rose to 54.6, the highest since February 2014.

(6) Forward revenues and earnings rising rapidly. Over the past year, forward revenues and earnings have been rising to new record highs for the US MSCI stock price index. Since early this year, there has been a significant rebound in the forward earnings of the All Country World ex-US MSCI (Fig. 15 and Fig. 16).

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Thanks a Million!

October 2, 2017 (Monday)

Strategy I: Buffett Is Bullish. Among the various stock market valuation gauges, Warren Buffett has said he favors the ratio of the value of all stocks traded in the US to nominal GNP, which is nominal GDP plus net income receipts from the rest of the world (Fig. 1). The data for the numerator is included in the Fed’s quarterly Financial Accounts of the United States and lags the GNP report, which is available a couple of weeks after the end of a quarter on a preliminary basis. Needless to say, it isn’t exactly timely data.

However, the S&P 500 price-to-forward-revenues ratio (a.k.a. the price-to-sales ratio), which is available weekly, has been tracking Buffett’s ratio very closely (Fig. 2). In an interview with Fortune in December 2001, Buffett said: “For me, the message of that chart is this: If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%—as it did in 1999 and a part of 2000—you are playing with fire.” That’s sage advice from the Oracle of Omaha.

Buffett’s ratio rose back to 176% in Q2-2017, nearly matching the Q1-2000 peak of 180, and the weekly measure rose to 198% in mid-September. Yet Buffett chose to ignore all that, predicting that the DJIA will be over 1 million in 100 years. He said that on September 19, 2017, speaking at an event in New York City marking the 100th anniversary of Forbes magazine. Buffett noted that 1,500 different individuals have been featured on Forbes’ list of 400 wealthiest Americans since the start of that tally in 1982. “You don’t see any short sellers” among them, he said, referring to those who expect equity prices will fall. He added, “Being short America has been a loser’s game. I predict to you it will continue to be a loser’s game.” Buffett also said, “Whenever I hear people talk pessimistically about this country, I think they’re out of their mind.”

CNBC reported that Mario Gabelli joked on Twitter about whether Buffett’s normally sunny outlook had darkened given the numbers: “one million in one hundred years ... has Buffett turned bearish?,” Gabelli tweeted. He noted that the roughly 3.9% compound annual growth rate (CAGR) needed to get from where the Dow is today to where Buffett predicts it will be in 2117 would be lower than the 5.5% CAGR from the beginning of the 20th century until now.

I asked Joe to go back 100 years and play with the numbers. Here is what he came back with:

(1) We have a monthly series for the DJIA starting December 1917. We can put it on a ratio scale and compare it to alternative compounded annual growth rate (CAGR) lines (Fig. 3). During the 1950s to 1970s, the DJIA crawled along between CAGR lines of 4%-5%. During the two bull markets of the 1980s and 1990s, it climbed from a CAGR of about 4% at the August 1982 trough to about 6% at the March 2000 peak. During the 2000s and 2010s, it has been rising between the 5%-6% CAGR trends.

(2) Starting from the last trading day of 2016, when the DJIA was at 19,763, Joe calculates the following DJIA targets in 2117 in round numbers: 54,000 (1% CAGR), 146,000 (2%), 391,000 (3%), 1,038,000 (4%), and 2,729,000 (5%) (Fig. 4).

(3) Adjusting for inflation, using the CPI since December 1920, the real DJIA has been rising between the 2%-4% CAGR lines averaging around 3% (Fig. 5). Since 2000, it’s been tracking the 3% line quite steadily.

(4) All of the above is based on the long-term annualized return of the DJIA ignoring dividends. Nevertheless, it is interesting that the 3.0% real annualized return from net capital gains isn’t far off the 3.3% average real earnings yield of the S&P 500 since 1952 (Fig. 6). Joe and I derived that yield by subtracting the CPI inflation rate from the S&P 500’s earnings-price ratio.

(5) We also have a total return index for the S&P 500 that includes reinvested dividends (Fig. 7). Since the mid-1950s, it has tended to rise around the 9%-11% CAGR lines. Adjusted for the CPI, it has been rising around the 6%-8% lines.

Strategy II: Fundamentals & Technicals Are Bullish. Notwithstanding Buffett’s happy talk, we now have to consider the front-cover curse. Buffett’s genial visage graces the cover of the Forbes’ centennial issue. Contrarians need to be on high alert. On the other hand, while most measures of stock valuation seem dangerously high, including Buffett’s ratio, Barron’s this week includes an article, “Bears, Return to Your Caves—at Least for Now,” by Vito Racanelli. He concludes with an observation that has been our mantra for quite a while during the current bull market: “Bear markets are generally caused by recessions.” He rightly notes that “the evidence for that anytime soon is weak.” Thankfully, Vito’s story wasn’t placed on the front cover.

The bullish article starts as follows: “This old bull market, the second longest in history, continues to be mocked, doubted, and just plain vilified. Okay, the last is an exaggeration, but investor euphoria is absent, even as stocks hit new highs after new highs in September. Instead, investor sentiment is neutral at best, not the kind of thing that dispatches an aging bull.” Vito reports that Goldman Sachs’ Chief US Equity Strategist David Kostin wrote in a recent report that institutional investors are “tormented bulls.” Joe and I have been calling them “fully invested bears” (“fibers”) for a long time.

Barring an exchange of intercontinental nuclear missiles with North Korea, an ETF flash crash, or some other black swan event, the outlook looks good for the rest of the year, according to the upbeat article: “Since 1928, there have been 29 Septembers in which the S&P 500 made a 12-month high. Following those 29 instances, the market rose over 80% of the time in the fourth quarter, averaging a 3.7% increase, says Doug Ramsey, chief investment officer of the Leuthold Group. Better still, 15 of those 29 September price highs were also accompanied by 12-month advance/decline line highs—as is the case now. Stocks increased an average 5.9% in the fourth quarter in those 15 instances.”

Consider the following supportive developments:

(1) Tax reform. It’s too soon to tell how bullish Trump’s tax reform plan will be for corporate earnings. The latest outline was released last week. It proposes to slash the statutory corporate tax rate from 35.0% to 20.0%. The effective tax rate was 26.4% for the S&P 500 companies last year (Fig. 8). It was 21.3% for all US corporations during Q2-2017 (Fig. 9).

Stock prices started to discount a bullish round of Trump tax reforms the day after Trump was elected (Fig. 10). From November 8 through the end of last year, forward P/Es soared as follows: 16.4 to 16.9 for the S&P 500, 17.2 to 18.7 for the S&P 400, 17.4 to 19.8 for the S&P 600. Investors obviously believe that smaller companies have more to gain from a tax cut than larger ones, which generally have plenty of resources to game the current system. The SMidCaps spent most of this year giving back some of these valuation gains as tax reform seemed like a more distant and less likely outcome.

However, these valuation multiples have started to perk up now that tax reform is actually on the table after release of the administration’s nine-page proposal, “Tax Reform: Unified Framework for Fixing Our Broken Tax Code,” dated September 27, 2017. Once again, investors are particularly upbeat about the impact of tax reform on smaller companies. The forward P/E of the S&P 600, which jumped from 17.4 on November 8 to a high of 20.5 on December 6, sank back to 18.3 on August 21. On Friday, it jumped back to 20.1.

The Trump proposal remains very sketchy on the lower tax rate that might be applied to repatriated earnings. However, short of a major geopolitical blowup, its hard to see the stock market going down much with the possibility of over $2.5 trillion coming back home.

(2) Forward revenues and earnings. While forward P/Es have been meandering lower since early this year until they rebounded last week, forward revenues and earnings have continued on to record highs for the S&P 500/400/600 (Fig. 11 and Fig. 12). Earnings estimates for both 2017 and 2018 for all three have been remarkably firm all year (Fig. 13). Earnings growth rates for this year and next year are currently as follows: 11.1% and 10.9% for the S&P 500, 11.0% and 13.7% for the S&P 400, and 5.7% and 20.3% for the S&P 600.

(3) Breadth. The percentage of the S&P 500 companies trading above their 200-day moving averages rose to 70.7% on Friday, up from a recent low of 59.6% on August 18 (Fig. 14). The percentage with gains on a y/y basis was 74.7% on Friday, a solid reading for sure (Fig. 15).

Movie. “American Made” (+ + +) (link) is loosely based on the true story of Barry Seal, who worked as a TWA pilot for a short stint before finding gainful employment as a drug runner, money launderer, and gun trafficker. He was employed (often at the same time) by the Columbian drug cartels, the CIA, the Sandinistas, the DEA, the Contras, and the Reagan White House. It’s fun watching Tom Cruise have fun playing Seal. It’s just another side of the bizarre and disturbing drug-infested relationship between the US and some Latin American countries, which also is entertainingly depicted in the Netflix docudrama “Narcos.”

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Good Rotations

September 28, 2017 (Thursday)

Strategy: Panics, Rotations & the Bull. The current bull market has been prone to panic attacks because the preceding bear market was so traumatic. Joe and I have counted 57 so far since March 9, 2009. The panic attacks were associated with “risk-off” trades involving a shift of funds from risky to safe stocks, e.g., from industrials to utilities. When the panic passed, it was back to “risk-on” trades. The bull market has also been associated with recurring “leaders-laggards” trades. Consequently, the bull market has been a broad one as leaders stall, allowing laggards to catch up and even lead for a while, then reassume leadership, and so on (Fig. 1).

The risk-on/risk-off phenomenon hasn’t been discussed much lately because the overall market has had fewer, shorter, and less severe panic attacks since early 2016. The leaders-laggards trades continue nonetheless. Consider the leaders and laggards since the current mini-bull run, which started on February 11, 2016:

(1) Since then, the S&P 500 is up 36.5% (Table 1). Here is the S&P 500 sectors’ performance derby since then: Financials (59.2%), IT (56.6), Materials (44.8), Industrials (42.3), S&P 500 (36.5), Consumer Discretionary (30.9), Health Care (28.3), Energy (24.0), Real Estate (20.1), Utilities (17.6), Consumer Staples (10.7), and Telecom Services (2.6).

(2) Here is the S&P 500 sectors’ performance derby during the two years prior to the mini-bull market, from January 2, 2014 through February 11, 2016 (Table 2): Utilities (21.6%), Consumer Staples (15.5), Health Care (14.8), Real Estate (11.9), IT (10.0), Consumer Discretionary (3.1), Telecom Services (1.9), S&P 500 (-0.2), Industrials (-5.1), Financials (-9.6), Materials (-15.6), and Energy (-36.8).

Industry Focus: Chip Dip. Two recent examples of leaders that turned into laggards are the S&P 500 Semiconductor and Semi Equipment industries. Ytd through 9/19, the S&P 500 Semiconductors index was up 19.2%, and the S&P 500 Semiconductor Equipment index had risen 50.5%. On the ensuing five trading days, those industries were among the worst performers, down 2.9% and 4.4%, respectively (Fig. 2 and Fig. 3).

Sentiment wasn’t helped by a CNBC report that Tesla was developing its own chip for autonomous driving instead of purchasing chips presumably from Nvidia, its current provider. A number of companies, including Apple, Google, and Microsoft, are also developing their own chips and opting for vertical integration—i.e., developing the parts needed for their products in-house instead of turning to suppliers. Let’s look at a few examples of this move toward vertical integration:

(1) Driven mad. Tesla appears to be the latest company developing its own semiconductor chips. A 9/20 CNBC article reported that Tesla is working with AMD to refine a new chip to be used for autonomous driving in its cars. Tesla has been using Nvidia graphics processing units (GPUs). But Tesla is now building a chip that uses AMD intellectual property and hopefully will be more power efficient. Heading Tesla’s project is Jim Keller, who joined Tesla in early 2016 after working at AMD and Apple.

CNBC explained that GPUs, like those Nvidia builds for various artificial intelligence (AI) workloads, are capable of doing many things and aren’t specialized. By developing custom chips with just a few narrow computing jobs in mind, the custom chip can be faster and more power-efficient. “Plus, Tesla would be less impacted by pricing dictated by Nvidia if it switches to in-house hardware.”

(2) Vertical-integrating Apple. Earlier this year, Imagination Technologies announced that Apple would no longer buy Imagination’s GPUs. Instead, Apple would develop its own chips for the graphics on iPhones and iPads. Apple proceeded to hire a “bevy” of Imagination’s engineers and its chief operating officer, a 9/22 Bloomberg article reported. Apple also opened its own R&D center close to Imagination’s UK offices. And when the new iPhone 8 was unveiled earlier this month, it contained Apple’s new A11 Bionic SoC.

“If anything, look at Apple’s move into graphics as a continuation of a trend it helped start. Rather than rely on outside partners for critical components, an increasing number of large-scale tech companies have invested in rolling their own silicon. The advantages are manifold; you can design them to work specifically with your own devices, find novel ways to differentiate, and avoid getting dragged down if something goes wrong on someone else’s watch,” a 4/3 Wired article reported.

But the move did have some downsides. Imagination Technologies’ stock fell roughly 70% on news that Apple, its largest customer, was defecting. Apple kicked in roughly 50% of the company’s revenue. The development sent Imagination looking for legal recourse. The company started a dispute resolution procedure as the company doubted Apple could develop its own GPUs without using Imagination’s intellectual property.

In addition, Imagination put itself on the block. And earlier this week, Chinese-backed private equity firm Canyon Bridge Capital Partners announced it will pay $675 million for Imagination, a 42% premium, according to a 9/22 Bloomberg article. Apple owns an 8% stake in Imagination.

(3) Google’s in chips too. In May, Google introduced the second generation of its artificial intelligence chip, dubbed tensor processing units (TPUs).

A 5/17 CNBC article explained the situation well: “Deep learning, a trendy type of AI, typically involves two stages: training artificial neural networks on lots of data, and then directing the networks to make inferences about the new data. Over the past five years, GPUs have become a standard for the training stage of deep learning, which can be used for image recognition, speech recognition and other applications. While (Google’s) original TPU was only meant for the inference stage of deep learning, the new version can handle training as well. … It takes a day to train a machine translation system using 32 of the best commercially available GPUs, and the same workload takes six hours atop eight connected TPUs.”

(4) Chips in HoloLens. Microsoft is continuing to improve its Holographic Processing Unit (HPU), which goes into its HoloLens goggles. The updated HPU will support deep neural network processing with an emphasis on AI, explained a 7/24 PCWorld article. It will allow the goggles to analyze what the user sees and hears in the goggles instead of sending the information to the cloud for processing.

(5) Tit for tat. Where does that leave Nvidia, which we profiled in our 9/21 Morning Briefing? Nvidia countered the Tesla report with its own announcement on Monday. The company will supply its AI-focused GPUs to several of China’s largest cloud-computing providers and server hardware manufacturers, including Alibaba Group Holding, Baidu, and Tencent Holdings, according to a 9/26 MarketWatch article. Nvidia will also be working with JD.com on its drones and robots.

“The new drones, powered by Nvidia’s Jetson supercomputer, will participate in several delivery pilot programs that aim to bring e-commerce to rural areas via airborne drones and on-the-ground delivery robots to service cities. JD will release more than 1 million drones over the next five years,” the article states.

Our guess is that this industry is still at such a young age that Nvidia will be able to continue its growth for many years even if some of the largest players decide to vertically integrate some of their operations. In other words, the pie is growing fast enough that all can succeed.

That was certainly on display Tuesday night when Micron Technology surprised the market with amazingly strong fiscal Q4 results. The company, which makes NAND flash and DRAM memory chips, reported a 91% y/y increase in revenue and record EPS of $1.99 compared to a 16 cents-a-share loss last year.

Micron is benefitting from the continued increase in the use and collection of data, as applications like autonomous driving and AI take off. The shares gained more than 8% yesterday due to the earnings report, bringing their ytd gain to almost 70%.

US Labor Market: Screws Tightening. While we continue to believe that powerful structural forces are keeping a lid on inflation, we are also mindful of the basic law of supply and demand. So we are keeping a careful watch on any inflationary pressures we can find. If three items make a trend, then it may be time to watch for wage pressures in certain sections of the labor market. Specifically, there have been news reports about tight labor markets in housing, in the oil patch, and at retailers. Let’s take a look:

(1) Building tightness. The construction market was having a tough time finding labor before the hurricanes. Now that the storms have wreaked havoc in Florida, Houston, and the Caribbean islands, the market for labor in the housing market down south could devolve into a severe shortage.

“Nearly 70 percent of Texas contractors had trouble finding concrete workers, electricians, cement masons and carpenters, according to a survey of construction firms that the Associated General Contractors of America conducted in July. Texas has long struggled to replenish its aging construction workforce. The average age of a master electrician in Texas is 59. For plumbers, it’s 62,” according to a 9/13 article by the Associated Press in The Dispatch. The state was expected to see the construction of 30,000 new homes started this year, and now an estimated 200,000 homes need to be repaired or rebuilt—in Texas alone.

(2) Raising the Target. Target announced last week plans to boost wages to $11 an hour starting next month and to $15 an hour within three years. The new rate will apply to all staff, including temp workers being hired for the holidays.

“The retail industry is the largest private-sector employer in the US, and competition for hourly workers has ratcheted up both in traditional stores and distribution centers that fulfill online orders. Retail trade workers in the US earn an average hourly wage of $15.35 as of August, an increase of about 10% from five years ago, according to Bureau of Labor Statistics data,” noted a 9/25 WSJ article.

(3) Drill, baby, drill. The price of a barrel of oil may still be below $60, but drilling activity has continued in certain areas, and that’s making workers tougher to come by.

“Experienced workers are harder and harder to find, and training newbies adds to expenses. The quality of work can suffer, too, erasing efficiency gains. [Elevation Resources CEO Steve] Pruett said [the company] recently had a fracking job that was supposed to take seven days but lasted nine because unschooled roughnecks caused some equipment malfunctions,” noted a 9/25 Bloomberg article.

China: Blue Skies by Decree. As the 19^th National Congress of the Communist Party of China convenes in Beijing on October 18 to revamp top leadership roles, two things are certain: President Xi Jinping will further consolidate his already considerable grip on power and the skies will be blue.

President Xi will be elected to a second five-year term because he has ruled with an iron grip and purged potential rivals in a wide-ranging anti-corruption campaign, so he is unlikely to face opposition. His political philosophies now will be included in the party constitution alongside those of Mao Zedong and Deng Xiaoping, according to a piece in the 9/18 South China Morning Post. The outstanding question is whether he’ll be crowned with a new moniker that elevates his status from “core” leader to something more comparable to Mao Zedong’s “thought” or Deng Xiaoping’s “theory” leader.

The usually smog-filled skies in China will turn a brilliant blue because the government will restrict the use of vehicles, barring millions of them from the roads, and order factory shutdowns during the week-long event, as it does for all high-profile government affairs.

This year, though, the blue skies will be more than just the visible display of the Communist Party’s control. They represent a vow made in March by Chinese Premier Li Keqiang at the launch of the annual National People’s Congress to “make our skies blue again” in response to increasing public protests about deadly air pollution, often referred to as “airpocalypses,” according to a 3/5 report in the U.K.’s Independent newspaper. A 2/14 Reuters article cited a study by the U.S.-based Health Effects Institute that estimates 1.1 million people die each year in China from the effects of air pollution.

Li called for upgrading coal-fired power plants, integrating renewable energy sources into the electricity grid, and cutting excess steel production. In the same speech, Li also lowered economic growth targets for 2017 to “around 6.5% or higher” as the country continues to pursue its transition to a domestic consumer-driven economy from its traditional role as an exporter. He referred to President Xi’s “China Dream” goal of becoming a “moderately prosperous society” by 2020. The message: blue skies will come at the expense of more robust economic growth. The trouble: reining in the powerful state-owned enterprises such as the steel companies and banks.

Despite the economic slowdown, the country continues to deliver steady growth that far exceeds that of the rest of the world. The 6.9% expansion in GDP in Q2 came in better than expected and matched Q1 growth. China so far has avoided a long-feared hard landing as it transitions to a more services-oriented economy from an industrial might, and the stronger showing in the first half of the year gave central planners latitude to continue their reform agenda, Reuters explained in a 7/16 piece.

In the performance derbies, the MSCI China Share Price Index is the fourth-best performer ytd of the 49 country stock markets we track, up 39.1% ytd through Tuesday’s close (Fig. 4). Yet China’s market continues to appear undervalued: it is trading at a P/E of 13.6, while 2018 earnings are estimated to increase by 14.5% (Fig. 5). That compares to the 12.1% earnings growth expected for the broader MSCI Emerging Markets Asia index. Moreover, forward earnings recently has been revised upward (Fig. 6). China remains attractive for investors.

Consider the following:

(1) Cool down. China’s economy has continued to slow through August. Industrial output rose 6.0% y/y in August compared with growth of 6.4% in July and a forecast of 6.6%. Retail sales also missed targets in August, expanding 10.1% y/y compared with a forecast of 10.5% and growth of 10.4% the prior month (Fig. 7). Capital spending grew at the slowest pace since 1999, rising 7.8% y/y in August, below the projected 8.2% growth and down from July’s 8.3% y/y advance, according to data supplied by Trading Economics.

(2) But not too cool. China’s official PMI rose to 51.7 in August on strength in new orders, up 53.1, and output, up 54.1 (Fig. 8). The Producer Price Index surged 6.3% as the prices of industrial commodities and building materials rose in response to the government’s shuttering of inefficient mines and mills amid a construction boom (Fig. 9).

(3) Revised GDP forecasts. The Asian Development Bank this week upgraded its growth forecast for China in 2017, to 6.7% from a previous 6.5%, and 2018, to 6.4% from 6.2%, following revisions to the same levels by the International Monetary Fund in July. “The PRC [People’s Republic of China] economy remains resilient, solidifying its role as an engine of global growth,” ADB Chief Economist Yasuyuki Sawada said in a 9/25 Reuters article.

“Supply-side reform is moving forward, but eventual success hinges on a careful balancing of the role of the market and the state, particularly as the country continues its transition to a more market and services-driven economy.” On 8/30, Moody’s Investors Service raised its 2017 GDP outlook on China to 6.8% from 6.6%.

(4) Debt load. You can’t talk about China without addressing its enormous debt levels. S&P Global Ratings brought the subject into sharp relief when it downgraded China’s sovereign credit to A+ from AA- on 9/21, citing the enormous level of debt and continued credit expansion. Curiously, the S&P action came four months after a similar downgrade by Moody’s Investors Service in May and Fitch Ratings four years ago and just weeks ahead of the important twice-a-decade meeting of the National Congress. Yet a 9/24 report in the FT noted that China’s debt-to-GDP ratio declined for the first time in nearly six years to 268% at the end of Q2, from 269% in the prior quarter, suggesting that Beijing’s efforts to curtail lending are beginning to take effect. One strategy for reducing China’s leverage ratio has been to promote debt-for-equity swaps in which lenders convert loans into equity, according to a 9/25 Reuters report.

The skies are looking bluer already.

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Keep On Trucking

September 27, 2017 (Wednesday)

US Economy I: On Cruise Control. Have you ever driven on a highway at 65 miles an hour, passed a cop car, and dropped your speed to 55 miles an hour because you couldn’t recall seeing a speed-limit sign? In the US, the latest batch of transportation indicators show that the economy continues to cruise along the highway, as Debbie and I review in the next section. There’s no sign that the economy is exceeding the speed limit. However, there is some debate about that limit.

During previous economic expansions, it was generally agreed that 3.0% was the limit for real GDP growth. If the economy ran faster than that, the engine would overheat. The Fed’s cops would shoot out the tires, causing the economy to swerve out of control and wind up in a ditch.

US real GDP has been rising around 2.0% on a y/y basis since mid-2010 (Fig. 1). For a while, lots of economists warned that was too slow. They called it the “stall speed.” In the past, every time that real GDP growth slowed to 2.0% on a y/y basis, the economy stalled and fell into a recession. That’s what happened in all 11 recessions since 1948!

On this trip, 2.0% has turned into the speed limit, so far. Debbie and I would like to believe that the speed limit will be raised to 2.5% or even back to 3.0%. We would like to believe that the Trump administration’s economic program of deregulation and tax reform will boost growth by stimulating faster productivity growth. However, while deregulation is underway, tax reform has yet to happen. There’s not much the administration can do to revive the growth rate of the labor force since it is mostly determined by the growth of the working-age population, which has slowed significantly. Consider the following:

(1) Real growth. The economy has been performing better than suggested by real GDP if we exclude government spending, which has been mostly falling during the current expansion (Fig. 2). We know that’s hard to believe, but government spending in GDP is on goods and services, not on redistributing income through entitlement programs. Since the start of the current expansion during Q2-2009, real government spending in GDP is down 6.5% (Fig. 3). Such spending rose during the previous six expansions.

Real nonfarm business output has been cruising around the good-old 3.0% growth rate since mid-2010 (Fig. 4). That still makes it the second-weakest expansion of the past seven (Fig. 5).

On a short-term basis, we monitor real GDP growth by comparing it to the y/y growth rate in the Index of Coincident Economic Indicators (CEI), which is available monthly, though with a lag of a month (Fig. 6). They are highly correlated, and often coincide. August’s CEI was up 1.9% y/y, suggesting that Q3’s real GDP growth rate should be close to Q2’s 2.2% growth rate. The Atlanta Fed’s GDP Now model is currently showing a quarterly annualized rate of 2.2% for Q3, which would make it up 2.1% y/y. By the way, also encouraging is that the Index of Leading Economic Indicators rose to another record high during August (Fig. 7).

(2) Productivity. Not so encouraging is nonfarm business productivity. Over the past 20 quarters (five years) through Q2-2017, the average annualized increase was just 0.6% (Fig. 8). The picture was a bit brighter over the past year, with productivity up 1.3% y/y through Q2 (Fig. 9). Combined with a 1.5% increase in hours worked, that added up to a 2.8% increase in nonfarm business output—close to the old speed limit of 3.0%.

(3) Labor force. Nevertheless, the underlying growth in productivity over the past five years remains depressed. The same can be said for the outlook for the growth in the labor force. The 20-quarter average annualized increase in hours worked in the nonfarm business sector was decent at 1.9% through Q2-2017 (Fig. 10). However, the 10-year growth rate in the population aged 16-64 years old dropped to 0.5% during August, the lowest on record (Fig. 11).

(4) Potential output. It’s no wonder that the Congressional Budget Office projects that real GDP growth will be below 2% through 2017 (Fig. 12). The average annualized growth in real GDP over the past 20 quarters through Q2-2017 was 2.2%, not much better than previous cyclical lows in this series (Fig. 13).

US Economy II: Pedal to the Metal. Despite the lackluster outlook for trend GDP growth, Debbie and I are impressed by the strength of a few recently released transportation indicators. Consider the following:

(1) Trucking. The ATA Truck Tonnage Index went vertical during August, jumping 7.1% m/m and 8.2% y/y to a new record high (Fig. 14). That suggests that retailers are loading up their inventories for the fall and holiday shopping seasons. Trucking serves as a barometer of the US economy, representing 70.6% of tonnage carried by all modes of domestic freight transportation, including manufactured and retail goods.

ATA’s chief economist said: “Tonnage was stronger than most other economic indicators in August and more than I would have expected. However, prep work for the hurricanes and better port volumes likely gave tonnage an added boost during the month. I suspect that short-term service disruptions from when the storms made landfall, as well as the normal ebb and flow of freight, could make September weaker and tonnage will smooth out to more moderate gains, on average.”

(2) Shipping. We track the 12-month sum of inbound shipping traffic, as well as outbound, in the Port of Los Angeles and the Port of Long Beach (Fig. 15). The inbound series rose during August, just surpassing the previous record high during February 2007, while the outbound series meandered below this cycle’s highs.

(3) Railcars. The sum of the outbound and inbound series for West Coast port traffic was at a record high in August (Fig. 16). Not surprisingly, this sum is highly correlated with intermodal railcar loadings on a 52-week moving sum basis. If you are looking for trouble in the transportation indicators, there’s some in the railcar loadings of motor vehicles, which suggest that car sales continued to weaken during September—though the hurricanes undoubtedly weighed on sales, which have been rolling over the past year (Fig. 17).

Eurozone: Ice Queen. The tried-and-true Angela Merkel once again was elected as German Chancellor, but the 9/24 vote was disappointing. Not only did Merkel’s Christian Democratic Union (CDU) lose support but the euroskeptic Alternative for Deutchland (AfD) gained seats in the German Bundestag, the national parliament of the Federal Republic of Germany. This marks the first time that a far-right-wing group has done so since 1945.

The important question for financial markets is: Could the AfD make a dent in the fate of the Eurozone? Probably not right now, because the group doesn’t have quite enough support to do major damage. But the AfD’s newfound voice could set the stage for future unease in the region. Further, the fractured election results could make it difficult for Merkel to form a coalition to do her job effectively. Consider the following:

(1) Ice Mum. In many ways, Merkel has become an icon for the stability of Germany, the largest national economy in Europe and founding member of the European Union and the Eurozone. The 63-year-old has been the effective leader of Germany’s parliament since November 2005, having just been reelected for the fourth time for another four-year term as German Chancellor.

Thanks in part to Germany’s lack of term limits for the role, Merkel has been dubbed the “eternal chancellor.” The 9/20 WSJ observed: “Her tenure has spanned three U.S. and four French presidents, and two Spanish, four British, six Italian, and seven Japanese prime ministers. She is the longest serving head of a major European government since her fellow German Helmut Kohl.”

Although a favorite, Merkel has taken her share of mockery. She has been dubbed “The Ice Queen” for her tendency to appear cold. But she is also warmly known as “Mum,” who has a love of German potato soup.

Whatever she is called, her performance has been good enough to get her reelected several times. Merkel “regularly ranks as one of Germany’s most popular leaders,” reported Reuters; it’s thanks to her leadership, many Germans feel, that Germany didn’t feel as much of the pain of the 2008 financial crisis and recent euro area turmoil as other Eurozone countries.

With support from all sides, Merkel is moderately conservative. She stands staunchly behind her core principle, an integrated Europe, for which she is the chief proponent. On other views, Merkel has flip-flopped on more than one occasion. But her tendency to do so is a secret to her success, observed the 9/20 WSJ article, which says Germans view that as a sign of strength.

For investors, the benefit of Merkel’s reelection is that, as she said four years ago in self-promotion, “You know me.” Maybe so. But the problem now is that we don’t know how she will perform in a freshly fractured Bundestag.

(2) Polar bears. Merkel’s CDU is now vulnerable to other parties. During 2013, the CDU combined with its sister party the CSU achieved nearly 42% of the vote, but their support fell to 33% this time around, highlighted a 9/25 FT article titled “Angela Merkel has passed the zenith of her power.” Both Merkel’s CDU and the second majority party, the Social Democratic Party (SPD), have fallen in favor. During this election, the CDU and the SPD lost about 65 and 40 seats, respectively, according to projected results posted in the 9/24 WSJ.

Recently, the Chancellor has been criticized for her highly liberal immigration policies, specifically relating to the Syrian refugee crisis. As a result, Merkel admitted at a press conference following the election that she felt responsible for the increased political polarization in Germany, according to a 9/25 FT article.

(3) Right turn. Merkel’s moves to the left might have paved the way for the AfD to enter Germany’s political scene from the far right. For a party to gain seats in the German parliament, at least 5% of the vote is needed, according to CNBC. Official preliminary results of the election showed that the AfD party gained nearly 13% of the vote and around 90 seats, flooring its political trajectory up from zero seats at the last election. Supporters are largely male, mostly living in rural areas, mostly employed in blue-collar jobs, and tend to earn less, according to a voter profile chart in the 9/25 WSJ.

The AfD is now the third-largest party in the Bundestag. Its victory “will have no immediate effect on policy per se,” but it will “alter the political tone. In a nutshell: things are about to get a lot nastier,” observed Deutsche Welle, a German publication. Exemplifying the AfD’s point of view at a press conference in Berlin, Alice Weidel, one of the party’s two top candidates, said: “Germany has become a safe haven for criminals and terrorists from all over the world,” reported a 9/19 FT article. Her right-hand man, Alexander Gauland, added: “Islam does not belong to Germany.”

Infighting could hurt the AfD’s prospects for making a difference in the long term. Just after the election, one of the AfD politicians elected told reporters that she would refuse to sit in the party’s group in parliament alongside the party’s extremists. German Foreign Minister Sigmar Gabriel has gone so far as to equate some in the AfD with Nazis.

(4) Uncharted path. In contrast, Gabriel, the former chairman of the SPD, has described Merkel as “always fair, always resilient.” Merkel’s next test of resiliency will be to form a coalition to govern, which could take months. “But she has no option for a center-right majority, and her current coalition partner, the Social Democratic Party, has announced it would go into opposition. The only coalition possible for Ms. Merkel appears to be an untested alliance with the pro-business Free Democrats, or FDP, and left-leaning Greens,” explained a 9/24 WSJ article.

Such a coalition would be difficult to manage, as she would have to “chart a path between the demands of her increasingly restless party, the misgivings of the FDP on such issues as surveillance, and the liberal views of the Greens.”

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Inflation Mystery Solved

September 26, 2017 (Tuesday)

Inflation I: Borio vs. Yellen. Last Wednesday, Fed Chair Yellen, in her press conference following the latest FOMC meeting, reminded me of Alice in Wonderland. She wondered why inflation remained so curiously low. In the world that she knows, ultra-easy monetary policy should stimulate demand for goods and services, lower the unemployment rate, and boost wage inflation, which would then drive up price inflation.

Since the time Yellen became Fed chair on February 3, 2014 through today, the unemployment rate has dropped from 6.7% to 4.4% (from February 2014 through August 2017) (Fig. 1). Yet over that same period, wage inflation has remained around 2.5% and price inflation has remained below 2.0% (Fig. 2 and Fig. 3). Yellen expected that by now wages would be rising 3%-4%, and prices would be rising around 2% based on the inverse correlation between these inflation rates and the unemployment rate as posited by the Phillips Curve Model (PCM)—which apparently doesn’t work on the other side of the looking glass (Fig. 4).

Last Friday, Claudio Borio, the head of the Bank for International Settlements’ (BIS) Monetary and Economic Department, presented a speech explaining to Janet in Wonderland that the real world no longer works the way she believes. The speech was titled “Through the looking glass.” The BIS chief economist started with the following quote:

“‘In another moment Alice was through the glass … Then she began looking about, and noticed that … all the rest was as different as possible’ – Through the Looking Glass, and What Alice Found There, by Lewis Carroll.” He might as well have replaced Alice’s name with Janet’s.

I agree with Borio’s underlying thesis that powerful structural forces have disrupted the traditional PCM, which logically posits that there should be a strong inverse relationship between the unemployment rate and both wage and price inflation. I have been making the case for structural disinflation for almost all 40 years that I’ve been in the forecasting business. I’ve discussed how globalization, technological innovation, demographic changes, and Amazon have subdued inflation and continue to do so.

The central bankers have been late to understand all this. Most still don’t, including Yellen. So it’s nice to see at least one of their kind showing up at the structural disinflation party, which has been in full swing for a very long time.

Inflation II: Yellen’s Mystery. Meanwhile, Fed Chair Janet Yellen is still trying to come up with the answer to the following question: “What determines inflation?” She first asked that in a public forum on October 14, 2016. She did so at a conference sponsored by the Federal Reserve Bank of Boston titled “Macroeconomic Research After the Crisis” that should have been titled “Macroeconomic Research in Crisis.” She still doesn’t have the answer, as evidenced by a review of what Janet in Wonderland said at her press conference last Wednesday about inflation:

(1) Transitory. “However, we believe this year’s shortfall in inflation primarily reflects developments that are largely unrelated to broader economic conditions. …. [T]he Committee continues to expect inflation to move up and stabilize around 2 percent over the next couple of years, in line with our longer-run objective.”

(2) Imperfect. “Nonetheless, our understanding of the forces driving inflation is imperfect, and in light of the unexpected lower inflation readings this year, the Committee is monitoring inflation developments closely.”

(3) Mysterious. “For a number of years there were very understandable reasons for that [inflation] shortfall and they included quite a lot of slack in the labor market, which [in] my judgment [has] largely disappeared, very large reductions in energy prices and a large appreciation of the dollar that lowered import prices starting in mid-2014. This year, the shortfall of inflation from 2 percent, when none of those factors is operative is more of a mystery, and I will not say that the committee clearly understands what the causes are of that.”

(4) Lagging. “Monetary policy also operates with the lag and experience suggests that tightness in the labor market gradually and with the lag tends to push up wage and price inflation….”

(5) Idiosyncratic. “So, you know, there is a miss this year I can’t say I can easily point to a sufficient set of factors that explain this year why inflation has been this low. I’ve mentioned a few idiosyncratic things, but frankly, the low inflation is more broad-based than just idiosyncratic things. The fact that inflation is unusually low this year does not mean that that’s going to continue.”

(6) Persistent. “Of course, if it, if we determined our view changed, and instead of thinking that the factors holding inflation down were transitory, we came to the view that they would be persistent, it would require an alteration in monetary policy to move inflation back up to 2 percent, and we would be committed to making that adjustment.”

(7) And again, mysterious. “Now, inflation is running below where we want it to be, and we’ve talked about that a lot during this, the last hour. This past year was not clear what the reasons are. I think it’s not been mysterious in the past, but one way or another we have had four or five years in which inflation is running below our 2 percent objective and we are also committed to achieving that.”

Inflation III: Borio’s Solution. The man from the BIS has the answer for Fed Chair Janet Yellen and all the other central bankers who have a fixation with their 2% inflation targets: “Fuggetaboutit!” In his speech, Borio sympathized with their plight: “For those central banks with a numerical objective, the chosen number is their credibility benchmark: if they attain it, they are credible; if they don’t, at least for long enough, they lose that credibility.” His advice to just move past the quandary rests on many of the points I’ve been making on this subject for some time:

(1) Inflation is neither a monetary nor a Phillips curve phenomenon. He starts off by challenging Milton Friedman’s famous saying that “inflation is always and everywhere a monetary phenomenon.” He also acknowledges Yellen’s confusion: “Yet the behaviour of inflation is becoming increasingly difficult to understand. If one is completely honest, it is hard to avoid the question: how much do we really know about the inflation process?” He follows up with two seemingly rhetorical questions: “Could it be that we know less than we think? Might we have overestimated our ability to control inflation, or at least what it would take to do so?” The rest of the speech essentially answers “yes” to both questions.

As Exhibit #1, Borio shows that, for G7 countries, “the response of inflation to a measure of labour market slack has tended to decline and become statistically indistinguishable from zero. In other words, inflation no longer appears to be sufficiently responsive to tightness in labour markets.” If the PCM isn’t dead, it is in a coma.

Borio mentions, but doesn’t endorse, former Fed Chairman Ben Bernanke’s view that central bankers have been so successful in lowering inflationary expectations that even tight labor markets aren’t boosting wages and prices. In a 2007 speech, Bernanke explained: “If people set prices and wages with reference to the rate of inflation they expect in the long run and if inflation expectations respond less than previously to variations in economic activity, then inflation itself will become relatively more insensitive to the level of activity—that is, the conventional Phillips curve will be flatter.”

So according to Bernanke, the PCM isn’t dead, but in a coma because inflationary expectations have been subdued (Fig. 5).

(2) Globalization is disinflationary. Borio, who seems to be the master of rhetorical questions, then asks: “Is it reasonable to believe that the inflation process should have remained immune to the entry into the global economy of the former Soviet bloc and China and to the opening-up of other emerging market economies? This added something like 1.6 billion people to the effective labour force, drastically shrinking the share of advanced economies, and cut that share by about half by 2015.” Sure enough, the percentage of the value of world exports for the G7 countries fell from 52.4% at the start of 1994 to 33.1% in April, as the percentage for the rest of the world rose from 47.6% to 66.9% (Fig. 6).

I am getting a sense of déjà vu all over again. In my 5/7/97 Topical Study titled “Economic Consequences of the Peace,” I discussed my finding that prices tend to rise rapidly during wars and to fall sharply during peacetimes before stabilizing until the next wartime spike. I wrote: “All wars are trade barriers. They divide the world into camps of allies and enemies. They create geographic obstacles to trade, as well as military ones. They stifle competition. History shows that prices tend to rise rapidly during wartime and then to fall during peacetime. War is inflationary; peace is deflationary.” I called it “Tolstoy’s Model of Inflation” (Fig. 7).

Borio logically concludes that measures of domestic slack are insufficient gauges of inflationary or disinflationary pressures. Furthermore, there must be more global slack given “the entry of lower-cost producers and of cheaper labour into the global economy.” That must “have put persistent downward pressure on inflation, especially in advanced economies and at least until costs converge.” That all makes sense in the world most of us live in, if not to the central bankers among us with the exception of the man from the BIS.

(3) Technological innovation is keeping a lid on pricing. Borio explains that technological innovation might also have rendered the Phillips curve comatose or dead, by reducing “incumbent firms’ pricing power—through cheaper products, as they cut costs; through newer products, as they make older ones obsolete; and through more transparent prices, as they make shopping around easier.”

Wow—déjà vu all over again! In the same 1997 study cited above, I wrote: “The Internet has the potential to provide at virtually no cost a wealth of information about the specifications, price, availability, and deliverability of any good and any service on this planet. Computers are linking producers and consumers directly.” I predicted that alone could kill inflation. Online shopping as a percent of GAFO retail sales rose from 9.1% at the end of 1997 to 30.3% currently (Fig. 8).

Borio concludes, “No doubt, globalisation has been the big shock since the 1990s. But technology threatens to take over in future. Indeed, its imprint in the past may well have been underestimated and may sometimes be hard to distinguish from that of globalisation.”

(4) The neutral real rate of interest is a figment of central bankers’ imagination. Borio moves on from arguing that the impact of real factors on inflation has been underestimated to contending that the impact of monetary policy on the real interest rate has been underestimated. In the US, Fed officials including Fed Chair Yellen and Vice Chair Stanley Fischer have contended that the “neutral real interest rate” (or r*) has fallen as a result of real factors such as weak productivity.

Borio rightly observes that r* is an unobservable variable. Ultra-easy monetary policies might have driven down not only the nominal interest rate but also the real interest rate, whatever it is. Last year, in the 10/12 Morning Briefing, I came to the same conclusion, comparing the Fed to my dog Chloe barking at herself in the mirror when she was a puppy:

“In any event, in their opinion, near-zero real bond yields reflect these forces of secular stagnation rather than reflect their near-zero interest-rate policy since the financial crisis of 2008. …. Their ultra-easy policies have depressed interest income, reducing spendable income and also forcing people to save more. Cheap credit enabled zombie companies to stay in business, contributing to global deflationary pressures and eroding the profitability of healthy companies. Corporate managers have had a great incentive to borrow money in the bond market to buy back shares as a quick way to boost earnings per share rather than invest the proceeds in their operations.”

(5) Ultra-easy monetary policies are stimulating too much borrowing. Borio concludes that central banks should consider abandoning their inflation targets and raise interest rates for the sake of financial stability. He is concerned about mounting debts stimulated by ultra-easy money. I am too, and I’m also concerned about a potential for stock market melt-ups around the world.

The risk he sees is a “debt trap … [which] could arise if policy ran out of ammunition, and it became harder to raise interest rates without causing economic damage, owing to the large debts and distortions in the real economy that the financial cycle creates.”

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Bulls Flying With Doves

September 25, 2017 (Monday)

Strategy: Flying Bulls. An “adynaton” is a figure of speech that is a hyperbole so extreme that it must be impossible. A good example is: “That will happen when pigs fly!” In effect, many of the most vocal bears were saying just that about the current bull market during its early years. Yet the bulls continue to fly. The bull market in the S&P 500, which started on March 9, 2009, is now more than eight years old, with a gain of 270% through Friday’s close. That makes it the second best bull market since the start of the data in 1928.

Still in first place is the bull market from December 4, 1987 through March 24, 2000 with a gain of 582%. In current dollars, the market capitalization of the current bull market has flown well above the first-place holder. Consider the following stats:

(1) Market capitalization. The Fed’s data, released last week through Q2, show that the value of all equities traded in the US rose by $28.9 trillion from Q1-2009 through Q2-2017, to a record $42.2 trillion (Fig. 1). From Q4-1987 through Q1-2000, this value rose by $17.5 trillion, to $20.2 trillion. Of course, on a percentage basis, it’s still no contest, with the current bull market’s market cap rising 216%, lagging the 646% recorded by the undisputed champ so far.

The market cap of the S&P 500 is up $15.5 trillion to $21.4 trillion during the current bull market through Friday’s close (Fig. 2).

(2) Valuation. The only bad news is that the Buffett Ratio, which is the market value of all equities traded in the US (excluding foreign issues) divided by nominal GNP, was 1.76, approaching its record high of 1.81 during Q1-2000 (Fig. 3). The comparable ratio for the S&P 500 (relative to S&P 500 revenues) was 2.00 during Q2, matching the previous record high during Q4-1999.

These ratios suggest that the bull might be flying too close to the sun and could suffer the same fate as the mythical Icarus. Then again, the situation appears less perilous when Joe and I compare the market value of all equities traded in the US (excluding foreign issues) to the after-tax profits reported along with GDP in the National Income and Product Accounts (NIPA). During Q2, the P/E ratios of the two were 19.2 using profits as reported to the IRS and 20.7 using profits from current production (a cash-flow measure) (Fig. 4). Those are relatively high P/Es for both of these series that start in 1952, but well below the peaks of around 35 for both during Q1-2000.

(3) Real earnings yield. Besides, as Joe and I observed last week, the real yield of the S&P 500 suggests that the index is fairly valued rather than overvalued. We calculated that by subtracting the CPI inflation rate (on a y/y basis) from the earnings-to-price (E/P) ratio of the S&P 500. During Q2, this measure of the real earnings yield was 2.6%, below the 3.3% average of this series since 1952. That’s a “fairly valued” reading for this measure, which typically falls closer to zero before bear markets (Fig. 5).

Our initial work on the S&P 500 real yield last Monday was inspired by our good friend John Apruzzese, the chief investment officer of Evercore Wealth Management. Today, let’s extend the analysis to calculating the E/P with the NIPA series for after-tax profits reported to the IRS as “E” and the market value of all stocks traded in the US (excluding foreign issues) as “P.” The real yield on this basis was 3.3% during Q2-2017, below its average of 4.9% since 1952 (Fig. 6). Again, readings closer to zero have been associated with bear markets in the past. The two measures of the real earnings yield are similar, though not the same, but neither is flashing warnings signals of significant overvaluation (Fig. 7).

(4) Tobin ratio. The Fed’s quarterly flow-of-funds database was also updated last week to show Tobin’s q, which is the ratio of the market value of equities to the net worth of corporations, including real estate and structures at market value and including equipment, intellectual property products, and inventories at replacement cost. In theory, when q is well above (below) 1.00, investors are paying too much (too little) for companies relative to their replacement cost (Fig. 8).

This ratio was 1.09 during Q2. Joe and I prefer adjusting the ratio so that its average is 1.00 since the start of the data in 1952. Doing so reveals an adjusted q of 1.51 during Q2. That’s relatively high, but well below the record high of 2.23 in this series during Q1-2000.

The Fed: White Dove. Melissa watched Fed Chair Janet Yellen’s press conference on CNBC last Wednesday. I was at a meeting with one of our accounts and read the transcript afterwards. Melissa observed that Yellen wore a stark white suit jacket, subliminally projecting her underlying dovish stance on monetary policy. The word “gradual” appeared 14 times during her press conference. (This word appeared as many times during her 6/14 presser.) She signaled one more rate hike before the end of this year and three next year. That’s the scenario outlined in Wednesday’s Summary of Economic Projections (SEP), reflecting the consensus view of the FOMC participants. That would take the federal funds rate up to 2.25% by the end of 2018. The Fed will let its balance sheet shrink starting in October, but will do so gradually.

Yellen’s term as chair of the FOMC expires on February 3, 2018. She could stay on as a Fed Board governor until January 31, 2024. However, she’s not expecting to be reappointed or to stay. In her presser, she mentioned that she met with President Donald Trump only once. Twice she said that it will be “up to future policymakers to decide” on the course of monetary policy. (This phrase wasn’t mentioned at all in June!) Here are a few other key points she made:

(1) On inflation. The word “inflation” was mentioned 68 times by Yellen and those questioning her during the conference. (It appeared 54 and 31 times at the previous two pressers.) She admitted that she and her colleagues are perplexed by why it remains below their 2.0% target despite a tight labor market: “Nonetheless, our understanding of the forces driving inflation is imperfect, and in light of the unexpected lower inflation readings this year, the Committee is monitoring inflation developments closely.”

She also said, “This year, the shortfall of inflation from 2 percent, when none of those factors is operative, is more of a mystery, and I will not say that the committee clearly understands what the causes are of that.” One of the best and brightest macroeconomists in America is mystified by inflation! Our advice: Janet, order something from Amazon!

Nevertheless, Yellen stubbornly continues to believe that “transitory” factors are keeping a lid on inflation. She observed that the median inflation projections on the FOMC are 1.6% this year, 1.9% next year, and 2.0% in 2019 and 2020.

(2) On interest rates. Regarding the federal funds rate, Yellen noted that “the ongoing strength of the economy will [continue to] warrant gradual increases.” She said: “That expectation is based on our view that the federal funds rate remains somewhat below its neutral level, that is, the level that is neither expansionary nor contractionary and keeps the economy operating on an even keel. Because the neutral rate currently is quite low by historical standards, the federal funds rate would not have to rise much further to get to a neutral policy stance.”

She added: “But because we also expect the federal funds rate to rise over time, additional gradual rate hikes are likely to be appropriate over the next few years to sustain the economic expansion. Even so, the committee continues to anticipate that the longer run neutral level of the federal funds rate is likely to remain below levels that prevailed in previous decades.

“This view is consistent with participant’s projections of appropriate monetary policy. The median projection for the federal funds rate is 1.4% at the end of this year, 2.1% at the end of next year, 2.7% at the end of 2019, and 2.9% in 2020. Compared with the projections made in June, the median path for the federal funds rate is essentially unchanged, although the median estimate of the longer run normal value edged down to 2.8%” from 3.0%.”

This marks the first time during the current process of normalizing monetary policy that the longer-run federal funds rate target dropped below 3%. It’s possible that some of the softening in the projections reflects officials building in a cushion for unintended effects of winding down the Fed’s balance sheet.

(3) On the balance sheet. Last week’s FOMC statement announced that unwinding the Fed’s balance sheet will begin in October. This program was described in the 6/14 Addendum to the Policy Normalization Principles and Plans. It will gradually decrease the reinvestments of proceeds from maturing Treasury securities and principal payments from agency securities.

As a result, the Fed’s balance sheet will decline “gradually and predictably,” according to Yellen. For October through December, the decline in the Fed’s securities holdings will be capped at $6 billion per month for Treasuries and $4 billion per month for agencies. These caps will rise gradually over the course of 2018 to maximums of $30 billion per month for Treasuries and $20 billion per month for agency securities and “will remain in place through the process of normalizing the size of our balance sheet.”

Movie. “Viceroy’s House” (+ + +) (link) is the kind of movie my wife and I especially enjoy. It is based on remarkable historical events and personalities with a remarkable cast, direction, and cinematography. This one is about the final Viceroy of India, Lord Mountbatten, who is tasked with overseeing the transition of British India to independence. The challenge is to accomplish it as quickly and smoothly as possible. It happens all too quickly, but not too smoothly. The situation spirals out of control, resulting in a mass migration between India and Pakistan that turns into a human tragedy of epic proportions.

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Chips & Bricks

September 21, 2017 (Thursday)

Industry Focus I: Semis. “Plastics.” It’s perhaps the most famous word ever spoken in a movie. Say it softly, and people of a certain age know exactly what you’re talking about: The Graduate, the 1968 classic movie starring Dustin Hoffman. A neighbor takes Hoffman’s character Ben aside at his parents’ party and in hushed tones tells the recent college grad: “I just want to say one word to you. Just one word. Are you listening? ‘Plastics.’ There’s a great future in plastics. Think about it. Will you think about it? Enough said.”

Today, the neighbor would be whispering “semis” … as in “semiconductors.” They’re in everything, and the need for them appears to be growing exponentially. The S&P 500 Semiconductors stock price index is up 19.2% ytd through Tuesday’s close (Fig. 1). The industry is expected to grow revenues by 6.0% over the next year and profits by 7.5% (Fig. 2). The industry sports a below-market forward P/E ratio of 14.8 (Fig. 3).

While those expectations are perfectly satisfactory, they’re hardly worth hushed tones. However, the industry averages mask the extraordinary. Behind the Semiconductor stock index’s composite ytd return is a broad range of stock moves. At the bottom of the barrel is Qualcomm, down 19.8% ytd, and Intel, up 2.7%.

Conversely, Nvidia shares have soared 75.5%, besting all of the FAANG (Facebook, Apple, Amazon, Netflix, and Alphabet’s Google) stocks ytd and by a wide margin. The closest competitors in this performance derby: Facebook and Netflix, which each are up 50.0% ytd. Let’s take a look at the market’s semiconductor darling and consider whether it’s worth whispering about:

(1) Big dreams. Like all good tech darlings, Nvidia has a great story. It was dreamed up in 1993 by three friends—Chris Malachowsky, Curtis Priem, and Jen-Hsun Huang—sitting around one night in a Denny’s restaurant. Huang is the company’s CEO, Malachowsky is a member of the executive staff and a senior technology executive of the company, and Priem was the company’s chief technical officer until 2003 when he retired.

Huang has his own interesting story. He was living in Thailand with his family in 1973, when there was social unrest. His parents sent Huang and his brother to live with his aunt and uncle in the US. The boys were sent to the Oneida Baptist Institute, a boarding school in eastern Kentucky, which the family thought was a prep school but at the time was a reform school for troubled kids. Those attending studied, but also had chores. Huang’s brother worked on the tobacco farm, and Huang had to clean bathrooms. Now Huang presides over company events in a Steve Jobs-like uniform of black pants, black shirt, and black leather jacket.

(2) Fun and games. Nvidia made its name designing graphics processing units, or GPUs, chips that process graphics often used in video games played on consoles or computers. The gaming business generates $1.2 billion, or 53.2% of the company’s total FQ2 revenue. The growth in that business is up an amazing 52% y/y in fiscal Q2, which ended July 30, according to the company.

Gaming has moved well beyond your teenage son sitting in the basement playing games on a console. Check out the International Dota 2 Championships, which were held in August. Sixteen teams of five persons each played the online video battle game Dota 2 over six days. The winning team received $10.9 million, and the entire prize pool totaled $24.8 million! As Huang pointed out in Nvidia’s Q2 conference call, the purse is twice as much as the prize money at the US Open, golf’s richest event. Viewers watched the “eSports” championships online or at Seattle’s KeyArena. The final rounds were also available on ESPN2 and ESPN3.

Last week, we got a glimpse of what’s coming in mobile gaming when augmented reality games being developed for the new iPhone X were included in Apple’s presentation on the phone. Apple developed its own GPU chip for the iPhone X. Apple’s older phones have GPU chips based on technology from Imagination Technologies. Nvidia hasn’t been successful in supplying chips into the phone industry, and Apple’s arrival on the GPU scene is certainly a competitive threat to be watched.

In addition to gaming, Nvidia chips power artificial intelligence, deep learning, autonomous vehicles, and cryptocurrencies. While these are much smaller businesses than the gaming operation, they are the areas that have captured analysts’ imaginations.

(3) The brains behind AI. Nvidia’s Datacenter business includes chips used in artificial intelligence (AI) and deep learning. It kicked in $416 million, or 18.7% of the company’s fiscal Q2 revenue. Shares sold off after the Q2’s results were announced, reportedly because the segment grew revenue by only 2% q/q. The 175% y/y growth wasn’t satisfactory. The explosion of activity that’s occurring and will occur in data centers, including high-performance computing, PC activity in the cloud, inferencing, and live video should mean plenty of demand for Nvidia’s chips.

“If you have a data-intensive application, and the vast majority of the future applications in data centers will be data intensive, a GPU could reduce the number of servers you require or increase the amount of throughput pretty substantially,” explained Huang in the Q2 conference call. “Just adding one GPU to a server could reduce several hundred thousand dollars of reduction in number of servers. And so the value proposition and the cost savings of using GPUs is quite extraordinary.”

(4) Bitcoin could bite. The company’s OEM and IP unit generated only $251 million of fiscal Q2 revenue, but it did grow 61% q/q and 54% y/y driven by the desire for chips that run the servers used in mining cryptocurrencies. Recent news that China is outlawing the trading of bitcoin has raised concerns that this area won’t see further growth. The segment is 11.3% of total revenue. If cryptocurrencies are kaput, the company certainly will feel the loss. However, Nvidia has plenty of other growth areas to propel it forward.

(5) Behind the wheel. Nvidia’s Automotive segment, with $142 million of revenues, grew revenues only 1% q/q and 19% y/y last quarter. However, it’s another potential growth area if autonomous vehicles go mainstream with Nvidia chips under the hood. Huang gave investors his vision of the future in the Q2 earnings conference call:

“Starting next year, you’re going to start to see robot taxis start to come to the road. We’re working with a handful, maybe I guess about six or seven really exciting robot taxi projects around the world. And you could see them start to go into a prototype or beta testing starting now, and then next year you’ll see a lot more of them. And starting 2019, you’ll see them go into real commercial services. And so those are robot taxis, what some in the industry call Level 5s, basically driverless cars.

And then the fully autonomous … driven cars, branded cars will start hitting the road around 2020 and 2021. So, the way to think about it is this year and next is really about development. Starting next year and the following year is robot taxis. And then 2021 to forward you’re going to see a lot of Level 4s.”

(6) Priced for perfection? At a recent $187.35, Nvidia shares trade at 51.9 times analysts’ consensus estimate of $3.61 for fiscal 2018 and 47.4 times the $3.95 consensus for fiscal 2019. Fiscal 2018 earnings are expected to grow 40.5% y/y, but that rate slows sharply the following year to 9.4%. Fiscal 2019 earnings estimates would have to be revised upward sharply to justify the stock’s multiple. None of the above is a recommendation to buy/hold/sell, only the facts. Enough said.

Industry Focus II: Crushed Bricks. News out of the retail sector continued to lay bare the competitive nature of the business. Bed Bath & Beyond shares cratered almost 16% on Wednesday after the company missed Q2 earnings expectations and lowered its forecast for the future. Meanwhile, Toys R Us’ US operations filed for bankruptcy protection. The toy retailer, which was taken private in a 2005 LBO, didn’t even wait for the holiday season to fill its coffers before waving the white flag. And Kohl’s announced plans to accept returns on behalf of Amazon clients in some of its stores.

The news is the latest reminder of the stark differences between the winners and losers in the retail industry. Shares of the winners are up nicely ytd through Tuesday’s close: Internet & Direct Marketing Retail (30.9%), Computer & Electronics Retail (23.6), and Home Improvement Retail (15.2) (Fig. 4, Fig. 5, and Fig. 6). Those in competitive areas are having a horrible year: Apparel Retail (-12.9%), Department Stores (-20.7), Food Retail (-22.0), and Automotive Retail (-25.7) (Fig. 7, Fig. 8, Fig. 9, and Fig. 10). Let’s take a look at the latest news flow:

(1) Trouble at home. Bed Bath & Beyond reported earnings of $94.2 million, or 67 cents a share, down from $167.3 million, or $1.11 a share a year earlier. The quarter’s results were depressed by the company’s restructuring ($0.08), Hurricane Harvey ($0.02), and the new share-based payment accounting standard ($0.01). Analysts were targeting 95 cents a share in earnings. Same-store sales dropped by a mid-single-digit percentage y/y in Q2, while digital sales surged more than 20%.

The company also reduced its 2017 forecast to $3.00 a share, down from $4.58 a share last year. In April, the company thought earnings could fall as much as 10%, and analysts expected earnings of $4.01 a share, a 9/19 WSJ article reported. The shares, which dropped into the S&P 400 from the S&P 500 this summer, are down more than 40% ytd.

(2) No game. Toys R Us had been talking in August with its creditors about an out of court restructuring for its US and Canadian businesses, but no deal ensued. Then on September 6, word of a potential bankruptcy filing leaked on CNBC, which spooked suppliers, according to a 9/19 Bloomberg account.

The article states: “Within a week, almost 40 percent of the vendors were refusing to ship toys and other products without immediate cash payment and in some cases, payment of all outstanding obligations. The vendors faced pressure at their end, too, as their credit insurers and financing firms also withdrew.” So once the vendors got nervous, the company had little alternative but to file for bankruptcy protection. The company’s unsecured bonds due in 2018, which traded near 100 cents on the dollar in August, fell to 19 cents on the dollar.

Toys R Us was highly leveraged from its 2005 leveraged buyout, with more than $5 billion of debt that cost $400 million a year to service. It also faced intense competition from Amazon, Walmart, Target, and others. The company doesn’t plan to close stores, although the retailing industry certainly would benefit if it did take some capacity out of the market.

(3) Deal with the devil? Kohl’s announced that 82 of its stores across Los Angeles and Chicago would offer free returns for Amazon customers beginning in October. Kohl’s will pack and ship the items back to Amazon at no cost to customers. Kohl’s will have designated parking spots near the store entrance for Amazon’s customers.

This partnership follows another, announced earlier in the month, where 10 Kohl’s stores in Los Angeles and Chicago will provide 1,000 square feet of space to display the Amazon smart home experience. Customers will be able to purchase Amazon “devices, accessories and smart home devices and services directly from Amazon, within select Kohl’s stores,” Kohl’s 9/6 press release stated. Customers can expect to see the Amazon Echo, Echo dot, Amazon Fire TV, and Fire tablets on display, among other things.

Kohl’s has more than 1,100 stores in 49 states, so this experiment affects only a small number of its storefronts. The deals could certainly boost store traffic or even lay the groundwork for a deeper venture with Amazon. However, a skeptic might argue that Kohl’s may be allowing the fox into the hen house. Kohl’s shares have climbed roughly 10% since before the first announcement. Either way, it seems clear that Amazon, which also recently purchased Whole Foods, is looking to add bricks and mortar to complement its online operation.

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A Trillion Here, A Trillion There

September 20, 2017 (Wednesday)

Global Economy: The Trillionaires. Everett Dirksen was a Republican politician from Illinois who served in both houses of Congress from 1933 to 1969. He was the Senate Minority Leader from 1959 to 1969. He helped write and pass the Civil Rights Act of 1964 and the Civil Rights Act of 1968. This man was a professional politician and a conservative, who recognized that the government’s spending habits were turning into a compulsive disorder. Dirksen is quoted as having said, “A billion here, a billion there, pretty soon, you’re talking real money.” Although there is no direct record of the remark, he is believed to have made it during an appearance on The Tonight Show Starring Johnny Carson.

In today’s world, this observation needs to be amended to, “A trillion here, a trillion there, pretty soon, you’re talking real money.” That’s the kind of money that fiscal and monetary authorities around the world have been spending to keep the world turning. It certainly has been spinning the heads of conservatively inclined people, like me. However, as I often have observed, in our business we can’t afford to be preachers. We don’t do right vs. wrong. We do bullish vs. bearish. So far, the policy-making trillionaires have been wildly bullish for asset prices. They’ve been able to be so because powerful structural forces have been keeping a lid on price inflation, so much of their trillion dollars in spending has gone into asset inflation.

Yet it is somewhat disconcerting to see that despite everything they’ve done to boost economic growth, which was presumably their main goal, the policy-making trillionaires haven’t delivered as much bang per buck, euro, yen, and yuan as was expected. Consider the following:

(1) Trillions of yuan. In China, bank loans have quadrupled from $4.4 trillion at the end of 2008 to a record $17.5 trillion during August (Fig. 1). By comparison, US commercial bank loans increased $2.1 trillion to a record $9.3 trillion over this same period. On a 12-month basis, Chinese bank loans are up $2.0 trillion through August, the fastest pace on record (Fig. 2).

How well did all that cash stimulate China’s economy? Not so well. Since the end of 2008, Chinese bank loans rose 284%, while industrial production rose 126%. The ratio of loans to production, which had been relatively stable around 100 from 2000-2008, soared to 174 during August (Fig. 3). The y/y growth rate of industrial production declined from just over 20% during early 2010 to roughly a third as much this year (Fig. 4).

(2) Trillions of dollars. Here in the USA, the federal government’s spending rose to a record $4.0 trillion over the past year through the end of Q2-2017 (Fig. 5). That’s according to the US Treasury’s data. According to the Bureau of Economic Analysis, federal government spending on goods and services, which is included in nominal GDP, has been flat around $1.3 trillion since 2010! The difference between the two is federal government spending on entitlements, i.e., on redistributing income. It rose to a record $2.8 trillion over the four quarters through mid-2017. Outlays on income redistribution now account for a record 70% of total government spending (Fig. 6).

How well did that work out? Not so well. Real GDP has been lumbering along at a y/y growth rate of about 2% since mid-2010. In the past, this pace was called the “stall speed” because the economy always fell into a recession after growth had slowed to it (Fig. 7).

(3) Trillions of high-powered money. The three major central banks have weighed in with their trillion-dollar QE programs. During August, the balance-sheet assets of the ECB, BOJ, and Fed were all at record highs, of $5.1 trillion, $4.7 trillion, and $4.4 trillion (Fig. 8). That added up to a record $14.1 trillion, up 249.5%, or $10.1 trillion, since August 2008 (Fig. 9).

They’ve succeeded in stimulating subpar growth in the US, Europe, and Japan. So far, they’ve averted another financial crisis. They’ve been frustrated in their goal of boosting their inflation rates to their targets of 2.0%. The core CPI inflation rate for the G7 industrial economies has been below that target and hovering around 1.5% since late 2011 (Fig. 10).

Debbie and I find it hard to view this “miss” as a serious problem. However, the central bankers view it as such. They are mostly maintaining their ultra-easy monetary policy, although there is increasing evidence that their economies don’t need it. The main beneficiary of all this monetary largess continues to be financial markets. The All Country World MSCI (in US dollars) continues to soar into record-high territory (Fig. 11).

Strategy: Bye-Bye, Buybacks? Speaking of trillions, S&P 500 buybacks plus dividends totaled $6.2 trillion during the current bull market from Q1-2009 through Q2-2017 (Fig. 12). Over this period, the market capitalization of the S&P 500 has increased by a whopping $15.6 trillion to a record $21.4 trillion (Fig. 13). Together, buybacks and dividends have been the main driving force behind the bull market, with the former totaling $3.6 trillion and the latter totaling $2.6 trillion.

Buyback activity may be slowing, but it isn’t suddenly going to come to a halt, thus slamming the brakes on the bull market. That’s because the after-tax corporate borrowing rate remains well below the forward earnings yield of the S&P 500. That provides a great incentive to borrow in the bond market to buy back shares. It also suggests that there is room for the S&P forward earnings yield to decline as buyback activity continues to arbitrage the relationship between this equity yield and the corporate bond yield. Consider the following:

(1) Buybacks. During Q2, buybacks slowed to an annualized rate of $480 billion, the second slowest pace since Q2-2014 (Fig. 14). The S&P 500 forward earnings yield was 5.70% in mid-September, while the pre-tax corporate bond yield was under 4.00%.

(2) Bond borrowing. Over the past 12 months through July, gross issuance in the corporate bond market totaled $1.7 trillion, with nonfinancial corporations raising $880 billion while financial ones borrowed $773 billion (Fig. 15 and Fig. 16).

(3) Impact on valuation. This bull market has been driven by the corporate finance version of the Fed’s Stock Valuation Model rather than the asset allocation version. This suggests that the forward P/E should be driven more by the corporate bond yield than by the Treasury bond yield. Using the reciprocal of either one shows more upside for the forward P/E.

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On the Margins

September 19, 2017 (Tuesday)

Strategy I: Refusing To Revert. The S&P 500 stock price index hasn’t been following the script of the bears during the current bull market. Admittedly, there aren’t too many left, which is something for contrarians to worry about. When the bears were more numerous and growling more loudly, one of their predictions was that the profit margin would “revert to the mean.” It usually starts doing so during booms when corporations ramp up spending on labor and capacity expansion faster than revenues, which squeezes margins. Booms are inevitably followed by busts, which is when the profit margin reverts to the mean and falls below it, so that it can revert back up to the mean and surpass it during the inevitable recovery.

So far, this boom-bust narrative hasn’t played out as it did during previous business cycles. Joe and I believe that’s because corporate managements were traumatized by the Trauma of 2008, and have been very conservative ever since. In addition, most of them are facing intense pressures from disruptive technologies that pose existential threats to their business models. No wonder that they might be obsessed with maintaining as high a profit margin as possible. It has been different this time—so far. Consider the following:

(1) The S&P 500 profit margin rose to 10.8% during Q2, the highest on record. Okay, the record only starts with Q1-1993 (Fig. 1). However, this measure is highly correlated with the ratio of after-tax book profits of all corporations in the US divided by nominal GDP, which are data included in the National Income & Product Accounts (NIPA). By this measure, the profit margin peaked at a record high of 10.8% during Q1-2012, and was down to 9.3% during Q2-2017.

Nevertheless, it remains well above almost all previous cyclical peaks. Besides, we put more weight on the S&P 500 profit margin because that’s a key variable in determining the profitability of the widely followed S&P 500 index.

(2) The NIPA profit margin that we just related to the S&P 500 profit margin has tended to peak during the booms at the tail ends of business cycles. Debbie and I have found that these peaks, which marked the beginning of the margin reverting to the mean, coincided with business costs rising rapidly relative to GDP (Fig. 2).

(3) Business costs are compensation of employees plus private nonresidential fixed investment spending as measured in the NIPA (Fig. 3 and Fig. 4). The sum of the two as a percentage of GDP fell to a cyclical low of 64.0% during Q1-2010, which was the lowest reading since Q1-1955. It was back up to 66.0% during Q2-2017, which remains below the previous four cyclical troughs!

Strategy II: Margin Differences. In last Wednesday’s Morning Briefing, Joe and I noted that the forward revenues and the forward earnings of the S&P 500/400/600 were continuing to trend higher in record-high territory (Fig. 5 and Fig. 6). We also observed that the forward profit margin for the S&P 500 LargeCaps has been rising to new highs since early 2016, reaching 11.1% during the first week of September (Fig. 7). The forward profit margin for the S&P 400 MidCaps also has moved higher since early last year, to 6.7%, matching previous cyclical highs since 2008. This all makes sense to us.

The oddity is the forward profit margin of the S&P 600 SmallCaps. It’s down from a cyclical high of 6.1% during October 2013 to 4.9% currently. Despite the margin erosion over the past four years, the S&P 600 is up 30.8% over this period, outpacing the S&P 500 (26.0%) and S&P 400 (23.9%) (Fig. 8).

We said we’d investigate further. A few clients were interested in seeing the margins for the 11 S&P sectors and asked whether the marked difference in profit margins was caused by different sector weightings across the three indexes. I asked Joe to have a look. Here is what he found:

(1) LargeCaps beating SmallCaps across all sectors. The marked difference in forward profit margins was not due to sector market-cap weighting differences across the three indexes. Looking at the latest forward profit margin data through the week of September 7, the S&P 500’s margins are higher than those of the S&P 400 and the S&P 600 for ALL 11 sectors (Fig. 9).

The S&P 400’s profit margin is higher than the S&P 600’s for all sectors except Tech and Telecom. Furthermore, looking at the data back to 2006, we can see that LargeCaps and most of their sectors have consistently had a profit margin advantage over MidCaps and also the SmallCaps.

Here’s how the sectors stacked up as of September 7: Tech sector (20.6% LargeCaps, 6.9% MidCaps, 7.1% SmallCaps), Real Estate (17.6, 13.9, 12.6), Financials (16.5, 14.8, 14.6), Telecom (11.4, -1.5, 3.5), Utilities (11.3, 10.3, 10.2), S&P 500/400/600 (11.1, 6.7, 4.9), Health Care (10.7, 6.4, 3.3), Materials (10.3, 6.5, 4.5), Industrials (9.6, 6.1, 4.3), Consumer Discretionary (7.6, 5.6, 3.2), Consumer Staples (6.8, 4.3, 2.5), and Energy (4.8, 0.4, 0.0).

(2) Why are LargeCaps more profitable? In our opinion, the S&P 500 companies got that big by being more successful and better managed over the long term than their peers. By virtue of their size, LargeCaps have a better chance of maintaining their dominant profitability. A wider product line, better customer support, and a larger client base help to minimize the effect that any missteps would have on revenues and profits.

They also have greater bargaining power when it comes to controlling costs and squeezing suppliers. That goes for health care costs too. Plus, LargeCaps can afford to hire the best lawyers to defend their patents and lobbyists to help craft legislation that is beneficial for their business. They also hire accountants to help shelter their overseas earnings from the IRS. In all likelihood, LargeCap companies have a lower effective tax rate since they do more business outside the US than the SMidCaps. In addition, their overseas operations are able to reap benefits from less regulation and lower labor costs in other countries relative to the US.

The statuary corporate tax rate has been 35.0% since 1993 (Fig. 10). The effective tax rate for all corporations was actually 21.2% during Q2-2017, according to the NIPA. However, that’s skewed downward by companies that are losing money now, or profitable ones that are taking deductions for losses incurred during prior periods.

For the S&P 500, the effective rate was 26.4% during 2016 (Fig. 11). Odds are that the average S&P 400/600 company has a higher effective tax rate. A 2016 CNBC article hypothesized that the primary reason for this is because smaller companies tend to be more domestically focused than larger ones.

(3) Some sectors are more equal than others. The forward margin spread is 6.2ppts between the S&P 500 (11.1%) and the S&P 600 (4.9%). What’s interesting is that the comparable spread for Utilities in those two indexes is only 1.1ppts (11.3% vs. 10.2%). What differentiates Utilities from the other sectors is that it is heavily regulated and its business activity is primarily concentrated in the US, so the LargeCap Utilities sector does not enjoy the advantages and tax benefits of having substantial overseas operations. The same could be said of the Financials sector, with a spread of only 1.9ppts (16.5% vs. 14.6%).

(4) Drags on the S&P 600 margin. A closer look at the S&P 600 sectors over the past four years shows that the Consumer Discretionary sector’s forward profits margin weighed down the index as it declined from 4.3% to 3.2% in a fairly linear fashion. Consumer Staples was down from 4.2% to 2.5% over this period, in a more irregular downward trend. Health Care has been surprisingly weak over the past year, falling from 5.5% to 3.3%.

(5) Lifting the S&P 500 margin. In the S&P 500, the profit margins of the Consumer Staples and Health Care sectors have been remarkably stable since the start of the data in 2006. The former has been meandering around 6.5% since then, with a current reading of 6.8%. The latter has been meandering around 10.0% over this period with a current reading of 10.7%.

The S&P 500 sector with the highest profit margin is Information Technology. It is currently at 20.6% and has been slowly and steadily rising in recent years to new record highs. Also boosting the S&P 500’s profit margin this year have been Financials (16.5% currently), Industrials (9.6), Real Estate (17.6), and Utilities (11.3).

(6) Not much happening to S&P 400 margins. The S&P 400 MidCap sectors tend to have profit margins that are closer to the ones for the SmallCaps than for the LargeCaps. Among the MidCap sectors, two have been trending higher in recent years, namely Financials and Utilities. Flat trends have been discernible in the following: Consumer Discretionary, Consumer Staples, Health Care, Industrials, Information Technology, and Materials.

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Stocks Not Too Hot

September 18, 2017 (Monday)

Strategy I: Shiller vs. Goldilocks. The valuation question has been hanging over the current bull market. Valuation ratios such as price/earnings, price/sales, and market capitalization/revenues are uniformly bearish, showing that stocks are as overvalued as they were just before the tech bubble burst in 2000. On the other hand, valuation measures that adjust for inflation and interest rates, both of which are near record lows, suggest that the market is fairly valued. They are mostly in the Goldilocks range: Not too cold, and not too hot. Joe and I have been siding with Goldilocks.

Not surprisingly, Yale Professor Robert Shiller strongly disagrees with Goldilocks. He is issuing dire warnings that stocks are as grossly overvalued as they were in 2000. The man won the Nobel Prize in economics, so he must know something. He won primarily for his work on speculative bubbles, including his book Irrational Exuberance (2000). (Goldilocks dropped out of high school, and is now doing jail time for petty larceny.) The professor’s latest alarming views were reviewed last Friday in an article posted on Nasdaq.com titled “A Nobel Prize Winner's Dire Market Warning — And What To Do About It...” Here are some of the key points and our takeaways:

(1) Trailing P/E. The article observes: ”The price-to-earnings (P/E) ratio of the S&P 500 … is about 24.5. This is about 67% above its long-term average of 14.7.” Our data, using four-quarter trailing earnings for S&P 500 operating earnings, show the P/E at 20.7 at the end of June, 37% above its long-term average of 15.1 since 1935 (Fig. 1). It is still well below its record high of 28.4 during Q2-1999.

(2) Forward P/E. The article focuses on backward-looking P/E measures, including Shiller’s CAPE, which is a cyclically adjusted measure based on earnings over the past 10 years. The four-quarter trailing P/E, using operating earnings, has exceeded the forward earnings P/E since 1989, which is when the operating data series starts (Fig. 2). The latter was 17.7 in August. That’s high, but still well below the record high of 24.5 during July 1999.

(3) CAPE. The article notes: “Nobel Prize-winning economist Robert Shiller's cyclically adjusted P/E ratio is also warning the market is overvalued. At 30.2, this ratio is more than 85% above its long-term average of 16.1.” Jeremy Siegel, the professor who wrote Stocks for the Long Run (1994), has yet to win a Nobel Prize despite his great long-term call. In a 2016 FAJ article, he sides with Goldilocks and counters Shiller’s pessimism as follows:

“Robert Shiller’s cyclically adjusted price–earnings ratio, or CAPE ratio, has served as one of the best forecasting models for long-term future stock returns. But recent forecasts of future equity returns using the CAPE ratio may be overpessimistic because of changes in the computation of GAAP earnings (e.g., “mark-to-market” accounting) that are used in the Shiller CAPE model. When consistent earnings data, such as NIPA (national income and product account) after-tax corporate profits, are substituted for GAAP earnings, the forecasting ability of the CAPE model improves and forecasts of US equity returns increase significantly.”

(4) VCI. In a 9/5 interview with Quartz, Shiller reported: “I have something I call a valuation confidence index [VCI]. I don’t have it really up to date because it’s only a six-month moving average based on small surveys. Maybe I should expand my size. But valuation confidence is at the lowest it’s been since around 2000. In other words, people think the market is highly valued. They don’t have to look at CAPE. People think it. I know that. Both individual and institutional investors. We are in a time of mistrust of the market. The only time mistrust of the market was lower since 1989 was in 2000.”

Shiller’s VCI seems a bit like licking one’s finger and raising it up in the air to see which way the wind is blowing. It seems a bit at odds with the conventional wisdom that the conventional wisdom must be bullish at market tops—not cautious. How else would we have gotten to these tops?

Strategy II: A Bullish Valuation Indicator. John Apruzzese, the chief investment officer of Evercore Wealth Management, is a very thought-provoking fellow. He sends us many thought-provoking insights about the stock market in occasional email messages. He has been thinking about the relationship between inflation and stock market valuation. He asked us for our opinion on an inflation-adjusted valuation measure that he has devised. It’s a more rigorous metric than rules of thumb like the Rule of 20, which compares the S&P 500 P/E, on either a trailing or forward basis, to 20 minus the CPI inflation rate on a year-over-year basis (Fig. 3 and Fig. 4). Consider the following:

(1) Rule of 20. In August, the CPI inflation rate was 1.9% y/y (Fig. 5). According to the Rule of 20, that meant that the P/E should be around 18.1 (Fig. 6). The average of this measure is 16.6 since 1935. That’s historically high, though obviously because inflation is historically low. Again, as noted above, the four-quarter trailing P/E was 20.7 during Q2, while the forward P/E was 17.7 in August. By the way, the Rule of 20 was devised by Jim Moltz, my friend and previous colleague at CJ Lawrence.

(2) Misery-Adjusted P/E. Another valuation metric that Joe and I devised is simply the sum of the S&P 500 forward P/E and the Misery Index, which is the sum of the unemployment rate and the CPI inflation rate. We’ve observed an inverse relationship between the forward P/E and the Misery Index (Fig. 7). That makes sense: When consumers are less miserable because unemployment and inflation are low, investors are happier too and willing to pay a higher multiple for earnings.

Adding the actual forward P/E and the Misery Index together produces the Misery-Adjusted P/E (Fig. 8). It has averaged 23.9 since the start of the series in 1979. It was 24.0 during August, suggesting that stocks were fairly valued. This metric can be thought of as the Rule of 24: The fair-value forward P/E was 17.7 during August based on 24 minus the Misery Index, which was 6.3 last month.

(3) Real earnings yield. John suggests an alternative valuation measure that is adjusted for inflation in a more rigorous fashion than is reflected in the rules of thumb. He flips the P/E over and focuses on the S&P 500 earnings yield (i.e., E/P). It can be calculated on a quarterly basis back to 1935 using S&P 500 reported earnings data (Fig. 9). The real earnings yield is the nominal yield less the CPI inflation rate (Fig. 10).

The average of the real earnings yield is 3.7% since 1935. When the yield is above (below) this average, stocks are undervalued (overvalued). The actual reading was 2.6% during Q2, suggesting that stocks were somewhat overvalued, but not excessively so. Excessive overvaluation would be reflected in a real earnings yield close to or below zero.

Economy: A Misleading Income Indicator. Last week, the Census Bureau updated its senseless measure of real median household income. It was good to see that the metric rose 3.2% during 2016 to a new record high, following a solid 5.2% increase in 2015 (Fig. 11). That upward movement does make sense. What makes no sense to Melissa and me is that last year’s total was up just 0.8% since the previous peak during 2000!

That’s 16 years of income stagnation. Typical American households have had no increase in their standard of living for too long—that’s what this data series implies. They must be getting ripped off by the rich! After all, real GDP rose 39% from 2000 through 2016. If real GDP had been flat over this period, then we would all be equally miserable. But seeing the economy expand with no increase in the standard of living for most Americans confirms that income inequality has gotten much worse. Heads must roll! Wait a minute: Not so fast, Robespierre! Consider the following:

(1) Real mean household income, which gives more weight to the rich than the median measure, is up just 5.4% since 2000. The ratio of the median to the mean was 71.0% during 2016, down from 73.5% during 2000 (Fig. 12). That suggests some increase in inequality, but not much. There was a much more significant increase in inequality in the past when this ratio fell from 89.4% in 1967 to 73.5% during 2000. Go figure.

(2) Hey, wasn’t 1968 the year that the New Deal was put on steroids to morph into the Great Society? That’s a rhetorical question; it was the year. The problem is that the Census measure is only for pre-tax money income, based on survey data. It excludes noncash government benefits such as Medicaid and Medicare, food stamps, and the Earned Income Tax Credit. They all have increased rapidly since 1968.

The senseless Census measure also doesn’t capture demographic changes. The same Census survey used to calculate the series we view as senseless, shows that families accounted for about 65% of all households during 2016, down from about 75% in 1982 (Fig. 13). That means that nonfamilies now account for 35% of households, up from 25% over this period. Guess what? The real median income of nonfamily households was 40.8% below the same measure for all households in 2016 (Fig. 14).

If there are more nonfamilies who tend to earn less than do families, that must depress the household income data, which includes families and nonfamilies.

(3) In any event, comparing apples to apples, we find that real average personal income per household (pre-tax) is up 26% from 2000 through 2016 (Fig. 15). That’s not stagnation. Even more compelling is that real personal consumption per household is up 28% from 2000 through 2016 (Fig. 16). That’s the best measure of the standard of living, and it isn’t stagnating.

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What Is Real?

September 14, 2017 (Thursday)

 

Augmented Reality: Seeing Things. When the iPhone first came out ten years ago, we all knew it was cool, but never in our wildest dreams did we imagine how dependent we’d become on smartphones and all the apps that would be designed for the gadgets. Now, here comes the iPhone X and the augmented reality (AR) features it enables. It isn’t obvious yet how we’re going to use AR, but developers are scrambling to develop apps that our future selves won’t be able to live without.

The iPhone X is designed to enable AR apps. It contains Apple’s A11 bionic neural engine chip, which runs machine-learning and artificial-intelligence software, including the facial recognition software used to unlock the phone. The phone also contains an Apple-created GPU, a graphics processing chip designed for 3D apps and games. Both chips help the phone run more quickly. And last summer, Apple rolled out its ARKit for developers to use in building AR apps for the Apple systems.

Apple appears to be ahead of the pack in AR. According to a 9/12 Business Insider article, “The company is already outpacing its rivals in the industry. Apple announced ARKit earlier this year, which lets developers more easily build augmented reality apps for iPhones, and the community has already grabbed ahold of the technology. A Twitter account documenting the cool apps that developers are creating has had several viral tweets showing off the new tech already. Google recently offered its own AR development kit, called ARCore. [Morgan Stanley analyst Katy] Huberty notes that the tech only works on Pixel and Samsung devices right now, which limits its potential user base.”

Huberty also wrote in a report that in a bullish scenario, AR could add “$404 billion to [her] smartphone device and services revenue forecasts over the next three years,” the Business Insider article reported.

Apple’s presentation on Tuesday included a few examples of the AR programs that will be available on the new phone. Here’s Jackie’s brief run-down after she watched the action in the Apple presentation (where the augmented reality demonstrations begin at 71 minutes 50 seconds):

(1) AR gaming. Warhammer 40K Freeblade by Pixel Toys is a video game where the animated combatants look like they are in the real world, wherever you point the phone. And Directive Games has produced The Machines, a multiplayer game where players actually feel like they’re in the game.

(2) AR at the ballpark. The MLB At Bat app is being enhanced using Apple’s ARKit. The app will allow users to hold up their phones at a live baseball game and real-time stats and player information will pop up on the screen above the players in the game as they’re playing.

(3) AR in the sky. Fifth Star Lab’s Sky Guide shows constellations superimposed on the actual night sky. In the earlier version, a user pointed the phone at the sky, and an animated sky popped up to show constellations and stars.

(4) AR enlivens emojis. “Anemojis,” or animated emogis, come straight from Apple developers. The phone reads your facial expressions as you say something and gives the expressions and words to an emoji. You can then text the talking/emoting emojis to family and friends. This app may not improve productivity, but it will mean that kids will pester their parents for a $1,000 phone.

Apple shares slid a little on the day of the iPhone X unveiling, but they’re up 38.9% ytd through Tuesday’s close, trouncing the S&P 500’s 11.5% return. The stock’s importance to the market has grown tremendously over the past 13 years. Joe reports that Apple’s market cap makes up 3.9% of the S&P 500’s market capitalization today, up from less than 0.5% in 2004 (Fig. 1). As a result, Apple has boosted the S&P 500’s return by almost a full percentage point so far this year.

The company’s impact on the S&P 500 Tech sector is even more dramatic. The sector is up an amazing 25.9% ytd. Without Apple, the sector would be up roughly 23%. Despite the amazing run, Apple’s shares still trade at reasonable valuations: 17.9 times analysts’ consensus earnings estimate of $9.01 a share in FY2017 and 14.8 times FY2018’s estimate of $10.85. The company’s fiscal year ends 9/30. Those P/Es are both below the company’s 20.4% earnings growth rate forecasted for 2018.

None of the other FAANG (Facebook, Apple, Amazon, Netflix, and Alphabet’s Google) stocks carry P/Es that are below their earnings growth rates. Facebook shares sport a P/E of 26.8 on the consensus 2018 earnings estimate, which represents expected earnings growth of 21.9% y/y. Netflix shares trade at 92.1 times 2018’s estimated earnings, which represents growth of 70.3% y/y. Amazon, has the fastest growth and the highest P/E. Its shares trade at 122.1 times the 2018 earnings estimate, which implies growth of 112.4% over the earnings expected for 2017. FAANGs make up 12.1% of the S&P 500’s market cap, almost twice where that figure stood in 2013 (Fig. 2).

Financials Update: Turbulence. Financials got battered by Hurricane Irma. First, interest rates declined, pounding the yield spread between 10-year and 2-year Treasuries down to 84 bps from 134 bps late last year and from 177 bps during July 2015 (Fig. 3). Then insurance company stocks were socked on fears that the losses in Florida would be catastrophic. The two events left Financials barely in positive territory for the month so far (Fig. 4). As if that were not enough misfortune, some of the banks warned that their trading revenue would be down in Q3.

On a ytd basis, the sector is performing moderately better, but lags the S&P 500 nonetheless. Here’s the ytd performance derby for the S&P 500 sectors: Tech (25.9%), Health Care (20.7), Materials (12.3), Utilities (12.1), S&P 500 (11.5), Consumer Discretionary (10.3), Industrials (9.2), Consumer Staples (7.0), Real Estate (7.0), Financials (6.2), Energy (-13.7), and Telecom Services (-13.7) (Fig. 5).

We’ve been optimistic about the sector in hopes that the yield spread would widen as the Fed raised the federal funds rate this year. We’ve also been expecting that the Trump administration’s lifting of financial regulations would help boost the sector’s bottom line. While we stand by our thesis, right now it feels like we’re in the midst of a hurricane. Here’s Jackie’s quick look at some of the recent news flow:

(1) Trading slump. With volatility near record-low levels, trading revenue fell 12% in Q2 at the five of the biggest US banks, the 9/12 WSJ calculated (Fig. 6). The article continued: “What’s more, many assets are trading within narrow price bands, meaning it is hard for brokers to make much money standing between buyers and sellers.”

The environment is expected to put a damper on Q3 results as well. At a banking conference earlier this week, executives at Citigroup and Bank of America said trading revenue could fall roughly 15%, and J.P. Morgan Chase estimated the drop would be 20%. The environment has even pushed Goldman—the king of traders—to move into lending in a bid to grow revenue.

After many months of increasing earnings estimates, analysts trimmed expectations this summer. Net earnings revisions for the S&P 500 Diversified Banks industry were slightly negative in July and August, -3.5% and -0.4% (Fig. 7). That said, earnings are still expected to rise 12.1% this year, which is almost equal to the industry’s 11.8 forward P/E (Fig. 8). If estimates come through, the index should add to its 4.4% ytd gains.

(2) Darn Harvey and Irma. The S&P 500 Property & Casualty Insurance stock index had been having a good year until hurricanes destroyed millions of homes and cars in Texas, Florida, and the Caribbean. Over the past four weeks, the S&P 500 Property & Casualty stock index fell 2.8%. However, the index enjoyed slight bounce this week on news that Irma was less powerful than feared. All told, the index is up 12.7% ytd (Fig. 9). The industry’s recent decline has pushed its forward P/E down to a five-month low of 13.4, but the multiple remains near record-high levels (Fig. 10).

(3) Thank the money managers. The standout industry in Financials this year is asset management. The S&P 500 Asset Management & Custody Banks stock price index is up 12.9% ytd (Fig. 11). The industry benefitted from strong upward revisions to its earnings estimates this summer, and that has lifted its forecasted revenue growth estimate for the next 12 months to 5.3% and its forward earnings growth estimate to 11.0% (Fig. 12). At a recent 14.0, the industry’s forward P/E remains in between the highest and lowest P/Es it has had over the past 20 years (Fig. 13).

Brazil Update: ‘It’s the Economy, Estúpido.’ Battling corruption took a backseat to bolstering the beleaguered economy in Brazil’s most recent quarter. Lawmakers in early August refrained from choosing to prosecute President Michel Temer on bribery charges, according to an 8/2 NYT article. Their preference: political stability rather than more upheaval in a bid to lift Latin America’s largest economy out of its deepest recession in 25 years. It helped that to win their support, Temer approved $1.5 billion in pork-barrel spending, an 8/11 Reuters piece explained. Consumer spending jumped, providing the oomph that the economy needed to expand for the second straight quarter and deepening the sense that a recovery is slowly but surely underway. That provided more fuel to a stock market that’s been rocketing higher since late June.

The Brazil MSCI stock price index (in dollars) is the top performer among emerging markets in Q3 to date through Tuesday, rising 25.1% (Fig. 14). That represents most of its ytd gain of 27.2%. In comparison, the US MSCI stock price index has gained 3.0% in Q3 to date, while the Emerging Markets MSCI index is up 9.0% and the Emerging Markets Latin America MSCI has advanced 16.9%. Brazil continues to look attractive, trading at a forward P/E of 12.1, with an earnings growth rate estimated at 24.3% for this year.

We noted in the 7/13 Morning Briefing that the worst appeared to be over for Brazil’s economy. I asked Sandy Ward to have a closer look at developments since then:

(1) Politics. No sooner did Temer win a reprieve from possible impeachment than he returned to his promise of enacting structural reforms and announced a sweeping plan to privatize state-owned assets. Everything from oilfields, to highways, to the majority of Eletrobras—the region’s biggest electrical producer—to even possibly the federal mint, Casa da Moeda do Brasil, and the lottery run by state-owned bank, Caixa Economica Federal, will be put on the auction block to raise revenue, noted an 8/24 story in the FT.

His government also expects to push through pension reforms by year-end and perhaps as early as November, according to a 9/4 piece in the WSJ. Under Brazil’s current pension system, many workers can retire in their 50s at full salary for life. Its social security system represents more than half the annual budget of the federal government. The country’s finance minister, Henrique Meirelles, also voiced plans to reform the bankruptcy code and tax system by yearend, according to the same WSJ story. “The idea is to create the conditions for Brazil to be able to grow for a longer period on a more sustainable basis,” Meirelles was quoted as saying in the WSJ article.

Still, Temer’s plan to open up a protected reserve in the Amazon forest to copper mining went too far and was temporarily blocked by a federal judge.

This was the political backdrop behind the economic expansion that occurred in Brazil’s Q2.

(2) GDP growth. Brazil’s economy expanded 0.3% y/y in Q2, better than expected and the first positive growth since Q1 2014, technically bringing the recession to an end (Fig. 15). Economists surveyed had expected GDP to stay flat y/y and gain 0.1% from the prior quarter. As a result of the improving economy, Brazil’s finance minister said the government may raise its forecast for 2017 GDP growth to “around 1% from 0.5%,” a 9/6 Reuters article reported. Currently, GDP is expected to increase by 0.4% in 2017 and 2.0% in 2018, according to economists surveyed by Brazil’s central bank.

(3) Consumer spending. Consumers opened their wallets in the quarter, driving a 1.4% quarterly rise in spending, the first increase in 10 quarters. Lower prices and more disposable income played a role as inflation dropped to its lowest level since 1999. But a government decision to allow a one-time withdrawal from a federal unemployment insurance fund likely had a bigger impact, according to a 9/1 article in the WSJ. Indeed, consumer confidence continued to slip, despite the rise in spending (Fig. 16).

(4) Retail sales. Complicating the consumer-spending picture further, July retail sales came in flat with the previous month’s level, disappointing forecasters who had expected a rise of 0.1%. Monthly growth in June was revised down to 0.9% from the previously reported 1.2%. The 3.1% y/y growth also was softer than the 3.5% forecast. A tax hike implemented mid-month on gasoline, diesel, and ethanol fuels led to a 1.6% drop in fuel and lubricant sales (Fig. 17).

(5) Industrial production. Output rose for the fourth month in a row in July, gaining 1.5% y/y (saar). Strong demand for big-ticket items such as machinery and equipment drove the gains, signaling rising business investment (Fig. 18).

(6) Exports and imports. Exports strengthened for the second straight quarter, up 2.5% y/y in Q2 following a rise of 1.4 y/y in Q1 (Fig. 19). Yet imports fell by 3.3%, a sign of continued weakness in the domestic economy and nosediving fixed investment.

(7) Interest rates. In response to consumer prices rising at the slowest pace in nearly 20 years, Brazil’s central bank cut the benchmark Selic rate by a full percentage point to 8.25% on September 6. Rates are at their lowest level since July 2013, according to a 9/6 WSJ report, and the central bank suggested that it is approaching the end of the easing cycle, with future rate cuts expected to be more moderate.

For all the good news, there are offsets that cast doubt on the durability of Brazil’s recovery, such as still-high unemployment, declining government spending, and falling foreign investment (Fig. 20).

That the economy could continue to make headway amid the uncertainty of political scandal is a hopeful sign. Another sign of strength: Of the BRIC countries, Brazil boasts the highest OECD Leading Indicator reading—102.8—and it’s been rising steadily for the past year, suggesting that the expansion will continue (Fig. 21).

Mexico Update: Endless Fiesta. Despite having been rocked last week by the most powerful earthquake to hit in 100 years, one that ravaged some of the most impoverished areas in the south, Mexico has remained undaunted, and its economy remains on solid footing.

Bolstering our bullish case for Mexico, which we discussed in our 8/23 Morning Briefing, that country’s Finance Minister, Jose Antonio Meade, last week raised the government’s outlook for 2017 GDP growth to between 2.0% and 2.6%, up from a previous estimate of 1.5%-2.5%. That marked the second time in less than six months that the government has lifted its outlook, according to a 9/8 WSJ article. The government cited solid domestic demand and rising manufacturing exports and noted that financial volatility has diminished as NAFTA renegotiation talks have proceeded in a constructive manner. The government sees GDP growth of between 2.0% and 3.0% in 2018.

Let the fiesta continue, come what Trump may or may not do!

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Another Seinfeld Episode

September 13, 2017 (Wednesday)

 

Strategy: Back to Basics. The panic-prone bull market in stocks since 2009 has been less panic-prone. The bull turned a bit anxious again last week as Hurricane Irma threatened to level all of Florida after Hurricane Harvey swamped all of Houston and surrounding areas. Irma did lots of damage, but so have previous hurricanes without any consequences for the US economy and stock market. There was also some lingering anxiety about geopolitical tensions with North Korea. However, for now, the US continues to seek nonlethal options, particularly more UN-imposed trade sanctions. Immediate worries about the US federal debt ceiling vanished last Wednesday, when President Donald Trump cut a deal with congressional Democrats to raise the ceiling for three months and agreed to provide emergency funds for Texas and Florida.

When Seinfeld aired on television, millions of Americans viewed the show that was mostly about nothing. Nothing ever happened, which viewers found very entertaining. The bull market has turned into the Seinfeld market. During every episode, investors are watching for something to happen. When nothing happens, especially nothing bad, investors are bemused and show their appreciation by throwing more money at the bull. So it’s back to some of the basics that continue to drive the bull market:

(1) Fundamental Stock Market Indicator. Our Fundamental Stock Market Indicator edged down in early September, but remains in record-high territory (Fig. 1). It has been highly correlated with the S&P 500 since 2000. Its two components declined slightly in early September (Fig. 2).

The Boom-Bust Barometer has been rising in record-high territory since late September 2016 (Fig. 3). It is simply the ratio of the CRB raw industrials spot price index to initial unemployment claims. The commodity index has been moving higher recently, led by the soaring price of copper (Fig. 4). Initial jobless claims remain near recent cyclical lows, but rose in early September as a result of Hurricane Harvey, according to the Bureau of Labor Statistics (BLS) (Fig. 5).

The Weekly Consumer Comfort Index rose at the end of August to a 16-year high, but edged down at the start of September. This index has been highly correlated with the S&P 500 forward P/E since 1995 (Fig. 6). When consumers are happy, investors tend to be willing to pay more for earnings.

(2) Forward revenues. S&P 500/400/600 forward revenues all rose to record highs last month (Fig. 7). Also impressive is that analysts’ consensus expectations for S&P 500 revenues remain remarkably stable at elevated levels, with current estimates implying a solid gain of 5.0% in 2018, following 5.6% this year.

Also impressive is that analysts have been raising their 2017 and 2018 revenues estimates for S&P 400/600 since the start of this year.

(3) Forward earnings. The forward earnings of the S&P 500/400/600 continue to trend higher in record-high territory (Fig. 8). During the first week of September, forward earnings for the S&P 500/400 both rose to record highs.

Interestingly, the forward profit margin was 11.0% at the end of August for the S&P 500, near recent record-high readings (Fig. 9). The margin for the S&P 400 remains near its cyclical high at 6.7%. Joe and I are trying to figure out why the forward profit margin for the S&P 600 SmallCaps has declined from a cyclical high of 6.1% during October 2013 to 4.8% currently.

US Labor Market: Help Wanted. Yesterday, the BLS released its JOLTS report with July data on job openings and turnover. Also yesterday, the National Federation of Independent Business (NFIB) released its monthly survey of small business owners with August data. Both confirm that the job market remains tight with lots of job openings, as Debbie reviews below. Let’s look at the key takeaways from both:

(1) Job openings. There’s a high correlation between the NFIB’s series on the percentage of small business owners reporting that they have job openings and both the number of job openings and the job openings rate in the JOLTS report (Fig. 10 and Fig. 11).

The advantage of the NFIB series is that it starts in 1974, while the JOLTS data are only available since December 2000. In any case, all three job openings series show that the labor market is as tight as it was in late 2000, when the unemployment rate was at 3.9% during the final four months of that year (Fig. 12).

During July, the number of job openings was a record-high 6.17 million, while the number of unemployed workers totaled 6.98 million. The ratio of the number of unemployed workers to the JOLTs job-openings series sank to 1.13 during July, the lowest since January 2001 (Fig. 13).

(2) Quitters. In the JOLTS report, the quits rate edged down during July (Fig. 14). But it remains on an uptrend and near its cyclical high during May. It is highly correlated with both the Consumer Sentiment Index and the Consumer Confidence Index. That makes sense since workers tend to be most confident when the job market is tight. That creates opportunities for them to quit their job to take a better one.

(3) Wages. Presumably, when most workers quit their jobs, it is to take better-paying ones. So a tight labor market with lots of job openings and a rising quits rate should be associated with rising wage inflation. The Atlanta Fed’s Wage Growth Tracker (WGT) shows that job switchers tend to enjoy bigger wage gains than job stayers (Fig. 15).

Yet the yearly percent change in average hourly earnings (AHE) for production and nonsupervisory employees remains subdued around 2.5% even as the NFIB job openings measure is the highest since May 2001 (Fig. 16). Back then, this measure showed wages rising 4.0%.

On the other hand, the WGT showed a wage inflation rate of 3.7% during July. It is based on median rather than average wages, and may be doing a better job of adjusting for the impact of retiring high-wage Baby Boomers being replaced by low-wage Millennials. When Baby Boomers quit, more and more of them are likely to be leaving the labor force rather than moving to higher-paying jobs.

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Over There & Over Here

September 12, 2017 (Tuesday)

 

Global Warming I: Hot Stock Markets. The debate over “Global Warming” is now about “Global Climate Change.” The latest two monster hurricanes that hit Texas and Florida certainly provide fuel for the alarmists. The Atlantic Ocean has been warmer than usual, which is why the hurricanes have been larger and more devastating. There’s no debate about that. The debate is whether this is a secular or a temporary development. Also being debated is whether humans have contributed to global warming if it is in fact a more permanent development.

There’s no debating that global stock markets have been on fire this year. The All Country World MSCI stock price index (in US dollars) edged up to a new record high on March 6, 2014, slightly exceeding the previous record high on October 31, 2007 (Fig. 1). It then sold off 18.9% from May 21, 2015 through February 11, 2016 before recovering to a new record high on February 10, 2017. It is now up 33.7% since last year’s low, 12.6% y/y, and 12.2% ytd.

Which side is winning in the Go Global vs. Stay Home debate on investment strategy? Joe and I warmed up to the former late last year after staying home during most of the bull market. So that puts us on the “all the above” side of the debate for now.

We saw signs that the global economy was warming up late last year. We reckoned that the negative consequences of the plunge in crude oil prices had played out and that the beneficial consequences of cheaper fuel costs would prevail. We calculate that oil users have been enjoying an annualized windfall of $1.5 trillion since 2014 (Fig. 2). For US consumers of oil, the annualized windfall is around $150 billion. Also contributing to global economic warming is better growth in Europe and China, as Debbie and I discuss below.

For now, let’s review the global stock market derby:

(1) World in local currencies. Through Friday’s close, the US MSCI stock price index is up 35.2% since last year’s low, 12.8% y/y, and 10.1% ytd (Fig. 3). The All Country World (ACW) ex-US MSCI stock price index (in local currencies) is up 30.6%, 11.9%, and 8.5% over the same time frames (Fig. 4).

(2) World in dollars. The MSCI currency ratio index shows that foreign currencies relative to the US dollar are up 1.6% y/y and 8.6% ytd (Fig. 5). So the All Country World ex-US MSCI stock price index (in US dollars) is up 36.2% since last year’s low, 13.6% y/y and 17.8% ytd.

(3) Eurozone & Japan. The EMU MSCI stock price index in euros is up 13.2% y/y and 7.1% ytd (Fig. 6). In dollars, it is up 20.7% y/y and 21.9% ytd, reflecting the 14.0% rebound in the euro ytd (Fig. 7).

The Japan MSCI is up 3.3% ytd in yen and 11.7% in dollars (Fig. 8).

(4) Emerging Markets. The Emerging Markets MSCI (in local currency) is up to a record high with gains of 44.7% from last year’s low on January 21, 16.0% y/y, and 20.7% ytd (Fig. 9). In dollars, it remains 18.5% below the 2007 record high, but has gained 17.7% y/y and 26.5% ytd.

(5) Lots of winners. Joe and I monitor the relative performance of Stay Home vs. Go Global using the ratio of the MSCI stock price index to the ACW ex-US stock price index (Fig. 10). This shows that the US has performed in line with the rest of the world’s performance in local currencies since late last year, but underperformed since it peaked out on a relative basis in dollars on December 27, 2016. The bottom line is that it’s another great year so far for the global bull market in stocks.

Global Warming II: Hot Economies. Heating up the global economy this year have been Germany and China. Consider the following:

(1) Germany stands out among the Eurozone nations, as its production is in record-high territory while the other major regional output indexes are lagging (Fig. 11). Germany’s IFO business climate index rose to a record high this past summer (Fig. 12).

The country has benefitted from a 24% decline in the euro since mid-2014, when the ECB adopted a negative interest-rate policy, through the end of 2016. However, the euro is up 14% ytd, which might start to weigh on Germany and the other Eurozone economies. Then again, there may be another reason why Germany’s economy is booming. The huge influx of immigrants over the past couple of years may be boosting the economy much more than widely recognized.

(2) China is showing improving growth. That’s to be expected as the government continues to encourage debt-led growth. Bank loans are up a record $2.0 trillion over the past 12 months through July (Fig. 13). That’s helped to fuel another construction boom, as evidenced by the 130% rebound in China’s steel price index (for 1mm hot rolled sheet) from the end of 2015 through the week of September 8 (Fig. 14).

The 12-month average of electricity output is up 8.0% y/y, the best pace since July 2014 (Fig. 15). The China MSCI stock price index (in dollars) has been soaring this year (up 38.5% ytd) along with the price of copper, which is deemed to be very sensitive to Chinese growth (Fig. 16).

Global Warming III: Hot Revenues & Earnings. The global stock market rally this year has been fueled by an upturn in the All Country World’s forward revenues (in dollars) (Fig. 17). Industry analysts around the world are estimating the 2018 global revenues will be up 4.9% from this year. ACW MSCI forward earnings (in dollars) is at a nine-year high and just 2.1% below the July 2008 record high, with analysts expecting earnings to grow 9.8% next year (Fig. 18).

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The Jokers Are Wild

September 11, 2017 (Monday)

 

US Economy: Four Deuces & a Joker. I was in Chicago and Toronto at the end of last week visiting our accounts. Almost all of us were in agreement on the outlook for the US economy, which means that almost all of us are nervous that our consensus outlook is too consensus. So we also talked about alternative scenarios.

The consensus scenario is “what you see is what you’ll get.” It is the Three Deuces scenario. In our conversations, I raised the ante, adding a couple of scenarios as follows:

(1) Three Deuces. In the consensus view, real GDP should continue to grow at a sluggish pace around 2.0% y/y. Inflation is likely to be no higher than 2.0%. The Fed should gradually raise the federal funds rate to 2.00% by the end of next year (Fig. 1). That’s the Three Deuces scenario.

(2) Four Deuces. I added that if inflation remains subdued and if there is no boom, then there should be no bust for the foreseeable future. In this Four Deuces scenario, the unemployment rate, which is currently 4.4%, could fall below 3.0% toward 2.0%, though the lowest it has ever been in the post-war era was 2.5% during May/June 1953 (Fig. 2).

(3) Four Deuces and a Joker. In one of my meetings, with an account who invests mostly in bonds, one fellow pointed out that the US Treasury 10-year bond yield is another deuce card. When I was at that meeting in Chicago on Thursday, the yield fell down to 2.05%, the lowest reading since November 8, 2016 (Fig. 3). It’s been led back down recently by the comparable TIPS yield, which fell from 0.66% on July 10 to 0.25% on Friday, the lowest since November 9, 2016. Interestingly, the expected inflation rate for the next 10 years implied by the spread between the nominal and TIPS yields has been fairly steady around 1.8% for the past few weeks (consistent with the deuce card for inflation) (Fig. 4). Since there are only four deuces in a pack of playing cards, we agreed to call this the “Four Deuces and a Joker” scenario.

In a breakfast meeting with one of our accounts on Friday in Toronto, my guest suggested that the joke could be on the consensus view. Like most Canadian investors, he is very aware and knowledgeable about commodity markets. He noted that the jump in metals prices over the past year is telling him that a typical late-cycle boom may be underway. So he is on the lookout for big upside surprises in economic growth, inflation, and interest rates. In this scenario, stocks might continue to rise for a while. But this should all end badly by 2019 because booms always set the stage for busts. In his opinion, the business cycle isn’t dead, and is about to make a widely unanticipated comeback.

My response was that I don’t see an inflationary boom coming, but that his scenario is probably the most plausible contrary one out there right now. He asked me to be alert to signs that he might be right. I told him that my contrary instincts were already on high alert, and even more so after our breakfast.

Commodities: The Joker Is Wild. There is only one Joker in a pack. In my Four Deuces and a Joker scenario, the Joker is the bond yield, which has fallen from a high for this year of 2.62% on March 13 to 2.06% on Friday, with the comparable TIPS yield down from 0.61% to 0.25% over this period. My Canadian friend’s Joker is the price of copper, which has soared 19% over this same time period (Fig. 5). There are two alternative Jokers: North Korea’s deranged leader and our kooky president.

In other words, the Joker could be a deuce or a King. Or the Joker might be the Ace pilot leading commodity prices higher. I know: My metaphor just turned into a losing hand. Before I turn into a court jester, let’s have a closer look at the high-stakes poker game underway on the commodity tables:

(1) Copper & other commodities. The price of copper is one of the 13 prices included in the CRB raw industrials spot price index, and the two are highly correlated (Fig. 6). The metals component of this index—which includes scrap copper, lead scrap, steel scrap, tin, and zinc—soared 68% since it bottomed on December 17, 2015 to its recent peak last Tuesday, which was the highest reading since September 10, 2014 (Fig. 7). That’s quite an impressive rebound. It shows that the metals and mining industry restructured remarkably quickly when their prices tanked in 2014 and 2015. Now that the global economy is growing in a synchronized fashion for the first time since the recovery from the 2008 recession, commodity prices are soaring as robust demand is tightening up supplies.

(2) Commodities & the dollar. But there is more going on behind the soaring CRB raw industrials spot price index than just global synchronized economic growth. The inverse of the trade-weighted dollar is highly correlated with the CRB index, its basic metals components, and the price of copper (Fig. 8, Fig. 9, and Fig. 10). The trade-weighted dollar fell nearly 10% since peaking recently on January 11 through Friday to the lowest level since July 14, 2015.

Market Correlations: Lots of Wild Cards. Besides the breakdown of the correlation between the bond yield and the price of copper there have been a few other notable divergences:

(1) Copper and oil. From 2004 through 2016, the price of a barrel of Brent crude oil was highly correlated with the nearby futures price of copper (Fig. 11). So far this year, they’ve diverged significantly as the price of copper has soared while the price of oil has been relatively flat. The same can be said for the relationship of the CRB raw industrials spot price index and the price of oil (Fig. 12).

(2) The dollar and oil. From 2005 through 2016, there was a good correlation between the price of a barrel of Brent crude oil and the inverse of the trade-weighted dollar (Fig. 13). This year, the dollar has dropped 9%. Yet, instead of moving higher as suggested by the past correlation, the price of oil is down 5% since the start of the year.

Then again, some correlations are still working, such as:

(1) EMs and commodities. The CRB raw industrials spot price index bottomed on November 23, 2015 and is up 30% since then. The Emerging Markets MSCI index (in local currencies) bottomed on January 21, 2016, and is up 44.7% since then (Fig. 14). The correlation is even tighter when the stock price index is in dollars (Fig. 15).

(2) EMs and the dollar. There was a tight correlation between the EM stock price index (in local currencies) and the inverse of the dollar from 2001 through 2012 (Fig. 16). Then they diverged for a while, or at least didn’t move in tandem as they had, from 2013 through 2016. However, they’ve found their mutual groove this year as the EM stock price index rose 20.7% ytd, while the trade-weighted dollar fell 9% ytd.

So what’s the story? It looks like a global synchronized boom, according to the prices of basic metals and Emerging Markets stocks. The boom may be attributable to the windfall that users of oil are enjoying, as ample supplies have cut the oil price in half since 2014. The global boom isn’t inflationary so far given the weakness in oil, which has a much bigger weight in the S&P GSCI than other commodities. The weaker dollar is keeping a lid on inflationary pressures overseas. Here in the US, slow growth, political gridlock, geopolitical risks, and overvalued stocks have attracted bond buyers. All the above may continue to be a winning hand for stocks.

Mother Nature: The Wildest Card. On Friday, when I was in Toronto, Jennifer Lawrence was in the UK promoting her new film “Mother!” She suggested the devastating hurricanes in Texas and approaching Florida were signs of “Mother Nature’s rage and wrath” at America for electing Donald Trump and not believing in man-made climate change.

She must know what she is talking about since she is an Oscar-winning actress. In any event, a consequence of these disasters is that lots of homes will have to be repaired or rebuilt. The government is likely to finance some of this reconstruction since so few homeowners had flood insurance. This could boost economic activity in the US. However, there is a serious shortage of construction workers. That could boost wage inflation, though it is likely to be limited to the construction industry. Trump might have to beg Mexican construction workers to come back to the US after an estimated 500,000 of them went back home when the US housing boom turned into a bust in 2008. He may also need them to build the wall on their way back home.

The real problem in Texas and Florida is what they used to say in the TV commercial for Chiffon margarine: “It's not nice to fool Mother Nature.” If you want to live in areas that are prone to flooding, hurricanes, and tornadoes, perhaps you should be required to have insurance for such disasters, especially if you take out a mortgage.

According to a 9/10 article posted on Quartz, “Homeowners’ insurance does not cover damage to a home caused by flooding. A homeowner must have a separate policy to cover flood-related losses, defined as water traveling along or under the ground. Most such policies are underwritten by the National Flood Insurance Program, which is part of the Federal Emergency Management Agency (FEMA). The National Flood Insurance Program was established in 1968 to address the lack of availability of flood insurance in the private market and reduce the demand for federal disaster assistance for uninsured flood losses.”

Now technically, flood insurance is required in high-risk areas. According to an 8/29 Washington Post article: “Legally, homeowners in places that FEMA designates as ‘high-risk’ flood areas are supposed to have the insurance, but the rule isn't tightly enforced.” To us, it seems logical that the enforcement problem probably reflects owners allowing in-place policies to lapse more so than new home owners not getting flood insurance in the first place since many mortgage companies require it to obtain a home loan in risky areas. In any event, “the vast majority of people hit by Harvey weren't even in a high-risk flood zone,” a storm damage estimator was quoted as saying for the Washington Post article.

It’s too bad that homeowners (either in or outside floodplains) don’t see the value in the flood insurance until it’s too late. Usually that’s when a storm is brewing. Last-minute coverage isn’t available because of the 30-day wait period after a National Flood Insurance Program (NFIP) policy is purchased.

Generally, these policies seem relatively cheap for the coverage to protect one of life’s biggest assets, our homes. On average, the cost for a policy in Texas is about $500 per year, though it is higher in areas designated as floodplains. That typically covers around $250,000 for damages and $100,000 for personal property inside the damaged structure. In contrast, those who forgo the insurance might be eligible for aid from FEMA. But that could be just about $33,000 max. That’s all according to the article.

Interestingly, private insurance companies have hesitated to touch flood policies because of the potential for catastrophic losses. Indeed, according to the article, the NFIP is $25 billion in debt after Sandy and Katrina. That’s not even including Harvey, let alone Irma. The program is authorized to borrow only up to $30 billion, so that limit undoubtedly will need to be extended if more aid is to be provided.

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Healthy Returns

September 07, 2017 (Thursday)

 

Health Care: More Drugs. Drug prices and Obamacare were hot-button issues in the 2016 presidential election. But with North Korea shooting missiles and hurricanes wreaking havoc, Washingtonians are focused elsewhere. Meanwhile, a bevy of new medical breakthroughs—and a little M&A—are lighting a fire under the S&P 500 Biotechnology stock index. It’s up 23.0% ytd through Tuesday’s close.

Biotechnology is one of three industries propelling the S&P 500 Health Care sector higher. The other two are Managed Health Care, up 29.3% ytd, and Health Care Equipment, up 22.7% (Fig. 1). They’ve helped make Health Care one of the best-performing sectors so far this year. It’s a trend we highlighted in the 6/15 Morning Briefing, and it continues today. Here’s how the S&P 500 sectors’ ytd performances stack up through Tuesday: Tech (24.1%), Health Care (17.1), Utilities (12.3), Consumer Discretionary (10.0), S&P 500 (9.8), Materials (9.5), Industrials (7.2), Real Estate (6.5), Consumer Staples (6.3), Financials (3.8), Telecom Services (-12.2), and Energy (-15.6) (Fig. 2). I asked Jackie to have a closer look at what’s healing the drug industry:

(1) More new drugs, higher prices. The biotech and pharmaceutical industries have benefitted from a resurgence of new drug approvals. So far this year, 31 drugs have received FDA approval. That’s a nice rebound from last year, when only 22 drugs were approved for the entire year. Last year’s meager crop of new drugs led to fears that productivity in drug development had fallen. Now, however, it looks more like a quirky timing issue—some drugs won early approval in 2015, and other approvals were pushed into 2017—caused last year’s dip.

Going forward, the industries’ pipeline of drug approvals looks healthy as well. “According to QuintilesIMS, which compiles data for the pharmaceutical sector, the robust state of the industry’s late-phase R&D pipeline means it is well placed to yield an average of 40 to 45 new launches annually through to 2021,” a 5/25 Reuters article reported.

Many of the drugs being developed are more specialized. They treat fewer patients, but they get faster FDA reviews and higher price points. This may help to explain why branded drug prices jumped 10% y/y in June, while generic drug prices fell 8%, the WSJ reported. “What the data masks is that while there might be more approvals, the total number of people getting new drugs is probably not going to up hugely because these are more specific, personalized treatments,” Hilary Thomas, chief medical adviser at KPMG told Reuters.

(2) Amazing innovations. One of the most fascinating new therapies being developed involves genetically altering patients’ cells so they can fight cancer. Novartis received FDA approval for a therapy that uses this technique to fight acute lymphoblastic leukemia in kids and adults up to 25 years old, an 8/30 WSJ article explained. The therapy is broadly known as “CAR-T,” or “chimeric antigen receptor T-cell” therapy. Novartis’ version is dubbed “Kymriah.”

During Kymriah therapy, white blood cells, or T-cells, are extracted from a patient. Genes that recognize specific cancer cells are inserted into the T-cells using an inactive virus. The genes produce receptors on the surface of the T-cells that are attracted to malignant proteins on the surface of cancer cells. The modified T-cells are grown in a lab for 10 days. The patient undergoes chemotherapy to kill off some white blood cells to help the body accept the modified T-cells. Then the modified T-cells are injected back into the patient, where they multiply, target, and kill the cancer cells.

Some patients who received the treatment in trials seven years ago remain cancer-free. Novartis undoubtedly will get pushback on its plans to charge $475,000 for the treatment, which can take roughly a month. However, it will counter that the treatment can only occur in a limited number of approved facilities, and it’s tailored to individual patients. That makes it more expensive to dispense than a mass-produced pill. Novartis is also testing the process on other cancers, including some forms of lung and brain cancer.

(3) An M&A pop. Gilead Sciences is paying $11 billion to get in on CAR-T therapy. The company agreed to purchase Kite Pharma, a biotech company that has a CAR-T therapy dubbed “axi-cel” that attempts to cure an aggressive non-Hodgkin lymphoma when standard therapy has failed. The company’s axi-cel is awaiting FDA approval.

For the acquisition to pay off, Gilead will have to extend axi-cell’s use to other blood cancers and perhaps in combination with other immunotherapies, the 8/28 WSJ explained.

(4) High risk, high reward. The success of CAR-T therapies is far from guaranteed. Some of the therapies being tested have resulted in serious to deadly side-effects.

Two Phase I clinical trials of CAR-T cancer therapy by Cellectis were placed on hold following the death of a patient who suffered from a severe toxic reaction to the treatment. The company is now working with the FDA to redesign the treatment to reduce the risks involved, according to a 9/5 article in FierceBiotech.

Likewise, Juno Therapeutics stopped development earlier this year of one of its CAR-T therapies for adults with relapsed/refractory B-cell acute lymphoblastic leukemia after patient deaths from cerebral edema, Genetic Engineering & Biotechnology News reported on 3/2.

(5) More genetic tinkering. Scientists are also working to prevent inherited disorders by altering the genes in embryos. They’ve focused on a mutation that leads to hypertrophic cardiomyopathy, or thickening of heart muscles, which is the most common cause of death in young, healthy athletes. Scientists used CRISPR gene editing on lab-fertilized human embryos to correct the disease, according to an 8/6 newsletter from ARK Investment Management.

“CRISPR refers to a DNA sequence encoded in a bacterial genome that protects it from viral invaders. In the bacterial genome, the DNA sequence latches on to a pre-specified portion of the virus’ DNA and, using a pair of molecular scissors, disables it at that spot. In 2012, scientists realized that CRISPR could be re-engineered and redirected to attach to any stretch of DNA in other organisms. In effect, they found a gene-function disabling tool that would direct them to most targets of interest,” ARK explained in a 1/12 newsletter.

However, there are risks. From the same newsletter: “Currently, CRISPR-based editing still produces a number of off-target cuts, a known risk that scientists are addressing. The FIND-DELETE function may find and delete unintended regions of the genome, a key weakness of the technology. As scientists continue to develop and perfect the DELETE function of CRISPR, the FIND feature already has proven to be useful as a low-cost diagnostic tool for infectious diseases.”

(6) By the numbers. The S&P 500 Biotechnology stock index’s 23.0% ytd (through Tuesday’s close) rally follows a sideways performance for much of the past two years (Fig. 3). Despite the rally, the industry’s forward P/E ratio of 14.7 continues to look reasonable compared to history and compared to that of the S&P 500. The industry’s forward P/E was close to 25 times forward earnings in 2014 and north of 40 times earnings in the heady days of 2000 and 2001 (Fig. 4).

The industry is expected to generate revenue growth of only 3.1% over the next 12 months and earnings growth of 4.3% during the same period (Fig. 5). But earnings estimates are moving the right direction. Analysts expect earnings to fall 0.3% this year, rise 6.7% in 2018, and increase by 10.4% in 2019, though that’s awfully far away to speculate.

Pharmaceuticals haven’t fared quite as well as biotech stocks. The S&P 500 Pharmaceutical stock index is up 7.6% ytd, leaving the index at the upper end of its three-year trading range (Fig. 6). The industry is expected to grow revenue by 3.7% over the next year and earnings should rise by 7.9% over that period (Fig. 7). Annual earnings growth is expected to come in between 7.0%-8.4% from 2016 through 2019. The industry continues to have a modest forward P/E, 15.4 (Fig. 8).

Cryptocurrencies: Illegal. We thought the cryptocurrency market was looking a little bubbly when we wrote about Initial Coin Offerings (ICOs) in the 8/17 Morning Briefing. Turns out Chinese regulators did too.

The People’s Bank of China and other Chinese regulators essentially declared ICOs illegal, prohibited the sale of new ICOs, and requested the refund of money to investors who bought into ICOs that were already sold. They also will tighten the regulation of trading platforms.

The joint statement by regulators described ICO financing in withering terms: “ICO financing refers to the activity of an entity raising virtual currencies, such as bitcoin or ethereum, through illegally selling and distributing tokens. In essence, it is a kind of non-approved illegal open fund raising behavior, suspected of illegal sale tokens, illegal securities issuance and illegal fund raising, financial fraud, pyramid schemes and other criminal activity,” a 9/4 CoinDesk article reported.

The Chinese weren’t the first to warn of ICOs potential problems—the SEC and Singapore’s Central Bank issued warnings to investors—but the Chinese were the first to say they will take action. The price of bitcoin and ethereum fell sharply on the news because in order to buy into an ICO, investors had to first exchange traditional currency into bitcoin or ethereum to make the purchase. Without ICOs, a major source of recent demand for bitcoin and ethereum disappears.

The price of ethereum, the currency most frequently used to buy ICOs, dropped 31.0% from its Friday peak through Tuesday. It bounced back on Wednesday, cutting its losses almost in half, according to CoinDesk data. If no new ICOs hit the market, a new source of demand will have to be found to send ethereum higher once again.

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H-Bomb Ultimatum

September 06, 2017 (Wednesday)

 

Geopolitics: A-H. What’s the difference between an A-bomb and an H-bomb? Today, the major difference may be that the announcement over the weekend by North Korea’s Stalinist regime that the country can produce H-bombs brings the country closer to a push-comes-to-shove military confrontation with US military forces.

The rogue regime’s obsession with all things nuclear from A-H including intercontinental ballistic missiles, along with the saber-rattling rhetoric about aiming it all at the US, is certainly upping the ante for the Trump administration. On September 4, 2017, US Ambassador to the United Nations Nikki Haley told an emergency session of the 15-member U.N. Security Council in New York that North Korean leader Kim Jong Un is “begging for war.”

Shooting down the next test launch by the North Koreans may be too risky a response by the US to the flagrant provocations from North Korea’s deranged leader. He might respond by pounding Seoul, South Korea into oblivion. The city’s metropolitan region has over 25 million people living within four minutes' reach of North Korean artillery shells. The Trump administration seems rightly intent on exhausting all non-lethal alternatives to a military confrontation.

Increasingly, the only viable one seems to be to put intense pressure on the Chinese to swat their neighbor’s pesky nuke-obsessed brat. One option is to slap tariffs on Chinese imports. So far, threatening to do so hasn’t worked. This greatly increases the chances that Trump will impose prohibitive tariffs on China to get their attention. Another option is to place tactical nuclear missiles in South Korea. That would drive the Chinese nuts. It would also put the US in a better negotiating position to work out a no-nukes deal for the Korean peninsula with the Chinese.

When I did a Google search on “Does President Trump have the power to impose tariffs,” a 1/23 CNN article by Patrick Gillespie was at the top of the list. It was titled “President Trump can levy tariffs without Congress.” Here are the main points:

(1) Carte Blanche. The article quotes Gary Hufbauer, a trade expert at the Peterson Institute of International Economics, saying, “A president who wants to restrict trade enjoys almost carte blanche authority.”

(2) War powers. Gillespie reported, “Trump could invoke the ‘Trading with the Enemy Act of 1917’ to hit a nation with tariffs as high as he wants. Under the law, the president can restrict all types of trade ‘during time of war.’ That definition is very loose though. America doesn’t have to be at war with a particular nation—it just has to be ‘at war’ somewhere in the world in order to apply tariffs against other countries.”

(3) National emergency. The International Emergency Economic Powers Act of 1977 gives the president authority to use tariffs on another country during a “national emergency.”

The article at the beginning of the year was clearly inspired by Trump’s threats to impose tariffs on Mexico and China in retaliation over what he deemed to be their unfair trade practices. Trump has hinted a few times that if China solves the North Korea problem for the US, his administration will back off on trade protectionism. The pendulum is swinging the other way now as the Chinese have ignored Trump’s deal. Now, the US may have to hit the Chinese with a 2-by-4 to get them to make the deal.

The financial markets may have started yesterday to pay attention to this geopolitical crisis, giving greater odds to the possibility that Trump might launch an economic war against China in a last-ditch effort to avoid an actual war with North Korea. Increasingly, it seems to me that just as deranged as North Korea’s regime is the one running the show in China. What are they thinking? Why would they possibly want a nuked-up neighbor, let alone a deranged nuked-up neighbor? They must know that the US would happily let them put any puppet regime in North Korea in exchange for a nuclear-free Korean peninsula.

I’m not advising you to push the panic button. But it might be a good idea to prepare for a market selloff if the crisis continues to worsen rapidly. I’m not predicting Armageddon. However, the risks of a severe geopolitical panic attack are increasing. If that happens, it should once again be followed by a big relief rally assuming that the Chinese take executive action in North Korea. In other words, I still see potential for a stock market melt-up, but it might be preceded by a wicked sell-off.

The safest investment for the near term might be US Treasury bonds. If the North Korean problem is resolved peacefully, bond yields most likely will remain flat. If push-comes-to-shove, bond prices could jump higher as stock prices fall lower. I’m just thinking out loud. I’m also thinking: Didn’t our previous president win the Nobel Peace Prize for his much-anticipated efforts to end nuclear proliferation?

ETFs: Greasing Melt-Ups & Meltdowns. Yesterday, in my “What I Am Reading” email, I linked a 9/3 FT article titled “Vanguard chief dismisses ETF bubble fears.” It reported:

“Bill McNabb, head of the $4.5tn asset management giant Vanguard, has shot down accusations that record breaking inflows into exchange traded funds were helping inflate a stock market bubble. Mr McNabb said index tracking funds, which includes the $4tn invested in ETFs, represent much less than 15 per cent of the equity market capitalisation around the world. He added that index tracking funds accounted for less than 5 per cent of daily trading volumes of global financial markets. ‘I don’t see the bubble,’ he said in an FT interview. ‘The data belie the fears.’”

The article also quoted Howard Marks, co-founder of Oaktree Capital, the $100bn US alternative investment manager, who last month warned it was unclear whether ETFs and index mutual funds would find buyers for their holdings in the event of a market crunch: “When the management of assets is on autopilot, as it is with ETFs, then investment trends can go to great excess.”

Melissa and I are inclined to agree with Marks. More specifically, in the context of the North Korea issue, if the problem is resolved quickly without military action, ETFs should fuel a melt-up in stocks. If the problem seems more likely to blow up into a blow-up, then panic selling of ETFs could significantly worsen the selloff. ETFs could then fuel a melt-up if the panic is followed by a non-lethal solution. I’m just thinking out loud about a very messy situation that could go either way for the markets, with the end result likely to be new record highs in 2018.

Here is how the ETFs could worsen a selloff, as Melissa first explained in the 7/19 Morning Briefing. A broker is required for retail investors to make ETF trades. These transactions occur in the secondary market where ETF shares are traded rather than the underlying securities associated with them. Retail investors do not have the power to create new ETF shares, or destroy them. That happens in the primary ETF markets where SEC approved “authorized participants” come into play. Their role is to keep ETFs trading near the funds’ net-asset values (NAVs), based on the prices of the underlying securities. But what could happen during a massive selloff? Well, APs aren’t under any obligation to engage in these transactions. They only do so when they have the cash or credit available to capitalize on a perceived ETF arbitrage opportunity at a risk they’re willing to take.

Melissa and I worry that these buyers and sellers could take a cigarette break or shut down their high-frequency trading algos and cause the gap between the price and NAV to widen, resulting in some retail investors getting lower prices than they should be based on the value of the stocks held by the ETF. That could cause other retail investors to hurriedly sell their ETF shares, causing more market dysfunction, especially if the APs bow out. It’s possible that the market could turn extremely illiquid for ETFs. However, the odds of that are slim because there are currently lots of APs out there with the incentive to maintain ETFs at equilibrium. It would take a big negative shock to shake things up, but then we’d have bigger problems than just the ETF markets.

In Barron’s 9/1 cover story, Ben Levisohn explored the ways the bull market could end, including one related to ETFs. The article quoted Michael Shaoul, CEO of Marketfield Asset Management, saying: “A bear market dominated by passive investing will be more volatile.” Because, the author paraphrased, “if they all own the same ETFs, everyone selling will be dumping the same stocks at the same time, exerting enormous downward pressure on their prices.” Levisohn reminds us of the rise of portfolio insurance during the 1980s. It was “a fairly simple system designed to protect against losses that involved quickly selling into market downdrafts—that turned what could have been a run-of-the-mill selloff on Oct. 19, 1987 into Black Monday.”

For now, ETFs continue to enjoy solid net inflows. Let’s review July’s data:

(1) Monthly. Equity ETFs attracted $17.7 billion during July, the weakest since last October (Fig. 1). Some of that money might have come out of equity mutual funds, which had net outflows of $11.8 billion.

(2) 12 months. Over the past 12 months through July, equity ETFs had net inflows of $337.9 billion, down slightly from June’s record of $357.8 billion (Fig. 2). Equity mutual funds had net outflows of $95.3 billion over the same period.

(3) Domestic vs world. Over the past 12 months, investors have poured $212.0 billion into domestic equity ETFs while pulling $150 billion out of domestic equity mutual funds (Fig. 3 and Fig. 4).

Investors have been uniformly keener on both sorts of funds that invest globally. Inflows into global equity ETFs rose to a record $125.9 billion over the past 12 months, while global equity mutual funds attracted $54.7 billion over the same period.

The Fed: In Another World. Might the developing geopolitical crisis between the US and North Korea cause the Fed to hold its fire on raising the federal funds rate again at the September 19-20 meeting of the FOMC? Melissa and I think so. The monetary policy committee started raising rates at the end of 2015, then it did so once again at the end of 2016, and twice so far this year (Fig. 5). Along the way, the FOMC signaled that monetary policy would be normalized at a very gradual pace.

Apparently, bond investors think it will be very gradual indeed, as the US Treasury 10-year yield fell from last year’s high of 2.60% on December 16 to this year’s low of 2.07% yesterday. The yield curve has flattened dramatically over this period from 213bps to 91bps (Fig. 6). The 12-months-ahead federal funds futures contract is priced for a rate of 1.33% in 12 months, down from a high of 1.45% on July 7 (Fig. 7). The current federal funds target rate is 1.13%, implying just one rate hike over the next 12 months.

Yesterday, Fed Governor Lael Brainard gave a speech at The Economic Club of New York. She often reflects the views of Fed Chair Janet Yellen and provides useful insight into what may be the consensus view on the FOMC. The title of her talk was “Understanding the Disconnect between Employment and Inflation with a Low Neutral Rate.”

We didn’t expect her to mention the geopolitical crisis, and she didn’t. The speech basically confirmed our view that the Fed is disconnected from the world most of us live in. We really wonder if any members of the FOMC have ever ordered anything on Amazon. They seem to be clueless about the forces keeping a lid on inflation to the benefit of all consumers. Brainard would like to see higher inflation. In her conclusion she said, “I am concerned that the recent low readings for inflation may be driven by depressed underlying inflation.”

She said that she is frustrated by the Fed’s inability to hit its inflation target: “[W]hat is troubling is five straight years in which inflation fell short of our target despite a sharp improvement in resource utilization.” In another sign of disconnecting from reality, or at least a major non sequitur, she said, “I believe it is important to be clear that we would be comfortable with inflation moving modestly above our target for a time.”

Her nostalgia for 2.0% inflation, which is the Fed’s target, is obviously shared by other members of the FOMC (Fig. 8). She suggested that the committee might move forward with reducing its balance sheet while holding off on instituting another rate hike anytime soon. The brewing geopolitical crisis may also be on their radar screen. They can’t be that disconnected from reality.

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Back to School

September 05, 2017 (Tuesday)

 

US Economy: More of the Same. Welcome back. I hope you had a good summer and took some time off to recharge your batteries. It certainly was a good summer for stock and bond investors. From the end of May through the end of August, the S&P 500 rose 2.5%, while the bond yield remained relatively flat around 2.20%, earning the coupon. On the other hand, the trade-weighted dollar fell 3.5% over this period, but that helped to boost commodity prices as the CRB raw industrials spot price index rose 2.0%. It was a good summer for global investors too, with a solid gain in the All Country-World ex US MSCI stock price index (in local currencies), up 1.3%, led by the MSCI stock price indexes for Emerging Markets (7.6%) as Europe fell 2.1%.

It may be rougher going during the rest of the year as domestic political tensions heat up over the debt ceiling and tax reform, while geopolitical tensions with North Korea could come to a boil. The good news is that the US and global economic outlooks remain relatively calm. In case you were on the beach over the past couple of weeks, here is a quick refresher course on the US economy:

(1) GDP & profits. The growth rate in real GDP was revised higher last week, from 2.6% to 3.0% (saar) for Q2. On a y/y basis, real GDP was up 2.2%. It has been fluctuating around 2.0% since mid-2010 (Fig. 1). Excluding government spending, which has been relatively weak during the current expansion, it was up 2.7%. Nothing new here, so let’s move along. The Atlanta Fed’s GDPNow estimate for Q3 is currently 3.2%.

Inflation-adjusted consumer spending in real GDP rose 2.7% y/y during July (Fig. 2). Capital spending rose 4.4% y/y to a new record high during Q2, confirming the post-election strength in the CEO confidence index (Fig. 3). Leading the way are record-high capital outlays on information processing equipment (up 7.0% y/y) and industrial equipment (6.8%) (Fig. 4).

Released along with the first revision of GDP were data on corporate profits during Q2 (Fig. 5). On an after-tax basis, both profits reported to the IRS and adjusted to a cash-flow basis continued to meander at record highs, recovering this year from their energy-related dips last year. Nothing new here either.

(2) Inflation. So far, inflation remains MIA. The GDP implicit price deflator rose just 1.6% y/y during Q2. Leading the way to nowhere new was the PCED, which edged down on a y/y basis during July to 1.4% for both the headline and core readings (Fig. 6). Also going nowhere special is wage inflation. The average hourly earnings (AHE) measure rose 2.5% y/y for all workers in the private sector. It has been hovering around this pace since fall 2015.

(3) Employment & income. While wage inflation remains subdued, it continues to outpace the PCED headline inflation rate. So real AHE for production and nonsupervisory workers, who currently account for 70% of all private-sector workers, rose to yet another record high during July (Fig. 7). This measure is up 17.5% since the start of 2000, contrary to the widespread myth that real wages have stagnated since then.

On the other hand, as Debbie reports below, our current-dollar Earned Income Proxy for private-sector wages and salaries stagnated during August (Fig. 8). But it remains in record-high territory. While private-sector payrolls disappointed during August with a gain of 165,000, the comparable ADP series showed a solid increase of 237,000 (Fig. 9).

(4) Car sales & manufacturing. Debbie and I weren’t surprised to see August’s auto sales fall to 16.1 million units (saar), the lowest since February 2014 and down from a cyclical peak of 18.2 million units during December (Fig. 10). That’s because this series is highly correlated with weekly railcar loadings of motor vehicles, which also has been weak over the past year.

We are surprised by how well the M-PMI has been doing, having risen from 56.3 during July to 58.8 last month, with solid readings for New Orders (60.3), Production (61.0), and Employment (59.9) (Fig. 11). Confirming this strength are the regional business surveys, which are available with August data for the following Fed districts: New York, Philadelphia, Richmond, Kansas City, and Dallas. Debbie and I average the indexes for overall business activity, new orders, and employment (Fig. 12). They all rose to solid levels last month.

Global Economy: More Growth. The global economy is running on all six cylinders. It may not be a global synchronized boom, but it is the most synchronized expansion of economic activity that the global economy has had since the recovery from the 2008/2009 recession. The direction of change can be seen in the titles of the past four issues of the International Monetary Fund’s World Economic Outlook: “Subdued Demand: Symptoms and Remedies” (Oct. 2016), “A Shifting Global Economic Landscape” (Jan. 2017), “Gaining Momentum?” (Apr. 2017), and “A Firming Recovery” (Jul. 2017).

Why is this happening now? The global synchronized expansion may be attributable to the plunge in the price of a barrel of Brent crude oil from a 2014 peak of $115.06 on June 19 to a low of $27.88 on January 20, 2016 followed by the recovery to $52.75 last week. Over this same period, Debbie and I calculate that global crude oil revenues dropped from an annualized $3.2 trillion during June 2014 to $952 billion in early 2016, back to $1.5 trillion currently (Fig. 13).

The initial freefall in revenues depressed the global energy industry, which slashed capital spending rapidly around the world. The rebound in oil revenues has given a lift to this industry, but surely not enough to explain the global synchronized expansion. The flip side of crude oil revenues is outlays by users of crude oil. The drop in the cost to users of oil is like a 50% cut in the global “oil tax” on consumers. Now that the downside of the energy price shock is over, the benefits to the global economy are rising to the surface of the barrel. Let’s review some of the recent more buoyant global data:

(1) Europe. The Eurozone’s Economic Sentiment Index rose to 111.9 during August, the highest since July 2007 (Fig. 14). It is highly correlated with the region’s real GDP growth rate on a y/y basis, which was 2.2% during Q2, the best pace since Q1-2011. The Eurozone’s M-PMI rose to 57.4 last month, matching June’s reading, which was the highest since April 2011.

(2) China. China’s official M-PMI edged up to 51.7 during August, the 11th consecutive reading above 51.0. However, its NM-PMI declined from 54.5 during July to a 15-month low of 53.4 last month.

(3) Japan. Japan’s real GDP rose 4.0% (saar) during Q2, the fastest such pace since Q1-2015.

(4) Global manufacturing. Last month, the global M-PMI rose to 53.1, the highest since May 2011 (Fig. 15). Solid increases were registered for both the developed economies and the emerging ones (Fig. 16).

Movie: “Tulip Fever” (- - -) (link) is a very disappointing film. It has an all-star cast of very fine actors. The fundamental flaw is with the convoluted story, which is set in Amsterdam during the tulip bubble, which burst in 1637. During such manias, people tend to lose their minds. In this film, they’ve lost their minds while pursuing love, lust, and revenge. My wife and I left before it ended, and before the crash in the tulip market’s bubble. I hope I do as well exiting markets before the next bubble that forms suddenly bursts.

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Store Wars

August 31, 2017 (Thursday)

 

Industries: Targeting Alexa. “World’s Greatest Price Wrecker” is a moniker that seems appropriate for Amazon, especially after the price cuts it announced earlier this week at its new subsidiary, Whole Foods. However, the phrase actually dates back to the 1930s. It was used in ads by Michael J. Cullen, who’s widely credited with having had the idea for supermarkets. During an era of mom-and-pop enterprises, the suggestion of “monstrous” stores, with plenty of parking, separate departments, self-service, discount pricing, and high-volume sales was revolutionary.

When Cullen’s idea was ignored by his then-employer Kroger Grocery & Baking Co., he struck out and opened King Kullen on Long Island. Ads for the new enterprise cried out: “King Kullen: World’s Greatest Price Wrecker.” King Kullen continues today as a family-controlled operation on Long Island with 32 locations.

Now King Kullen and other grocers need to evolve in response to Amazon’s arrival. We spill a lot of ink tracking Amazon because it’s disrupting so many different industries across the world of retailing (clothing, office supplies, food, etc.), entertainment, and technology (Alexa, Kindle, web services). Amazon is also affecting the broader economy, as the competition and lower prices it typically offers are helping to subdue inflation and preventing the Fed from achieving its 2% inflation target.

The most recent reminder of Amazon’s influence came last week when Whole Foods slashed prices on certain items. The move shook investor confidence in food retailers and suppliers alike. The S&P 500 Food Retail stock price index, which holds Kroger shares, has fallen 19.5% ytd through Tuesday’s close (Fig. 1). Likewise, the S&P 500 Packaged Foods & Meats stock price index, which contains General Mills, Campbell Soup, and others, has lost 6.9% (Fig. 2).

One related industry that hasn’t lost ground this year is Hypermarkets & Super Centers, which includes Wal-Mart and Costco. It’s up 8.3% ytd (Fig. 3). The gains are thanks to Wal-Mart, as the giant retailer’s shares are up 14.0% ytd, ahead of the S&P 500’s 9.3% advance.

Why would Sam Walton’s creation be faring so well in the face of growing competition? We have two possible explanations. In anticipation of Amazon’s arrival to the world of bricks and mortar, Wal-Mart has made numerous acquisitions and introduced new, competitive offerings that are having a positive impact on business. Another possibility: The continued downward spiral of Sears and Kmart is helping Wal-Mart land new business. I asked Jackie to take a gander at why Wal-Mart’s shares have eluded the bargain bin. Here are her findings:

(1) Hey, Google. Wal-Mart may not be the first to introduce a new technology, but it certainly knows how to copy a good idea when it sees one. Earlier this month, Wal-Mart announced plans to team up with Google to compete with Amazon’s Alexa. Wal-Mart will share its consumers’ purchase history with Google, and Wal-Mart customers will have access to Google’s online-shopping marketplace, Google Express. Google Express can be accessed by speaking to Google’s virtual assistant, which sits in phones and in Google’s voice-controlled speaker, Google Home.

As an 8/23 WSJ article explained, “The increasing importance of voice shopping suggests Wal-Mart and Google, part of Alphabet Inc., need each other to compete against Amazon. Voice-controlled ordering is a small but rapidly growing share of online sales, analysts say, and one of the top reasons to use Amazon’s virtual assistant Alexa and its Echo speakers.” Wal-Mart will be available on the service in September.

Wal-Mart is also introducing new functions that make shopping easier. It launched Easy Reorder, which lists a consumer’s purchases made online and in-store and makes them available for purchase. It has teachers’ school supply lists available on Walmart.com, and just clicking on the listed items puts them in your cart. The website also has a section dedicated to students shopping for college.

(2) Efficiency rules. In an attempt to keep costs down, Wal-Mart is introducing in-store kiosks from which customers can pick up goods ordered online. Customers access their order by scanning a barcode in the machine. “The massive orange towers stand 16 feet tall by 8 feet wide and deliver items through a conveyor belt inside the contraption,” a 7/6 AOL article explained. Packages are loaded into the kiosk by workers.

Wal-Mart is also experimenting with a kiosk for groceries that stands in a store’s parking lot. Consumers order in advance online, and Wal-Mart employees gather the items and store them in the 20-foot-by-80-foot refrigerated kiosk, according to a 6/6 Business Insider article. Customers walk up to the kiosk anytime day or night, type in a code, and their groceries are dispensed.

Other initiatives: Wal-Mart employees who opt into a program can deliver packages ordered online on their way home from work. The company is offering discounts to customers who ship purchases, especially large items, to Wal-Mart stores. And perhaps most importantly, the company introduced free two-day shipping on orders over $35 on more than 2 million items. Take that, Amazon Prime.

“We believe that we’re uniquely positioned to grow and delight customers by providing the seamless shopping experience they desire. Having stores within 10 miles of approximately 90% of the U.S. population allows us to serve customers in ways that are most convenient for them,” said Wal-Mart’s CEO Douglas McMillon, according to the company’s Q2 conference call transcript.

Wal-Mart has online grocery service in more than 900 of its US locations. In the US, there are 4,741 Wal-Mart stores compared to 444 Whole Foods stores.

(3) Winners and losers. The slow demise of Sears and Kmart shouldn’t be underappreciated in Wal-Mart’s success. Sears, of course, was the Amazon of the 1920s and ’30s. Its catalogs, offering a wide range of merchandise at low prices, dominated the industry. And when the automobile came along, Sears rapidly opened stores that ultimately overshadowed its catalog business.

These days, Sears and Kmart are shrinking. Kmart’s Q2 same-store sales declined 9.4%, and at Sears they fell 13.2%. Shoppers likely will head elsewhere as Sears Holdings continues shuttering stores. At the start of the year, the company had 735 Kmarts and 670 Sears. That’s down from 979 Kmarts and 709 Sears just two years prior. And the footprint will continue to shrink as the closure of 178 Sears and Kmart stores is planned for this year.

(4) Jetting higher. Wal-Mart’s Q2 online sales rocketed higher by 60% y/y, helped by the company’s September 2016 acquisition of Jet.com. Wal-Mart followed up with acquisitions of Moosejaw, Shoebuy, and Bonobos, as well as the rollout of online grocery delivery. Total sales rose 2.1% y/y to $123.4 billion, while the gross margin narrowed by 0.11pps, and adjusted EPS rose by a penny to $1.08. For the full year, the company is expected to earn $4.37 a share, basically flat from last year’s $4.38 EPS.

Here’s the rub: Wal-Mart doesn’t have a rapidly growing cloud service that throws off oodles of profit. As long as Amazon has Amazon Web Services (AWS), it can sell consumers bananas at a loss. And that’s a problem for everyone in the industry.

“AWS’s juicy operating profit margin of more than 25% gives Amazon a way to fund its new ventures and a retail business that has notoriously skinny margins. The cash and financial flexibility AWS provides ensures that Amazon will be a lethal competitor in the retailing industry for many years to come,” we wrote in the 3/30 Morning Briefing. It’s dilemma that we have no doubt Michael Cullen would understand.

India Update: What a Difference a Month Makes. Forget April. August can be the cruelest month when it comes to the stock market. The MSCI India share price index fell 2.4% in US dollars from 8/1 through 8/29 after rising 28.4% ytd through 7/31 (Fig. 4). The BSE-Sensex hit a new high of 32,575.17 on 8/1 and as of 8/30 stood at 31,646.5, down 2.9% in that short span. We weighed in on India in the 7/20 Morning Briefing, noting the stock market was vulnerable to a correction and highlighting the disconnect between a slowing economy and a soaring stock market.

Since our commentary, the July reading of Indian manufacturing activity contracted sharply, dropping to the lowest level since February 2009, according to a piece in the 8/1 FT, as confusion surrounding a new multi-tiered goods and services tax that went into effect on 7/1 is hampering Indian businesses. India’s central bank cut the benchmark interest rate by 25 basis points to 6.00%, the lowest level in more than six years. Bad loans at state-owned banks have surged, fueling worries about the health of financial institutions. Consumer prices ticked sharply higher in July, the first acceleration in four months.

Also, shares of software outsourcing powerhouse Infosys plunged following the abrupt 8/18 resignation of CEO Vishal Sikka amid boardroom intrigue and challenging conditions in its core business, dragging down the broader market. Geopolitical tensions in the region have weighed on stocks too. And for the first time in 21 weeks, emerging market funds witnessed outflows during the week of 8/16, as investors yanked $1.7 billion from stock and bond funds dedicated to developing nations, Bloomberg reported in an 8/21 story.

Despite the recent weakness, India is among the 15 top-performing markets ytd through 8/29, up 25.4%. It remains susceptible to setbacks as the MSCI India index continues to trade at elevated levels: Its forward P/E of 18.2 is well above its forward earnings growth rate of 14.5% (Fig. 5 and Fig. 6). I asked Sandy to take a closer look at recent developments in India. Here’s what she says:

(1) Manufacturing slowdown. The Nikkei India M-PMI registered 47.9 in July—the below 50.0 level signaling a contracting manufacturing economy (Fig. 7). The latest M-PMI reading was down sharply from June’s 50.9 level and marked the lowest level in eight years. The folks at IHS Markit, which compiles the PMI data, noted that new orders and output dropped for the first time this year, according to an 8/1 release by IHS Markit. Principal economist at IHS Markit, Pollyanna De Lima, said, “The downturn was broad-based across all subsectors covered by the survey, with output scaled back among firms in the consumer, intermediate and investment goods categories amid falling order books.” The slowdown was blamed widely on confusion related to the 7/1 introduction of the goods and services tax. On the other hand, manufacturing conditions across Southeast Asia slowed, with five of seven countries in the region showing economic contraction, according to an 8/10 article in the Nikkei Asian Review.

(2) Exports slowing. India notched its 11^th straight month of export growth in July, based on the 12-month percent change, but the rate of growth was at an eight-month low (Fig. 8). Ganesh Kumar Gupta, the president of the Federation of Indian Export Organizations, said, “A rising rupee and a not-so-encouraging order book position could make it difficult for the country to achieve the full-year export target of $325 billion,” according to an 8/15 Scroll Today News story. “The order booking position from October onwards is not very promising and the appreciation of [the] Indian Rupee with increasing pressure on liquidity under GST may affect exports in the last quarter of 2017 bringing exports to about $310 billion in the current fiscal,” Gupta said.

(3) Interest-rate easing. The Reserve Bank of India, as expected, cut rates to 6.00% from 6.25% on 8/1 in response to the economic slowdown (Fig. 9). The central bank noted a “weakening of the industrial performance” from April to June, when output of consumer durables and capital goods both contracted and pointed to “continuing retrenchment of capital formation in the economy,” according to an 8/2 article in the FT. The central bank also noted that the announcement of investment projects in the quarter fell to a 12-year low.

In announcing the rate action, the RBI adopted a cautious tone toward future rate cuts, noting that it expected prices to begin rising sharply in August, the FT article noted. Muted consumer demand and high debt levels are expected to blunt the effectiveness of the RBI easing. Along those lines, state-owned banks are reluctant to lend and are not reducing their base lending rates proportionately.

(4) Rising prices. As if on cue, consumer prices ticked higher for the first time in four months, rising 2.4% y/y in July from 1.5% in June (Fig. 10). Housing, energy, and clothing gained, while the decline in food prices slowed significantly, as did that of vegetable prices.

(5) Bad loans. India’s largest lender, the State Bank of India, revealed its ratio of non-performing loans jumped to nearly 10% at the end of June, from 6.9% in March. SBI’s profit fell 20% as it increased reserves for the bad loans. Weak asset quality is a problem plaguing all the state-owned banks, noted an 8/11 article in the FT. An 8/17 WSJ piece reported that more than 9% of all bank loans in India are considered non-performing, the highest percentage of the largest developing nations except for Russia. Bad loans are crimping lending and investment and contributing to the economic slowdown. The Reserve Bank of India has ordered banks to initiate bankruptcy proceedings against 12 large companies with high levels of loan defaults, mainly to the steel, textile, and construction industries, according to a 6/14 story from The Wire.

These issues for the Indian economy are beginning to weigh more heavily on investors’ minds if recent stock market action is any guide. The good news is that international capital flows remain very positive. We monitor a monthly proxy for such flows simply by subtracting India’s 12-month trade balance from the 12-month change in the non-gold international reserves held by the country (Fig. 11 and Fig. 12). This calculation shows net capital inflows since the start of the data in 1997. They dipped to a recent low of $103.9 billion at the end of last year, but recovered smartly to $159.7 billion during July.

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Tariffying

August 30, 2017 (Wednesday)

 

Geopolitics: Rocket Boy. When I was a teenager growing up in Campbell, California during the early 1960s, my friends and I wanted to go to space, or at least be rocket scientists. On October 4, 1957, the Soviets launched Sputnik 1, the world’s first artificial satellite. The US launched its first Earth satellite on January 31, 1958. On October 1, 1958, Congress and the President of the United States created the National Aeronautics and Space Administration (NASA) with an “Act to provide for research into the problems of flight within and outside the Earth’s atmosphere, and for other purposes.” NASA’s birth was directly related to the pressures of national defense. After World War II, the United States and the Soviet Union were engaged in the Cold War. During this period, space exploration emerged as a major area of contest and became known as the “Space Race.”

NASA began to conduct space missions within months of its creation. Project Apollo became NASA’s top priority on May 25, 1961, when President John F. Kennedy announced: “I believe that this nation should commit itself to achieving the goal, before this decade is out, of landing a man on the Moon and returning him safely to Earth.” NASA’s major achievement during its early years involved the human exploration of the Moon, with the first landing occurring on July 20, 1969.

Here on Earth, young wannabe rocket scientists like me and my friends in California during the 1960s could experiment with model rockets as a hobby. We ordered them by mail from the Estes catalogue. Vern Estes established this company over 50 years ago as a leading manufacturer of innovative hobby products for the model rocket industry. The company now sells model rockets on its website and on Amazon.

North Korean leader Kim Jong Un has a rocket fetish too. However, unlike hobbyists, he likes the big intercontinental variety that can carry nuclear warheads. He was officially declared “the supreme leader” following the state funeral of his father on December 28, 2011. He is currently somewhere between 33 and 35 years old, depending on the source. The United Nations Security Council has passed several resolutions banning Pyongyang’s missile tests. That hasn’t stopped Li’l Kim from attempting to rapidly develop his country’s nuclear and missile programs.

Despite President Donald Trump’s “fire and fury” warning to North Korea on August 8 to cease and desist, another NK missile was fired on Tuesday just before 6 a.m. in Japan. It flew over Japan, where the launch set off alarms in the northern part of the country, with people urged to seek shelter. In response, US President Donald Trump warned that “all options are on the table.”

One of the options has been to pressure the Chinese to do something about North Korea’s supreme Rocket Boy. That hasn’t worked, as evidenced by the latest missile test over Japan. At some point, the US may have no choice but to shoot down a test missile notwithstanding the potentially dire consequences to South Korea. For now, Trump is turning up the heat on the Chinese by threatening trade protectionism. Implicit in his threats is that if China neuters the pesky brat, he’ll back off on imposing tariffs.

On Sunday, Jonathan Swan reported on the Axios website that during General John Kelly’s first week as Trump’s chief of staff, “Kelly convened a meeting to discuss the administration’s plans to investigate China for stealing American intellectual property and technology. Kelly stood beside Trump, behind the Resolute desk. In front of the desk were U.S. Trade Representative Robert Lighthizer, senior trade adviser Peter Navarro, top economic adviser Gary Cohn, and Trump’s former chief strategist Steve Bannon. Trump, addressing Kelly, said, ‘John, you haven’t been in a trade discussion before, so I want to share with you my views. For the last six months, this same group of geniuses comes in here all the time and I tell them, ‘Tariffs. I want tariffs.’ And what do they do? They bring me IP. I can’t put a tariff on IP.’ (Most in the room understood that the president can, in fact, use tariffs to combat Chinese IP theft.) ‘China is laughing at us,’ Trump added.”

Swan reported that the meeting ended with Trump saying, “John, let me tell you why they didn’t bring me any tariffs. I know there are some people in the room right now that are upset. I know there are some globalists in the room right now. And they don’t want them, John, they don’t want the tariffs. But I’m telling you, I want tariffs.”

Strategy: Fundamentally Sound. Speaking of rocket ships, the stock market has been like the Starship Enterprise on “Star Trek.” It continues to “boldly go where no man [or woman] has gone before.” The S&P 500 has been setting new record highs with only two significant corrections since March 28, 2013, when it was 1569.19. It is up 58.5% since the prior bull market record high as of the most recent record high of 2480.91 set on August 7.

In other words, it has been 1,594 days in outer space. During the previous bull market of the 2000s, it was in outer space (i.e., exceeded the previous bull market record high) for only 133 days (Fig. 1). Granted, the air is thin in outer space, as measured by various valuation gauges. However, there’s no gravitational pull either, so the Starship S&P 500 can continue to fly as long as it doesn’t run out of rocket fuel. The fundamental gauges for the S&P 500 that Joe and I watch show plenty of solid rocket fuel:

(1) The Fundamental Stock Market Indicator (which we sometimes call the “YRI Weekly Leading Index”) rose to a new record high during the week of August 19, as Debbie reported yesterday (Fig. 2). It has been very highly correlated with the S&P 500 since 2000.

Our indicator isn’t a leading index of the S&P 500. Nothing leads the S&P 500, since it is a leading indicator itself, and is one of the 10 components of the Conference Board’s Index of Leading Economic Indicators. Our indicator simply confirms or raises doubts about the underlying trend in the stock market. Its new high certainly confirms that the bullish trend in stocks remains intact.

Our indicator comprises just three components that reflect the underlying strength or weakness in the domestic and global economies. It is the average of the Consumer Comfort Index (which is a four-week average) and the four-week average of the Boom-Bust Barometer, which is the CRB raw industrials spot price index (weekly average) divided by weekly initial unemployment claims.

(2) The CRB raw industrials spot price index is up 30% since it bottomed late in 2015 (Fig. 3). It had stalled during late 2016 through the first half of 2017, but has been advancing again in recent weeks. One of its 13 components is the price of copper, which has gone vertical in recent days (Fig. 4).

(3) The Boom-Bust Barometer (BBB) is simply the ratio of the CRB raw industrials spot price index divided by initial unemployment claims (Fig. 5). To smooth it out, we track the four-week moving average, which is extremely procyclical. The BBB has taken off like a rocket ship since late 2015 and has been in record-high territory this summer.

It is also highly correlated with the S&P 500 since 2000 (Fig. 6). That’s not surprising since it is highly correlated with another very procyclical indicator, namely S&P 500 forward earnings (Fig. 7).

(4) Consumer confidence is the third component of the Fundamental Stock Market Indicator (FSMI), which averages the Weekly Consumer Comfort Index (WCCI) and the BBB (Fig. 8). While the BBB is highly correlated with the S&P 500, the FSMI better tracks the stock index. That’s because the BBB is highly correlated with forward earnings and the WCCI is highly correlated with the S&P 500 forward P/E (Fig. 9). The WCCI has recovered sharply since late 2011, and so has the P/E.

US Consumers: Fearless. While North Korea’s Li’l Kim is doing his best to terrify the US and our allies in Asia, President Trump is doing his best to “tariffy” the Chinese. Showing no fear are US consumers, which may be one reason why stock investors continue to push stock prices higher. The WCCI is highly correlated with the S&P 500 forward P/E, as noted above. Both are in Happy Land, where terrifying things don’t happen.

Also in Happy Land are August’s readings of the Consumer Sentiment Index and the Consumer Confidence Index (CCI). The WCCI is most highly correlated with the expectations component of the University of Michigan’s Consumer Sentiment Index (Fig. 10). Let’s review the latest monthly data:

(1) CCI and CSI. The two monthly indexes include components showing opinions about current conditions and expectations (Fig. 11). Standing out is the outstanding ascent in the current conditions component of the CCI to the highest reading since July 2001.

(2) COI. Debbie and I like to average the CCI and CSI to derive the Consumer Optimism Index and its two components (Fig. 12). The COI current conditions index is the highest since March 2001.

(3) Jobs. Debbie and I think that the CCI provides greater insights into the labor market than does the CSI. Indeed, the survey used to construct the former includes an important question on whether jobs are plentiful, available, or hard to get. In August, the percentage saying jobs were hard to get fell to 17.3%, the lowest since August 2001, while the percentage saying jobs are plentiful rose to 35.4%, the highest since July 2001 (Fig. 13). The former is highly correlated with the unemployment rate, and suggests the jobless rate could fall from 4.3% currently to 4.0% soon!

The big puzzle is why wage inflation remains subdued. The jobs plentiful series has been highly correlated with the yearly percent change in average hourly earnings for production and nonsupervisory workers in the past, suggesting that wage inflation should be moving higher (Fig. 14). Yet it has been stuck around 2.5% since December 2015.

The jobs-plentiful series is highly correlated with the percent of small business owners reporting that they have job openings (Fig. 15). In July, 33.0% had job openings, the highest since the start of 2001. Yet, wage inflation remains subdues (Fig. 16).

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Theatre of the Absurd

August 29, 2017 (Tuesday)

 

US Tax Reform: Godot’s Addiction. Waiting for Godot is a play by Samuel Beckett. It premiered on January 5, 1953 in a Parisian theater. It features two characters, Vladimir and Estragon. They are waiting for someone named “Godot” who never arrives. In a poll conducted by the British Royal National Theatre in 1990, it was voted the “most significant English language play of the 20th century.” That might say more about the audience than the play because not much happens during the play. The dialogue is so nonspecific that the characters’ situation is far from clear and is open to wide interpretation. Beckett didn’t include any clues about the setting of the play, or about the characters for that matter. There are three other characters, who come and go. One of them is named “Lucky.” When Beckett was asked why Lucky was so named, he replied, “I suppose he is lucky to have no more expectations.”

Beckett’s play was one of several, by various mostly European playwrights, that were collectively called the “Theatre of the Absurd” during the 1950s. It was a part of the existential (a.k.a. absurdist) philosophy, which postulated that human existence has no meaning or purpose. The plays were mostly either fashioned as comedies or tragi-comedies combining vaudeville, clichés, word games, and meaningless and/or repetitive action. The characters grapple to find significance amid hopeless circumstances in what seems like a vacuous universe.

Sounds exactly like the endless theatre of the absurd in Washington! Just like Lucky in Beckett’s play, we are lucky to have no expectations. We are certainly lucky that the stock market is at a record high despite greatly reduced great expectations about the Trump administration’s economic agenda.

Yesterday morning, I wrote about the administration’s tax-reform plan. I noted that it will be hard to get a deal done, despite the Republicans’ majorities in both houses of Congress, if it isn’t deficit neutral. In other words, any tax cuts would have to be offset by significant cuts in so-called “tax expenditures,” which currently exceed $1 trillion per year. The problem is that most of these items are sacred cows, with lots of high-priced lobbyists prepared to protect them. Indeed, the three biggest deductions for individuals—on charitable donations, mortgage interest payments, and retirement savings—won’t be touched, according to National Economic Council Director Gary Cohn.

If the “untouchables” include not only entitlement spending but also lots of tax expenditures, then the Trump tax cuts won’t be deficit neutral. The administration will have to argue that their “dynamic scoring” of the tax-reform plan shows that tax revenues will be boosted by higher economic growth resulting from the plan sufficiently to pay for the tax cuts. That’s a conclusion that probably won’t be confirmed by the Congressional Budget Office when it runs the numbers through its economic model. That could cost the votes of Republican fiscal conservatives in Congress, which would cause the Republican majorities to crumble when the Trump tax-reform plan comes to a vote.

Also yesterday morning, Bloomberg posted an article titled “Trump’s Pivot to Taxes Is Fraught With ‘Pitfalls Everywhere’.” It observed that Trump’s tax-reform plan is facing an existential crisis. That’s because it doesn’t exist. It remains all talking points: “Instead of providing details that could help build support for a bill, the president will largely rely on the same talking points he and his advisers have highlighted since January: The middle class deserves a tax cut and businesses need changes to help them compete with global rivals.” Here is another key point: “The lack of specifics has kept Washington lobbyists on the sidelines—but that could change as soon as tax writers target any treasured loopholes.”

While meaningful tax reform, including a cut in the corporate tax rate, may no longer be discounted in the stock market, investors may still be anticipating that something will be done to stimulate the repatriation of $2.6 trillion in profit that US companies have stockpiled overseas. So far, the administration hasn’t provided any specifics on this element of the tax plan.

What may keep the hoped-for tax reform from showing up is an addiction to government spending, especially spending on entitlements. Godot is a junkie. And he’s not alone. Absurdly, many Americans who have become addicted to opioids are paying for the pain- and life-killing medication with Medicaid. Previous attempts to wean Americans off their tax deductions have failed. In Washington’s theatre of the absurd, tax reform may be hopeless, certainly with the current cast of characters.

Stocks: Forget About Godot. Fortunately for stock investors, we aren’t forced to watch this depressing play. A much happier one is corporate earnings, which continue to rise:

(1) Earnings. As Joe reviews below, forward earnings per share rose to new record highs for the S&P 500 and S&P 400 last week (Fig. 1). It has edged down from its record high in mid-July for the S&P 600. Estimates for 2018 are holding up very nicely, implying earnings growth rates for the S&P 500/400/600 of 11.0%, 13.0%, and 20.5%.

(2) Revenues. S&P 500/400/600 forward revenues per share also rose to new highs two weeks ago (Fig. 2). Growth rates for the three during 2018 are currently estimated at 4.9%, 4.5%, and 5.2%.

(3) Profit margins. The S&P 500 forward profit margin rose to a record high of 11.1% two weeks ago (Fig. 3).

US Consumers: Godot Is Coming! Melissa and I have been waiting for Millennial Godots to show up in the suburbs. Some of them have been out there, but living in their parents’ basements for lack of a good job—or lack of interest in finding any job, getting married, having kids, and buying houses and cars. Most of the Millennials have been extending their stays in college, and accumulating lots of student loans, which also delay them from getting married, having kids, and buying houses and cars.

But they may be coming on stage now. They were spotted doing so by an 8/22 Bloomberg article titled “Millennial Americans Are Moving to the ’Burbs, Buying Big SUVs.” According to the story, “Millennials are finally starting their own baby boom and heading for the suburbs in big sport utility vehicles, much like their parents did. Americans aged about 18 to 34 have become the largest group of homebuyers, and almost half live in the suburbs, according to Zillow Group data. As they shop for bigger homes to accommodate growing families, they’re upsizing their vehicles to match. U.S. industry sales of large SUVs have jumped 11 percent in the first half of the year, Ford Motor Co. estimates, compared with increases of 9 percent for midsize and 4 percent for small SUVs.”

Significantly, “Millennials ranked having children, buying a suburban home and driving a big family vehicle higher in terms of importance than living in a major city or relying on alternate forms of transportation in a survey that Ford conducted in June.” The hard data may be starting to confirm these sightings:

(1) Household formation. The pace of household formation has actually slowed recently (Fig. 4). The number of households fell to 118.4 million in June from a record high of 119.2 million during May. Over the past 12 months through June, only 100,000 households were formed, down from a recent high of 1.5 million in the 12 months through February (Fig. 5).

(2) Owners vs renters. Quarterly data are available showing how many of the new households are renters versus owners of their homes. Of the 0.6 million in net new households over the past four quarters, based on the quarterly average, 1.3 million were owners as the number of renters dropped 0.7 million (Fig. 6 and Fig. 7). That decline in renters was the first since Q3-2004! The increase in owners was the most since Q1-2005.

This all augurs well for single-family housing starts, and not so well for multi-family starts (Fig. 8 and Fig. 9). This development has yet to show up in a slower pace of tenant rent inflation as measured in the CPI (Fig. 10).

By the way, the suburban legend about lots of Millennials staying at home with their parents is a bit of a myth. It seems that many Millennials are delaying their transition from childhood to adulthood with a period of “emerging adulthood,” according to an April 2017 Census Bureau study titled The Changing Economics and Demographics of Young Adulthood: 1975-2016. It reported that 31% of young people, or 22.9 million 18- to 34-year-olds, lived in their parents’ home in 2016. That’s more than in any other living arrangement. It is up from 26% in 1975. The percentage living with a spouse dropped to 27% in 2016 from 57% in 1975. This strongly suggests that while many young adults were no longer childish, they had become “adultish,” i.e., still very dependent on their parents.

The news media accurately reported that the Census numbers show that one out of three young adults still lives at home. But Melissa found something wrong with the picture that statistic paints; buried in a footnote was this information: “College students who are living in dormitories are counted as living in the parents’ home.” So the widespread notion that Millennials are living in the furnished basements of their parents’ home and playing video games all day is a myth. On the other hand, the Census study found that 25% of young people living in their parents’ home neither go to school nor work. This figure represents about 2.2 million 25- to 34-year-olds, or about 8% of them.

Inflation: Godot Remains MIA. If rent inflation starts to moderate as the latest owners-vs-renters household formation data suggest should happen, then the Fed’s 2.0% target for the PCED inflation rate will be harder to achieve (Fig. 11). I never quite understood why the members of the FOMC are so intent on raising inflation, especially since it has been mostly propped up by rent and medical care inflation.

In any case, instead of Godot (the widely anticipated inflation character) showing up, the stage is now dominated by a much more powerful new character—Jeff Bezos. He is the Deflator from Amazon. Yesterday, Amazon.com Inc. spent its first day as the owner of brick-and-mortar grocery chain Whole Foods Market cutting prices as much as 43%. I wonder if any of the members of the FOMC have ever ordered anything from Amazon.

Forget about the Theatre of the Absurd. In the real world, the boxing match between Janet Yellen and Jeff Bezos is much more interesting. My money is on the Great Deflator.

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Poker Game

August 28, 2017 (Monday)

 

Strategy: Winning Hand. In my meetings last week with our California accounts in LA, Pasadena, Newport Beach, San Francisco, and Sacramento, we mostly discussed how the stock market might be affected by earnings, inflation, monetary policy, exchange-traded funds (ETFs), the dollar, and lots of other factors. Rarely mentioned was the presidency of Donald Trump. That’s quite a change from late last year and early this year, when Trump and his economic agenda dominated conversations I had with our accounts around the world.

Almost everyone I met last week has been tuning out the noise coming out of Washington. The noise-to-signal ratio coming out of our nation’s capital is higher than anyone can remember. Widely noted when the matter of our president came up was that he can’t seem to take a victory lap during the few times that he could have done so—e.g., his handling of Syria and North Korea come to mind. Instead, he changes the subject, always managing to stir up more controversy.

I’ve often observed in the past that our economy and financial markets have done remarkably well despite Washington, and should continue to do so. This view has certainly been stress-tested by the current mess in Washington. It could soon be stress-tested by a government shutdown.

Yet the stock market remains in record-high territory, and bond yields remain subdued near record lows. The economy continues to grow slowly, with real GDP up around 2.0% y/y. Inflation remains moderate below 2.0%. The Fed seems to be on course for a gradual normalization of monetary policy that could push the federal funds rate to 2.00% by the end of next year. In this Three Deuces scenario (2-2-2), it’s conceivable that the unemployment rate might fall to 2.0%, which would convert the Three Deuces scenario into the Four Deuces scenario (2-2-2-2). That would certainly be a winning hand for the economy and the stock market.

Tax Reform I: Good Luck with That! Many of the investors I met with on the West Coast last week have concluded that most of Trump’s agenda will drown in Washington’s swamp. However, late last week, there was some bullish excitement about the possibility that tax reform is one important piece of the Trump agenda that just might have come up for air. After all, the Republicans should be ashamed of themselves if they can’t get any of Trump’s agenda done despite their majorities in both houses of Congress and a Republican in the White House.

They surely know that failing to do anything significant at all could cost them their thin majorities come the midterm elections in 2018. Their failure to repeal and replace Obamacare should put more pressure on them to simplify the tax code in a way that reduces deductions and exemptions in exchange for lower tax rates. However, we shouldn’t underestimate their capacity to screw up on an issue, like tax reform, which should be a layup for them given their current majorities. They should have the winning hand, yet they could still lose the poker game they are playing with the Democrats. If they don’t play their Trump card on tax reform, they could lose their majorities.

To pull an elephant out of the hat on tax reform, the Republican plan probably would need to be revenue-neutral to satisfy the deficit hawks in the Republican party. That could be hard to achieve since it would require the elimination, or the capping, of all sorts of so-called “tax expenditures.” These are programs that amount to government spending through the tax code by allowing exemptions, deductions, or credits to select groups or specific activities.

The Tax Policy Center (TPC) at the Brooking’s Institution reports that the US Treasury projects that the 13 biggest tax-expenditure programs will cost more than $1 trillion during FY2018. The TPC observes:

(1) “The largest (an estimated $235.8 billion in 2018) is the exclusion of employers’ contributions for employees’ medical insurance premiums and medical care. Under this provision of the tax code, contributions are excluded from an employee’s gross income, while an employer may deduct the cost as a business expense.”

(2) “The next largest tax expenditure ($112.7 billion in 2018) is the exclusion of net imputed rental income, which is the return on housing equity in the form of rent-free housing. This is one of several tax preferences that focus on housing. Others include the home-mortgage interest deduction ($68.1 billion), the deduction for nonbusiness property taxes as part of the deductibility of nonbusiness state and local taxes ($63.3 billion), and the exemption of the first $500,000 of capital gains for couples ($250,000 for singles) on the sale of principal residences ($48.5 billion).”

(3) “In general, tax expenditures for individuals are larger than tax expenditures for businesses. Only two business tax expenditures that made it into the list of the top 13: the deferral of income from controlled foreign corporations ($112.6 billion in 2018) and accelerated depreciation of certain machinery and equipment ($50.3 billion in 2018). Among other business tax expenditures, the largest in 2018 are the deduction for US production activities ($17.2 billion), the credit for low-income housing expenditures ($8.9 billion), and the expensing of research and experimentation outlays ($7.7 billion).”

Eliminating and/or capping these deductions and exemptions could face a great deal of political resistance from all the Democrats and enough Republicans to kill tax reform, much the way that the Republicans’ drive to repeal and replace Obamacare failed earlier this year. There might be less resistance among Republicans if individual income tax rates are cut enough to offset the reduction in tax expenditures.

Tax Reform II: West Coast to West Wing. As noted above, while I was on the West Coast last week, there was some chatter about tax reform. It was stimulated by news reports that the Trump administration will be focusing on this issue in coming weeks. Here is what we know:

(1) Kick off. On Thursday, Bloomberg reported, “President Donald Trump will spend the next several weeks leading a public campaign in support of a tax overhaul while the White House leaves Republican lawmakers to hash out details of the plan, National Economic Council Director Gary Cohn said in an interview with the Financial Times.” Trump will kick off this campaign on Wednesday in a speech in Missouri.

(2) Outline. The FT article reported that Cohn and Treasury Secretary Steve Mnuchin have been meeting with key Republican lawmakers and have come up with a “skeleton” agreement. Now it is up to the House Ways and Means Committee “to put flesh and bone on it, and they will do it next week when the House comes back into session,” Cohn said.

(3) Untouchables. Cohn also told the FT that “the plan would preserve three of the biggest deductions for individuals: on charitable donations, mortgage interest payments and retirement savings. It would raise the standard deduction cap that applies to most tax filers, but would eradicate many other personal deductions, he said, adding that the White House also wanted to get rid of ‘death taxes,’ Republican terminology for estate taxes, which will face resistance from Democrats.”

US Economy: High Stakes. In my California meetings, there was general agreement that the economic expansion could last for a very long time if it remains subpar so that inflation remains subdued. That’s the obvious implication of the Four Deuces scenario. Since we all know that comfortable consensus scenarios tend to turn uncomfortably wrong, we spent some time discussing how a boom-bust scenario might unfold. With Washington playing a high-stakes game of poker with the economy, we came up with two possible alternatives to the Four Deuces that could take back some of the stock market’s winnings:

(1) An ace and a joker. If the Republicans do pull the elephant out of the hat on tax reform, it is likely to be revenue-neutral. However, if the tax-reform package includes any significant tax break that leads to a significant repatriation of overseas earnings (say, anywhere between $1 trillion and $2 trillion), that deluge could be very stimulative no matter whether the proceeds are used to hire workers, expand capacity, buy back shares, and pay dividends—and for M&A. That might stimulate an inflationary boom and a stock market melt-up that would force the Fed to tighten monetary policy more aggressively, which could trigger a recession—and a bear market.

(2) Joker is wild. The path of least resistance for stock prices has been higher since the start of the bull market in early 2009. Along the way, there have been a few significant corrections. There hasn’t been one since the 13.3% drop in the S&P 500 from November 3, 2015 through February 11, 2016 (Fig. 1). There have been a few panic attacks since then, but they didn’t last more than a few days (Fig. 2). There has been some concern about the narrowing breadth of the stock market advance in recent months, with large caps leading the latest advance while small caps have stumbled (Fig. 3 and Fig. 4).

This development may reflect the big inflows into the big equity ETFs, which are mostly market-cap-weighted. If these inflows continue at a record pace, they could cause a stock market melt-up. Tax incentives to repatriate overseas earnings could also trigger a stock market melt-up. Such an advance would be on sounder fundamental footing if it were based on a corporate tax cut that would boost after-tax corporate earnings.

A melt-up could stimulate an inflationary economic boom, which presumably would set the stage for an economic bust. Or else, it might simply set the stage for a stock market meltdown that would be short-lived if the economy remains on the 2-2-2-2 course.

(3) Flush. The most plausible scenario might be something like what happened in 1987, when a melt-up was followed by a meltdown. Back then, the bear market was relatively short, lasting just 101 days from August 25 through December 4, with the S&P 500 falling 33.5% (Fig. 5). The market recovered relatively quickly, rising to a new record high on July 26, 1989. That happened because the economy continued to grow despite the meltdown. There was no recession. S&P 500 forward earnings rose throughout the selloff (Fig. 6).

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Material Improvement

August 24, 2017 (Thursday)

 

Strategy: Big Apples & Small Oranges. The Russell 2000’s poor performance is one of the key items that has the bears growling lately. The small-cap stock index is up a mere 1.1% ytd through Tuesday’s close compared to the S&P 500’s 9.5% gain ytd. Likewise, the Russell 2000 is off 5.4% from its July high, while the S&P 500 is only 1.1% off its highest level (Fig. 1).

The underperformance of small-cap stocks can sometimes foreshadow an economic downturn. But the Russell 2000’s lackluster returns may have less to do with economics and more to do with politics and sector weightings.

The Russell 2000 rallied 13.6% in the wake of President Trump’s election through yearend 2016 on hopes that the new administration would push through tax cuts. Many small-cap stocks are domestically focused and have higher tax rates than large, international companies that can shelter their earnings in jurisdictions with low tax rates. Over the same period, the S&P 500 rallied only 4.6% and the Russell 1000 rallied 4.8%.

The P/E on small-cap stocks rose sharply—roughly three points—from the election into early December. Conversely, the multiple on large-cap stocks rose by only 0.7 point (Fig. 2). As 2017 ensued, and the debate over healthcare reform derailed any quick reduction to tax rates, the gains in small-cap stocks stalled.

The underperformance of the Russell 2000 can also be attributed to its sector weightings, which differ from the sector weightings in the S&P 500 in some very important ways. For example, the Russell 2000 had a 14.1% weighting of Technology stocks as of June 30. That’s far less than the 23.3% weighting of Tech in the S&P 500 (Fig. 3). Tech has been the S&P 500’s top-performing sector, returning 23.0% ytd. So the Russell’s lower exposure to Tech would weigh on the index’s returns.

Another big difference in the sector weightings is in the Financials sector. The Russell 2000 has a 26.3% weighting to Financials, while the S&P 500 has a 14.5% weighting (Fig. 4). Being more exposed to Financials may be deleterious to the Russell as the S&P 500 Financials have underperformed, returning only 6.3% ytd, below the S&P 500’s 9.5% ytd return.

There are a couple of other differences between the two indexes, but they are much more minor. The S&P 500 has more exposure to Consumer Staples (8.7%) than the Russell 2000 does (2.4%), and there’s no break-out for Telecommunications or Real Estate in the Russell 2000, but they do have 2.2% and 2.9% weightings, respectively, in the S&P 500. The S&P 500 Telecom sector has lost 10.3% ytd, but the Real Estate sector has gained 4.8% and Staples is up 7.1%.

If tax reform had returned to the front burner and if the Russell had more exposure to Tech and less to Financials, the index would be having a better year and bears would have less to growl about.

Industry Focus: Materials Matter. Anyone who bought metals over the past year has certainly been smart and lucky, as good times have returned to the commodities markets. Prices are up, and miners are flush (Fig. 5). It’s the latest sign that the global economy is growing nicely.

Jackie admits: “Anytime I come across a penny—especially if it’s heads up—I feel compelled to pick it up. It doesn’t matter that it won’t pay for a piece of penny candy anymore. I just hope it will bring good luck my way.” Ancient civilizations can supposedly be thanked for this widespread superstition. They believed metals were gifts from the gods and protected against evil. Hence, the popularity of horseshoes over doorways, charm bracelets, and good luck coins. Given her attraction to things metallic, I asked Jackie to dig deeper into recent developments in the S&P 500 Materials sector. She reports on how far it has come from the dark days of 2015:

(1) What’s up. The CRB raw industrials spot index has risen 4.3% ytd through Tuesday’s close and 29.3% from its 2015 low, driven higher by both precious and industrial metals (Fig. 6).

(2) Dollar doldrums. Metals undoubtedly have benefitted from the weak dollar. The JP Morgan trade-weighted dollar index has fallen 7.9% from its January 11 peak (Fig. 7). The global economy has been relatively strong. Most recently, the Purchasing Managers Manufacturing Index in advanced economies came in at 54.0 in July, and it stood at 50.9 in emerging economies (Fig. 8).

(3) Emerged. The Emerging Markets MSCI stock price index has risen almost in lockstep with the CRB raw industrials spot price index. The MSCI Emerging Markets index has risen 24.4% ytd in dollars and 39.1% from its 2015 low (Fig. 9). This suggests that emerging economies are emerging again.

(4) Minting money. Higher metals prices have meant a return to profits for mining companies. Glencore—which produces coal, copper and zinc—reported a $2.5 billion gain for the first six months of this year compared to a $369 million loss last year. “Rio Tinto PLC reported a net profit of $3.3 billion in the first half, up from $1.7 billion a year earlier, fueled by a 25% gain in revenues,” reported a 8/10 WSJ article. “Anglo American PLC reported first-half net income of $1.4 billion, compared with a net loss of $813 million last year.”

Companies have used much of their cash flow to repair their balance sheets by reducing debt levels that were menacingly high during the downturn in commodity prices. “As of June, BHP, Rio Tinto, Anglo and Glencore collectively held net debt of about $44 billion, down about 50% from the end of 2014, according to a review of their earnings reports,” reported a 8/22 WSJ article.

The S&P 500 Materials sector is expected by analysts to generate 5.9% revenue growth and 13.9% earnings growth over the next 12 months, soundly above the 10.8% earnings growth that the S&P 500 is expected to deliver over the same period. The industries in the Materials sector that offer earnings growth prospects that are faster than the S&P 500’s expected earnings growth include: Copper (78.4%), Construction Materials (31.4), Steel (27.5), Fertilizers & Agricultural Chemicals (22.1), Metals & Glass Containers (19.2), Paper Packaging (18.8), and Specialty Chemicals (12.8).

Improved earnings have propelled the stocks of the metals and mining companies over the past year, as many of them defied calls of their untimely deaths and bounced off lows of early in 2016. Here are the amazing one-year stock performances of some of the sector’s largest players through Tuesday’s close: Glencore’s ADRs rallied 85.2%, Anglo American’s ADRs (52.7%), Rio Tinto’s ADRs (46.0), BHP Billiton’s ADRs (30.8), and Freeport-McMoRan (27.4).

It’s only when you look back five or even 10 years that it becomes clear how far these names fell in the commodities recession of 2014 and 2015. Even after the amazing run over the past 12 months, these stocks all are still in negative territory measured over five years: Glencore’s ADRs (-18.6%), Anglo American’s ADRs (-44.8), Rio Tinto’s ADRs (-2.9), BHP Billiton’s ADRs (-36.0), and Freeport-McMoRan (-57.4). As long as global growth continues, these stocks will continue build on their recovery.

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Out West & Down South

August 23, 2017 (Wednesday)

 

Industries: That’s Entertainment. I am visiting our accounts on the West Coast this week. They are all institutional investment managers. None of them are in the entertainment business. However, to take me around town in Los Angeles, I always hire the same limo driver, who once had a role as a Klingon on the television hit series “Star Trek.” He always brags about the Hollywood stars he drove around in recent months. Silicon Valley is also star-struck. The largest tech titans are spending billions to become movie moguls to gain more subscribers. Apple is the latest to announce it’s willing to spend big bucks, following in the footsteps of Netflix and Amazon.

It’s not like the entertainment industry was starved for capital. Traditional Hollywood types—like Disney, 21^st Century Fox, CBS, and many others—have deep pockets that funded the industry for years. But now the competition has hit a frenzied level that has left the studios scrambling, the talent calling the shots, and consumers with plenty of choice. I asked Jackie to have a look at the business of show business from her home office on the East Coast. She has done so once before this year. Here is her Take #2 on the disruptive impact that Silicon Valley is having on this industry:

(1) Apple takes a bite. The 8/16 WSJ reported that Apple plans to spend roughly $1 billion to buy and produce original content over the next year in an effort to fill its streaming-music service or possibly launch a new video-focused service. That follows the company’s move in June to hire Jamie Erlicht and Zack Van Amburg from Sony to oversee its content acquisition and video strategy.

Apple appears to be cracking open its sizable piggy bank because its iTunes business may be in danger of becoming passe. “Apple’s existing video business—movie and TV-show rental via iTunes—has been challenged by the rise of Netflix and other video-subscription services that charge a monthly fee. Last year, iTunes generated an estimated $4.1 billion in revenue, but its share of the movie rental-and-sales market has dropped below 35% from about 50% in 2012,” the WSJ reported.

Meanwhile, Netflix and Amazon strike deal after deal to create more content. Amazon struck an agreement to stream Thursday Night Football games for about $50 million, or five times what Twitter paid the NFL for the rights to stream the games last year, noted a 4/5 Los Angeles Times article. Earlier this month, Netflix bought comics publisher Millarworld, which includes comic book writer Mark Millar and the many characters Netflix hopes to turn into TV shows and movies.

(2) Talent wars heat up. It takes a lot of humans to create all this content, so times are good for Hollywood producers and talent. Netflix entered into an exclusive agreement with Shonda Rhimes, who previously had worked with ABC, where she created “Scandal” and “Grey’s Anatomy.” It also lured David Letterman out of retirement with a deal to do a six-episode talk show next year. And Amazon struck a development pact with Robert Kirkman, creator of AMC Network’s “The Walking Dead.”

“Netflix’s heavy spending continues to raise eyebrows in Hollywood. It often doubles salaries to lure talent away from traditional players. The company’s spending on new and acquired programs is expected to be more than $6 billion this year, compared with $5 billion a year ago. That is more than twice what HBO spends and five times as much as 21^st Century Fox’s FX or CBS Corp.’s Showtime,” an 8/14 WSJ article observed.

(3) Old media fights back. With the tech titans looming large, the old dogs of media are learning new tricks. They’re attempting to stream their entertainment directly to consumers, cutting out the middlemen like Netflix, Amazon, and the cable and satellite operators.

Time Warner’s Turner Sports is launching a direct-to-consumer subscription service that will air the Union of European Football Associations’ Champions League and Europa League soccer matches, noted an 8/17 WSJ article. The move followed Disney’s announcement that it plans to create a subscription streaming service that would bring ESPN and its entertainment programing directly to consumers. CBS also plans to stream a digital sports service, in addition to the news service and CBS network programing that it already streams to consumers.

(4) Earnings and valuation. These various players, each attempting to bring TV shows and movies to our big and little screens, are in very different industries with very different growth and valuation profiles.

The S&P Movies & Entertainment industry includes Disney, Fox, Time Warner, and Viacom. Its stock price index has fallen 1.2% ytd through Monday’s close, making it essentially flat over the past two years (Fig. 1). The industry is expected to grow revenues by 5.0% and earnings by 8.5% over the next 12 months, yet it has a below-market P/E of 14.8 (Fig. 2 and Fig. 3).

The S&P 500 Cable & Satellite stock price index—which contains Charter Communications, Comcast, and DISH Network—is up 22.3% ytd (Fig. 4). Analysts forecast that the industry will produce revenues growth of 7.2% and earnings growth of 14.7% over the next 12 months (Fig. 5). For that slightly faster earnings growth, the industry boasts a forward P/E of 24.1, which is near its all-time high (Fig. 6).

Netflix and Amazon both are part of the S&P 500 Internet & Direct Marketing Retail industry along with Expedia, Priceline, and Trip Advisor. That industry’s index is up 26.9% ytd (Fig. 7). Analysts see the industry producing revenue growth of 21.7% and earnings growth of 32.5% over the next 12 months (Fig. 8). For that astronomical growth, investors bestow a 68.7 forward P/E on the industry (Fig. 9).

Mexico: Not Trump’s Chump. The closest I will get to Mexico on this business trip is Newport Beach, California. Mexico is among the strongest-performing markets this year, evidenced by the 30.2% advance ytd of the MSCI Mexico Share Price Index in dollars through 8/21. In contrast, the S&P 500 has advanced 8.5% (Fig. 10).

Yes, Mexico. That’s the same Mexico that President Trump loves to vilify and berate and threaten to wall off from the US. Through Q2, the second-largest economy in Latin America has produced 16 straight quarters of economic growth, witnessed its exports climb to a record high of $198 billion, and created a record number of jobs as well.

That’s the Mexico that came to the table last week, joining teams from Canada and the US, to renegotiate the 23-year-old North American Free Trade Agreement, or NAFTA, which directs $1 trillion of trade among the nations. Though enacted into law in January 1994 under President Bill Clinton, the agreement was formulated a few years earlier under the administrations of President George H.W. Bush, Canadian President Brian Mulroney, and Mexican President Carlos Salina.

President Trump made scuttling NAFTA and other trade agreements a centerpiece of his election campaign, railing against trade deficits. Only more recently has he softened his tone and adopted a more conciliatory attitude. In a meeting with Mexican President Enrique Pena Nieto at a two-day Group of 20 economic summit in Hamburg, Germany on July 7 and 8—their first since Trump won the election—Trump called Nieto his “friend” and described making “very good progress” in their discussions of NAFTA, according to a 7/7 Reuters article.

While Trump’s success in November promptly led to a selloff in the Mexican peso, driving it to record lows against the US dollar on fears that foreign investment would shrivel up, business conditions and monetary policy have combined to lift the peso to its highest levels in more than a year. It is now ranked among the best-performing currencies against the US dollar y/y and ytd (Fig. 11 and Fig. 12).

The opening round of the NAFTA talks gives us a good excuse to examine more closely the health of the Mexican economy (Fig. 13). While the Mexican stock market appears fairly valued based on its forward P/E of 17.2 compared with a forward earnings growth rate of 14.2%, forward earnings estimates have been rising (Fig. 14). That, along with a surprising resiliency and strong consumer momentum, could lead to continued upside. Viva Mexico! I asked Sandy Ward—who, like Jackie, is an alumnus of Barron’s—to update us on the fiesta south of the border:

(1) GDP. The economy grew faster than expected in the June quarter, up 0.6% q/q compared with an estimated 0.2%. On a y/y basis, it met expectations with a gain of 1.8% (Fig. 15). But that was a marked deceleration from Q1 growth of 2.8%. Much of the strength came from the service sector, up 3.2% y/y but slightly diminished from the 3.7% delivered in Q1.

Robust consumer spending played a big role in driving the services sector higher. Consumer confidence continues to rebound from the depths to which it had sunk after Trump’s election. The seasonally adjusted index hit a y/y high in July of 86.6, up from 85.1 in June. Newfound optimism surrounding the NAFTA renegotiations and a vastly improved employment picture go a long way to explain the positive consumer sentiment.

Also, remittances from the US, an important source of income for Mexicans, have been showing steady gains, rising 4.5% y/y in June after a 4.3% gain in May. In a notable recent shift, the number of transactions has dropped, but the average value of the remittances increased for the fifth straight month, according to an 8/2 FocusEconomics report—an indication that wages are rising for Mexican workers in the US. That perhaps explains the keen demand for big-ticket items, despite a sharp rise in inflation.

(2) Exports. Mexican exports showed powerful gains in the first six months of the year, increasing 10.4% y/y, according to a 7/28 article in the FT based on statistics from Mexico’s National Institute of Statistics and Geography (Fig. 16). Manufacturing exports took the lead, rising 9.2% y/y, buoyed by automotive exports (finished cars and auto parts), which were up 10.9% y/y. A jump in the value of oil exports also helped as the category surged 30.5% y/y in the first half to $10.6 billion. Total exports to the US were up 7.7%, accounting for 82.2% of Mexican exports.

Automotive exports to the US—Mexico’s No. 1 export category to the US—expanded by 9.8% and represent 76.8% of the total of exports to the US. Those figures go hand in hand with record-setting auto production numbers: In June, production of light vehicles reached 334,606, up 4.9% y/y. For the first half of 2017, 1,884,315 vehicles were produced, for a gain of 12.6% y/y. In a twist of fate, concerns about the future of NAFTA have resulted in increased trade flows between the US and Mexico, according to the 7/28 FT article.

(3) Imports. Mexico imported about as much as it exported in the first half of 2017: Imports expanded by 7.8% to $200 billion. Electrical machinery and equipment and computers are the top one and two import categories. The third-biggest and fastest-growing category: vehicles.

(4) Industrial production. Manufacturing output was the bright spot in an overall weak June report, up 2.7% y/y (Fig. 17). Mining production plummeted by 7.6% y/y, and utilities had a 0.9% drop in output. The construction sector stayed stable.

(5) Foreign investment. After slumping sharply in Q4-2016, foreign investment in Mexico rebounded in Q1 to $7.9 billion. Continued gains are likely following reforms that have opened the energy sector to foreign firms coupled with significant new offshore oil discoveries that are creating excitement. The Italian oil group Eni has made two substantial finds in the shallow-water Amoca field since early this year, and a consortium including Houston-based Talos Energy, Mexico’s Sierra Oil & Gas, and the UK’s Premier Oil & Gas has uncovered one of the largest shallow-water oil field finds in the past 20 years, according to a report in the 8/16 FT.

Vista Oil & Gas, Mexico’s first special-purpose acquisition company, raised $650 million earlier this month in the country’s third-largest IPO since 2015, notes an article in the 8/10 FT. The offering proceeds exceeded expectations. Vista is backed by Miguel Galuccio, former CEO of Argentina’s YPF, and Riverstone Holdings, a private equity firm and energy specialist. Earlier this month, Zuma Energia—a Mexican renewable energy group 80% owned by the UK-based private equity firm Actis—secured $600 million in project financing to build Mexico’s largest wind farm, reported an 8/8 FT story.

In May, automotive supplier Lear Corp. opened its 45^th plant in Mexico in Zacatecas, investing $21 million and hiring 1,300 workers, according to a 5/20 Mexico Now story. It plans to spend an additional $9.5 million to expand the facility and add another 600 jobs in 2018. In the past four years, Lear has opened 11 plants in Mexico and estimates that it will employ 56,000 workers by the end of this year.

Walmex, as Walmart de Mexico is known, announced in December that it planned to invest $1.3 billion over the next three years to improve its logistics infrastructure, build new distribution centers, expand existing ones, and add 10,000 permanent new jobs, according to a 12/7/16 Reuters report. Said CEO Guilherme Loureiro, “We are convinced that Mexico is a country rich in opportunities,” noting that Walmart has invested $2.6 billion in Mexico in the previous four years.

(6) Jobs. The unemployment rate is at the lowest level in more than a decade as Mexico creates jobs at a record pace, according to a 7/18 Bloomberg report (Fig. 18). Labor law changes, creating more flexibility in contracts and more accountability in corporate payrolls, have led to 517,000 Mexican workers gaining access to social security in the first half of this year, up 17% from the same period in 2016 and the most in at least two decades.

The formalization of job arrangements provides workers with health and retirement benefits. The percentage of workers in the so-called “informal” economy—including artisans, construction workers, vendors, and domestic workers—continues to shrink and is now estimated at 57.2% compared with 58.0% in 2016 and 60.0% in 2009 at the height of the global financial crisis. Importantly, the formally registered workers are responsible for three-quarters of Mexico’s economic production, according to a 12/17/16 Associated Press article, based on data from Mexico’s National Statistic Institute.

(7) Inflation. After the Bank of Mexico raised its overnight interest rate to 7% in June, the seventh straight increase since September 2016, the central bank suggested that it was done tightening, according to a 6/22 WSJ story (Fig. 19). The rate hikes were a response to US rate increases and designed to give a boost to the peso as well as respond to a government-ordered 20% hike in gasoline prices that, in turn, drove transportation costs higher (Fig. 20). Despite the rise in inflation, consumers are confounding economists by continuing to spend.

Rose-colored glasses may be the best for viewing Mexico at this juncture. What’s that they say about success being the best revenge?

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Après L’Eclipse

August 22, 2017 (Tuesday)

 

Strategy: The Sun Also Rises. The Sun Also Rises is a novel written by Ernest Hemingway in 1926 about a group of American and British expats who travel from Paris to the Festival of San Fermín in Pamplona, Spain to watch the running of the bulls and the bullfights. The bulls have certainly had a great run in the stock market since March 9, 2009. The S&P 500 is up 258.9% since then. It’s up 32.8% from last year’s low on February 11. It’s up 8.5% ytd.

The latest record high was made on August 7, with the S&P 500 down just 2.1% since then. Yet every time that the bull stops charging ahead, the bears start growling that a major correction is imminent, which could turn into a serious bear market. Many of them are particularly good at finding bearish omens in the market’s technical indicators.

Yesterday, everyone in America was watching the running of the solar eclipse from the West Coast to the East Coast. Despite all the excitement, or maybe because of it, the stock market shrugged it all off. Perhaps that’s because there is no folklore about the usefulness of eclipses as omens of the future.

When all else fails, there is always the “Hindenburg Omen.” On Friday, Associated Press reported that it has been sighted. The market has the potential to crash when both the number of securities that form new 52-week highs and the number of securities that form new 52-week lows are greater than 2.2% of the total number of issues that trade on the NYSE (for that specific day).

Also on last Friday, The Street reported that 177 stocks hit new 12-month highs, while 226 fell to new 12-month lows. It warned that this “terrifying stock market indicator” means that investors should “stay vigilant and be ready to move as the price action continues.” The omen supposedly works best after flashing a few times. Omen watchers say there has been a rash of them in recent days. One of these spotters has counted 74 of them so far in 2017, second only to 78 recorded in November 2007.

You have been warned. However, it’s obvious that the running of the bulls since March 9, 2009 has run over lots of bearishly inclined market technicians. Consider the following:

(1) Moving-average watchers have seen plenty of (obviously bearish) “Death Crosses”—when the 50-day moving average of the S&P 500 fell below the 200-day moving average—along the way, just before they were killed by the latest stampede to higher ground (Fig. 1). The 200-day moving average of the S&P 500 continues to rise, with the 50-dma stumbling a bit recently but remaining above the 200-dma (Fig. 2).

(2) Market-cap watchers regularly manage to find ominous divergences in their charts. They compare the equal-weighted S&P 500 to the market-cap weighted version of the index (Fig. 3 and Fig. 4). They’ve warned that the ratio of the two has been declining all year, showing that large-cap stocks are outperforming smaller-cap ones. They gave us a similar warning during 2015 just before the market’s latest advance started early last year.

(3) Breadth watchers tend to get especially alarmed when an advancing stock market is led by fewer and fewer stocks. It’s happening again now. At the end of last week, 65.6% of the S&P 500 stock price components were up on a y/y basis, down from a recent peak of 89.8% on February 10 at the start of the year (Fig. 5). Not surprisingly, this measure is highly correlated with the percentage of S&P 500 companies trading above their 200-day moving averages (Fig. 6). This indicator fell sharply recently to 59.6% on Friday, down from 64.6% the previous week.

Strategy II: The Sun Will Come Out Tomorrow. Eclipses come and go. Yet the sun is always shining even at night, on the other side of our planet. We take the sun for granted except for on days like yesterday when it played peekaboo with the moon. The sun is pretty amazing. It’s a star that is almost three-quarters hydrogen, with the rest mostly helium. Lucky for us Earthlings, it is brighter than 85% of the stars in the Milky Way. It’s hot up there, with the sun’s core around 15 million Celsius. It’s a bit cooler in the photosphere (5,500 degrees C) and the chromosphere (4,320 degrees C). The latter could be seen as a red rim around the sun during yesterday’s eclipse. The sun's light and heat take about eight minutes to reach us.

Fortunately, Joe and I don’t need to comment on the cosmic meaning of life. Currently, we are doing our best not to get blinded by dark technical sightings that some seers have observed. We continue to focus on the fundamentals, which remain bullish. As we noted on Monday, the Q2 earnings season was a good one:

(1) Forward earnings. Auguring well for the July-September earnings season, S&P 500/400/600 forward earnings continued to rise in record-high territory through the week of August 10 (Fig. 7). The earnings estimates for 2018 continue to hold up remarkably well, which is a big arithmetic plus for forward earnings, since it is a time-weighted average of consensus earnings estimates for the current year (2017) and the coming year (2018). The same can be said of S&P 500/400/600 forward revenues, which also are rising in record-high territory across the board (Fig. 8).

(2) Earnings hooks. The traditional earnings hooks were visible during the Q2 earnings season as results turned out to be better than estimates at the beginning of the earnings season (Fig. 9).

(3) Outlook. Joe and I need to tweak our S&P 500 earnings-per-share estimate. We are raising it from $130 to $131. The outlook for 2018 depends a lot on the prospects for the Trump administration to focus on tax reform. Most Washington watchers seem to have concluded that not much can be done or will be done. Given how badly the Republicans have failed to pass any Republican agenda item despite their majorities in both houses of Congress, they might be under a lot of pressure to give the voters something good before the mid-term elections next year. That would be tax reform.

Our S&P 500 earnings forecast for 2018 is $136.75 assuming no reduction in the corporate tax rate. It is currently set at a statutory rate of 35.0% (Fig. 10). However, Joe observes that the effective rate fell from 27.5% in 2015 to 26.4% last year (Fig. 11). Here are our estimates at lower statutory rates—assuming that they are also the effective rates, with the elimination of deductible expenses as a quid pro quo for the lower tax rate: $141.50 (20% rate) and $150.00 (15% rate).

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Eclipse

August 21, 2017 (Monday)

 

The Fed I: Lurking in the Shadows. Don’t look up at the eclipse today while you are driving. That’s just common sense. Get out of stocks when they are overvalued, especially when P/E multiples eclipse earnings. That’s common sense too, but it makes more sense if stocks are overvalued and a recession is lurking over the horizon. Stocks may be overvalued, but it’s hard to discern a recession in the foreseeable future. It isn’t hard seeing earnings continue to rise in record territory. So any sell-off is more likely to be yet another panic-attack correction rather than the beginning of a bear market.

The S&P 500 dropped sharply, by 1.5%, on Thursday last week. The financial press blamed the latest brouhaha in the White House for the selloff. Melissa and I think it had more to do with the July 25-26 FOMC minutes released on Wednesday. Fed officials are suddenly focusing on “financial stability.”

The phrase appeared just four times in the minutes of the June 13-14 FOMC meeting. It appeared eight times in the latest minutes, with a lengthier discussion of this topic than in the recent past. Perhaps Fed officials are all getting excited about going to their annual conclave at Jackson Hole this week, from Thursday through Saturday. The topic this year is “Fostering a Dynamic Global Economy.” Fed Chair Janet Yellen, who might be singing her swan song, is scheduled to speak on Friday and focus on, you guessed it, financial stability.

During their meeting in late July, the FOMC participants did something they rarely do—they “considered equity valuations in their discussion of financial stability.” Such attention by the Fed should make stock investors nervous. However, the discussion must have been fairly brief and benign. This was the gist of what was said on this subject per the minutes:

(1) “According to another view, recent rises in equity prices might be part of a broad-based adjustment of asset prices to changes in longer-term financial conditions, importantly including a lower neutral real interest rate, and, therefore, the recent equity price increases might not provide much additional impetus to aggregate spending on goods and services.”

(2) “A couple of participants noted that favorable macroeconomic factors provided backing for current equity valuations; in addition, as recent equity price increases did not seem to stem importantly from greater use of leverage by investors, these increases might not pose appreciable risks to financial stability.”

That’s not very threatening to the bull market. There was more concern expressed about a potential jump in bond yields: “A number of participants pointed to potential concerns about low longer term interest rates, including the possibility that inflation expectations were too low, that yields could rise abruptly, or that low yields were inducing investors to take on excessive risk in a search for higher returns.”

It sure doesn’t sound like the Fed is about to tighten monetary policy for the sake of restoring financial stability in the stock market, i.e., to push valuations lower. Quite the opposite, the minutes suggested that Fed officials remain puzzled by how low inflation remains, presumably giving some of them second thoughts about raising interest rates again anytime soon.

The Fed II: In the Dark. At the latest FOMC meeting, there was also a discussion about the Phillips Curve Model, on which policymakers rely heavily to predict inflation: “A number of participants noted that much of the analysis of inflation used in policymaking rested on a framework in which, for a given rate of expected inflation, the degree of upward pressures on prices and wages rose as aggregate demand for goods and services and employment of resources increased above long-run sustainable levels.” However, the model isn’t working, as noted in the minutes: “A few participants cited evidence suggesting that this framework was not particularly useful in forecasting inflation.”

Yet just because it isn’t working doesn’t mean they won’t continue to believe in it: “However, most participants thought that the framework remained valid, notwithstanding the recent absence of a pickup in inflation in the face of a tightening labor market and real GDP growth in excess of their estimates of its potential rate.” How does a model that isn’t working remain valid? Easy, just come up with excuses for it to explain its temporary shortcomings. The following were ticked off in a short list of possible reasons:

(1) “a diminished responsiveness of prices to resource pressures”

(2) “a lower natural rate of unemployment”

(3) “the possibility that slack may be better measured by labor market indicators other than unemployment”

(4) “lags in the reaction of nominal wage growth and inflation to labor market tightening and restraints on pricing power from global developments and from innovations to business models spurred by advances in technology”

Additionally, “[a] couple of participants argued that the response of inflation to resource utilization could become stronger if output and employment appreciably overshot their full employment levels, although other participants pointed out that this hypothesized nonlinear response had little empirical support.”

Debbie and I pick Door #4. Intense global competition, proliferating technological innovations, and aging populations all are fundamentally disinflationary. Of course, this explanation for the failure of the Phillips Curve Model isn’t a temporary shortcoming but rather a total breakdown, suggesting that it is time to deep-six it.

Earnings: The Shining. Meanwhile, on the bright side, the earnings recession is over. S&P 500 operating earnings per share were eclipsed by the energy recession from Q4-2014 through Q2-2016, when the Thomson Reuters (TR) measure was flat to down on a y/y basis (Fig. 1). Growth resumed during the second half of 2016 and first half of 2017.

Joe has updated all of our chart publications with Q2 earnings data. He reports that the TR measure of earnings rose 10.1% y/y during Q2-2017 to a new record high, while revenues rose 5.7% y/y (Fig. 2 and Fig. 3).

That put the S&P 500 operating profit margin (based on TR data) at a record high of 10.8% (Fig. 4). “Ouch” is the sound you just heard from all those reversion-to-the-mean bears, who can go back to sleep. The 52-week forward outlook looks outstanding:

(1) S&P 500 forward revenues per share, which tends to be a weekly coincident indicator of actual earnings, continued its linear ascent into record-high territory through the week of August 10 (Fig. 5).

(2) S&P 500 forward operating earnings per share, which works well as a 52-week leading indicator of four-quarter trailing operating earnings, has gone vertical since March 2016 (Fig. 6). It works great during economic expansions, but terribly during recessions. If there is no recession in sight, then the prediction of this indicator is that four-quarter-trailing earnings is heading from $126 currently (through Q2) to $140 over the next four quarters.

Some sectors shone more brightly than others during Q2. Here is the y/y performance derby for the S&P 500 revenues growth (Fig. 7): Energy (14.3%), Tech (9.7), Industrials (7.8), S&P 500 (5.7), Utilities (5.3), Consumer Staples (4.8), Financials ex-Real Estate (4.4), Consumer Discretionary (3.5), Health Care (2.4), Real Estate (0.8), Materials (-1.4), and Telecom (-3.9).

Here is the same for earnings growth (Fig. 8): Energy (returned to a profit), Telecom (45.8%), Tech (34.3), S&P 500 (19.6), Utilities (14.2), Financials ex-Real Estate (13.0), Industrials (12.5), Health Care (8.6), Consumer Staples (6.7), Consumer Discretionary (1.9), Materials (-0.4), and Real Estate (-14.6).

Valuation: Too Close to the Sun. Now that we have S&P 500 revenues for Q2, we can calculate the ratio of the S&P 500 market capitalization to it, yielding a valuation measure that is very similar to the Buffett Ratio—which is the ratio of the market cap of all equities traded in the US except foreign issues to nominal GNP (Fig. 9). The former remains unchanged at 2.00 during Q2, matching the previous record high during Q4-1999. The weekly version of this price-to-sales ratio rose to 1.96 during the week of August 10 (Fig. 10). Valuation is certainly very close to the sun. However, it isn’t totally eclipsing earnings.

Movie. “Wind River (+ +) (link) is a murder mystery set in an Indian reservation in Wyoming. It’s well written. It is also well paced, taking the time to develop the lead character, who is well played by Jeremy Renner. It was filmed during the winter, and clearly demonstrates why Fed officials schedule their annual meeting in Jackson Hole, Wyoming late in August.

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Curbed & Unleashed Exuberance

August 17, 2017 (Thursday)

 

Retailing: Woes for Sale. Retail investors finally got a dose of good news yesterday. Target reported Q2 same-store sales that rose 1.3% y/y and upped its full-year EPS outlook to $4.34-$4.54, compared to the prior expectation of $3.80-$4.20. The shares rallied roughly 4% on the news.

That said, the rally barely dents the damage done this year to retail shares. Prior to Target’s report, a number of retailers slashed earnings targets and reported drops in same-store sales. The carnage in some of the industry’s leading stocks is truly shocking. Here are some of the worst performers ytd through Tuesday’s close: J.C. Penney -55.7%, Dick’s Sporting Goods (-49.4%), Advanced Auto Parts (-48.5), Macy’s (-43.3), L Brands (-40.7), Kroger (-33.0), and Target (-24.8). I asked Jackie to go shopping for bargains. She came back with the following cautionary tale:

(1) Two sources of grief. The retail sales report released earlier this week unequivocally proves that retailers can’t blame consumers, because consumers are spending what they earn and then some. Inflation-adjusted retail sales for the three months through July averaged 7.0% (saar) (Fig. 1). The problem comes down to two factors: over-expansion and Amazon.com. Occasionally, too much debt—often taken on to fund a leveraged buyout or stock buybacks—adds to the strain.

We discussed the glut in retail space just about a year ago (see our 8/18/16 Morning Briefing) and have been keeping a close eye on the amazing increase in Internet sales. It looks like the amount of goods sold by general merchandise stores has fallen so far that, if trends continue in the next year or two, the amount of goods sold by general retailers could be less than the amount of goods sold by Internet retailers (Fig. 2).

Ironically, strong Internet sales helped Target: Comparable digital channel sales grew 32% and contributed 1.1ppts to the overall company’s same-store sales.

“Target has been launching exclusive brands and sprucing up its stores in an effort to keep customers from being wooed away by” Wal-Mart Stores and Amazon.com, a WSJ article explained yesterday. The company also plans to buy a logistics-software company and test a same-day delivery program in New York.

That said, while Target’s total Q2 sales did improve 1.6% y/y, its costs jumped as well, so operating income before depreciation and amortization, interest expense, and taxes dropped by 6.9%. EPS increased 5.1% because the company’s diluted share count dropped 6.0% y/y. Nonetheless, its shares jumped liked a coiled spring.

(2) Closing for good. So far, outside of Internet retailing and home improvement sales, analysts remain gloomy on the industry. Here are analysts’ forecasts for the earnings growth of certain S&P 500 retail industries over the next 12 months: Department Stores (-4.2%), General Merchandise (1.1), Apparel Retail (6.6), Home Improvement (13.5), Specialty Stores (5.8), Automotive Retail (9.2), and Internet & Direct Marketing Retail (32.4) (Fig. 3, Fig. 4, and Fig. 5).

Some value investors are doing what they do best and scooping up shares that have been left in the sales bin. An 8/15 WSJ article reports that the Dodge & Cox Stock fund bought 5.4 million Target shares; Smead Value Fund also bought 220,000 shares of the general retailer. David Einhorn’s Greenlight Capital boosted its Dillard’s stake to 2.5 million shares in the quarter. And the T. Rowe Price Mid-Cap Value fund bought about 5.8 million shares of Kroger.

Earnings multiples in certain retail industries have compressed sharply over the past year. S&P 500 Home Furnishing Retail has a forward P/E of 7.3 compared to the 8.9 multiple it had a year ago; others with shrunken valuations include: Automotive Retail (14.4, 19.2), General Merchandise Stores (14.6, 16.5), and Apparel Retail (15.3, 19.0). Other P/E multiples in the industry have held their ground: Department Stores (10.3, 10.9), Apparel & Accessories (17.1, 17.2), and Home Improvement Retail (18.6, 19.4).

What could turn things around? Companies are shuttering stores at a pace that would normally imply a serious recession. Ytd, 5,630 store closures have been announced, up 175% y/y, according to retail analyst Deborah Weinswig, who expects the number will climb to 9,452 by yearend. If she’s on target, store closures this year will top those closed in 2008 by 361%. When enough stores have been shuttered—and capacity is taken out of the system—same-store sales will start improving.

Another alternative: Amazon could stub its toe. The Internet giant is expanding—and spending—in many different directions. It’s taking on its largest acquisition, the $13.4 billion purchase of Whole Foods. It’s also facing angry tweets from the POTUS.

So far, Amazon’s execution has been nearly flawless, witness the 60% jump in sales during the most recent Prime Day. But competing CEOs—and value investors—can always dream!

IPOs: Exuberant Offerings. There is lots of chatter about bubbles these days, and, unfortunately, they’re not the tiny ones Don Ho crooned about. While much of the bubble talk has centered on high stock multiples or low bond yields, we’d suggest taking a look at the new issue market. There are two bubblicious areas of note, and of course they have acronyms: SPACs and ICOs.

“SPAC” stands for “Special Purpose Acquisition Corp.,” which is sometimes referred to as a blank-check company. “ICOs” means “Initial Coin Offerings.” Together, both offerings have raised billions of dollars this year from investors who may not know what their money is buying. I asked Jackie to speculate on these developments. Here is her take:

(1) Blank checks. SPACs raise money in the IPO market just like traditional companies. The difference is a SPAC doesn’t have any operations. It has an investment management team who plan to use the proceeds from their IPO to purchase not-yet-identified businesses. Usually, those businesses are in an area of expertise for the managers.

Through the beginning of August, there have been 18 SPAC IPOs, which raised $5.5 billion, according to data from Renaissance Capital. That compares to 13 such IPOs raising $3.2 billion during all of last year and 20 deals raising $3.6 billion during 2015. The number of deals has been gradually increasing from the recession when none were priced in 2009 or 2010.

The previous peak in SPAC activity was in 2007, when 58 deals raising $10.7 billion hit the market. While the number of deals this year may not reach the prior heyday, the dollar amount raised could come close. This is concerning because ideally SPACs should raise and invest money when prices are low and they can make acquisitions on the cheap. However, when stock prices are low, investors aren’t usually brave enough to buy into a blank-check offering. High stock prices appear to embolden bravery at what may turn out to be exactly the wrong time.

(2) Minting money. Initial coin offerings, ICOs, are done in the world of crypto currencies. They’re often sold by organizations that have little more than a business plan, laid out in a white paper. Speculators are buying virtual coins, such as bitcoin, which typically don’t have rights to any profits or ownership in the business. They are betting that the coins will rise in value because they are issued in limited supplies, which seems to be their only selling point. This is an odd bet on demand getting stimulated by a shortage of this funny money. It might be a good bet if the demand is bolstered by criminal activity, like hacking “Game of Thrones” episodes for ransom to be paid in the coin of the virtual realm. The coins, or “tokens,” as they are sometimes called, can be traded on exchanges and held in a virtual wallet. No big bags of unmarked Benjamins are necessary to grease the criminal intents behind some of the demand for crypto currencies.

The SEC published on 7/25 an Investor Bulletin detailing the potential risks that investors face by participating in ICOs. The SEC also put issuers on notice that ICOs may be considered securities that are subject to federal securities laws. If they are securities, then they must be registered with the SEC.

If fraud does occur, the SEC warned that there may be limited recovery options because it’s hard to follow the flow of money that’s not being handled by banks. Issuers and exchanges can be overseas, and there’s no central authority governing the offerings. It would be hard for the SEC or other agencies to freeze or secure the funds because they are being held in encrypted accounts and not by a third-party custodian.

But investors/speculators are undeterred by the risks. An 8/12 article in the WSJ estimated that $1.3 billion was raised in ICOs ytd. That doesn’t include ongoing offerings (offerings can take place over a few weeks) or the additional 48 ICOs listed as coming to market between today and November 1, according to a listing on tokenmarket.net.

Deals are raising more than chump change. “Venture-backed startup Protocol Labs Inc. raised about $193 million for its Filecoin Network, according to the Filecoin website Saturday. The project, designed to create a marketplace for unused computer memory, raised about $187 million in the first hour Thursday and had earlier raised about $52 million from a group of venture capital investors,” the WSJ article stated.

Given the structure of the market, success begets more success. Because an interested investor first has to exchange dollars into ether or bitcoin to purchase an ICO, these deals are creating demand for ether or bitcoin. Ether has risen 3,536% ytd, and bitcoin is up 337% (Fig. 6). At some point, if the number of ICOs falls, a major source of demand for these crypto currencies will be declining. ICOs could stall if too many dollars are required to buy an ether or if too many of these business-plan companies fail to germinate. This complicated area with its own language seems to be filled with exuberance, and that rarely ends well.

Of course, “a proliferation of new limited-supply coin offerings” is an oxymoron.

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Pay Day

August 16, 2017 (Wednesday)

 

US Consumers: Alive & Well. We knew they had it in them. Consumers are spending money because they are earning good money. Our Earned Income Proxy (EIP) for wages and salaries in the private sector rose 0.5% during July and 4.6% y/y (Fig. 1). However, recent retail sales reports prior to the one released yesterday were relatively weak. As Debbie discusses below, yesterday’s report showed a solid gain of 0.6% m/m last month, with significant upward revisions for the previous two months. As a result, retail sales excluding gasoline rose 4.4% y/y, in line with the gain in our EIP (Fig. 2).

Debbie doesn’t like inflation. So she has a habit of inflation-adjusting retail sales, which also eliminates the impact of volatile gasoline prices. She observes that over the past three months through July, real retail sales rose 7.0% (saar), based on the three-month average, the best gain since March 2015 (Fig. 3).

The folks who update the Atlanta Fed’s GDP-tracking model reported yesterday: “The GDPNow model forecast for real GDP growth (seasonally adjusted annual rate) in the third quarter of 2017 is 3.7 percent on August 15, up from 3.5 percent on August 9. The forecast of the contribution of personal consumption expenditures to third-quarter real GDP growth increased from 1.91 percentage points to 1.97 percentage points after this morning's retail sales release from the U.S. Census Bureau.”

These developments confirm our hunch that the Bureau of Labor Statistics (BLS) has been underestimating wages and salaries in personal income in recent months. So we still expect the data to be revised higher.

Wages: Mixed Bag. As we have noted before, while wage growth has been sluggish, it is still outpacing consumer price inflation. Strong employment gains have also been boosting inflation-adjusted incomes. Sluggish wage growth has been one of the major reasons why the FOMC has been normalizing monetary policy at a sub-normal pace. It has remained weak even as the labor market has tightened. While it isn’t an official target, Fed Chair Janet Yellen started saying in early 2004 that she expected to see hourly wages growing in a range of 3%-4% y/y as the labor market continued to tighten.

The most widely followed gauge of wage inflation, based on Average Hourly Earnings (AHE) for all private-sector workers, has continued running below 3.0% since May 2009, notwithstanding Yellen’s expectations that it would be higher by now (Fig. 4). The data are available since March 2007 for all workers and since January 1965 for production and nonsupervisory workers.

But that’s not the only measure of wage inflation. The Atlanta Fed’s Wage Growth Tracker (WGT) is already at Yellen’s target range. In fact, it has been consistently rising faster than 3.0% since November 2015 (Fig. 5). So this provides one good answer to the question: Why has wage growth been so sluggish? It hasn’t been, according the WGT, which is available since March 1983. This measure has usually outpaced the wage inflation rate based on AHE for all production and nonsupervisory workers, which is also available that far back so we can compare the two.

I asked Melissa to have a closer look to see if there is an apples-and-oranges issue when comparing AHE and WGT. She found that an important compositional factor is reflected in the monthly WGT but not in the other widely followed measures, including the monthly AHE as well as the quarterly Employment Cost Index (ECI). Consider the following:

(1) Simple AHE. The AHE is defined as follows: “To establish average hourly earnings, the reported payroll is divided by the reported worker hours for the same establishments,” according to the BLS’ Handbook of Methods, Chapter 2. That’s a simple definition, but it might be too simple.

(2) Weightier ECI. Though obviously less timely, the ECI, also released by BLS, is considered a more accurate measure of wage inflation than the AHE. The BLS explained in a note: “The Employment Cost Index (ECI) measures the change in the cost of labor, free from the influence of employment shifts among occupations and industries.” How so? Without getting too technical, the BLS Handbook of Methods, Chapter 8, notes that the ECI “is simply a weighted average of the cumulative average wage changes” within “a narrowly defined set of workers.” Though occasionally refreshed, the index weights are fixed.

The AHE and ECI wage inflation rates tend to cycle in a similar fashion, though they have occasionally diverged owing to the few differences in the ways they are calculated (Fig. 6). However, even the ECI inflation rate has been below 3.0% since Q3-2008 despite the tightening of the labor market.

(By the way, the ECI also happens to have a series including benefits. For comparability purposes, the wages & salaries component is relevant here because the AHE doesn’t include benefits.)

(3) In & out. Importantly, neither the AHE nor the ECI addresses a different compositional interplay: labor force shifts between workers who recently entered the labor force and those who recently exited it.

In a March 2016 Economic Letter, San Francisco Fed economists explained: “In particular, while higher-wage baby boomers have been retiring, lower-wage workers sidelined during the recession have been taking new full-time jobs. Together these two changes have held down measures of wage growth.”

They observed that the problem gets worse in times when labor force shifts are paramount. For example, “[a]s baby boomers have begun to retire, the fraction of exits occurring from above the median wage has gotten larger, reflecting the relatively high earnings of older workers. The exits from full-time employment of older, higher-paid retirees have also pushed down wage growth. Furthermore, with so many of this generation still to retire, the so-called Silver Tsunami will be a drag on aggregate wage growth for some time.” But the silver lining is that maybe traditional measures of aggregate wage growth don’t make sense in times like these.

(4) Unique WGT. WGT measures the wage growth of continuously employed unique workers, discounting the impact of people entering and exiting the workforce. Interestingly, the WGT seems to track the quarterly ECI more closely than the monthly AHE does (Fig. 7).

Unlike other wage measures that compute an average based on wage levels, the creative folks at the Atlanta Fed used a distribution of wage growth for the WGT. Think of the WGT as the middle data point in the distribution of a wage growth sample—that is not the same as the growth of the middle wage! So the WGT cannot tell us anything about wage inequality, but it can tell us what the same workers are experiencing over time.

According to the Atlanta Fed’s website, the WGT “is the time series of the median wage growth of matched individuals. This is not the same as growth in the median wage. Growth in the median wage represents the experience of a worker whose wage is in the middle of the wage distribution in the current month, relative to a worker in the middle of the wage distribution 12 months earlier. These would almost certainly include different workers in each period.”

To determine the WGT median series, the number crunchers at the Atlanta Fed first compile individual hourly earnings data for a sample. Next, the “the hourly earnings of individuals observed in both the current month and 12 months earlier” are matched. Then, “the median of the distribution of individual 12-month wage changes for each month” is computed. Lastly, the data are smoothed using a three-month moving average.

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Global Rounds

August 15, 2017 (Tuesday)

 

Global Strategy: Reenergized Bull. From a global perspective, the bull market in equities that started on March 9, 2009 has been three bull markets interrupted by two mini-bear markets, a.k.a. corrections—so far. To be more specific, the All Country World MSCI stock price index (in local currency) rose 170.6% since the start of the bull market through Friday’s close (Fig. 1). Now let’s have a closer look at its three phases so far:

(1) Phase I. During the first phase of the bull market, the index rose 81.3% to peak on February 18, 2011. The dramatic recovery was a typical bull market rebound following the end of a severe bear market. It was led by a solid upturn in forward earnings around the world (Fig. 2). Forward earnings (in local currency) rose 43.4% during the first phase of the bull market (Fig. 3). The forward P/E rose from a low of 8.7 during the week of October 30, 2008 to a high of 14.6 during the week of September 17, 2009 (Fig. 4).

The All Country World MSCI index then fell 20.6% through October 4, 2011. The correction (mini-bear) was mostly caused by concerns that the Eurozone’s Greek debt crisis could lead to the disintegration of the monetary union and to another global financial crisis.

(2) Phase II. These concerns magically evaporated following ECB President Mario Draghi’s pledge to do “whatever it takes” to defend the euro. He said so in a speech on July 26, 2012. During 2012, forward earnings stalled along with global economic activity, particularly in the Eurozone.

From the October 4, 2011 low, the world index rose 76.1% to a record high on April 27, 2015. Leading the way was the forward P/E, which rose from 9.7 to 15.7. Forward earnings, which had stalled in 2012, resumed rising gradually during 2013 through 2014. But they were tackled again by the energy recession during 2015 through early 2016. That precipitated another correction, with the index falling 19.1% from the 2015 peak to bottom on February 11, 2016.

(3) Phase III. It’s been up, up, and away since the low in early 2016, with the index up 31.8% since then through Friday’s close. This time, both earnings and valuations contributed to the latest phase. Forward earnings is up 13.9% since early 2016 through early August of this year, and the forward P/E is up from about 13.8 to 16.0.

In other words, the bullish phases of the bull run since early 2009 seem almost like mini-bull markets following mini-bear markets. The latest mini-bull started early last year. From this perspective, the bull market may be keeping relatively young by pausing every now and then as it charges ahead.

Global Economy: Old & New Worlds. As noted above, after mostly stalling from mid-2011 through mid-2016, the All Country World MSCI forward earnings (in local currency) has been rising steadily, and has been doing so in record territory since March 24. Joe, who is the world’s greatest slicer-and-dicer of the world’s earnings data, calculates the forward earnings by sectors for the global index (Fig. 5). The recent cyclical upturn in forward earnings for the composite (in US dollars) has been led by Consumer Staples, Energy, Financials, Industrials, Information Technology, Materials, and Utilities. In other words, it has been broad-based. That confirms other global economic indicators showing widespread improvement in global growth:

(1) Global PMIs. The Composite PMI, Manufacturing PMI, and Nonmanufacturing-PMI for the global economy have been remarkably stable at recent cyclical highs from December 2016 through July 2017 (Fig. 6). Over this period, the global C-PMI has been hovering between 53.0 and 54.0. The global M-PMI has been hovering around 53.0, while the global NM-PMI has been hovering close to 54.0 since late last year. Interestingly, the PMIs for the advanced economies continue to outperform those for emerging economies, as they have since the second half of 2013.

(2) Global production & exports. Data available through May show both global production and world exports volume in record-high territory (Fig. 7). Their growth rates (on a y/y basis), which were close to zero early last year, have picked up to 3.5% for the former and 5.3% for the latter (Fig. 8). The world export volume growth rate is highly correlated with the growth rate of the sum of real US exports plus imports, which was 4.2% during June (Fig. 9).

(3) Advanced vs emerging economies. Interestingly, the data on global industrial production show that output growth among emerging economies has been relatively stable around 3.5% y/y since roughly early 2015 (Fig. 10). Apparently, the energy recession hit advanced economies hardest as their production index fell slightly on a y/y basis during late 2015 through mid-2016. It has recovered nicely since then with a gain of 3.4% during May.

Now let’s take a quick tour around the world to see the sights—actually, to cite some of the noteworthy indicators of economic activity.

Global Economy: Europe. Germany’s economy is wunderbar. Most amazing is the IFO business confidence index, which soared to a record high during July (Fig. 11). Also impressive is that much of that strength is coming from domestic demand both in Germany and the Eurozone, rather than mostly from exports to other parts of the world as in the past. The volume of retail sales excluding motor vehicles is at a record high in the Eurozone, with a 3.1% y/y increase through June led by a 3.6% gain in Germany, also to a new record high (Fig. 12).

Global Economy: Asia. Like Germany, Japan historically has been an export-led economy, relying more on foreign demand than domestic demand for growth. Like Germany, Japan is surprising us all with strong domestic demand recently. Japan’s real GDP rose 4.0% (saar) during Q2, the best quarterly gain since Q1-2015, led by a 5.2% increase in domestic demand (Fig. 13). Consumer spending rose 3.7% and capital formation jumped 11.7% during the quarter.

On the other hand, China’s latest statistics have been lackluster, though consistent with recent readings. During July, industrial production was up 6.4% y/y and inflation-adjusted retail sales rose 9.0% (Fig. 14).

Global Economy: USA. Here in the US, economic growth also remains lackluster, though our lackluster is certainly slower than their lackluster (over in China). Here are a few recent tidbits pointing to slow growth in the US:

(1) Income tax receipts. Debbie and I are puzzled by individual income tax receipts collected by the federal government (Fig. 15). The 12-month sum of this series has been virtually flat just under $1.6 trillion since November 2015, following a strong uptrend that started in 2011. That’s despite strong payroll employment gains over this same period totaling 3.8 million, and reflected in the record high in payroll taxes. Maybe all those jobs don’t pay much, which is why they may be boosting payroll taxes but not income taxes. (Let us know if you have a better explanation.)

(2) Railcar loadings of autos. Less of a mystery is the stalling of auto sales over the past seven months just below the cyclical peak of 18.2 million units (saar) during December. Lenders are curbing their enthusiasm for making subprime auto loans as used car prices fall. Debbie and I track weekly railcar loadings of motor vehicles, which confirms that sales remain stalled (Fig. 16).

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Inflation: Ghost Stories

August 14, 2017 (Monday)

 

Strategy: Panic Season. It’s time to prepare for a hurricane. I’m talking about the weather, not the stock market. I’m still a stock market forecaster, not a weather forecaster. My backup career in case this one doesn’t work is movie reviewer. I rely on the National Oceanic and Atmospheric Administration (NOAA) in the US Commerce Department for long-term weather projections. In an 8/9 news release, the agency warned:

“Today NOAA issued the scheduled update for its 2017 hurricane season outlook. Forecasters are now predicting a higher likelihood of an above-normal season, and they increased the predicted number of named storms and major hurricanes. The season has the potential to be extremely active, and could be the most active since 2010.

“Forecasters now say there is a 60-percent chance of an above-normal season (compared to the May prediction of 45 percent chance), with 14-19 named storms (increased from the May predicted range of 11-17) and 2-5 major hurricanes (increased from the May predicted range of 2-4). A prediction for 5-9 hurricanes remains unchanged from the initial May outlook.”

So batten down the hatches! Stock investors may have started to do so last week in reaction to worsening tensions between the US and North Korea. The S&P 500 lost 1.4%, putting it 1.6% below the 2480.91 record high on August 7 (Fig. 1). That’s still a minor storm, and isn’t big enough to add to our list of corrections (when the S&P 500 is down 10%-20%), but we are adding it to our list of panic attacks since the start of the current bull market (Fig. 2). There have been 57 of them now including the latest one. (See our S&P 500 Panic Attacks Since 2009.) They’ve all been selloffs triggered by frightening events that turned out to be false alarms, and were followed by relief rallies to new cyclical highs and then new record highs since March 28, 2013.

I suspect that the latest panic attack could last a while longer, but will probably set the stage for a powerful relief rally, perhaps even a melt-up. The relief should be that the latest panic attack didn’t cause a (nuclear) meltdown. Last week’s selloff occurred mostly during Thursday after President Donald Trump, on Tuesday, threatened to hit North Korea with “fire and fury” if the country’s regime doesn’t cease and desist with their nuclear arms program and their war-mongering. Consider the following:

(1) VIX. The S&P 500 VIX woke up from its summertime siesta, rising from 9.93 on Monday to 16.04 on Thursday (Fig. 3). Admittedly, that’s not much of a panic reaction for the S&P 500, especially since the South Korea MSCI stock price index (in local currency) dropped 3.5% last week, though it is still up 21.3% y/y (Fig. 4).

(2) The worst month. It’s still early in the stock market’s often-stormy fall season. A week ago Friday in Barron’s, Randy Forsyth noted, “Since 1950, however, August has been the worst month for the Dow Jones Industrial Average, according to the Stock Trader’s Almanac edited by Jeffrey A. Hirsch. And, in a note written along with Christopher Mistal, Augusts in years after presidential elections have been especially treacherous.” Our data for the S&P 500 since 1928 show that September has been the worst month for this index (Fig. 5).

(3) Unlucky 7. In his column this week, Randy relates, “And, for reasons possibly mystical, years ending in 7 have been particularly treacherous during this period. In Leuthold’s Green Book (as the firm’s widely read monthly publication for clients is popularly called), Ramsey reproduces charts of stock prices for years ending in 7, going all the way back to 1887, and darned if they all don’t have some sort of swoon around this time of year.”

As an amateur numerologist, I’m surprised since seven is considered to be a lucky number. In addition, there are seven seas, seven continents, seven colors in a rainbow, seven notes on a musical scale, seven days in a week, and the Seven Wonders of the World. In the movies, the good guys were the protagonists in “The Seven Samurai” and “The Magnificent Seven.”

(4) Bay of a Pig. My current worst-case scenario for the North Korean Missile Crisis is that it will be like the Cuban Missile Crisis. I doubt that Lil’ Kim will back down during the current one as did Nikita Khrushchev during the previous one. More likely is that the US will shoot down Kim’s next test missile launch and once again threaten “fire and fury” on all of North Korea if Kim retaliates with an artillery barrage against South Korea. In this Wrath of Don scenario, the US might launch surgical strikes against North Korea’s military installations. Before that happens, China is likely to get sufficiently alarmed to depose Kim in exchange for US assurances that North Korea will remain a Chinese protectorate forever, if China de-nukes the country.

This scenario could trigger a major panic attack in the stock market followed by an extraordinary relief rally. It could also be seen as a HUGE win for not only President Trump but also President Xi. In other words, a win-win scenario is possible and could easily trigger a melt-up, assuming that a meltdown is averted.

Inflation I: Pesky Disinflation. I like that Minneapolis Fed President Neel Kashkari thinks outside the box. He seems to have resisted the groupthink mentality that afflicts most FOMC participants. However, he tends to spend too much time on the lefty outside of the box for my conservative sensibilities. Nevertheless, I do agree with the following comment he made last Friday about inflation fears a few hours after July’s lower-than-expected CPI was released:

“I call this—and I mean this with no disrespect—I call this a ghost story, meaning, I cannot prove to you that there’s not a ghost underneath this table. I cannot prove it definitively. There may be. But there is no evidence that there is a ghost under this table. There is no evidence in any of the data that wages have this acceleration factor and are all of a sudden going to take off.”

Speaking the same day, Dallas Fed President Robert Kaplan also said that the Fed can hold off on raising interest rates until inflation shows signs of picking up. Kaplan is a voting member of the FOMC. He voted to raise the federal funds rate in March and June. He sounds like he won’t do it again at the September 19-20 meeting. Kashkari is also a voter, but dissented against the past two rate hikes, which otherwise were unanimously accepted.

The last public pronouncement about inflation from Fed Chair Janet Yellen occurred on Thursday, July 13 in her semi-annual monetary policy testimony to Congress: “It is premature to conclude the underlying inflation trend is falling well short of 2 percent [which is the Fed’s inflation target].” She stuck to her position, saying higher wages and prices are likely as economic slack shrinks. She acknowledged that recent readings on inflation have been lower than expected, but she attributed that to “unusual reductions in certain categories of prices.” Let’s have a closer look at some of the reductions that are deemed by Yellen to be temporary ones:

(1) Headline & core. Data released on Friday showed the headline and core CPI inflation rates both rose 1.7% y/y through July (Fig. 6). The Fed gives more weight to the PCED inflation rate, which tends to be below the CPI rate. The headline and core PCED inflation rates are available through June, and show increases of only 1.4% and 1.5% (Fig. 7).

(2) Services. Weighing down all four CPI measures was wireless telephone services, which is down 13.2% through July (Fig. 8). Physician services inflation dropped from a recent peak of 4.3% last August to -0.6% last month (Fig. 9). Airline fares are down 2.5% y/y, while hotel rates are 3.1% lower (Fig. 10).

(3) Durable goods. New car prices are basically flat y/y, while used car prices are down 4.1% (Fig. 11).

Melissa and I believe that powerful secular forces related to global competition, technological innovations, and aging populations are all keeping a lid on inflation, and offsetting the cyclical inflationary impact of less slack in the labor market.

Just last Thursday, Jackie noted that Marriott’s CEO warned in a recent conference call that hotel room rates are hard to raise despite high occupancy rates. That might have something to do with apps and websites like AirBNB and Trivago. Car prices may be weak because Millennials would rather take Uber everywhere than buy a new or used car. Many physicians are becoming salaried employees of health care companies, requiring that they use technology to increase their productivity.

At a press briefing last Thursday, New York FRB President Bill Dudley said, “I expect inflation to also start to move higher in the medium term but probably not get all the way back to 2% on a year-over-year basis, because remember, we’ve had these very weak inflation readings for a number of months. So we’re not going to get to a year-over-year number of 2% until some of these very low readings drop out of the statistics 6 to 10 months from now.”

Inflation II: Sticky Inflation. Melissa and I wouldn’t be surprised to hear Fed officials talk more often about the Atlanta Fed’s sticky-price CPI and other measures of consumer prices that show inflation is running at 2% or higher. Let’s review:

(1) Sticky and flexible CPI. The Atlanta Fed’s headline sticky-price CPI rose 2.1% y/y during July, while the core rate rose 1.0% (Fig. 12). Two Fed economists explain that sticky prices are the ones that don’t change very often or very much. They may be less responsive to economic conditions than flexible prices, but “may do a better job of incorporating inflation expectations. Since price setters understand that it will be costly to change prices, they will want their price decisions to account for inflation over the periods between their infrequent price changes.” During July, the flexible-price CPI rose 0.8% y/y, while the core version fell 0.8% (Fig. 13).

(2) Median and mean CPI. The Cleveland Fed also calculates its own funky CPIs based on the official data. Over the last 12 months, the median CPI rose 2.1%, while the trimmed-mean CPI rose 1.9% (Fig. 14). Trimmed-mean inflation measures remove the most volatile monthly price changes from the inflation calculation. The median CPI is considered to be an “extreme trim” measure.

Inflation III: Different Strokes. Melissa and I have previously observed that one of the main differences between the CPI and PCED measures of consumer prices is that the CPI, which is compiled by the Bureau of Labor Statistics (BLS), is based on surveys of consumers. The PCED, prepared by the Bureau of Economic Analysis, reflects surveys of businesses, which more accurately show what consumers are buying. So the market basket reflected in the PCED more accurately captures consumers’ shopping carts.

Interestingly, over the years, the CPI has risen more than the PCED (Fig. 15). It has also risen faster than the nonfarm business price deflator, which is largely based on the PPI for final demand, which is also up less than the CPI.

The CPI is often used to convert measures of compensation to inflation-adjusted ones, as it measures how the prices of a basket of consumer goods change over time. As noted in a June 2017 BLS post, “the CPI might not be the most appropriate deflator to use when comparing compensation to productivity. Workers are compensated based on the value of goods and services produced, not on what they consume. Using an output price deflator, a measure of changes in prices for producers, instead of the CPI is an alternative that better aligns what is produced to the compensation that workers receive.” Consider the following:

(1) Average hourly earnings for production and nonsupervisory workers has been growing faster when deflated by the PCED than the CPI (Fig. 16). Incredibly, the former has been rising in record-high territory since the late 1990s, while the latter remains well below its peak in the early 1970s!

(2) Nonfarm business productivity is highly correlated with real average hourly earnings using the nonfarm business deflator (Fig. 17).

Movie. “The Big Sick” (+) (link) is a funny movie about a young Pakistani-American stand-up comedian, who is also an Uber driver. He falls in love with an American girl from the South. She loves him too, but his parents insist on arranging his marriage to a Pakistani girl. Will love conquer all? It often does in the movies. In the real world, we are reminded by the violence in Charlottesville that hate remains a very destructive force in our society.

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Fast & Furious

August 10, 2017 (Thursday)

 

Strategy I: Fire & Fury. I said what I had to say about the decreasing odds of keeping the peace with North Korea in my piece in Monday’s Morning Briefing titled “Lil’ Kim & Big THAAD.” Push may be coming to shove faster than anyone expected given the escalation of hostile rhetoric between the fearless leader of North Korea and our fearless leader, President Donald Trump, who on Tuesday threatened a “fire and fury” response to any further provocations by North Korea. The stock market’s reaction on Wednesday to the mounting tensions wasn’t fast and furious, despite lots of loose talk suggesting that both sides are ready to go nuclear.

August and September have a history of being tough months for the stock market. Yet, so far, even talk of loose nukes isn’t triggering a meltdown in stock prices, which could still happen, I suppose. However, it’s more likely that the Chinese will wake up and conclude that they may be dealing with two wild and crazy guys, and they must do something to rein in the one who is in their neighborhood.

Another possibility, which might elicit a serious adverse reaction in the stock market, would be another test missile launch by North Korea that is immediately shot down by an American THAAD anti-missile missile. That would also wake up the Chinese to realize it’s time to replace their crazy guy in Pyongyang with another guy, one who remains beholden to their interests but isn’t deranged.

Strategy II: Less Misery. On a lighter note, I noted yesterday that the Misery Index, which is simply the sum of the unemployment rate and the inflation rate, is falling along with the jobless rate (Fig. 1). I observed that the sum of the Misery Index and the S&P 500 forward P/E has averaged 23.9 since 1979, when the data start for this homemade Misery-Adjusted Forward P/E (Fig. 2).

This valuation measure was 23.6 during June, suggesting that the market is fairly valued. Almost all the other valuation measures show that the S&P 500 is somewhere between very overvalued to grossly overvalued. Yesterday, I also observed that if the inflation rate remains steady while the unemployment rate continues to fall, that would lower the Misery Index and provide more room for the P/E to rise and still represent fair value.

Admittedly, the Misery-Adjusted Forward P/E isn’t flawless. It correctly warned that stocks were overvalued prior to the bear markets of the early 1980s and 2000s. It did not anticipate the last bear market, but that’s because the problem back then was overvaluation of real estate, not stocks. Our conclusion remains the same: Stay invested, but watch out for the crazy guy in North Korea.

Industry Focus I: Homebuilding. TV shows often reflect the best and the worst of American culture. In Q2, a home renovation show attracted more eyeballs watching cable TV than any of the crime shows or news programs available. “Fixer Upper,” on HGTV, is about a couple, Chip and Joanna Gains, who help folks buy and renovate run-down homes in Waco, Texas. They are the perfect couple, never fighting while encountering termites or raising four kids.

According to a 6/30 article in Variety, the rating for the 3/28 “Fixer Upper” episode was second only to that of an April episode of “The Walking Dead,” a series about life after a zombie epidemic. We haven’t quite figured out why Americans are obsessed with zombies, but the popular home improvement shows on HGTV are just the latest confirmation that the US real estate market has been reinvigorated.

More traditional indicators reinforce that assertion. New single-family home sales have climbed nicely since the 2011 bottom, but aren’t anywhere near the peak of 1.4 million units (saar) during July 2005 (Fig. 3). Meanwhile, inventories of existing single-family homes remain near post-recession lows, equaling 4.3 months’ supply on the market in June. Throw in a 4.3% unemployment rate and low-cost mortgages, and you have an environment any homebuilder would love.

Homebuilders are throwing off consistent, strong earnings growth this year, and more of the same is expected in 2018. The S&P 500 Homebuilding stock price index has risen 31.7% ytd through Tuesday’s close, beating the broader market and breaking out of a three-year trading range (Fig. 4). Analysts expect the Homebuilding industry to generate 12.4% revenue growth over the next 12 months and 17.7% earnings growth over the same period (Fig. 5). Meanwhile, the industry’s forward P/E ratio is a below-market 11.3 (Fig. 6).

Here’s Jackie’s take on what two industry members—D.R. Horton and PulteGroup—recently divulged in their upbeat earnings reports:

(1) Building on strength. D.R. Horton, the country’s largest builder by market cap, reported that for its fiscal Q3, ending June 30, the number of net homes it sold increased by 11% y/y, revenue jumped 17.0%, and net income improved by 15.7%. The company more than met its goal of producing double-digit annual growth in net revenue and pretax profits.

Horton also sounded upbeat about the future. It announced a $560 million acquisition of a 75% stake in Forestar Group, a publicly traded residential real estate development company. It also provided fiscal Q4 guidance for revenue that was higher than its previous announced range. In addition, Horton gave FY 2018 guidance of 10% to 15% revenue growth, excluding the Forestar acquisition.

“[R]ight now, what we’re seeing is a very solid, very consistent high-demand, low-inventory market that feels like it’s going to continue,” said CEO David Auld, according to the 7/26 earnings conference call transcript. Analysts expect the company’s FY 2017 earnings to grow 17.8% and its FY 2018 earnings to grow 12.2%.

(2) Almost all’s good at Pulte. PulteGroup reported 12% growth in orders and Q2 revenues, which led to a 16.5% jump in adjusted net income and a 27% increase in adjusted earnings per share thanks to share buybacks. Adjusted earnings excluded a charge related to selling underperforming land. The average sales price of a home increased by 6% y/y to $390,000.

Pulte’s earnings conference call had two notes of caution. The company said it was giving discounts of $14,000 on higher-end homes in select markets where there is more inventory. It also noted that wages, concrete, and lumber expenses could come in at the high end of the range the company has forecasted.

But overall, the transcript’s tone was upbeat, both about the current environment and the future. “We continue to see positive buyer sentiment and generally improving demand trends across our markets. Driven in part by an expansion of the first-time buyer segment, housing demand is supported by a variety of positive factors, including an improving economy with low unemployment, high consumer confidence, low interest rates and supportive demographic,” said CEO Ryan Marshall, according to a transcript of the company’s Q2 earnings conference call. He concluded: “Given this backdrop, we remain constructive on the market and the potential for several more years of growth in overall housing demand.”

Industry Focus II: Semiconductors. Semiconductor sales continued to power higher in June, a good omen both for the industry and the Information Technology sector as a whole. Worldwide semiconductor sales increased by 2.0% in June m/m and 23.7% y/y to new record highs, according to the latest report by the Semiconductor Industry Association.

Worldwide semi sales often align nicely with the S&P 500 Semiconductors industry’s forward earnings (Fig. 7). That would imply strong results are forthcoming at semiconductor companies. However, analysts are calling for the S&P 500 Semiconductors industry’s revenue to climb 6.2% over the next 12 months, and earnings are predicted to rise only 9.0%. That’s down sharply from the rapid 30.0% earnings growth forecasted for this year (Fig. 8).

Strong worldwide semiconductor sales may imply that Wall Street analysts have grown too conservative about the industry’s fortunes. Chips are certainly in great demand thanks to the advent of automated cars, the Internet of Things, and the upcoming arrival of the latest iPhone. If analysts’ sights aren’t high enough, the S&P 500 Semiconductor index, which is up 13.8% ytd, could have room to run further (Fig. 9 and Fig. 10). The industry’s forward P/E of 15.2 certainly gives it room to do so.

The other, more gloomy possible explanation for low forward earnings estimates could be analysts expect semi prices to fall in the not-so-distant future, which would put pressure on the industry’s bottom line. There are rumblings that China plans to jump into the industry, and companies there are building mammoth factories that could lead to oversupply by 2020, a fantastic 7/27 WSJ article reported. But that seems like something to worry about next year.

Industry Focus III: Hotels. Conference call transcripts aren’t exactly beach reading, but every once and a while they contain a nugget of information that makes the slog worthwhile. Take Marriott International’s Q2 conference call transcript of 8/2. The company enjoyed nearly 80% occupancy in North America, and US corporations have posted strong earnings that should mean more corporate traveling. But despite the strong macro environment, Marriott reduced its North American revenue per available room (RevPAR) estimate to 1%-2% from 1%-3%. Where’s the pricing power the company should be enjoying in this environment?

CEO Arne Sorenson blamed “fairly anemic” US GDP, but he also called out the impact of technology. “It is a market with radical transparency in pricing. And that may have some impact on our ability to move rates in this cycle compared to prior cycles.”

Jared Shojaian at Wolfe Research picked up on this thread and asked whether the transparency Sorenson mentioned was related to third-party websites’ monitoring prices, online travel agencies, home sharing, or some combination. Sorenson’s response:

“Well, I think it’s all of it. But it’s not particularly focused on home sharing or the disruptors in the space. It’s much more about just the ubiquity of information. And I think with each passing year, it becomes simpler and simpler to know the rates at every single hotel, quite simply, within our own system. So, you’ve got that transparency on Marriott.com just as you do through other platforms. And with an increasing participation in the industry of the franchise community with individual pricing decisions that are being made by individual hotels, I think that’s the world we live in. It does not mean that there won’t be ability to drive rate in the future. We do have the ability to drive rate, certainly on midweek nights and others where the hotels are effectively full. But I don’t think it’s quite the environment we might have had in years past where probably there’s a little bit more flexibility to do that.”

And that’s why you read transcripts. (Maybe Fed officials need to start reading transcripts too.)

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Four Deuces Scenario

August 09, 2017 (Wednesday)

 

Strategy: Winning Hand. While real GDP growth continues to amble along at a leisurely pace of 2.0% y/y, the labor market is sprinting at a fast pace. In the 7/31 Morning Briefing, Debbie and I described our 2-2-2 economic scenario, with real GDP continuing to grow around 2.0% y/y, inflation remaining at or slightly below 2.0%, and the federal funds rate peaking late next year at 2.00%.

One of our accounts suggested expanding our Three Deuces scenario to Four Deuces (2-2-2-2) by adding the unemployment rate. The jobless rate was 4.3% during July and could fall to 2.0%, which would be the lowest on record starting in January 1948 (Fig. 1). The low for this series was 2.5% during May and June 1953. A new record low, even at 2.0%, is conceivable if the Three Deuces scenario continues to play out. That’s because having slow economic growth with subdued inflation and low interest rates increases the odds of a very long economic expansion, with the labor market continuing to tighten.

That would be ideal for our “long good buy” scenario for the stock market, since bull markets usually don’t end until the unemployment rate falls to its cyclical trough and starts moving higher (Fig. 2). The stock market also does well when the Misery Index, which is the sum of the unemployment rate and the inflation rate, is falling (Fig. 3 and Fig. 4). Indeed, there is an inverse correlation between the Misery Index and the S&P 500 P/E since 1979 (Fig. 5). Consider the following:

(1) The sum of the forward P/E and the Misery Index has averaged 23.9 since 1979 (Fig. 6). It was 23.6 during June, suggesting that the stock market is fairly valued.

(2) A lower Misery Index, as a result of a further decline in the unemployment rate, would leave more room for P/E expansion without irrational exuberance. If the unemployment rate drops from 4.3% to 2.0% and the inflation rate remains at 2.0%, that would lower the Misery Index, leaving room for a reasonable increase in the forward P/E from 17.8 currently to 19.9 (since 19.9 + 4.0 = 23.9, which is the average of the Misery Index since 1979).

So, hold ’em, don’t fold ’em because there is no reason to be miserable. As the song goes: Don’t worry, be happy!

US Economy I: Help Wanted! Yesterday’s releases of June’s JOLTS report and July’s NFIB survey of small business owners both confirm that the labor market is getting tighter and tighter, which means that the unemployment rate could continue to fall, which means less misery and higher stock prices, as we just explained above. Debbie reviews both releases in detail below. For now, let’s consider a few of the reasons to be happy if you are looking for a job, but not so happy if you are looking for help:

(1) JOLTS. At the end of June, there were a record 6.2 job openings (Fig. 7). That month, there were 7.0 million unemployed. So the ratio of unemployed workers to job openings was 1.1, matching the low for this series in January 2001, which is one month after the start of this data. As we’ve noted before, this suggests that the economy is at full employment with only “frictional” unemployment resulting from geographic and skills mismatches.

Labor market activity remained brisk in June, with near recent cyclical highs in hires (5.4 million) and separations (5.2 million). Over the past 12 months through June, hires totaled 63.4 million, while separations totaled 61.1 million (including 3.1 million quits and 1.7 million layoffs) (Fig. 8). Given that payroll employment totals 146.6 million, that’s an amazing amount of turnover in the labor force. (By the way, could it be that productivity suffers when there is too much turnover of workers?)

(2) NFIB. During July, 35.0% of small business owners reported that they had job openings (Fig. 9). That’s the highest reading since November 2000. Most disturbing is that 52.0% reported that there are few or no qualified applicants for job openings.

There is a strong inverse correlation between the unemployment rate and the percentage of small business owners with job openings (on a three-month average basis) (Fig. 10). The latter suggests that the unemployment rate could easily fall to the 2000 low of 3.8%.

(3) Wages. Meanwhile, despite the tightness of the labor market, wage inflation remains subdued. While lots of small business owners report that they could use some help, average hourly earnings inflation remains around 2.5% y/y (Fig. 11). On the other hand, median wage inflation was 3.2% during June, suggesting that the Phillips Curve isn’t completely flat (Fig. 12). I asked Melissa to look into why median wages are rising faster than average ones. Stay tuned.

US Economy II: The Best of Times. During the Great Depression, “Brother, Can You Spare a Dime?” was a song that resonated with the grim economic environment. The best-known versions, sung by Bing Crosby and Rudy Vallee, were released right before Franklin Delano Roosevelt’s election to the presidency. It was an anthem to the shattered dreams following the Roaring ’20s. Today, employers are singing, “Buddy can you spare some time?”

Yet, there remains lots of chatter about how the standard of living has stagnated for most Americans and income inequality has worsened. The implication is that if income inequality hadn’t worsened, then the standard of living would have increased for more people. The rich have been getting richer, the narrative goes, while everyone else has suffered. The 1% must be bad, greedy people, and should be taxed to punish them, with their incomes redistributed for the greater good of the 99%. The government, of course, is Robin Hood.

How can the stock market possibly be doing so well when so many people are suffering from the effects of income stagnation? The stock market has clearly made lots of rich people richer, though lots of workers with corporate pensions and 401K plans invested in stocks are also benefitting. In any case, don’t corporate earnings depend on a healthy economy with prosperity for all, not just a few? This seems to be yet another conundrum. Then again, the data belie the stagnation view, which therefore also challenges the worsening inequality thesis:

(1) Income and consumption. Progressives’ favorite measure of income stagnation in the US is inflation-adjusted median money income per household (Fig. 13). It had a nice bounce in 2015, but it’s back to where it was during 2000. That’s 15 years of stagnation! Heads must roll! Not so fast, Robespierre. Mean money income, which is higher than median, has also stagnated since 2000 even though it gives more weight to the filthy rich.

Lo and behold, real mean personal income per household, which is a much broader and more accurate measure of incomes, is up 25% from January 2000 through June 2017—to a record high. Is that all because rich people are getting paid much more and enjoying huge capital gains on their stocks and bonds? In the National Income Accounts, personal income excludes capital gains and losses. So are the rich getting paid a lot more now than 15 years ago?

I don’t know, but I do know that real mean personal consumption per household is up 28% from January 2000 through June 2017 to a record high of $100,100 (saar). Surely, that can’t be totally because of the rich stuffing their faces with gourmet meals and living the high life. There aren’t enough of them to be having that impact on consumption, which is the most convincing evidence that the standard of living has increased broadly over the past 15 years, IMHO.

(2) Wages. More evidence is provided by the inflation-adjusted average hourly earnings of all production and nonsupervisory workers, which currently accounts for 70% of private payroll employment (Fig. 14). This measure of the real hourly wage rate is up 17% from January 2000 through June 2017. That’s not stagnation. I presume that the rich are not classified as production and nonsupervisory workers. Other measures of real hourly compensation are up as much.

(3) Piketty, et al. This weekend, I am looking forward to reading a 7/6 working paper titled “Distributional National Accounts: Methods and Estimates for the United States,” by Thomas Piketty, Emmanuel Saez, and Gabriel Zucman. This crew is renowned for data mining and finding lots of income stagnation and inequality. The abstract of their paper suggests that I won’t be disappointed. It claims that the resourceful authors have found a way to “capture 100% of national income.” Their punchline is:

“Average pre-tax real national income per adult has increased 60% since 1980, but we find that it has stagnated for the bottom 50% of the distribution at about $16,000 a year. The pre-tax income of the middle class—adults between the median and the 90th percentile—has grown 40% since 1980, faster than what tax and survey data suggest, due in particular to the rise of tax-exempt fringe benefits. Income has boomed at the top. The upsurge of top incomes was first a labor income phenomenon but has mostly been a capital income phenomenon since 2000.”

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Resolving Conundrums

August 08, 2017 (Tuesday)

 

Strategy: S&P 500 Revenues Rising. Joe reports that S&P 500 revenues data for Q2 are now available for 84% of the companies (Fig. 1). The blended revenues per share, using actuals and estimates, rose to an annualized $1,203.68 during the quarter, up 2.8% from Q1 and matching the Q4-2016 result. Joe and I compare this series to S&P 500 forward revenues, which is the time-weighted average of analysts’ consensus expectations for the current year and next year. This series has been on a solid uptrend since mid-2016, and climbing into record-high territory consistently since October 2016 through late July, when it exceeded $1,250.

Both series had stalled from the second half of 2014 through the first half of 2016 as a result of the global recession in the energy sector caused by the freefall in oil prices from mid-2014 through early 2016. The S&P 500 stock price index fell to a low of 1829.08 on February 11 last year on fears of a widespread recession. However, oil prices firmed over the rest of the year, and so did global economic growth. The S&P 500 index is now up 35.4% since last year’s low.

This is just the latest example of our simple observation that, historically speaking, fears of recession cause bull market corrections, with a resumption of the bull market when those fears evaporate if the economy continues to grow. Bear markets occur when those fears are realized as a result of an economic downturn. (See our S&P 500 Bull & Bear Market Tables.)

One obvious exception was the 1987 bear market, when the S&P 500 fell 33.5% between August 25 and December 4 yet a recession did not occur. The selloff was mostly attributed to financial factors, including the threat by a congressional committee to eliminate the deductibility of interest expense in corporate takeovers. Portfolio insurance exacerbated the selloff. Importantly, revenues continued to grow. We can’t show that with S&P 500 revenues-per-share data because that data series doesn’t start until 1992 (Fig. 2). However, the series does track closely with manufacturing and trade sales of goods, which confirms that revenues grew in 1987 and 1988 (Fig. 3).

From August 2014 through February 2016, however, business sales did drop 6.8%. Excluding sales of petroleum products, business sales edged down 0.2% over this same period. That pattern was repeated in aggregate S&P 500 revenues with and without the revenues of the S&P 500 Energy sector (Fig. 4). Here are a few observations on the latest data:

(1) Totals. S&P 500 revenues per share rose 5.7% y/y through Q2. On an aggregate basis, revenues rose 4.5% over this same period, while business sales rose 5.2% y/y through May (Fig. 5).

(2) Ex Energy. S&P 500 aggregate revenues excluding Energy rose 3.7% y/y during Q2 (Fig. 6). Business sales excluding petroleum products rose 4.6% through May.

(3) Leading indicators. Not surprisingly, the Index of Leading Economic Indicators is a good leading indicator of S&P 500 revenues per share (Fig. 7). The former jumped 0.6% m/m during June to a record high, auguring well for revenues.

(4) The dollar. Of course, there is an inverse correlation between the y/y growth rate of S&P 500 revenues per share and the yearly percent change in the trade-weighted dollar (Fig. 8). The strong dollar, along with plummeting oil prices, weighed on revenues especially during 2015. The dollar is now down 1.5% y/y, which should help revenues a bit.

US Consumer I: Aggregate Income Conundrum. On Monday, Debbie and I observed that there has been a strange divergence since early 2016 between our Earned Income Proxy (EIP) for private wages and salaries in personal income and the series it is supposed to be tracking (Fig. 9). From January 2016 through June of this year, the former is up $364 billion, while the latter is up $263 billion. The former has been growing with remarkable consistency around 4.0% since 2011, reflecting relatively stable growth in private payroll employment and in wages (Fig. 10). The growth rate of private wages and salaries has tended to fluctuate around our proxy, but has been mostly below it since 2016. Over the past 12 months through June, wages and salaries is up only 2.5% y/y while EIP is up 4.6%.

When Debbie and I first started to calculate the EIP, a seasoned economics reporter at The New York Times called me and asked me to explain how I calculated it. He double-checked the validity of my procedure with his sources at the Bureau of Economic Analysis (BEA). They told him—then he told me—that this is actually the way the BEA comes up with the preliminary estimate of private wages and salaries that is included in the monthly personal income release that comes out a couple of weeks after the employment report.

So what gives? The EIP is based on the number of private-sector payroll jobs multiplied by the average number of hours worked multiplied by average hourly earnings of all workers in private industries. Consider the following additional conundrums:

(1) Consumer spending. The EIP’s growth rate has been tracking the growth rate in retail sales excluding gasoline, both on a y/y basis, awfully well since 2010 through all of 2016 (Fig. 11). This year, they’ve started to diverge a bit with the former up 4.6% through June and the latter up 3.1%.

The growth rate in total personal consumption expenditures has also been fluctuating around the growth rate of our EIP (Fig. 12). PCE rose 3.8% y/y during June, closer to the growth rate of our EIP (4.6%) than the growth rate of private wages and salaries (2.5%).

(2) Personal saving. The official data show consumption has been growing faster than disposable income, resulting in falling personal saving (Fig. 13). Over the past 12 months through June, personal saving has totaled $572 billion, well below the $714 billion average of this series since January 2009. Prior to the financial crisis, the average from 1990-2008 was $357 billion, or roughly half as much as post-crisis. This suggests that rapidly rising home prices prior to the crisis depressed personal saving, as consumers figured they could always tap into their home equity if they needed more cash. They figured wrong and have been saving twice as much since the crisis.

If our EIP is more in tune with reality than is the wages and salaries component of personal income, then personal saving is higher than shown by the official data.

US Consumer II: Hourly Wage Conundrum. Our EIP is based on hourly wages using average hourly earnings for all private-sector workers. The data are available since March 2006. A longer time series, starting in January 1964, is available for production and nonsupervisory workers, who have tended to account for roughly 82% of all workers (Fig. 14). Both measures show that wage inflation (on a y/y basis) remains remarkably subdued around 2.5% (Fig. 15).

Like all markets, there is a supply side and a demand side to the labor market. There’s no doubting that demand for workers is strong. Monthly employment gains have been robust in recent years. They remained so through the first seven months of this year, when payroll employment rose 184,300 per month on average. The number of job openings has been hovering just north of 5.5 million since mid-2015 (Fig. 16). That almost matches the number of jobless workers, suggesting that unemployment is mostly frictional, resulting from geographic and skills mismatches. In July, 35% of small business owners said they had job openings, the highest percentage since 2000.

So why aren’t employers raising wages at a faster pace to fill their job openings? The simplest answer was offered by one small business owner who was asked that very same question on a nightly TV news program recently. He said that he can’t afford to pay more because his overseas competitors have cheaper labor. In a competitive market environment, any employer can compete for workers by paying more for them, but they can’t raise their product prices above the market price to cover the extra cost. If they do so, they will lose revenues at the very same time as their costs are going up. Most would rather settle for the status quo on wages and do the best they can with the workers they have or can attract at current wage rates.

But why aren’t workers demanding higher wage rates if the supply side of the labor market is so tight? During May, a record 3.2 million workers quit their jobs, presumably for better jobs, yet that isn’t showing up in faster average wage hikes. The logic may be a bit circular, but here it is: The slow rate of wage increases has been outpacing consumer price increases, which have been held down by the slow pace of wage increases. As a result, perhaps workers haven’t been unsatisfied, on the whole, with the buying power of their slowly rising wages. As we observed on Monday, real average hourly earnings rose to a record high in June (Fig. 17).

Interestingly, the Atlanta Fed’s data on median wage growth does show that job switchers for the most part have been getting bigger wage gains than job stayers since the start of the data during 1997 (Fig. 18). That’s continued to be the story during the current expansion, with switchers’ wages up 3.6% y/y through June, while stayers are lagging behind with a 2.9% increase. Yet, on average, wages are showing gains around 2.5% y/y.

The solution to the conundrum may be that average wage inflation for all workers in fact has rebounded from a low of 1.5% near the end of 2012 to 2.5% currently, outpacing consumer price inflation. So, from this perspective, there is no conundrum: Wage inflation has increased in response to tighter labor markets, and real wages are rising to new highs; wage inflation hasn’t been remarkably subdued when considered relative to consumer price inflation. This leads me to think that productivity might actually be better than the official data suggest.

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Lil’ Kim & Big THAAD

August 07, 2017 (Monday)

 

Strategy: Looking for Trouble. In the past, I’ve frequently noted that geopolitical crises since the start of the 1960s have often created buying opportunities for stock investors (Fig. 1). Stocks would sell off quickly and sometimes sharply for a brief period, then rebound when the crises passed. The two major exceptions were the oil price shocks of 1973 and 1979, which triggered severe recessions as US consumers retrenched in the face of soaring gasoline prices, which boosted inflation, forcing the Federal Reserve to raise interest rates significantly (Fig. 2).

In recent meetings with our accounts in the Mid-Atlantic states, I found that they all were fully invested in stocks and believed that the bull market could last for quite some time longer. Based on the S&P 500, on April 11, it became the second-longest bull market since the data started in 1928 (Fig. 3). On June 29, 2021, it would be the longest on record, if the bull continues to charge ahead that long.

In the past, the bulls were tripped up by recessions. The investors I’ve met with recently are all hard-pressed to see what might cause the next recession anytime soon. A geopolitical crisis is not on their worry list. When they asked me for my opinion, I noted that Debbie and I started to predict back on October 27, 2014 that the expansion could be one of the longest on record, and we still think so. It is currently the third longest since the end of WWII. In May 2018, it would become the second-longest expansion and in July 2019 the longest, if it lasts so long (Fig. 4).

Barring a major geopolitical crisis, if there is trouble ahead for the stock market, it might be internally generated. The bulls could get too cocky, continuing to pour money into equity exchange-traded funds (ETFs), setting new records for 12-month net inflows over the rest of this year and into next year. They have been doing just that since January, as we discussed last week (Fig. 5). That could cause a P/E-led melt-up, especially given the extraordinary complacency, as evidenced by the record-low readings for the S&P 500 VIX recently around 10.0, with Investors Intelligence reporting that only 16.2% of their respondents were bearish last week (Fig. 6).

Based on the record inflows continuing into ETFs and widespread complacency, Joe and I raised the odds of a Melt-Up scenario last week from 40% to 50%, while lowering the odds of a Nirvana scenario to 30% from 40%. We left the Meltdown scenario at 20%. But we will have to raise it, taking points away from the Melt-Up, if stocks do go into orbit first.

The Melt-up/Meltdown tag team could set the bull up for a nasty fall. However, that would not necessarily cause a recession. So it might very well be like 1987 all over again, with a fast and furious bear market setting the stage for a resumption of the secular bull market, as earnings should continue to move higher if the economic expansion continues to set records and maybe break the record for the longest run.

In my conversions with our accounts, we all seemed to agree that this may be the most obvious and plausible outlook for stocks and the economy. But surely, it can’t be that simple? What about geopolitical risk?

Before we go there, let’s consider domestic politics first. Then again, why bother when the stock market seems to be disinterested and totally tuning out all the melodrama? After all, the checks-and-balances system is working just as our Founders designed it to work; it is causing gridlock so that extremist policy initiatives on both sides of the aisle are stymied. Investors seem to agree with my long-held view: “Look how well our economy is doing despite all the meddlers in Washington!” Consider the following recent developments:

(1) Various indicators. The Citigroup Economic Surprise Index has rebounded from this year’s low of -78.6 on June 16 to -40.8 on Friday (Fig. 7). Earlier this year, this was a widely followed indicator because it suggested that US economic growth might be slowing more than anyone expected. Turns out that real GDP rose 2.6% (saar) during Q2, well outpacing Q1’s lackluster gain of 1.2%. On a y/y basis, real GDP growth continues to hover around 2.0%, as it has since mid-2010.

Another weak indicator earlier this year was commercial and industrial, or C&I, loans at commercial banks (Fig. 8). The growth rate of this series definitely has slowed so far this year, but it remains in record-high territory.

Inflation-adjusted exports rose to a record high during June (Fig. 9). Imports also edged up and are just below January’s record high. Incredibly, US exports of crude oil and petroleum products rose to a record 5.9mbd during the four-week period through January 6 of this year, up from a low of 0.8mbd during late 2005 (Fig. 10). Net imports of this category is down to 4.5mbd currently from a record high of about 13.0mbd during 2005. Frackers continue to make America a great oil producer again.

(2) Employment & wages. As we do every month, Debbie and I go straight to the bottom line of the monthly employment report. Friday’s data for July showed that the Earned Income Proxy (EIP) for private-sector wages and salaries rose 0.5% m/m and 4.6% y/y (Fig. 11). Our proxy was tracking wages and salaries very closely until mid-2016, but has been stronger than wages and salaries since then. Our hunch is that the latter variable could be revised higher substantially.

While wage inflation remained subdued at 2.5% y/y during July, as Debbie discusses below, it has been outpacing price inflation. As a result, real average hourly earnings (using the PCE deflator) rose to another record high in June (Fig. 12). This measure of purchasing power (and the standard of living) is up 0.9% y/y, 5.7% since January 2009, and 17.4% since January 2000. In other words, the notion that wages have been stagnating for several years is a HUGE myth.

Geopolitics: Bay of a Pig. Now let’s consider geopolitical risk. President Donald Trump and his agenda are sinking in the swamp of domestic politics. He seems to score more points when he goes abroad, such as when he lobbed some cruise missiles into Syria on April 7, when he met with leaders in the Middle East and Europe during May, and when he gave his praiseworthy Western Civ speech in Warsaw on July 6. When he met with President Barack Obama on November 10 last year, the outgoing president told his successor that his number one geopolitical challenge would be posed by North Korea’s nuclear missile ambitions.

Sure enough, North Korea conducted its second ICBM test a week ago Friday in what it called a warning to the “beast-like US imperialists.” It came less than a month after its first test, on July 4. This could develop into a geopolitical crisis that could have a bearish impact on the stock market, though more likely triggering a correction and a buying opportunity rather than a bear market. Consider the following:

(1) US Secretary of State Rex Tillerson hit back on Saturday, July 29, describing North Korea’s launch as a “blatant violation” of multiple UN Security Council resolutions. He also blamed Beijing and Moscow: “As the principal economic enablers of North Korea’s nuclear weapon and ballistic missile development program, China and Russia bear unique and special responsibility for this growing threat to regional and global stability.”

(2) This past Saturday, Trump’s National Security Adviser H.R. McMaster said in an interview with MSNBC that the US is preparing for all options to counter the growing threat from North Korea, including launching a “preventive war.”

(3) A week ago Sunday, the US conducted a test of its Terminal High Altitude Area Defense (THAAD) defense system in Alaska by launching a ballistic missile over the Pacific Ocean. The weapon was fired by a US Air Force plane and intercepted by the system, the Missile Defense Agency (MDA) said, describing the test as “successful.”

THAAD is designed as a “bullet to hit a bullet.” It carries no warhead, relying on its kinetic energy to destroy an enemy’s incoming missile. That’s to reduce the chances of exploding a conventional warhead or detonating a nuclear one. The system is designed, built, and integrated by Lockheed Martin Space Systems, acting as prime contractor. Key subcontractors include Raytheon, Boeing, Aerojet Rocketdyne, Honeywell, BAE Systems, Oshkosh Defense, MiltonCAT, and the Oliver Capital Consortium.

(4) China's state-owned Xinhua news agency blasted the South Korean government on Friday over its decision to deploy additional THAAD launchers. The Chinese are convinced that the system’s very sophisticated radar will be used to track missiles launched from China. That’s a fear that Trump could heighten for the Chinese by convincing Japan to install a THAAD system, in an effort to pressure the Chinese to stop the North Koreans.

(5) On Saturday, the UN Security Council passed a resolution imposing new sanctions on North Korea. It targets the country's primary exports, including coal, iron, iron ore, lead, lead ore, and seafood. Also targeted are other revenue sources, such as banks and joint ventures with foreign companies. The sanctions will slash North Korea's annual export revenue of $3 billion by more than a third, according to a statement from the office of Nikki Haley, the US ambassador to the UN. Though it’s doubtful, let’s hope the sanction approach works.

(6) This rapidly evolving crisis remains under the stock market’s radar screen for now. In many ways, it reminds me of the Cuban Missile Crisis during October 1962. Emboldened by America’s botched April 17, 1961 Bay of Pigs fiasco, aimed at toppling Fidel Castro, Soviet leader Nikita Khrushchev put nuclear missiles in Cuba. President John Kennedy called his bluff by imposing a naval blockade around the island nation. Khrushchev blinked and withdrew the weapons.

This time, the US is moving antimissile systems close to China, not only to defend against North Korean missiles but also to spur the Chinese to get rid of North Korean leader Kim Jong Un, who is certainly cruel and dangerous and probably crazy too. The deal: Make Kim go away, and we won’t deploy THAAD.

(7) If China fails to make the deal, then the US might very well use THAAD to shoot down a North Korean missile test. That would certainly get everyone’s attention, including complacent stock investors’. It would also unambiguously resolve the question about Kim’s sanity. If he does nothing to retaliate other than to kick and scream, he is sane. If he attacks South Korea with an artillery barrage, he is insane.

Performance: Running of the Bulls. The Dow broke through 22,000 last Wednesday for the first time on the strength of Apple and its better-than-expected earnings. So this seems to be an opportune time to look back at what has driven the stock market to this large, round number and what today’s earnings forecasts could mean for the future:

(1) Leading the charge. Since the S&P 500 bottomed on March 9, 2009, five of its sectors have outperformed the broader index’s gain of 266.1%: Consumer Discretionary, up 476.1%, Financials (402.4%), Information Technology (395.7), Real Estate (352.7), and Industrials (343.0). The remaining six sectors have lagged behind the S&P 500’s return since that fateful day. Here’s how the remaining sectors performed: Health Care (262.7), Materials (214.3), Consumer Staples (183.4), Utilities (139.9), Telecom Services (82.8), and Energy (55.5) (Table 1).

Since the most recent correction bottom on February 11, 2016, Financials led the way (58.9%), followed by Tech (55.3), Materials (40.0), and Industrials (38.9), S&P 500 (35.4), Consumer Discretionary (33.3), Health Care (25.3), Real Estate (21.1), Energy (19.0), Utilities (18.0), Consumer Staples (11.9), and Telecom Services (2.2) (Table 2).

(2) Earnings power. With the benefit of hindsight, it’s easy to see why the S&P 500 Tech sector has led the way for most of the past 10 years: The sector’s earnings growth has outpaced the earnings growth generated by the S&P 500’s 10 other sectors. And over the past year, that earnings outperformance has accelerated (Fig. 13 and Fig. 14).

Going forward, Tech again is expected to generate strong earnings growth, but Energy, Materials, and Financials may do even better. Here’s the earnings growth forecasted for the S&P 500 sectors over the next 12 months: Energy (81.8%), Materials (14.0), Financials (12.1), Tech (11.0), S&P 500 (10.8), Industrials (9.9), Consumer Discretionary (9.5), Health Care (7.7), Consumer Staples (6.9), Utilities (4.0), Telecom Services (0.6), and Real Estate (-10.3) (Table 3).

(3) High on life. Over the past year, the Tech sector’s forward earnings multiple has increased by almost two percentage points, to 18.6. Even so, it’s not much higher than the S&P 500’s earnings multiple, nor is it much higher than the P/Es of other sectors in the index. Here’s where forward earnings multiples stand today and where they were a year ago for the S&P 500’s 11 sectors: Real Estate (38.8, N/A), Energy (28.3, 39.8), Consumer Staples (19.9, 20.5), Consumer Discretionary (19.7, 17.7), Tech (18.6, 16.7), Materials (18.1, 17.1), S&P 500 (18.0, 17.1), Utilities (17.9, 18.3), Industrials (17.7, 16.7), Health Care (16.4, 15.9), Financials (14.0, 13.9), and Telecom Services (12.6, 14.6) (Table 4).

See you at Dow 23,000. But keep an eye on the crazy guy in North Korea.

Movie. “Detroit” (+ +) (link) is a very intense movie about intense racial tensions that flared up in major riots in Detroit, and elsewhere around the country, during the mid-1960s. It starts out in a documentary fashion chronicling the turmoil that engulfed Detroit and turns into a docudrama about one harrowing incident one night when a couple of cops entrapped several law-abiding African-American citizens and behaved more like murderous vigilantes than officers of the law. A great deal of progress has been made in race relations since then, though clearly not enough.

 

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Sangria Summer

August 03, 2017 (Thursday)

 

Industry Focus: Electrifying Autos. It’s often hard to tell when a tipping point has arrived. When the mobile phone was the size of a large brick and mounted in executives’ cars, few would have guessed that in 30 years a much slimmer version would be considered de rigueur for 12-year-olds. Today it feels like Tesla’s Model 3 may be tipping the scales in favor of electric cars. Unveiled on Friday to rave reviews, the Model 3 seems able to compete toe-to-toe with gas-powered cars, even if gas prices are low and tax incentives disappear. If nothing else, Tesla has sparked a race to see who will be able to produce the best electric car—and who can do so profitably. The Model 3’s launch also gives governments the leeway to increase auto emissions requirements. I asked Jackie to look at some of these electrifying developments.

(1) Superlatives abound. Tesla delivered the first 30 of its new Model 3 cars on Friday to employees, and allowed a handful of reviewers to drive it. Motor Trend’s reviewer called the car “the most important vehicle of the century” in a 7/28 article. She deemed the interior “incredibly light and airy,” the trunk “yawning,” and wrote: “The ride is Alfa Giulia (maybe even Quadrifoglio)–firm, and quickly, I’m carving Stunt Road like a Sochi Olympics giant slalomer, micrometering my swipes at the apexes.” While written in car-aficionado code, it seems apparent that she liked the car.

The Model 3 “changes everything,” enthused a Bloomberg 7/31 review. “We took one out for a spin, and have little doubt that the age of electric cars has arrived. … It’s nimble, comfortable, and has tight steering that’ll keep you grinning.” The author believes the company is trying to compete with other $35,000 luxury cars, specifically the BMW 3 and the Mercedes-Benz C-Class—and it succeeds.

We went searching for negative reviews and came up empty. A 7/30 Quartz article put together a list of reviews, and all were glowing.

(2) The specs. Here are some of the car’s most interesting highlights. The standard car, for $35,000, boasts the ability to drive 220 miles on one charge. Those willing to spend $44,000 can have a battery upgrade that extends the mileage to 310 miles on a charge. The Chevy bolt, for almost $38,000, gets 238 miles on a charge, and all other non-Tesla competitors get under 150 miles.

The Model 3 has nothing on the dashboard. All controls are handled by a 15.4-inch, flat touchscreen. Because the batteries are under the car, the Model 3 has a “frunk,” a storage space in front of the car where a gasoline engine would normally go. And keys? They’re so 1990s. The Model 3 synchs to your phone and unlocks as you approach. It also has a key card to give to a valet.

Another upgrade for $5,000: a roof made entirely of glass that protects against the sun like SPF 90. One reviewer notes that the back seats fold down, and some people are talking about sleeping in their cars instead of in a tent when camping. The glass roof would make for amazing star-gazing. In all, upgrades can boost the Model 3’s price to almost $60,000, before tax credits.

(3) The competition responds. Automakers haven’t been standing still as Tesla developed the Model 3. Many have their own offerings, and more are on the way, both to fend off Tesla and to meet upcoming tougher requirements on car emissions. Europe has a target for each new car to produce no more than 95 grams of carbon dioxide per kilometer by 2020, explained a 3/29 Reuters article.

Daimler plans 10 new all-electric cars, representing 15% to 25% of their product by 2022. The push will cost north of $10 billion. The news came after the company reported that it failed to cut its fleet emissions in Europe last year, blaming customers’ preference for SUVs. “Last year the average fuel emissions remained at 123 grams for Mercedes-Benz Cars, the same level as in 2015,” the article stated. “It is the first time since 2007 that it has failed to cut average pollution levels despite the introduction of more fuel-efficient engines throughout its range.”

Chinese-owned Volvo announced all of its new models would either be fully electric or a hybrid from 2019, making it the first major auto manufacturer to abandon gasoline-powered engines. Its target: to sell 1 million electric cars and hybrids by 2025.

“Volvo also said it would launch five new electric and hybrid vehicles between 2019 and 2021. Two of the new models would be built by Polestar, the performance-car unit that Volvo is spinning off as a ‘separately branded electrified global high-performance car company.’ Volvo Cars would build the other three models,” a 7/5 WSJ article reported. “Industry analysts estimate that rising costs of developing combustion engines that meet ever-stricter emissions regulations could make some electric models more affordable as soon as 2025.”

Toyota Motors plans by the early 2020s to sell cars with solid-state batteries, a new type of battery that would roughly double the range of electric cars and cut the charging time, the 7/27 WSJ reported. The batteries wouldn’t be as susceptible to cold weather, which can reduce the charge of a battery.

At Fiat Chrysler CEO Sergio Marchionne said the premium Maserati sports cars will offer electric-powered engines after 2019 and “by early next decade more than half of the brand’s cars will be electrified,” noted a 7/27 WSJ article.

(4) Governments respond. The recent embrace of battery technology has been hastened by the recall of diesel-engine powered cars in Europe, after they were shown to produce more emissions than previously believed. Software in the cars artificially reduced emissions during testing. Now car makers are scrambling for ways to meet Europe’s stringent emissions regulations.

Even more dramatically, some cities and countries are banning diesel cars altogether. The UK announced a ban of sales of diesel and gasoline vehicles by 2040. Meanwhile, Athens, Paris, and Madrid have pledged to ban diesel vehicles by 2025.

Tesla may be delivering the right car at just the right time to make gas- and diesel-powered cars oh so last century. Not all is perfect, however. Tesla would have an easier sales pitch if the price of gasoline were approaching $4 a gallon instead of the $2.27 it fetches today (Fig. 1). The low price of gas has made cross-over vehicles and trucks far more popular than sedans. In addition, the company is burning through cash. Tesla had negative free cash flow of $1.8 billion in the first half of this year, including the $1.5 billion spent on capital expenditures. It plans to spend another $2 billion on cap ex during the remainder of 2017 and had $3 billion of cash on hand as of 6/30. This year alone, analysts forecast the company will lose $6.06 a share. Enthusiasm for the company’s product and faith in its future will have to continue if Tesla aims to keep raising funds from the markets.

(5) Stalling sales. In the meantime, sales of traditional vehicles dropped 7% y/y last month, according to Autodata, as consumers opted against buying cars and instead purchased light trucks and as companies decreased discounts on leases and sales to rental fleets. The preference for light trucks accelerated in 2014 and continues today (Fig. 2 and Fig. 3). Total vehicle sales slid 15.4% in July y/y at General Motors, 7.4% at Ford Motor, 10.5% at Fiat Chrysler Automotive, and 1.2% at Honda. The only company to buck the trend was Toyota, which saw sales rise 3.6% in July. The slowdown this year has left dealers’ lots full as inventory levels climb (Fig. 4).

Tesla’s looming shadow combined with the slowdown in gas-powered car sales has weighed on the S&P 500 Automobile Manufacturers stock price index, which is down 4.8% ytd through Tuesday’s close (Fig. 5). Analysts are calling for industry revenues and profits each to fall 3.6% over the next 12 months (Fig. 6). While a forward P/E of 6.3 reflects the concerns about the auto industry, it still might not reflect a world where the tipping point for electric vehicles has arrived.

Europe I: ‘Whatever it Takes’ Took. If there were any questions about the strength and durability of the economic recovery in the Eurozone, they were laid to rest with the latest Q2 numbers released Tuesday showing that the region grew at the fastest pace since the Q2-2011 and posted its 17^th straight quarter of growth.

The stellar results—five years after ECB President Mario Draghi famously declared a “whatever-it-takes” strategy to save the euro and launched a massive bond-buying program at the start of 2015 that now totals 2.3 trillion euros (US$2.6 trillion) to relieve the debt burden on the region’s countries—increases the pressure on the ECB to pull back the punch bowl when it meets this autumn. Rate watchers will take heed of the July uptick in core inflation—excluding energy, food, and alcohol and tobacco—to 1.2% from 1.1% from the previous month, according to the flash estimate, as Draghi has said he is looking for a convincing upward trend in core inflation before raising rates and tapering the bond-buying.

The number-crunchers at the European Union’s Eurostat agency reported GDP in the 19-country single-currency region rose 2.1% y/y and notched a gain of 2.4% (saar) from Q1. The growth comes amid a boom in manufacturing, increased tourism, higher exports, improving labor markets, and rising business and consumer confidence. Unemployment in the region dropped to 9.1%, its lowest level since February 2009.

Europe II: Touché, Brexit! All the sweeter: The pace of growth was twice that of the UK, where economic output grew by 1.2% (saar) in the three months ended June, up slightly from the sluggish 0.8% pace of Q1. No wonder the EMU is the second-best-performing major market index ytd in dollar terms through Tuesday’s close, up 20.5%. Only the Emerging Markets turned in better performance, rising 24.0% (Fig. 7 and Fig. 8).

It’s instructive to look at two of the region’s biggest success stories that were particularly hard hit in the financial crisis, Portugal and Spain, members of the so-called “PIIGS”—those countries on the periphery of Europe that also include Italy, Greece, and Ireland. Once among the Eurozone’s biggest basket cases, Spain and Portugal are now the brightest stars in its firmament. I asked Sandra Ward, who recently joined us from Barron’s as a contributing editor, to have a closer look.

First, to Spain, the regional standout:

(1) GDP growth. Spain’s economy grew by 3.6% (saar) in Q2, triple that of the UK and nearly double the 2.2% rate of growth in France (Fig. 9). The expansion came on top of a 3.2% advance in Q1 and marks the 15^th consecutive quarter of economic growth. Spain is now on track to deliver annualized growth of 3.1% this year, an impressive third straight year of plus-3.0% economic growth; that’s the fastest of any of the major countries in the Eurozone, according to a 7/28 NYT article.

(2) Exports. Now only Germany produces and exports more cars than Spain in continental Europe, an astonishing fact noted in the NYT article. Exports—which include professional services, machinery, and pharmaceuticals—now represent 33% of Spain’s $1.4 trillion GDP, according to World Bank data. That’s up from 23% in 2009, and Q2 exports grew at the fastest rate since 2010 (Fig. 10). This is a far cry from Spain’s economic picture early in the century, when the construction sector was the major contributor to GDP.

(3) Manufacturing. Spain’s purchasing manager’s index came in at a solid 54.0 in July, but it dropped from 54.7 in June for the weakest showing since March (Fig. 11). Total new order growth slowed for the second straight month to the lowest level since September 2016, and manufacturing production rose at the most sluggish pace in nine months, according to research collected by IHS Markit in its Purchasing Managers’ Index survey. One explanation: Raw materials shortages reported by those Markit surveyed might have held back stronger growth.

(4) Jobs. The unemployment rate in Spain now stands at 17.2%, the second highest in the EMU after Greece but the lowest that Spain’s has been since 2008. The rate has been dropping steadily from a record high of 27% in 2013. In July, Spanish manufacturers hired at the fastest pace since May 1998 in order to meet production demand.

(5) Tourism. At 11% of Spain’s GDP, tourism is a big deal … and getting bigger. The number of tourists visiting Spain rose 12% in the first half of the year, according to a 7/31 Associated Press story, to 36.3 million. This is the fourth year of record-breaking tourist levels in Spain.

(6) Valuation. Spain is the eighth-best performer among the MSCI country indexes ytd, up 29.3% in dollar terms (Fig. 12). Among Eurozone countries, only Greece, with a 30.9% gain, has done better. With earnings forecast to rise 11.2% this year and 9.9% next year, Spain still represents good value for investors despite a forward P/E of 13.7 times because earnings continue to be revised upward and profit margins are widening.

Now to Portugal:

(1) Consumer confidence. The Portuguese are more confident in the financial outlook for their country than they have been in the 20 years since economists started collecting consumer confidence data for Portugal, according to a 7/28 Reuters report based on the latest government statistics. July’s reading of 2.5 was up from 1.7 in June. Both numbers took forecasters by surprise. Consumer confidence has been rising since 2013 but crossed into positive territory for the first time in May when it registered 0.1, again surprising economists (Fig. 13). There’s a lot to be optimistic about: The economy is growing at the fastest rate in a decade and at twice the rate of the Eurozone on average in Q1.

(2) GDP. Portugal is set to deliver its strongest economic growth in more than two decades this year, as the Bank of Portugal lifted its growth targets sharply in June to 2.5%, from a previous forecast of 1.8% and up from 1.4% in 2016. This comes on the heels of a 2.8% y/y advance in Q1, its strongest performance in a decade, twice the rate of the Eurozone average. A strong export market, an improving investment climate, and tourism led to the revised numbers. In a 5/24 Reuters interview, Finance Minister Mario Centeno said he expected y/y growth in Q2 to be above 3%. He also asserted that economic growth would exceed 2% for the full year.

(3) Budget deficit. For the first time, Portugal is in compliance with the Eurozone’s fiscal rules, with a budget deficit of 2.1% of its $204.6 billion GDP, below the 3% limit set by the European Union. As a result, in May the European Commission ended disciplinary procedures against the country.

(4) Debt upgrade? All the good news has led to a drop in Portugal’s bond yields as it increasingly appears that the country’s debt will be upgraded to investment-grade status from junk, based on the improving fundamentals.

(5) Valuation. Investors have been attracted to Portugal’s improving outlook, making it one of the best-performing markets in the week ended Tuesday, with a 3.2% gain (Fig. 14). It’s up 16.2% ytd, right in line with its forward P/E (Fig. 15). But it appears to have gotten ahead of itself based on its short-term and long-term earnings growth rates of 5.5% and 7.6%, respectively (Fig. 16).

Maybe PIIGS can fly after all.

 

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Call of the Wild

August 02, 2017 (Wednesday)

 

Strategy I: Going Feral. The Call of the Wild is a short adventure novel by Jack London. It was published in 1903 and set in Yukon, Canada during the 1890s Klondike Gold Rush. The central character of the novel is “Buck,” a large and powerful, but domesticated, St. Bernard-Scotch Shepherd dog. Buck is stolen from his home at a ranch in Santa Clara Valley, California, and sold to be a sled dog in Alaska. He becomes increasingly wild as he is forced to fight to survive and dominate other dogs. By relying on his basic instincts, he emerges as a leader in the pack.

This story seems to portray current developments in the White House and, more broadly, in Washington, DC. It also captures the essence of what we may be starting to see in the stock market. Following the stock market debacles of the early and late 2000s, retail investors retreated from the stock market and turned relatively domesticated, with more of their savings going into liquid assets and bonds. Since Election Day, they seem to have heard the call of the wild. Their feral instincts have been awakened, triggering a gold rush into both domestic and global stock markets.

As Debbie and I reviewed yesterday, over the past 12 months through June, a record $357.8 billion has poured into equity ETFs, led by $236.2 billion going into domestic ETFs and $121.6 billion going into ETFs that invest globally (Fig. 1). All three inflows are at, or near, recent record highs. Admittedly, some of these inflows came from equity mutual fund outflows, particularly from domestic ones (Fig. 2). However, that could be the call of the wild convincing investors that the stock market is going higher regardless, so they are ditching managed funds for passive ones with cheaper management fees. Consider the following developments:

(1) For a few dollars less. Apparently, Fidelity Investments has heard the call of the wild. The provider of both active and index investment products is lowering fees on 14 of its 20 stock and bond mutual funds as of yesterday. The average expenses across Fidelity’s stock and bond index fund lineup will decrease to 9.9 basis points, down from 11 basis points. The expense reductions are expected to save current shareholders approximately $18 million annually, Fidelity said.

(2) Gold rush. In a July 18 earnings conference call, Walt Bettinger, the CEO of Charles Schwab, said, “Strong client engagement and demand for our contemporary approach to wealth management have led to business momentum that ranks among the most powerful in Schwab’s history. Equity markets touched all-time highs during the second quarter, volatility remained largely contained, short-term interest rates rose further, and clients benefited from the full extent of the strategic pricing moves we announced in February. Against this backdrop, clients opened more than 350,000 new brokerage accounts during the second quarter, bringing year-to-date new accounts to 719,000—up 34% from a year ago and our strongest first half total in seventeen years.”

(3) The howling. All this supports our howling about a possible melt-up since early 2013—when Washington didn’t push the economy off a fiscal cliff, as was widely feared, though not by us. We started to argue back then that the bull market was more likely to end with a melt-up before there was any meltdown.

Today, we are raising the odds of the Melt-Up scenario from 40% to 50%. The Meltdown scenario remains at 20%, while the Nirvana scenario gets cut from 40% to 30%. By the way, a melt-up followed by a meltdown won’t necessarily cause a recession. It might be more like 1987, creating a great buying opportunity, assuming that we raise some cash at the top of the melt-up’s ascent. Our animal instincts will have to overcome our animal spirits, I suppose.

(4) The swamp. The stock market might continue to melt up during the remaining dog days of summer, blissfully ignoring the swamp people in Washington, who are mostly away on vacation. Unfortunately, they’ll be back. The Senate and House have 12 joint working days before September 29, when the Treasury Department would no longer be able to pay all of the government’s bills unless Congress acts. A default could set off turmoil in world financial markets.

Talks among Treasury Secretary Steven Mnuchin, Senate Majority Leader Mitch McConnell, and Senate Minority leader Charles Schumer broke up Tuesday morning with no progress on raising the country’s debt ceiling, an impasse that could threaten yet another fiscal cliff cliffhanger for the financial markets. That may turn out to be yet another buying opportunity. Stay tuned.

Strategy II: Fundamentally Sound. Our Blue Angels analysis of the S&P 500/400/600 shows that the bull market has been powered by a combination of rising forward P/Es and forward earnings (Fig. 3). The former are at or near cyclical highs, while the latter are all at record highs (Fig. 4 and Fig. 5). If stocks are on the verge of a melt-up, then most of the gains will be led by the P/Es.

As Joe and I noted last week, a fast ascent in stock prices isn’t really a stock market melt-up if it is led by rising earnings, which has been the story so far this year. However, there is a natural limit to how fast earnings can rise, which is determined by the growth of the economy. There is no natural limit to the P/E, as was demonstrated by the insane valuation of technology stocks in the late 1990s. Could a meltdown occur as a result of valuations getting too high even if the earnings outlook remains constructive? Of course. Indeed, that’s what happened in 1987. For now, we can say that the earnings outlook remains positive:

(1) M-PMI and revenues. As Debbie reports below, the M-PMI edged down from 57.8 in June to 56.3 in July (Fig. 6). That’s still high and consistent with S&P 500 revenues growth of about 5.0%.

(2) The dollar. Not surprisingly, there is an inverse correlation between the trade-weighted dollar and S&P 500 revenues, both on a y/y percent change basis (Fig. 7). The former has been positive since mid-2014, which is negative for revenues. At the end of July, the trade-weighted dollar was down 1.9% y/y, which should be modestly positive for both revenues and earnings.

The Fed: Target Practice. The FOMC can’t seem to hit a bullseye. It’s been targeting inflation since the January 24-25, 2012 meeting of the Fed’s monetary policy committee. For the first time, it set an official inflation target: “The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures [PCED], is most consistent over the longer run with the Federal Reserve's statutory mandate.” The headline PCED inflation rate rose 1.4% y/y during June, while the core (excluding food and energy) increased 1.5% (Fig. 8).

Only briefly at the start of this year has the FOMC hit a bullseye since they started target practice in early 2012. Melissa and I believe that the ability of monetary policy to target inflation is over-rated since monetary policy isn’t the only important factor influencing inflation. Competition, technology, demography can be just as important, if not more important.

Since April 27, 2011, Fed officials have been projecting both the headline and the core PCED in the Summary of Economic Projections (SEP) compiled and released quarterly by the FOMC. Prior to 2000, the FOMC focused on the CPI. Melissa, our Fed sleuth, found a footnote in the committee’s February 2000 Monetary Policy Report (MPR) to Congress explaining the switch in preference to the PCED from the CPI. It stated:

“In past Monetary Policy Reports to the Congress, the FOMC has framed its inflation forecasts in terms of the consumer price index. The chain-type price index for PCE draws extensively on data from the consumer price index but, while not entirely free of measurement problems, has several advantages relative to the CPI. The PCE chain-type index is constructed from a formula that reflects the changing composition of spending and thereby avoids some of the upward bias associated with the fixed-weight nature of the CPI. In addition, the weights are based on a more comprehensive measure of expenditures. Finally, historical data used in the PCE price index can be revised to account for newly available information and for improvements in measurement techniques, including those that affect source data from the CPI; the result is a more consistent series over time.”

Nevertheless, the report noted that the FOMC would “continue to rely on a variety of aggregate price measures, as well as other information on prices and costs, in assessing the path of inflation.” None of the alternative measures is ideal, giving the committee some flexibility for policy-making. The inflation derby based on the latest data for a selection of inflation measures is as follows: median CPI (2.2% y/y), sticky CPI (2.1), trimmed-mean CPI (1.9), core CPI (1.7), trimmed-mean PCED (1.7), headline CPI (1.6), core PCED (1.5), and headline PCED (1.4). Notice that the “skinnier” measures of inflation, which exclude the more volatile price categories, currently happen to fall at the top end of the range. Let’s review some of the alternative targets:

(1) CPI. The headline and core CPI inflation rates were 1.6% and 1.7% during June (Fig. 9). There are three main differences between the CPI and PCED measures: weight, scope, and formula. They use different baskets of goods and services with different weights for the included items. The relative weights for the CPI, prepared by the Bureau of Labor Statistics (BLS), are based on surveys of consumers, and the PCED, prepared by the Bureau of Economic Analysis, reflects surveys of businesses. It is known that response rates are higher and response quality is better for businesses than household surveys, noted a 2007 BLS and BEA joint paper.

Regarding scope, the CPI only covers out-of-pocket expenditures for urban consumers. The PCED more broadly includes other expenditures, such as medical care paid for by employer insurance, Medicare, and Medicaid. More broadly, the PCED coverage includes “the goods and services purchased by households and non-profit institutions serving households within the framework of the U.S. national income and product accounts,” according to the BLS and BEA joint paper. Finally, the price changes for the baskets are calculated using different formulas. The PCED formula tries to account for substitution between goods when one good gets more expensive. The basket doesn’t change for the CPI.

The core PCED inflation rate has been consistently lower than the comparable CPI rate (Fig. 10). That’s mostly because rent, which has been rising more rapidly than other prices, has a higher weight in the CPI and the prices of healthcare outlays paid by the government are excluded.

(2) Trimmed-mean (FRB Cleveland). Trimmed-mean inflation measures remove the most volatile monthly price changes from the inflation calculation (Fig. 11). The authors of a 2014 Cleveland Fed Working Paper explained: “These measures systematically remove sources of noise on a monthly basis, rather than ad hoc exclusionary measures such as the ex food and energy (‘core’) CPI which implicitly suggests that relative price changes in all other retail price components are [an] inflation signal, even though food prices are no more volatile than the core CPI itself.”

(3) Median (FRB Cleveland). The median CPI is considered to be an “extreme trim” measure. As the first step for calculating the median, the FRB Cleveland groups the array of consumer items into 45 categories. For each category, the percent change in the price is calculated for each month and is seasonally adjusted and annualized. On that basis, each category is sorted from highest to lowest. Each category is also weighted according to its relative importance. The median CPI is determined as the middle point where the cumulative relative importance reaches the 50% threshold.

(4) Sticky CPI (FRB Atlanta). The sticky CPI is just another way to strip out the noise from the inflation data. “[S]ome prices are ‘sticky,’ which means that they may not respond to changing market conditions as quickly as other more ‘flexible-price’ goods. And because sticky prices are slow to change, it seems reasonable to assume that when these prices are set, they incorporate expectations about future inflation to a greater degree than prices that change on a frequent basis,” as outlined a 2010 FRB-CLE Economic Commentary.

The 12-month annualized sticky CPI was 2.1% y/y during June. It has been above 2.0% consistently since October 2014. Meanwhile, the comparable measure for items with flexible prices was just 0.5%. That supports the view of Fed Chair Janet Yellen that current downward pressures on inflation are likely transitory. Lower flexible prices are depressing overall inflation, while sticky prices are steadily holding it up.

 

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Money Talks

August 01, 2017 (Tuesday)

 

Strategy I: The YRIs Have It! Yardeni Research is having more success in getting a majority vote than are Senate Republicans. CNBC posted an article titled “Market ‘melt-up’ could push stocks to new records, including an S&P 500 rally of 8%.” I was quoted extensively based on a telephone interview I had on Friday with my friends over there. I reiterated my view that the melt-up in stock prices this year is being driven by a melt-up in earnings, with our S&P 500 target at 2700 by mid-2018. Taking the opposing side in the debate was none other than Nobel Laureate and Yale University Economics Professor Robert Shiller. Poor guy is having trouble sleeping at night. He said he will “lie awake worrying” about the stock market:

“We have seen phenomenal earnings growth right now. Analysts are forecasting a continuation of that. So, I don’t know what is driving earnings. I would be skeptical that they would continue at such a blistering pace. History shows that big earnings increases like this have a tendency to revert to trend.”

At the bottom of the article is a neat feature allowing for a straw poll. The question posed was: “Do you believe an ‘earnings melt-up’ scenario will drive stocks higher into next year? After yesterday’s close, the vote was 51% “Yes,” 30% “No,” and 19% “Maybe.” It reflected the views of 4,933 voters.

From a contrarian perspective, that’s somewhat bearish. So is the extreme bullishness reflected in last week’s Investor Intelligence Bull/Bear Ratio (Fig. 1). The BBR recently jumped from 2.69 during the week of July 11 to 3.65 during the week of July 25. The good news is that this ratio works better as a bullish contrary indicator when it is below 1.0 than as a bearish contrary indicator when the ratio exceeds 3.0 (Fig. 2 and Fig. 3).

Strategy II: Follow the Money. Many years ago, Dennison Clothes in Union, New Jersey ran radio ads on WABC in New York with the catchy tagline: “Money talks, nobody walks.” The purveyors of equity ETFs don’t need any sales pitch apparently. June’s data from the Investment Company Institute show that the money continues to pour in their doors:

(1) Equity mutual funds and ETFs. During June, all equity funds attracted $42.5 billion, with $32.9 billion flowing into ETFs and the remaining $9.6 billion going into equity mutual funds (Fig. 4). Over the past 12 months through June, equity ETFs have attracted an astonishing $357.8 billion, which is a record for them, while equity mutual funds have seen $119.8 billion walk out the door (Fig. 5).

(2) Domestic vs global ETFs. The record inflows into equity ETFs over the past 12 months through June have been led by ETFs investing in domestic equities, with inflows of $236.2 billion (Fig. 6). However, in recent months there has also been a remarkable flood of money running into equity ETFs that invest globally, with the 12-month inflow soaring to a record $121.6 billion.

(3) Bond funds. So far there has been no “great rotation” out of bond funds into equity funds. Over the past 12 months through June, bond funds attracted $378.3 billion, led by mutual funds ($273.4 billion) and followed by a record inflow into bond ETFs ($104.8 billion) (Fig. 7).

(4) Massive monies. In other words, the stock market melt-up is being driven by melt-ups in earnings and in equity ETF fund inflows. There has been a mini-rotation out of equity mutual funds into equity ETFs. However, on balance, money is pouring into both equity and bond funds at a prodigious pace. Over the past 12 months through June, money market mutual funds had net outflows of $13.6 billion, savings deposits rose $499.7 billion, and all equity and bond mutual funds and ETFs attracted $616.3 billion—for a grand total of $1.1 trillion (Fig. 8).

Global Economy: Mutual Attraction. While we are counting all the spare change going hither and thither, one of the bottom lines of our analysis is that all equity funds flows are showing a strong preference for global ones, with a net inflow of $158.5 billion over the past 12 months, over domestic ones, with a net inflow of $79.6 billion (Fig. 9). That’s because despite their outperformance so far this year, foreign equities remain relatively cheap compared to US equities, especially as foreign economies have been surprising on the upside whereas US economic growth has remained lackluster and somewhat disappointing overall.

Joe and I have been in the Stay Home camp since early in the current bull market. However, we backed off late last year, seeing merit in the Go Global approach for the time being. Consider the following developments:

(1) Performance. On a ytd basis through Friday’s close, the US MSCI has actually beat most of the other major indexes in local currency terms: Emerging Markets (18.3%), US (10.6), EMU (7.4), Japan (5.2), and UK (3.2). It has mostly underperformed in dollar terms: Emerging Markets (23.2), EMU (19.5), Japan (11.1), US (10.6), and UK (9.6) (Fig. 10 and Fig. 11).

(2) Valuation. The US remains relatively expensive according to the latest forward P/E derby as of July 20: US (18.2), UK (14.6), EMU (14.4), Japan (14.3), and Emerging Markets (12.5) (Fig. 12).

(3) Earnings. The forward earnings of the US MSCI continues to rise into record-high territory (Fig. 13). Languishing from 2011 through 2015, the forward earnings of the All Country World Ex-US MSCI is showing signs of a solid cyclical recovery since early last year.

The Fed: Same Old Song. It must be lots of fun being Fed Vice Chair. You get to go to fun places; all you have to do is dust off your speech on “The Low Level of Global Real Interest Rates.” That’s the one Stanley Fischer delivered yesterday at the Conference to Celebrate Arminio Fraga’s 60 Years, Casa das Garcas, Rio de Janeiro, Brazil. Sounds like a blast! Arminio had been the president of the Central Bank of Brazil from 1999 to 2002. He must be pleased that he hasn’t had anything to do with Brazil’s economic and financial debacle of the past several years, which Sandra Ward recapped for us in the 7/13 Morning Briefing.

Fischer addresses two questions that have been on his mind for a while, and that he has discussed in many recent speeches: “Why are interest rates so low? And why has the decline in interest rates been so widespread?” I think the short answer might be: “Because you and the other major central banks have kept them this low.” However, Fischer has a longer answer:

(1) Fischer rightly observes that actual inflation has been remarkably low and subdued around the world. This has kept inflationary expectations low, along with “credible central back inflation targets.”

(2) He also observes the obvious: “[T]he coincidence of low inflation and low interest rates suggests that the natural [real] rate of interest is likely very low today.”

(3) Fed researchers have found that the real interest rate has dropped 150bps since the financial crisis of 2008, and may be only 50bps currently. This decline seems to have occurred in a number of foreign economies.

(4) The declines might be temporary if they were mostly caused by a preference for safe assets after the crisis along with central banks’ QE programs, which should “fade over time.”

(5) For the US, Fischer sees “three interrelated factors that are likely contributing to low interest rates: slower trend economic growth, an aging population and demographic developments, and relatively weak investment.” Slower economic growth has been attributable to disappointing growth in productivity and the secular slowdown in the growth rate of the labor force.

(6) Interestingly, Fischer believes that capital spending has been depressed by political and economic uncertainty, especially about health care reform, deregulation, tax reform, and trade. Of course, these uncertainties have been heightened by the Trump administration. However, these were not major uncertainties for the eight years under the Obama administration, which is when the slowdown occurred.

A more interesting idea proposed by Fischer for the weakness in capital spending is that the pace of technological innovation is disrupting the “viability of long-standing business models,” which could be weighing on investment decisions.

(7) Fischer seems to endorse the Greenspan/Bernanke thesis of a global savings glut. His spin is that slower US economic growth has reduced the demand for foreign funds, which are keeping interest rates even lower than when the housing bubble was inflating prior to the 2008 financial crisis.

(8) Fischer worries that low interest rates can have adverse consequences, including increasing the risks of liquidity traps and financial instability if the low rate environment “leads investors to reach for yield or hurts financial firms’ profitability.”

(9) Fischer concludes by asking, “What, if anything, can be done about low interest rates?” Not much, as far as monetary policy goes. It’s really up to fiscal and regulatory policies, according Fischer.

The conclusion is that Fischer and other Fed officials have concluded that interest rates are likely to stay low and that they can’t normalize rates in the ways they had in the past.

 

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2-2-2 Scenario

July 31, 2017 (Monday)

 

US Economy: Symbolism. On March 12, 2009, a subcommittee of the House Financial Services Committee held a hearing on the mark-to-market (MTM) accounting rule. Rep. Paul Kanjorski, who headed the subcommittee, warned the chairman of the Financial Accounting Standards Board (FASB) that if his organization didn’t suspend MTM, Congress would. At the hearing, my congressman Gary Ackerman reminded the man from FASB that Congress was considering a bill to broaden oversight of his organization. Ackerman instructed him to fix MTM: “It will be done in three weeks. Can and will.” On April 2, FASB did just that. (For more, see the 3/12/09 FT story titled “Congress warns on mark-to-market rule,” the 4/3/09 WSJ story titled “FASB Eases Mark-to-Market Rules,” and the 6/3/09 WSJ article titled “Congress Helped Banks Defang Key Rule.”)

Since I firmly believed that MTM had been a major contributor to the bear market in stocks—and shared that view with Ackerman at his Queens, NY office on November 25, 2008—I turned bullish four days after the hearing. On March 16, 2009, I wrote:

“We’ve been to Hades and back. The S&P 500 bottomed last week on March 6 at an intraday low of 666. This is a number commonly associated with the Devil. … The latest relief rally was sparked by lots of good news for a refreshing change, which I believe may have some staying power … I’m rooting for more good news, and hoping that 666 was THE low.”

That very same day (March 16), the bullish news included the Fed’s announcement that its QE1 bond-buying program would be expanded to $1.25 trillion in mortgage-related securities and $300 billion in Treasury bonds. On July 27, 2009, I wrote:

“I prefer melt-ups to meltdowns. The S&P 500 has been on a tear ever since it bottomed at the intraday low of 666 on Friday, March 6. We should have known immediately that this devilish number was the bear market low. It took me a few days to conclude that it probably was the low. … I felt like Tom Hanks in the ‘The Da Vinci Code.’” Subsequently, when I told this story to our accounts, I said that I called the bottom in stocks more as a symbolist than as an investment strategist.

Admittedly, I’ve recounted this story a few times since the start of the bull market. That’s what happens as I get older—I start repeating myself more often. Speaking of symbolism, my latest shtick is 2-2-2 for the US economy, with real GDP continuing to rise 2%, CPI inflation remaining around 2%, and the federal funds rate likely to top out at 2% during the current economic cycle. I’m not ready to call the next recession in 2022, but I do think it could be a while before the next downturn.

As for the S&P 500, we’ve already blasted through 1998, which is 666 times 3. The next objective is 2664 (666 times 4), which is my target, as a symbolist, for the middle of next year. Now let’s have a closer look at 222, which is 666 divided by 3:

(1) Real GDP at 2%. As Debbie reviews below, real GDP rose 2.6% (saar) during Q2, up from 1.2% during Q1. On a y/y basis, real GDP growth has been remarkably steady since 2010, fluctuating around 2.0% (Fig. 1). It was 2.1% during Q2, following Q1’s 2.0% (Fig. 2).

The growth of the economy during the latest expansion looks better using the real output of the nonfarm business (NFB) sector, which is essentially the same as real GDP excluding government (Fig. 3). It’s been hovering around 3.0% since the start of the current expansion. However, it may be slowing to 2.0% as nonfarm productivity growth remains weak, while the growth of hours worked is slowing for demographic reasons.

Over the past 10 years (40 quarters through Q1), NFB productivity is up just 1.3% per year, on average (Fig. 4). The civilian working-age age population is up just 1.0% on average over the past 10 years (120 months), while the 16- to 64-year-old segment is up just 0.5% through June (Fig. 5). Over that same period, the civilian labor force is up only 0.5%, while the 16- to 64-year-old segment is barely up, with a gain of 0.2% (Fig. 6). The only segments of the labor force that are growing are the 55 to 64 year olds and the 65+ year olds, with more of them dropping out for retirement (Fig. 7).

The 10-year annualized growth trend of the US was down to 1.5% during Q2 (Fig. 8). The Congressional Budget Office projects that real GDP growth will remain below 2.0% through 2027, based on a lackluster outlook for productivity combined with slow population growth rates (Fig. 9).

(2) CPI at 2%. The core CPI inflation rate, excluding food and energy, has been fluctuating around 2.0% since 1999 (Fig. 10). The Fed tends to focus on the core PCED inflation rate, which has been mostly below 2.0% since 1997, though that’s been the FOMC’s target since January 2012. In June, the headline CPI was up 1.6%, while the core was up 1.7%.

(3) Federal funds rate at 2%. The latest economic projections table of the FOMC participants was released after the 6/14 FOMC meeting. It shows that the median forecast for the federal funds rate is 1.4% by the end of this year. That implies one more 25bps rate hike this year to 1.25%-1.50%. The projection for the end of 2018 is 2.1%, implying an additional two or three rate hikes next year. Key Fed officials have been saying that while they expect the real “neutral” interest rate to rise, it is probably close to zero right now and for the foreseeable future. It’s hard to see what will make it move higher since they attribute the historically low rate to productivity and demographic factors, which don’t change very rapidly. They’ve also signaled that the nominal rate should be 2 percentage points above the real rate. That’s consistent with their forecast of 2.1% for the federal funds rate at the end of next year.

Strategy: Four-Bagger. Stock prices edged down on Friday, with the S&P 500 closing only 0.2% below the record high of 2477.83 set on Wednesday. So where do we go from here? On Thursday and Friday, there was some buzz about a bearish research note sent to clients by JPMorgan’s quantitative and derivative strategist Marko Kolanovic. According to an article posted on CNBC, he is warning about a possibility of a 1987-style meltdown. His main fundamental concern seems to be that “global central banks are likely to commence reducing their balance-sheet accommodation (level for Fed, and inflows for ECB/BOJ) in the near future.” He notes that all three have September meetings scheduled.

Kolanovic cited how the VIX closed below 10 every day for the past two weeks through last Wednesday, which is the “lowest level of volatility” since 1983. He is concerned if the market falls, levered investors will begin “selling into market weakness to cut losses,” just like what happened in 1987.

It’s a reasonable concern. Melissa and I have written that the next major selloff could be exacerbated by all the money that has been pouring into equity ETFs in recent months suddenly pouring out of them when/if something terrible occurs. We are hard-pressed to imagine what that might be. We are not convinced that a synchronized reduction in the balance sheets of the Fed/ECB/BOJ is either imminent or even likely to be the trigger for the next stock market selloff.

So, for now, the path of least resistance is still higher for stocks, especially since forward earnings continue to blaze that trail, as Joe and I have been noting since last summer. So the answer to “where do we go from here?” is probably “higher, for now.” Our yearend target of 2400-2500 has been achieved way ahead of schedule. Now, as strategists, we are aiming for 2700 by the middle of next year, a four-fold increase since March 2009 (Fig. 11). Assuming a forward P/E of 18, we would need to see forward earnings climb to $150 per share by the middle of next year, up about 7.4% from the latest reading in late July. That’s realistic, in our estimation.

Movie. “Atomic Blonde” (+) (link) features Charlize Theron playing a spy working for M16 British intelligence just as the Berlin Wall is coming down. The movie is intentionally campy with lots of pop hits from the late 1980s. Charlize leaves a long trail of dead bad guys as the one-woman death squad mercilessly pursues her mission impossible. This could be the beginning of a new spy thriller series. After all, James Bond must be ready for the nursing home of retired spies by now. The movie starts slow, but the pace of mayhem speeds up along the way.

 

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Shovel-Ready Industrials

July 27, 2017 (Thursday)

 

Industrials I: Digging Most of Them. In recent days, General Electric and Caterpillar reported earnings. Both companies are in the S&P 500 Industrials sector, and both have operations spanning the earth. But their results—and the response of their respective shares—couldn’t have been more different.

General Electric shares slumped 2.9% from Thursday’s close to Friday’s close after investors learned that the company’s fiscal 2017 earnings would come in at the low end of a range given earlier this year. Conversely, Caterpillar shares rallied 5.9% after the company increased both its revenue and its earnings guidance. GE suffered from its exposure to the oil and gas industry and the gas turbine market. Caterpillar benefitted from its exposure to the construction of housing and buildings, mining, and the fracking industry.

GE is such a large company that its underperformance this year—its stock is down 19.5% ytd—is overshadowing the strong performance of other industrial companies. The S&P 500 Industrials stock price index is up 8.7% ytd through Tuesday’s close, which means it’s lagging behind the S&P 500, which is up 10.6% over the same period. Without GE, however, the S&P 500 Industrials stock price index would be up roughly 13.0%, according to Joe’s calculations. It would be outperforming the S&P 500 and would be the third-best-performing sector.

Here’s the performance derby of the S&P 500’s sectors ytd through Tuesday’s close: Tech (22.9%), Health Care (16.6), Consumer Discretionary (12.3), Materials (12.0), S&P 500 (10.6), Industrials (8.7), Financials (8.2), Utilities (8.0), Consumer Staples (7.1), Real Estate (5.3), Energy (-12.7), and Telecom Services (-15.3) (Fig. 1).

An outperforming Industrials sector makes more sense given some of the strong economic data that has rolled in. Consider the following:

(1) Managers purchasing. The US and global M-PMIs have been solid this year. The US M-PMI, at 57.8 in June, has been north of 50.0 since last September. Likewise, the new orders component of M-PMI stands at 63.5, and the employment category clocks in at 57.2 (Fig. 2). The indicator is also throwing off positive readings around the world. In advanced economies the M-PMI was 53.9 last month, and in emerging economies it was 50.8, the latter indicating economies that were growing but just barely (Fig. 3).

(2) Commodity strength. The prices of most industrial commodities are signaling that all’s fine in the world of manufacturing. The CRB raw industrials spot price index is up 2.3% ytd through Tuesday’s close and 27.0% from its 2015 cyclical low (Fig. 4). The price of copper is up 14.3% since May 8 (Fig. 5). Even agricultural commodities look like they’re bottoming after falling sharply since 2013 (Fig. 6).

(3) Oil slick. There are certainly things to worry about, including the recent drop in the price of oil. A barrel of Brent crude oil recently topped out at $57.10 on January 6 and has since fallen to $44.92. However, the decline isn’t anywhere near the magnitude of the drop experienced from 2014 through early 2016, when a barrel of crude fell from $115.06 to $27.88, sending the industrial sector into a mini-recession (Fig. 7).

(4) Dollar tailwind. Looking ahead, Industrials stands to benefit if the recent decline in the dollar holds. The dollar, which rallied since the summer of 2014, continued to do so in the wake of the US presidential election last year and peaked on January 11 at 126.21, falling 7.2% since then to 117.10 (Fig. 8). If the dollar is flat for the remainder of the year, S&P 500 earnings growth will get a 4ppt earnings bump, according to a 7/25 Bloomberg article citing Morgan Stanley estimates.

Industrials II: Winners & Losers. A number of industries within the S&P 500 Industrials sector are generating very different returns this year. Some of the winners ytd through Tuesday’s close include: Construction Machinery & Heavy Trucks (19.7%), Aerospace & Defense (19.5), Industrial Machinery (14.9), and Electrical Components & Equipment (13.5) (Fig. 9). Meanwhile, some industries that have underperformed ytd include: Industrial Conglomerates (-4.1), Trucking (-4.5), Air Freight & Logistics (4.2), and Airlines (6.3) (Fig. 10).

Overall, the Industrials sector is expected to produce 4.1% revenue growth over the next 12 months and earnings growth of 10.1% over the same period. The fastest-growing industries in the sector include: Construction & Farm Machinery, with forward earnings expected to grow 17.2%, Diversified Support Services (16.7%), Agricultural & Farm Machinery (15.8), Construction & Engineering (14.6), and Railroads (14.6).

Some of the slowest earnings growth over the next year is expected to come from Human Resources & Employment Services (5.1%), Trading Companies & Distributors (6.9), Airlines (7.6), Building Products (8.0) Air Freight & Couriers (8.1), and Environmental & Facilities Services (8.1). Industrial Conglomerates clocks in at 9.8% earnings growth over the next 12 months.

Here’s a look at recent news from Industrials companies and what it may imply about the industries in which they reside:

(1) Caterpillar: Caterpillar’s Q2 sales rose 10.0% y/y, and operating profit soared 59.4%. The company credited strong results to construction in China and gas compression in North America. In addition, mining and oil-related activities have “come off recent lows, and we’re seeing improving demand for construction in most regions,” said CEO James Umpleby in the company’s Q2 earnings conference call transcript. Just imagine what the company could earn if an infrastructure spending bill ever passed Congress.

Caterpillar raised its FY revenue outlook to a range of $42 billion to $44 billion, up from its previous outlook of $38 billion to $41 billion. The EPS guidance was increased to $3.50 assuming revenue comes in at the middle of the expected range, up from an earlier estimate of $2.10. On an adjusted basis, EPS of $5.00 is now expected, up from $3.75.

Cat is part of the S&P 500 Construction Machinery & Heavy Trucks index, which is up 19.7% ytd (Fig. 11). Expectations for the industry’s earnings growth over the next 12 months have been improving since late 2015 and now stand at 17.2% (Fig. 12). Its forward P/E reached a high of 24.3 in December 2016, when forward earnings hit a cyclical bottom before falling to the current 19.2, which is still high relative to the past 20 years (Fig. 13).

(2) General Electric: The company that brings good things to life reported Q2 revenue of $29.6 billion, down 12%, and adjusted EPS of 28 cents, down from 51 cents a year earlier. Much of the decline was due to the boost in results received last year from the sale of GE’s appliance business.The results for the quarter beat analysts’ expectations; however, the company issued a disappointing warning that its full-year results would be on the “weak side” of its previously announced range of $1.60 to $1.70 a share, reported a 7/21 WSJ article. In addition, incoming CEO John Flannery won’t unveil his 2018 outlook for GE until mid-November, a lifetime on Wall Street.

GE is a member of the S&P 500 Industrial Conglomerates stock price index, which has fallen 4.1% ytd (Fig. 14). Other members of the industry have turned in much stronger performances: Honeywell International has risen 18.5% ytd, 3M is up 11.5% even after pulling back this week in the wake of its earnings report, and Roper Technologies has rallied 27.5%. The S&P 500 Industrial Conglomerates is expected to generate 2.9% revenue growth over the next 12 months and 9.8% earnings growth (Fig. 15). At 17.9, the Industry’s P/E has come off its high of 20.4 hit during July 2016.

(3) Boeing. The airplane manufacturer beat Q2 earnings expectations and raised its 2017 earnings estimates, which sent its shares flying. In Q2, the company earned an adjusted profit of $2.55 a share, above analysts’ consensus estimate of $2.30 a share and up from last year’s loss of 44 cents a share. The company is now calling for its 2017 earnings to fall between $9.80 and $10.00 a share, up from its previous guidance of $9.20 to $9.40 a share. The shares were up 9.9% Wednesday and have jumped 50.0% ytd.

Boeing is a member of the S&P 500 Aerospace & Defense stock price index, which is up 19.5% ytd through Tuesday’s close (Fig. 16). The industry is expected to grow revenue by 3.4% over the next 12 months and earnings by 9.1% (Fig. 17). Its forward P/E is at a lofty 19.9, but its forward profit margin, at 7.9%, is below its record high of 9.0% in September 2014 (Fig. 18). The ability to improve margins, combined with the continued increase in defense spending domestically and abroad, could keep shares afloat.

(4) Autos. Auto manufacturers are lumped into the Consumer Discretionary sector, but their manufacturing heft makes them important to watch when tracking the Industrials sector. Both GM and Ford reported disappointing Q2 earnings, with strong US truck sales unable to offset the decline in US car sales.

Ford’s Q2 operating income fell 16% to $2.5 billion, and the company lowered its 2017 EPS guidance to a level that implies pre-tax operating earnings will be in a range of $7.8 billion to $8.7 billion. That’s down from the previous outlook for $9 billion of pre-tax operating earnings and below the $10.4 billion earned last year, the 7/26 WSJ reported.

GM’s Q2 earnings dropped 42% to $1.7 billion, hurt by costs associated with exiting markets in Europe, India, and South Africa. Both companies have elevated inventory levels. At GM, nearly 1 million vehicles are on dealer lots, equating to 105 days of supply.

Much of this dour news is baked into the S&P 500 Automobile Manufacturing stock index, which is down 2.3% ytd. Analysts are calling for the industry’s revenue to drop 3.0% and earnings to fall 2.4% over the next 12 months.

 

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Earnings-Led Melt-Up?

July 26, 2017 (Wednesday)

 

Strategy: Climbing a Wall of Earnings. Technicians and contrarians, especially contrarian technicians, are most bullish when everyone seems to be most bearish. They observe that some of the best bull markets have “climbed a wall of worry.” The current bull market has certainly done so. Joe and I have counted 56 panic attacks since the start of this bull market in our S&P 500 Panic Attacks Since 2009.

Most recently, there was a one-day “Trump Impeachment Scare” on May 17 (Fig. 1). We count seven scares last year, including the “Endgame Panic” at the beginning of 2016, “Brexit” during the summer, and “FBI Flags HRC” last fall (Fig. 2). Since the start of the bull market, the panic attacks have been followed by relief rallies to new cyclical highs, then to new record highs since March 28, 2013 (Fig. 3). So here we are at yet another set of new record highs for the S&P 500/400/600 (Fig. 4). However, this year’s ascent has occurred without any meaningful panic attacks. There’s been no wall of worry. There’s been nothing to fear but nothing to fear, as we observed in Monday’s commentary titled “Summertime Lullaby.”

Helping to allay fears have been the steady increases in the forward earnings of the S&P 500/400/600 to new record highs over the past year (Fig. 5). These uptrends have been supported by rising forward revenues for all three S&P composites (Fig. 6). Most encouraging is that stock prices have been rising along with forward earnings, so that the forward P/Es of the S&P 500/400/600 have actually edged down slightly so far this year (Fig. 7).

That’s a very healthy development. Valuation multiples remain highly elevated, of course. But it isn’t a melt-up if stocks are rising along with earnings rather than on higher valuation multiples.

Confidence I: US Consumers Upbeat. Another healthy development is that the current conditions component of our Consumer Optimism Index (COI) rose to a new cyclical high during July (Fig. 8). It is at the highest level since May 2001. Debbie and I calculate the COI as the average of the Consumer Sentiment Index (CSI) and the Consumer Confidence Index (CCI). The current conditions component of the latter tends to fluctuate with more amplitude than the former. It also tends to be a more sensitive indicator of labor market conditions. In the CCI survey, we put a lot of weight on the “jobs plentiful” series. Here is what it shows:

(1) Bountiful. The percentage of respondents agreeing that jobs are plentiful rose to 34.1% during July, the best reading since July 2001 (Fig. 9). The percentage saying jobs are hard to get fell to 18.0%, the lowest since February 2007. This series is highly correlated with the unemployment rate and suggests it could continue to fall (Fig. 10).

(2) Help wanted. The jobs plentiful series is highly correlated with the percent of small business owners with job openings, a series compiled by the National Federation of Independent Business (Fig. 11). The latter, on a three-month-average basis, rose to 32.3% during June, the highest since January 2001.

(3) Wage paradox. There are fewer and fewer labor market indicators suggesting that there is still slack in the labor market. The one that really stands out is wage inflation. It remains remarkably subdued given its past tight correlation with the jobs plentiful series (Fig. 12). During the past three business cycles, wage inflation rose to about 4.0% when the jobs plentiful reading was as high as it is now.

Confidence II: Off the Charts in Germany. Meanwhile, over in Germany, they’ve started Oktoberfest early. July’s IFO Business Confidence Index soared to another fresh record high in July, led by its current conditions component (Fig. 13 and Fig. 14). Could it be that the huge influx of immigrants is boosting economic growth over there? It always has when it happened in other countries in the past.

US Labor Market: Shortage of Slackers. In our spare time, Debbie and I have been slicing and dicing the US labor market data to determine whether the remarkably subdued pace of wage inflation is attributable to the availability of more slack than suggested by the unemployment rate, job openings, and consumer surveys.

As we’ve noted before, there are currently as many job openings as there are unemployed workers. Both are around 6 million. In our opinion, that confirms that the economy is at full employment, with only “frictional” unemployment caused by geographic and skills mismatches. But what about the low labor force participation rate? Could it be that there are still lots of working-age people who are NILFs (not in the labor force) because they had dropped out but are starting to come back? We don’t think so. Many of the NILFs are retired Baby Boomers. In addition, more young adults are going from high school to college rather than straight to work. Consider the following:

(1) Participation rate. If the labor force participation rate of the civilian working-age population were still 65%, as it was when the unemployment rate peaked at 10.0% during October 2009, then the unemployment rate today would be 7.6% (Fig. 15). Instead, the jobless rate is only 4.4% because the participation rate has dropped to 62.8%.

Now, excluding people who are 65 years old or older from the numerator and denominator of the participation rate shows that the participation rate was 73.3% during June (Fig. 16). Removing 16-24 year olds as well results in a 77.2% participation rate.

(2) Employment/population ratio. Doing a similar analysis of the employment/population ratio shows it at 60.1% during June (Fig. 17). Excluding seniors, it was 70.1%; excluding seniors and juniors brings it up to 74.5%. It’s certainly hard to see any slack in the unemployment rate for 25-54 year olds, which fell to only 3.8% during June (Fig. 18).

 

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Go With the Capital Flows

July 25, 2017 (Tuesday)

 

Currencies I: Our Doves vs Theirs. The neighborhood is improving. Since late last year, the global economy has been showing signs of better growth that seems to be outpacing US growth. That’s most likely why the US trade-weighted dollar is down 7% to 116.90 since peaking at 126.21 on January 11 (Fig. 1). That’s after it rose 26% from 99.89 on July 1, 2014 to this year’s peak, with the rally reflecting the fact that the Fed started to normalize monetary policy during the second half of 2014, while the ECB and BOJ remained committed to maintaining their ultra-easy monetary policies.

The Fed had greater confidence in the US economy than the ECB had in the Eurozone’s economy and the BOJ had in Japan’s economy. So the Fed terminated QE on October 31, 2014, hiking the federal funds rate by 25bps at the end of 2015, and again at the end of 2016. The dollar jumped after Donald Trump’s Election Day victory boosted animal spirits and expectations of stimulative fiscal policies. While those high hopes haven’t been dashed, they certainly have been postponed given the ongoing turmoil in DC that’s weighed on the dollar.

The dollar peaked on January 11 despite another two Fed rate hikes of 25bps so far this year on March 15 and June 14, while the official rates of both the ECB and BOJ remain slightly south of zero (Fig. 2). Furthermore, despite speculation that the ECB and BOJ might soon join the Fed in normalizing their monetary policies, the assets on both their balance sheets continued to grow. They recently exceeded the Fed’s assets, which have been flat around $4.4 trillion since QE was terminated during October 2014 (Fig. 3). As Melissa and I wrote yesterday, both ECB President Mario Draghi and BOJ Governor Haruhiko Kuroda signaled last week that they are in no rush to normalize given that their CPI inflation rates remain below their 2.0% targets.

This suggests that perhaps the dollar might stop falling. We don’t expect it will resume rallying. More likely is that it will move sideways for a while. Consider the following:

(1) Easy does it on Fed tightening. Melissa and I have noted that during her congressional testimony on monetary policy during July 12 and 13, Fed Chair Janet Yellen reiterated that the FOMC is still committed to rate hikes. However, she added that her goal is to reach a neutral level of interest rates that is lower than it has been historically and not so far off from where the federal funds rate is set now.

She thus supported a similar view expressed by her colleague (and BFF) Fed Governor Lael Brainard, who said in a 7/11 speech that “the neutral level of the federal funds rate is likely to remain close to zero in real terms over the medium term.” Considering that, there would not be “much more additional work to do on moving to a neutral stance” from the moderately accommodative stance now. She added that the FOMC “decided to delay balance sheet normalization until the federal funds rate had reached a high enough level to enable it to be cut materially if economic conditions deteriorate.”

(2) Brainard’s dollar dialectic. Brainard’s speech was all about the impact of the Fed’s monetary normalization on the dollar. It was titled “Cross-Border Spillovers of Balance Sheet Normalization,” and mentioned “exchange rate” 47 times in her comments and footnotes, obviously acknowledging that the foreign exchange value of the dollar is now an important consideration in the setting of monetary policy. Brainard seemed to conclude that it is best to lean toward reducing the balance sheet, as it should put less upward pressure on the dollar than raising interest rates, in her opinion. In other words, rate-hiking might end soon once balance-sheet reductions start.

These dovish sentiments have been reflected in the recent weakness of the dollar, in our opinion, while the dollar’s rally from mid-2014 through early 2016 discounted the divergent monetary policy in the US and elsewhere—i.e., the gradual normalization of US policy and the continuation of ultra-easy policy in the Eurozone and Japan. On a relative basis, it seems to us that Draghi and Kuroda are even more dovish than Brainard and Yellen, which is why the dollar should stop falling.

Currencies II: Capital Flows Weaken Dollar. The value of the trade-weighted dollar is driven by the US trade balance with the rest of the world and by US capital inflows and outflows. The US has been running a trade deficit with the rest of the world for many years. The flip side of the US trade deficit is the trade surplus of the world with the US (Fig. 4). This trade surplus provides foreigners with dollars, which they can use to purchase US assets. If they would rather convert them to their own currencies, then the dollar will depreciate, unless foreign central banks intervene by purchasing the dollars and holding them as international reserves. Many foreign central banks have been inclined to do so over the years, supporting the dollar, because otherwise strength in their currencies relative to the dollar might depress the competitive position of their exports in America, the world’s largest market for foreign goods.

Debbie and I calculate implied net capital flows of the rest of the world (ROW) simply by subtracting the ROW’s trade surplus, on a 12-month basis, from the 12-month change in the non-gold international reserves held by the central banks of the ROW (Fig. 5). Our proxy is highly inversely correlated with the trade-weighted dollar on a y/y basis. Let’s have a closer look:

(1) Implied net capital flows & the dollar. Since the financial crisis of 2007/08, there have been a few significant swings in our proxy (Fig. 6). It showed large net outflows from the ROW during 2008, 2012, and 2014/15—coinciding with periods of strength in the dollar. There were net capital inflows for the ROW during 2010/11 and a significant easing in net capital outflows since early 2016—coinciding with weakness in the dollar.

(2) International reserves & the dollar. Most of the volatility in our proxy is attributable to the yearly change in international reserves held by the ROW, which is also highly inversely correlated with the trade-weighted dollar (Fig. 7). When the ROW’s reserves are increasing, that shows that foreign central banks are accumulating reserves mostly in dollars to keep their currencies from appreciating relative to the dollar. Most recently, reserves fell by $877 billion during the 12 months through January 2016, which coincided with the dollar’s strength. Over the past, 12 months through April, the proxy showed net capital outflows of only $49 billion.

Finally, there is even a better fit between the yearly percent change (rather than the y/y change) in international reserves and inverse of the yearly percent change in the trade-weighted dollar (Fig. 8). The former was flat y/y through April, but that’s better than the recent trough of -7.2%.

Currencies III: For Draghi, Strong Euro a Drag. Draghi’s dovish tone last week must have been related to the recent strength in the euro (Fig. 9). It is up from last year’s low of $1.04 to $1.16 currently. To an important extent, Draghi’s rounds of ultra-easy monetary policies were aimed at depreciating the Eurozone’s currency. His “whatever it takes” speech on July 26, 2012 didn’t do that at first, as the euro actually rose from $1.23 on that day to peak at $1.39 during May 6, 2014.

Draghi resorted to a shock-and-awe approach with negative interest rates starting on June 5, 2014 followed by a QE program on January 22, 2015, and an expansion of that program on March 10, 2016. That all worked to bring the euro down to last year’s low of $1.04.

What can Draghi do if the euro continues to strengthen? Not much other than to coo dovishly as often as possible.

Currencies IV: EM Currencies Emerging Again. Perversely, the weakness in the dollar since early this year may have something to do with the Fed’s two rate hikes during March and June. As noted above, Fed officials have been softening the blows by saying that the rate hikes should be gradual, and might be over relatively soon. Furthermore, the dollar may have weakened because the rate hikes haven’t had any adverse impact on the bonds, currencies, and stock markets of emerging market economies. There have been no tightening tantrums in any of those financial markets.

This suggests that emerging markets may be able to handle Fed rate hikes, at least gradual ones, without any adverse consequences. Indeed, the Emerging Markets MSCI stock price index is up 18.9% y/y in local currency through last Friday and 21.7% in US dollars (Fig. 10). The Emerging Markets MSCI Index Currency Ratio is up 2.3% y/y (Fig. 11).

Currencies V: Slippery Slope. The price of a barrel of Brent crude oil has had one of the best inverse correlations with the trade-weighted dollar since 2005 (Fig. 12). However, they’ve diverged so far this year, with the former down 14% ytd, while the latter is down 7% over the same period. In the past, a weak dollar would have been bullish for oil. Since we think causality runs both ways, weak oil prices should be bullish for oil. We think there is a better fundamental case to be made for weak oil prices than for a weaker dollar from this level.

 

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Summertime Lullaby

July 24, 2017 (Monday)

 

Strategy I: Jazzy Opera. “Summertime” is the aria in the opera Porgy and Bess (1935) composed by George Gershwin. The song became a popular and much-recorded jazz standard, with more than 33,000 covers by groups and solo performers. During these hot summer days, I sometimes like to listen to Ella Fitzgerald sing: “Summertime, and the livin’ is easy. Fish are jumpin’, and the cotton is high. Oh, your daddy’s rich, and your ma is good-lookin’. So hush little baby, don’t you cry.”

For stock investors, the living has been relatively easy since March 2009, when this great bull market started. It would have been far easier if we all fell asleep since then and just woke up occasionally to make sure we were still getting rich. There have been plenty of reasons to wake up crying. But the bull kept singing a lullaby that hushed us all up. Now it seems that we are all getting lulled to sleep by the monotonous advance of stock prices. They just keep heading to new record highs with less and less volatility (Fig. 1 and Fig. 2). Consider the following:

(1) Vix. The S&P 500 VIX fell to a record low 9.36 last Friday (Fig. 3). It had spiked to 28.14 early in 2016 on fears of four Fed rate hikes that year. The Brexit scare last summer caused it to spike to 25.76.

(2) High-yield spread. The yield spread between the high-yield corporate bond composite and the US Treasury 10-year bond remains extremely low around 325bps despite the recent weakness in the price of oil (Fig. 4). That spread widened dramatically from 253 bps on June 23, 2014 to 844 bps on February 11, 2016, when the price of oil plunged. Not surprisingly, the spread is highly correlated with the VIX (Fig. 5). Both suggest that investors are enjoying a summertime siesta.

(3) Sentiment. So does the Investors Intelligence survey, which shows that only 16.7% of investment advisers are bearish (Fig. 6). This series is also highly correlated with the VIX. The Bull/Bear Ratio was back above 3.00 last week (Fig. 7).

Strategy II: Hot Towns. It certainly is summertime in DC, Baltimore, Wilmington, Philly, and NYC. I was visiting our accounts in those hot cities last week. The heat is making all of us drowsy. That’s especially since the consensus seems to be very much at ease with an economic outlook that’s bullish for stocks. It’s easier to fall asleep when one has few worries. There’s also no noise coming from the VIX to wake us up. However, I found that some accounts are concerned about the lack of volatility and the proliferation of bullish sentiment from a contrarian perspective, but they don’t seem to be losing too much sleep over it.

Almost everyone seems to share my view, which I first mentioned in early 2013, that the risk is a melt-up that might set the stage for a meltdown. A few wondered why I still viewed it as a risk rather than a reality or at least a clear and present danger. Of course, the only trouble with a melt-up is that we must be wide awake to decide when to get out of stocks. I conceded that we might very well be starting a melt-up.

The consensus scenario that seems to be lulling everyone to sleep this summer is as follows: The economy will continue to grow at a leisurely pace, with real GDP rising 2.0% and inflation remaining just below 2.0%. This is certainly not a boom, which therefore reduces the risk of a bust. No boom, no bust (NBx2)! So the economic expansion could last for a long while. Back in 2014, Debbie and I explained why it might last until March 2019. It will be the longest expansion on record if it lasts until July 2019. Everyone has plenty of explanations for why wage inflation hasn’t rebounded and might remain subdued while the unemployment rate is so low and might stay that way. The Fed should continue to raise rates, but monetary normalization will remain very gradual, and the federal funds rate might peak at only 2.00% this cycle.

I am officially dubbing this the “2-by-2-by-2” scenario, with real GDP growing 2.0%, inflation at 2.0%, and the federal funds rate at 2.00%. This is the consensus currently, in my opinion, based on my discussions with some of our accounts, most recently in the Mid-Atlantic states.

So what could go wrong? What might lead to a meltdown (either a nasty correction or a bear market) without a stage-setting melt-up first? Consider the following:

(1) Central bank balance sheets. A few accounts last week raised some concerns about the adverse consequences on the stock and bond markets if the Fed, ECB, and BOJ all were to start to reduce the sizes of their balance sheets from June’s levels of $4.4 trillion, $4.7 trillion, and $4.5 trillion, respectively (Fig. 8). While the Fed is set to proceed, Fed officials seem to be signaling that they might slow or postpone rate hikes once they start to reduce their balance sheet. Neither the ECB nor the BOJ seem to be in any rush to halt their ultra-easy policies.

Last week, ECB President Mario Draghi expressed concern about the risk of a slowdown in bank lending and low annual CPI inflation in the Eurozone (Fig. 9 and Fig. 10). During his 7/20 press conference, Draghi observed that inflation was 1.3% y/y in June, down from 1.4% in May, mainly due to lower energy price inflation. That’s below the ECB’s target of close to, but just below 2.0%. Measures of underlying inflation remain low, he further noted, and do not appear likely to pick up.

Answering a question about inflation expectations, Draghi explained: “[B]asically, inflation is not where we want it to be, and where it should be. We are still confident that it will gradually get there, but it isn’t there yet.” Reiterating his prepared introductory statement, he continued: “Therefore a very substantial degree of monetary accommodation is still needed for underlying inflation pressures to gradually build up and support headline inflation developments in the medium term.”

Draghi added: “But let me just make clear one thing: after a long time, we are finally experiencing a robust recovery, where we only have to wait for wages and prices to move towards our objective. Now, the last thing that the Governing Council may want is actually an unwanted tightening of the financing conditions that either slows down this process or may even jeopardise it.” Reading from the introductory statement again, Draghi repeated: “If the outlook becomes less favourable or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation, we stand ready to increase our asset purchase programme in terms of size and/or duration.” Citing the Bank Lending Survey for Q2, however, Draghi observed that bank lending rates are currently at supportive levels, credit standards have further eased, and loan growth continues to be supported by demand.

Also last week, despite a recent slowdown in the pace of monthly purchases, the BOJ maintained its annual purchase target of “more or less the current pace” of 80 trillion yen in Japanese Government Bonds (JGBs). The bank also maintained its “QQE with YCC” policy, targeting 10-year JGB yields at around zero percent, with the short-term rate held at -0.1%. No change was made to the inflation target of 2.0%. However, the BOJ lowered its median CPI inflation forecasts last made during April as follow: to 1.1% from 1.4% for 2017, to 1.5% from 1.7% for 2018, and to 2.3% from 2.4% for 2019 (Fig. 11). Excluding the effects of the consumption tax hike, the bank expects CPI inflation to reach just under 2.0% around 2019. While the forecasted growth rates for Japan’s economy were somewhat higher than the previous ones, risks “to both economic activity and prices are skewed to the downside,” according to the BOJ’s “Outlook for Economic Activity and Prices (July 2017).”

(2) Inflation. While the major central banks are struggling to push inflation up to their 2.0% targets, I did run into one person in NYC last week who believes that both growth and inflation soon will make comebacks in the US because he is convinced that the Millennials are on the verge of getting married, having kids, and buying houses. I was skeptical, but remain open-minded about that possibility. I told him when I see it in the data, I’ll believe it.

My friend and I agreed that there are three possible scenarios. There’s the consensus sleepy, but bullish, 2-by-2-by-2 scenario. There’s my sleep-depriving melt-up scenario. There’s his sleep-jarring inflation scenario, which would force the Fed to tighten monetary policy at a more normal rate and might trigger a meltdown. My subjective probabilities on these three currently are 40%, 40%, 20%. I’m thinking about raising the odds of a melt-up above 50%, but the summer heat is slowing me down.

(3) The swamp. It’s certainly the dog days of summer in Washington, DC. President Donald Trump has called on members of Congress not to flee the city to go on their summer vacations but to stay and work until health care reform has been accomplished. It was mighty hot there last week when I stayed overnight at the Watergate Hotel, just for the fun of it. Even hotter is the political fighting between the Republicans and Democrats and infighting among the Republicans. However, the bull market couldn’t care less. There’s always the possibility of a selloff if the latest round of gridlock is so bad that another debt-ceiling deadlock could force yet another government shutdown. Then again, this bull market seems so charged up that a shutdown might be welcomed: If we can’t drain the swamp, then let’s shut it down.

Banks: Hits & Misses. High expectations and low interest rates and volatility are putting a damper on S&P 500 Financials’ Q2 earnings season. While most EPS results beat expectations, they failed to light a fire under the sector’s stock index. While it is up 29.7% y/y through Friday’s close, making it the second-best-performing S&P 500 sector over that period, over the last week the sector fell 0.3%, making it the third-worst-performing sector (Fig. 12).

Here’s the performance derby for the S&P 500 and its 11 sectors over the past week through Friday’s close: Utilities (2.6%), Tech (1.1%), Health Care (1.1), Consumer Discretionary (1.0), Telecom Services (1.0), Real Estate (0.8), Consumer Staples (0.6), S&P 500 (0.5), Materials (0.0), Financials (-0.3), Energy (-0.5), and Industrials (-1.0) (Table 1).

Despite the disappointment, forward earnings expectations for Financials remain optimistic. Analysts expect the sector’s revenues to grow 3.7% over the next 12 months, and earnings to increase by 12.3% (Fig. 13). As a result, Financials boasts the third-highest forward earnings growth of the 11 S&P 500 sectors (Table 2).

At 13.9, the industry’s forward P/E has rebounded from its recessionary lows, which will make further expansion tougher to come by (Fig. 14). However, the sector’s stocks should climb along with earnings, bolstered by higher dividend payments, stock buybacks, and a friendlier political environment. Here’s a quick look at some of the highlights of the Q2 earnings Financials have reported so far:

(1) Flattening spreads. Hopes were high that interest rates on long-term bonds would have risen by now, giving a boost to banks’ net interest margins. However, the 10-year Treasury yield is lower today than it was in December, while short-term interest rates have continued to climb (Fig. 15). As a result, the spread between the fed funds rate and the 10-year Treasury, which ran up to 213 bps on December 14, 2016, fell back to a low of 98 bps during June 26 of this year. The spread widened slightly in recent weeks to 111 bps (Fig. 16).

Bank of America’s Q2 net interest income may have risen by 8.6% y/y to $11.0 billion, but it fell by $72 million from Q1. The bank warned in May that the sale of a business and the interest-rate environment would weigh on results, the 7/18 WSJ reported. Banks earnings have room to improve dramatically if long-term interest rates rise. Their best chance may come this fall if the Fed goes through with reversing quantitative easing. Wall Street remains optimistic about the S&P 500 Diversified Banks industry, penciling in forward revenue growth of 4.0% and forward earnings growth of 12.2% (Fig. 17).

(2) Unprofitable VIX. Record-low volatility in the stock market and a sharp drop in the price of oil combined to hurt trading results for most financial players. As we mentioned above, the CBOE Volatility Index hit its lowest level since 1993 on Friday, July 14, in part because the stock market in the past year has gone only in one direction: up. The three major stock indexes in the US, Europe, and Asia have yet to pull back by 5% or more this year. “Never in at least the past 30 years have all three indexes—the S&P 500, MSCI Europe and MSCI Asia-Pacific ex-Japan—gone a calendar year without falling at some point by at least 5%,” a 7/19 WSJ article reported.

The markets took their biggest bite out of Goldman Sachs’ results; Q2 revenue in its fixed-income, currency, and commodities trading business fell 40% y/y. The declines were less dramatic at other shops, but the area was a drag nonetheless. FICC revenue fell 6% at Citigroup, 14% at Bank of America, and 4% at Morgan Stanley. Goldman still beat analysts’ estimates for the quarter, but leaned on profits from its private equity division to do so.

Wall Street’s analysts are forecasting 6.2% forward revenue growth and 14.4% forward earnings growth for the S&P 500 Investment Banking & Brokerage industry (Fig. 18).

(3) Languishing loans. There has been some concern about slowing loan growth given that we’re in the eighth year of an economic expansion. The y/y increase in C&I loans at banks was 1.4% in mid-July, slower than the 12% increases enjoyed just two years ago (Fig. 19). At BAC, Q2 loan growth was only 1.5% y/y, but at JPMorgan and PNC loans grew a bit faster, at 4.1%. The Pittsburgh-based bank said it expects loans to rise by a mid-single-digit rate for the full year.

Wall Street analysts are projecting some of the strongest results in the Financials sector to come from Regional Banks. Revenues is expected to grow 6.3% over the next 12 months for the S&P 500 Regional Banks industry, and earnings should jump 14.3% (Fig. 20).

Movie: “Dunkirk” (+ + +) (link) is one of the best-made war movies I’ve seen because it depicts the brutal intensity of war with no time for frivolous banter. It certainly shows how, for Britain, World War II was from the start about fighting first for survival, then for victory on the beaches, on the seas, and in the air, just as Winston Churchill proclaimed on May 13, 1940. There are plenty of British heroes, particularly the owners of small boats and ferries who participated in evacuating more than 330,000 mostly British and French soldiers in about 11 days from the beaches of Dunkirk before Hitler’s forces could annihilate them.

 

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Cashless

July 20, 2017 (Thursday)

 

Banks: Going Mobile. One of Jackie’s friends is visiting family in Sweden this summer, and her cousin advised against exchanging dollars into krona. Unfortunately, the cousin wasn’t offering to pick up the tab for the visit. She was merely cautioning that cash is rarely used in Sweden. Many shop owners literally don’t accept paper currency. Some local banks don’t even have cash at their branches. Instead, Swedes are using electronic payments or credit cards to purchase just about anything. Electronic payments is just one of the many disruptive technologies that Jackie and I have been monitoring. I asked her to have a closer look—though on her PC in her home office rather with an all-expenses-paid trip to Sweden. Here is what she found:

Instead of using cash, Swedes are increasingly using Swish, an app downloaded to cell phones that lets users make or receive payments directly to or from their bank accounts. Something similar launched in the US last month. It’s called “Zelle,” and it has the backing of some of the largest US banks, including Chase, Bank of America, and Wells Fargo. Here’s a look at the two apps that may make cash as antiquated as gold coins or clam shells in the not-too-distant future:

(1) Swish it. Swish was developed in 2012 by Sweden’s largest banks, including Nordea, Handelsbanken, SEB, Danske Bank, and Swedbank. Only customers of those banks can use Swish—so our American friend will have to use her US credit cards.

The app uses cell phone numbers and an account with a participating Swedish bank to transfer money via cell phone or to make an Internet purchase. Transactions are free to consumers, presumably because it costs banks less money for transactions to occur in the ether than it would were hard currency used. Cash costs banks money. It has to be handled, counted, and transported.

Even Swedish churches have adopted the technology. Churches will display their phone numbers at the end of each service and ask parishioners “to use Swish to drop their contribution into the virtual Sunday collection,” explained a 6/4/16 article in The Guardian.

Using Swish is so popular in Sweden that “Krona notes and coins in circulation have fallen every year for the past decade and accounted for only a fifth of all payments in Swedish stores last year, far below the global average of 75%,” a 7/7 FT article reported.

(2) Fewer stickups, more fraud. The move to a cashless society in Sweden has led to a reduction in physical crime. “The Swedish National Council for Crime Prevention counted only 23 bank robberies in 2014, down 70 percent from a decade earlier. In the same period, muggings dropped 10 percent. While it’s unclear the extent to which the transition to cashless has affected the rate of street crime, police point out that there’s a lot less incentive to rob a bus driver, cabbie, or shopkeeper if they don’t accept cash. Many workers say they now feel much safer,” reported a 5/8/16 article in Wired.

However, having a cashless society may be escalating cybercrime. Fraud in Sweden—usually involving identity theft—has more than doubled, the Wired article continued. And that probably understates the amount of fraud occurring because Swedish banks don’t publicly share how often their customers’ card information is stolen. Privacy advocates have raised concerns that consumers are giving banks and app providers a lot of personal information about what they are purchasing.

(3) Zelle it? For a number of years, US consumers made person-to-person payments with apps like Venmo (a unit of PayPal Holdings), Apple Pay, and Google Wallet. These apps lured away banking clients, especially Millennials, who turned “venmo” into a verb.

But last month, the big banks drew a line in the sand. They launched Zelle, undoubtedly in hopes of retaining customers. Zelle, which seems very similar to Swish, was built by Early Warning Services, a company owned by Bank of America, BB&T, Capital One, JPMorgan Chase, PNC, U.S. Bancorp, and Wells Fargo.

Today, Zelle is being offered by Bank of America, Capital One, Chase, Fifth Third Bank, First Bank, PNC, USBank, USAA, and Wells Fargo. Another 25 banks and credit unions have partnered with Zelle, but haven’t launched yet, according to Zellepay.com.

Zelle can be used to split a check with your friend or to make a payment to a business. Right now, banks are linking their smartphone apps to the Zelle transfer network, which will eventually be able to reach 86 million consumers. So, for example, Chase QuickPay is now QuickPay with Zelle. Later this year, a standalone Zelle app will be available to consumers and transfers will run on Visa’s and Mastercard’s payment networks.

(4) Zelle versus Venmo. A 2/22 Bloomberg article did a great job explaining the difference between Zelle and Venmo: “Request $40 from a roommate over the Zelle network using BofA's app, and the money shows up in your account within minutes of when he agrees to send it. On Venmo, that $40 would show up in your Venmo wallet right away, but then it stays there. To get the cash into your hands, you need to log into your Venmo account, cash out your balance, and wait—sometimes days—for the money to show up in your bank account.”

Venmo’s appeal is that it doesn’t require two customers to bank at the same institution. The two customers just have to have the Venmo app. Venmo also has a more social bent than Zelle. Venmo users can choose to make their transactions and any related messages public. Users will check their Venmo account just to see what friends are buying.

Which network will come out on top remains to be seen. But if the US market develops at all similarly to the Swedish market, the days of counting your greenbacks may be numbered.

India I: Monsoon Season. As I noted last week, Sandra Ward, formerly of Barron’s, has joined us as a senior contributing editor. She wrote an informative and relatively bullish piece on Brazil last week. This week, she isn’t as upbeat on India. Here is her take:

It’s monsoon season in India, one of the hottest emerging markets and, until recently, the fastest-growing big economy the past three years. The drenching rains tend to send spirits soaring and set expectations for a strong agricultural harvest and subsequent boost in farmers’ fortunes and surge in consumer spending. The giddiness often spills into the stock market, as a 5/10 Times of India article observed at the start of this rainy season. The S&P BSE Sensex set new highs last week, its best weekly showing in four months (Fig. 1). After plunging Tuesday, as tobacco stocks reacted to new taxes, it quickly resumed its bullish track Wednesday.

Anyone betting on a correlation between a good monsoon and good stock market returns may end up all wet. Celebrating its 70^th anniversary of independence on August 15, India is a whole lot less reliant on agriculture as an engine of economic growth than previously. Agriculture now represents 17.4% of gross domestic product, according to the World Bank, compared with 51.8% in 1950. The services sector, at 53.8%, is the biggest contributor to India’s GDP, up from 30% in 1950, and attracts the most foreign investment. Still, agriculture was the only sector where growth accelerated—up 4.9% y/y in India’s Q1, ended March—as total GDP growth slowed to a 6.1% pace. All other sectors decelerated, with services gaining 7.2% y/y compared with 10.0% in the previous year, and manufacturing slumping to a 5.3% gain versus an increase of 12.7% in the year-ago period. Construction turned negative, contracting by 3.7% y/y. Without the 31.9% y/y rise in government spending, growth in GDP would’ve been closer to 4.1%, said a 5/31 FT article.

The MSCI India Share Price Index, already up 25.8% in US dollars ytd through Tuesday’s close, looks vulnerable to a correction (Fig. 2). The MSCI India Index is trading at a forward P/E of 18.1, despite a forward earnings growth outlook of 15.5% and revenue growth expectations of 12.2% (Fig. 3 and Fig. 4). Here’s a look at some of the clouds that could rain on India’s economy and stock market:

(1) Modi’s honeymoon ending? Against a backdrop of a slowing economy and an expensive stock market, India’s reform-minded prime minister, Narendra Modi, is undergoing a reappraisal after enjoying an extended honeymoon since his election in 2014 on the promise of improving the business climate and creating jobs. There’s been much ink spilled on whether his bold moves to root out corruption and streamline India’s famously bureaucratic systems—including finally pushing through a unified Goods and Services Tax that was 17 years in the making—have been the right ones.

A 6/24 The Economist cover story criticized the reforms and job creation as illusory. The New York Times echoed those sentiments in a 7/17 editorial. It pointed out that Modi’s election promises have fallen short and voiced concern that the Hindu nationalist tendencies of his Bharatiya Janata Party are on the rise. Modi’s May ban on selling cattle for slaughter was widely seen as anti-Muslim and pandering to conservative Hindus, who hold cows sacred. His delay in condemning attacks by vigilantes on workers in the cattle-slaughter industry reinforced suspicions about the motive for the ban. The move also called into question his commitment to creating jobs and boosting exports: The $16 billion meat and leather industry employs millions and generates $4 billion in exports of beef and $6 billion in leather exports. For now, the ban has been suspended by India’s Supreme Court, a 7/11 Al Jazeera article pointed out.

Sentiment on Modi is souring to such a degree, a story in the 7/12 Indian Express noted, that a prospective bride and groom in the state of Uttar Pradesh called off their wedding after arguing about whether Modi is to blame for the current economic slowdown.

(2) Demon policy. No program, however, has engendered more controversy than Modi’s demonetization policy, instituted in a surprise move on November 8—the same day as US voters elected Donald Trump president. By banning 86% of commonly used bank notes, Modi slammed the brakes on commerce and consumer spending in the traditional cash-based society and has been widely blamed for throwing the economy into a tailspin.

India II: Running Out of Steam? While it’s easy to demonize the demonetization program as the cause of the current economic slowdown, truth be told, the economy began slowing long before demonetization took effect, though the currency ban certainly exacerbated the stresses. Consider the following:

(1) GDP. GDP growth has been decelerating for much of the last year. From a high of 9.1% y/y reported in Q1-2016, growth dropped to 6.1% in Q1-2017, down from 7.0% in the previous quarter, when demonetization began (Fig. 5).

(2) Households. Household consumption growth slowed to 7.3% y/y in Q1 from 11.1% the previous quarter (Fig. 6). Growth in household consumption had been slowing throughout 2016, and the Q4 jump likely reflected a surge in spending ahead of the ban, noted a 7/11 piece in Focus Economics.

(3) Capital spending. Capital spending has been slipping since Q4-2015 and is now firmly in negative territory for the first time since early 2014, contracting 2.1% y/y in the most recent quarter as banks have tightened lending standards and companies continue to be heavily indebted, the Financial Express explained in a 6/1 article (Fig. 7). Capital spending represented 28.5% of GDP in fiscal Q4-2017, down from 31.2% in fiscal Q1-2016.

(4) Government spending. Government spending rose 31.9% y/y in Q1, boosted by a pay raise for the bureaucratic sector, a not-insignificant prop to total GDP (Fig. 8).

(5) Production. Industrial production rose a measly 1.7% y/y in May, with the manufacturing and electricity industries supplying the gains, according to a 5/31 Moody’s Analytics article (Fig. 9). It cited supply bottlenecks and high debt levels as crimping factory output. Moody’s noted that a country the size of India should see industrial production expanding at double-digits.

(6) Inflation. Consumer price inflation reached a record low of 1.5% y/y in June, down from 2.2% a month earlier (Fig. 10). Food prices account for half the CPI, and they continue to drop following last year’s good monsoon season and disruptions in the food supply chain due to demonetization.

The challenges facing the Indian economy clearly are not reflected in the stock market. While Modi’s moves to retool the economy may prove effective in the long run, in the short run they have made a fragile situation more fraught. That’s led to increased pressure on the Reserve Bank of India (RBI) to cut interest rates by another 25 basis points when it next meets in August. The RBI last eased in October, when it cut rates by 25 basis points to 6.25%.

A rate cut could create more exuberance for stocks—and rate-sensitive issues such as banks and real estate would benefit, as would debt-heavy companies. But ultimately, when there’s a slowing economy and a soaring stock market, there will be a day of reckoning.

 

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Gray Swans

July 19, 2017 (Wednesday)

 

Strategy: Pesky Birds. If inflation remains subdued and the economic expansion continues, bond investors should earn yields on their bonds surpassing inflation. If this scenario persists for five to 10 years, they should earn a modest real return as long as their bonds mature over the same period. They are unlikely to have significant capital losses or gains along the way. Stock prices should continue to rise along with earnings and dividends.

Of course, it’s never quite so easy to predict the outlook for bonds and stocks. There are those pesky Black Swans that could show up when they are least expected. Black Swan events were discussed by Nassim Nicholas Taleb in his 2001 book Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets, which focused on financial events. His 2007 book The Black Swan: The Impact of the Highly Improbable generalized the metaphor as follows:

“What we call here a Black Swan (and capitalize it) is an event with the following three attributes. First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme ‘impact’. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable. I stop and summarize the triplet: rarity, extreme ‘impact’, and retrospective (though not prospective) predictability. A small number of Black Swans explains almost everything in our world, from the success of ideas and religions, to the dynamics of historical events, to elements of our own personal lives.”

Since the start of the current bull market, pessimistic prognosticators have industriously been anticipating all sorts of dire Black Swan events, including the disintegration of the Eurozone, a financial crisis in China, currency wars, and many more. Geopolitical crises also might turn into Black Swan events. Not surprisingly, none of these terrible prospects actually happened, since by definition Black Swans are very hard to predict. Despite the symmetry of Taleb’s argument, Black Swans are widely associated with bad outcomes. Plenty come to mind that could trip up bond and stock investors:

(1) Inflation. First and foremost would be a significant revival of inflation. That would force central banks to raise rates. Bond prices would fall, and stock markets might do so once rates got high enough to cause a recession, which might be signaled by an inverted yield curve. I have often discussed in the past all the reasons why inflation might be dead for the foreseeable future.

(2) Monetary policy. The bears are saying that stocks will fall once the European Central Bank and Bank of Japan terminate their QE programs and start to normalize their monetary policies. Then again, they warned that once the Fed terminated its quantitative easing (QE) program, stock prices would fall. The program was terminated at the end of October 2014, yet the S&P 500 rose 21.9% through the latest record high on July 14 of this year.

(3) Geopolitics. Tensions between China and its neighbors, especially the ones allied with the US, could flare up as China continues to build small islands in the South China Sea to claim sovereignty over this important trade route. The Trump administration may take a tougher stance against the nuclear ambitions of North Korea and Iran, raising the chances of a military confrontation. Russian President Vladimir Putin seems intent on reviving the Soviet Union even if that provokes another Cold War, with the potential for dangerous skirmishes with NATO forces. However, in recent years, and certainly during the current bull market, stock investors have learned that selloffs triggered by geopolitical crises tend to be buying opportunities that don’t last long.

(4) Melt-up. In late 2012, a widely feared and anticipated Black Swan event was that the US economy would fall off a “fiscal cliff” in early 2013 because Democrats and Republicans couldn’t agree on a federal budget. When they did so at the start of the new year, I wrote that investors might have tired of looking out for Black Swans. I suggested that the Black Swan this time might be a melt-up in the stock market.

During the first half of 2017, I observed that money was pouring into exchange-traded funds (ETFs). That influx was driving a broad-based surge in stock prices, since the most popular ETFs tend to track the broad market indexes. The problem with the popularity of this investment style is that while it works great on the way up, it has the potential to worsen future corrections and bear markets, as indiscriminate selling of ETFs causes indiscriminate selling of all the stocks they include, no matter their fundamentals. Unlike mutual funds, ETFs don’t hold liquid assets to meet redemption orders; they have to sell stocks when investors decide to redeem.

(5) Contrarian alert. Contrarians were put on high alert at the end of June 2017, when Fed Chair Janet Yellen said at a London conference: “Would I say there will never, ever be another financial crisis? You know probably that would be going too far, but I do think we’re much safer, and I hope it will not be in our lifetimes, and I don’t believe it will be.” Yet she also described asset valuations as “somewhat rich if you use some traditional metrics like price earnings ratios.” Yellen turned 71 on August 13, 2017, so her lifetime may not be as long as yours. For someone who tends to be very precise, her use of “our lifetimes” sure leaves room for interpretation! In any event, her comment is reminiscent of other ill-fated predictions by Fed chairs—like Greenspan’s “once-in-a-century” technology and productivity revolution and Bernanke’s no “significant spillovers” stance on the subprime mortgage debacle.

I’ll go out on a limb and predict that there will be another financial crisis in our lifetimes. However, like previous ones, it likely will offer a great opportunity for buying stocks. For now, I’m seeing lots of White Swans, no Black Swans, and a few Gray Swans.

US Politics: The Swamp Thickens. Yesterday morning, we all learned that the GOP effort to repeal and replace Obamacare in the Senate had collapsed. This is a Gray Swan, I suppose. It doesn’t come as much of a surprise, though it is somewhat surprising that the Republicans can’t get their act together. The stock market presumably rallied following the November 8, 2016 presidential election because Donald Trump, a Republican, won with Republican majorities in both houses of Congress. That seemingly increased the chances that Trump’s Reaganesque policy agenda would get implemented quickly. Not so fast: The Republicans are badly split between moderates and conservatives. So is tax reform now dead too?

Senate Republican Leader Mitch McConnell announced that he was calling the bluff of his fickle GOP colleagues and planning a repeal-only vote, putting them on the line to act on the promise they had repeatedly made in their campaigns, with no excuses: “Regretfully, it is now apparent that the effort to repeal and immediately replace the failure of Obamacare will not be successful. So, in the coming days, the Senate will vote to take up the House bill with the first amendment in order being what a majority of the Senate has already supported in 2015 and that was vetoed by then-President Obama: a repeal of Obamacare with a two-year delay.”

Republican Senators Susan Collins of Maine, Shelley Moore Capito of West Virginia, and Lisa Murkowski of Alaska immediately declared they could not vote to repeal the Affordable Care Act without a replacement—enough to doom the effort before it could get any momentum.

In any event, McConnell may be trying to get the issue buried so he can move on to tax reform, while showing the base he tried everything he could. Some politicos are speculating that the failure of health reform would make tax reform more likely—because of political desperation by Republicans, who’ll need something to run on.

Maybe so, but Joe and I aren’t convinced that the stock market rally since Election Day was all about Trump and his agenda. Corporate profits started to recover last summer from the earnings downturn that was mostly attributable to the energy industry’s recession. S&P 500/400/600 forward earnings all rose to record highs again last week (Fig. 1). In addition, global economic activity has improved since late last year with many overseas stock markets outperforming the US’s since then (Fig. 2). Here is the global performance derby…

(1) … in local currencies since November 8, 2016: Japan (18.0%), EMU (17.8), Emerging Markets (14.9), S&P 500 (14.9), All Country World (14.6), and United Kingdom (8.2).

(2) … in dollars over the same period: EMU (22.3), Emerging Markets (16.5), All Country World (15.3), S&P 500 (14.9), United Kingdom (14.0), and Japan (9.6).

US Consumer: MIA? Another Gray Swan is the puzzling weakness in consumer spending. June’s retail sales remained stalled around record highs, falling unexpectedly for the second month. That’s surprising given that payroll employment rose 222,000 during June following May’s 152,000 gain. Both are solid gains. Could it be that consumers are retrenching because of policy uncertainty in Washington, DC? Will they be relieved that Obamacare remains the law of the land? Or do they recognize that it is no bargain, and may be imploding in any case? Perhaps they’ve been hard hit by higher out-of-pocket costs for health care and are retrenching on discretionary purchases.

June’s total retail sales was down 0.2% m/m following a 0.1% decline in May (Fig. 3). Some of the weakness was attributable to gasoline sales, which declined along with the pump price (Fig. 4). Car sales have stalled in recent months (Fig. 5).

On the other hand, our Earned Income Proxy for private-sector wages and salaries rose to another record high in June, gaining 0.6% m/m and 4.5% y/y. Retail sales excluding gasoline has closely followed our proxy (Fig. 6). Debbie reports that adjusted for inflation, retail sales during the three months through June rose 4.9% (saar) from the previous three months (Fig. 7).

ETFs: 50 Shades of Gray. Equity ETFs are creating a new market structure that hasn’t been seriously stress-tested by a sharp decline in stock prices. Could the recent record inflows into ETFs, which have clearly boosted the stock market over the past year, turn into significant outflows that exacerbate or even cause the next bear market? ETFs still represent a small share of the markets, constituting less than 10% of US equity market capitalization, according to a May 2017 academic paper found on SSRN. That’s too small to matter, assuming all is functioning as it should. But ETFs could turn dysfunctional under stress if hordes of retail investors get spooked and sell their ETF shares all at once. Below, I’ve asked Melissa to have a closer look at this possibility:

(1) Similar shades. Created in the 1990s, ETFs were developed primarily as a vehicle for long-term investors to passively track indexes. Active ETFs have also since come to the markets, but there are a lot fewer of them than passive ones. One selling point of ETFs over their close cousin, traditional open-end mutual funds, for investors is that they don’t have to wait until the end of the day to buy or sell them. ETFs trade all day long, while traditional open-end mutual funds trade only at the market’s close of trading each day at the net asset value (NAV) of the underlying securities (although orders can be placed on traditional open-end mutual funds throughout the day). An ETF’s price, on the other hand, might represent a premium or a discount to the underlying securities, although the goal is to track the designated mix of underlying securities (such as an index in the case of passive ETFs) as closely as possible.

(2) Shadow market. Only those deemed “authorized participants” (APs) by the Securities and Exchange Commission (SEC) with ETF dealer agreements have the power to create and redeem ETF shares. APs buy in the primary market the underlying securities with which to create a basket of stocks at a prescribed mix (e.g., the same as that of the S&P 500 if its being tracked) to form the ETF shares, i.e., “creation units.” The portfolio of assets underlying ETF creation units are held in a trust. The opposite, “redemption units,” are existing ETF shares that APs transform back into the underlying securities, which may be sold back on the primary market. So far, so good.

While the above all occurs in the primary market, most of the action happens in the secondary market, where ETF shares are traded rather than the underlying securities. In fact, only 10% of daily activity in all ETF shares occurs on the primary market, according to a 2015 ICI study. It’s in the secondary market where retail investors can play, buying and selling ETF shares on a stock exchange like the shares of most publicly traded companies.

Here’s where it gets interesting. By nature, the price of ETFs on the secondary market doesn’t always perfectly equal the NAV of the underlying securities—thus creating an arbitrage opportunity for APs, who bring the ETF price back to equilibrium NAV by way of simple supply and demand. Everyone is happy.

By the way, the spread between an ETF’s intraday price and its NAV may also simply be traded away due to normal price fluctuations on the secondary market (“in-kind” between ETF shares), or on the primary market (among the underlying assets) absent any creation or redemption of ETF shares, or arbitrage transaction. It’s also important to note that APs are not under any obligation to engage in these transactions and only do so for their own benefit.

(3) Silver knights. So how does the arbitrage opportunity work? ICI neatly explained it in a 2012 blog post:

“When an ETF is trading at a premium to its underlying value, authorized participants may sell short the ETF during the day while simultaneously buying the underlying securities. At the end of the day, the authorized participant will deliver the creation basket of securities to the ETF in exchange for ETF shares that they use to cover their short sales. The authorized participant will receive a profit from having paid less for the underlying securities than it received for the ETF shares. The additional supply of ETF shares also should help bring the ETF share price back in line with its underlying value.

“When an ETF is trading at a discount, authorized participants may buy the ETF shares and sell short the underlying securities. At the end of the day, the authorized participant will return ETF shares to the fund in exchange for the ETF’s redemption basket of securities, which they will use to cover their short positions. The authorized participant will receive a profit from having paid less for the ETF shares than it received for the underlying security. The lower supply of ETF shares available also should help bring the ETF share price back in line with its underlying value.”

But what happens if a subset of the APs lacks enough incentive to step in? That could be the case either because the risk outweighs the benefit of doing so or because they don’t have the capital or credit to do so. Well, the good news is that the ratio of APs to ETFs is greater than 1 to 1. On average, each ETF has about 34 agreements, according to the previously cited 2015 ICI study. However, they might not all be active. On the other hand, one AP might represent multiple external institutional market-makers that are participating in the arbitrage game through the APs. The point is: if one AP (or market-maker) is out, another will likely step in. For example, when the high-frequency ETF trading market-maker Knight Capital Group experienced a technology glitch in 2012, it severely impaired the firm’s capital base. Consequently, the firm’s ability to provide liquidity in the ETF markets caused ETF spreads to widen. However, the gap was temporary. Knight reportedly enlisted the help of rival market-makers to provide adequate liquidity to restore balance to those shares impacted.

(4) Ashes, ashes. But what if all of the APs decide to take a metaphorical cigarette break at the same time? Well, the odds of that are as slim as a Black Swan event. But it could theoretically happen if investor confidence is so shaken that ETF prices come tumbling down faster than APs would dare to step in. ETF spreads could widen. Retail investors trying sell their ETF shares on the secondary markets might receive only the discounted price for their shares rather than the NAV of the underlying securities.

That situation could be bad for markets, but how bad depends on how big ETFs are relative to the markets, which is not that big. It could get really bad if the situation caused retail investors more broadly to pull their money out the markets. “There is no market mechanism to stop how perceived informed traders can cause other market participants to change behavior and sell alongside,” wrote Dean Barr in a relevant LinkedIn post. But they’d all probably be doing so anyway if they were spooked enough to sell their shares of ETFs en masse in the first place. In other words, we’d probably all have bigger problems than ETFs on our hands in that scenario (a North Korea gone ballistic is one example that comes to mind).

(5) Uncertainty principle. Ari Rubenstein, CEO and co-founder of Global Trading Systems LLC, told lawmakers at a 6/27 House Financial Services Committee hearing: “In some ways the markets are a bit untested … It’s definitely something we should talk about to make sure industry participants are prepared in those instruments.” Rubenstein was apparently referring to the untested nature of ETFs during a period of stress, according to a recent Bloomberg article.

By the way, financial markets blogger “Heisenberg” made a couple of interesting points in a 2/21 article for Seeking Alpha. The article explained that one of the selling points that ETF managers make to investors is that ETFs help to lower market volatility because large blocks of ETF shares can trade on the secondary market without impacting the price of the underlying securities. But that might not be a good thing, according to the author Heisenberg, because if “one day” everyone was “dumping” ETFs, the ETF model “goes out the window.” Ironically, elaborates the author, the advent of ETFs may have worsened the liquidity of the underlying assets by creating demand for the ETF portfolio in lieu of the assets themselves.

(6) Gray area. To address potential liquidity issues, the SEC passed a 400+ page rule pertaining to ETFs at the end of 2016 for which compliance dates begin in 2018. According to a summary of the rule from a March 2017 Morgan Lewis panel, most ETF firms would be required to establish and execute a written liquidity risk management program, required to be disclosed to the SEC.

The rule further stipulates that ETFs are prohibited from acquiring illiquid assets that would cause illiquid holdings to exceed 15% of the fund’s net assets. The SEC’s rule seems like a reasonable step in the right direction. However, some gray area remains, in our opinion. Illiquid assets are well defined as those that would be difficult to sell within seven calendar days at a reasonable price (i.e., not at a fire sale price). However, it seems to us that that it would be hard to predict what would happen if liquidity problems were to occur for assets that were already acquired. The SEC specifies that the rule is not intended to create “fire sales,” but that doesn’t mean that they can’t happen.

 

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Orient Express

July 18, 2017 (Tuesday)

 

China: The Xi Dynasty. China’s real GDP rose 6.9% y/y during Q2 (Fig. 1 and Fig. 2). During the quarter, it rose 6.7% (saar), which it’s been hovering around since the end of 2013. That’s a slowdown from the 10%-plus pace that was the norm in the years prior to the global financial crisis of 2008 and for a couple of years afterwards. Nevertheless, China’s growth rate is impressive compared to those in most other countries in the world. Even more impressive is how much credit it is taking to prop up China’s growth. Of course, this isn’t impressive in a positive way, since economic growth financed by excessive debt often ends badly.

Nevertheless, Melissa and I aren’t among China’s doomsayers. We don’t want to bet against over a billion Chinese people who are mostly hard-working, entrepreneurial, aspirational, and materialistic—kind of like Americans. Instead of a big-bang implosion, China may follow the path of Japan. China is going down the same demographic road as Japan, with a rapidly aging population. Both countries have piled up lots of debt to boost growth. Both are financing their debt extravaganzas mostly internally. Both of their central banks are pumping massive amounts of liquidity into their economies. So, like Japan, China’s economic growth inevitably will slow as the population continues to age. All the injections of debt are akin to injections of Botox, which can make you look younger while you age and slow down. Consider the following:

(1) Social financing. Total social financing over the past 12 months through June rose by a record 19.2 trillion yuan, or a record US$2.8 trillion (Fig. 3). It has been on a tear since the Chinese government pumped up the economy in response to the financial crisis of 2008. The country has become increasingly addicted to debt, and can’t seem to break the habit despite government officials’ previous assurances that will happen. It hasn’t happened so far because the government hasn’t figured out any other way (such as free-market capitalism) to boost growth. Since Premier Xi Jinping assumed command during November 2012, social financing has totaled a whopping $11.2 trillion, with bank loans up $6.4 trillion!

(2) Bank loans & M2. Bank loans are the largest component of social financing. Over the past 12 months through June, they rose by a record 13.2 yuan, or a record US$1.9 trillion (Fig. 4). Astonishingly, bank loans have more than tripled since the end of 2008, soaring by 280% to a record $16.8 trillion during June (Fig. 5).

The good news—we guess—is that all of this bank debt has been financed entirely by an increase in M2. So the Chinese owe it to themselves, similar to what has been happening in Japan for many years.

(3) Shadow banking system. Also mildly encouraging—we guess—is that the authorities seem to be making a bit of progress throttling back the shadow banking system. We estimate shadow banking activity by subtracting bank lending from total social financing (Fig. 6). Doing so suggests that on a 12-month basis, the shadow banks accounted for a record 55.1% of social financing through May 2013 (Fig. 7). That percentage fell to a recent low of 25.1% through July 2016. It was back up to 31.3% in June of this year.

(4) PBOC & capital flows. The Chinese government’s efforts since early last year to stem capital outflows are showing some signs of success. The PBOC’s non-gold international reserves, which peaked at a record $4.0 trillion during June 2014, fell to $3.0 trillion during December 2016 (Fig. 8). It has been stable since then through June. The yuan fell along with reserves, but has firmed up since making a recent low on January 3.

Debbie and I calculate an implied international capital flows proxy by subtracting China’s 12-month trade surplus from the 12-month change in China’s international reserves (Fig. 9 and Fig. 10). It still shows a significant net outflow of $602 billion over the past 12 months through June, but that’s a big improvement from the record $1.18 trillion through January 2016.

(5) Industrial production & trade. Just for fun, we compare the growth rates of China’s bank loans to industrial production and track the ratio of the former to the latter (Fig. 11 and Fig. 12). The ratio of bank loans to industrial production confirms our concerns about China’s increasingly debt-financed growth. All that debt seems to be having a decreasing impact on boosting economic growth. The ratio was relatively stable around 100 from 2000-2008. Since then, it has risen sharply and persistently to a record 170 during June. The Chinese seem to be getting less and less output bang per yuan.

The good news is that China’s trade data (in yuan) has improved significantly since early last year, with both exports and imports near record highs in June (Fig. 13). The y/y growth rates for these categories were strong at 16.9% and 22.6% (Fig. 14). The exports data suggest that the global economy is growing solidly, though some of that may be due to the stimulus provided indirectly by China’s ongoing borrowing binge.

(6) Demographics. Weighing on China’s growth rate is its geriatric demographic profile. The country’s fertility rate dropped below the replacement rate of 2.1 children per woman during 1995, and is expected to remain below that level through the end of the century, according to UN projections (Fig. 15).

The growth rate of the population is projected to turn negative during 2033 (Fig. 16). The growth rate of the working-age population (WAP) already turned negative during 2016 and is expected to remain so through the end of the century—with WAP falling to 558 million from a peak of 1,015 million during 2015 (Fig. 17 and Fig. 18).

(7) MSCI metrics. The China MSCI stock price index (in yuan) is up 29.3% ytd through Friday, and 57.6% from last year’s low on February 12 (Fig. 19). It is selling at a relatively low forward P/E of 12.6 currently (Fig. 20). Weighing on valuation may be the flat trend in forward revenues since early last year (Fig. 21). On the other hand, forward earnings has turned up since late last year. The big story in the MSCI data may be that China’s forward profit margin has been expanding from a low of 3.3% during the week of November 29, 2012 to a nine-year high of 4.1% in early July of this year (Fig. 22).

 

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Bulls Flying with Doves

July 17, 2017 (Monday)

 

The Fed I: Brainard’s Dovish Speech. The bull market in stocks is flying high with the doves. On the other hand, the dollar is losing altitude. Last week, the S&P 500 rose 1.4% to 2459.27, setting yet another new record high (Fig. 1). The trade-weighted dollar dropped 1.2% last week to the lowest reading since September 7 of last year (Fig. 2). The S&P 500 is right smack dab in the middle of our 2400-2500 forecast for yearend, and it is only July! On March, Joe and I raised the odds of a melt-up scenario from 30% to 40%, lowering the odds of a gradual ascent in stock prices from 60% to 40%. We raised the odds of a meltdown from 10% to 20%, since a melt-up is typically followed by a meltdown. We’ve been discussing the likelihood of a melt-up since the start of 2013, when the economy didn’t go over the widely feared “fiscal cliff.”

The financial press attributed the latest bullish stock market advance to the dovish congressional testimony of Fed Chair Janet Yellen on Wednesday and Thursday. Melissa and I agree, but we also credit Fed Governor Lael Brainard’s dovish speech on Tuesday. Though it was blandly titled “Cross-Border Spillovers of Balance Sheet Normalization,” the speech significantly discussed the impact of monetary policy tightening on the dollar. In the past, Fed officials rarely discussed the impact of their policies on the dollar. Now, it seems, they are strongly signaling that they don’t want to see the dollar strengthen as they continue to normalize monetary policy.

In her speech, Brainard focused on the Fed’s policy options. Specifically, she weighed the effects of normalizing through the federal funds rate (by hiking it), the balance sheet (by shrinking it), or both in tandem. She discussed several scenarios in a “stylized model” that would have different implications for exchange-rate effects depending on the monetary policy approach. She noted that it is “the commitment adopted by many leading nations to set monetary policy to achieve domestic objectives such that the exchange rate would not be a primary consideration in the setting of monetary policy.” However, she mentioned “exchange rate” 47 times in her comments and footnotes, obviously acknowledging that the foreign exchange value of the dollar is now an important consideration.

Brainard stated: “The balance sheet might affect certain aspects of the economy and financial markets differently than the short-term rate due to the fact that the balance sheet more directly affects term premiums on longer-term securities, while the short-term rate more directly affects money market rates. As a result, similar to the domestic effects, while the international spillovers of conventional and unconventional monetary policy may operate broadly similarly, the relative magnitude of the different channels may be sufficiently different that, on net, the two policy strategies have distinct effects.” Brainard seemed to conclude that it is best to lean toward the balance-sheet approach, as it should have fewer negative transmission effects, in her opinion (Fig. 3).

Oftentimes, Brainard’s remarks tend to foreshadow Fed Chair Janet Yellen’s thinking and the evolving consensus on the FOMC. Consider the following:

(1) Inflationary pressures muted. In a 3/7/16 speech, Brainard anticipated FOMC policy as follows: “If the labor market continues to improve, higher resource utilization should also put some upward pressure on inflation going forward. However, the effect of resource utilization on inflation is estimated to be much lower today than in past decades.” She also said that the FOMC should put a high premium on evidence that actual inflation is firming sustainably before moving to tighten monetary policy. The FOMC waited until the end of 2016 to raise the federal funds rate by 25bps, the same one-and-done hike as at the end of 2015 (Fig. 4).

(2) Phillips curve flatter. In a 9/12/16 speech, she opined that the Phillips curve has flattened, “appearing to be a less reliable guidepost than in the past.” In other words, inflation has remained remarkably subdued given the drop in the unemployment rate. More specifically, she said, “The apparent flatness of the Phillips curve together with evidence that inflation expectations may have softened on the downside and the persistent undershooting of inflation relative to our target should be important considerations in our policy deliberations. In particular, to the extent that the effect on inflation of further gradual tightening in labor market conditions is likely to be moderate and gradual, the case to tighten policy preemptively is less compelling.”

The CPI inflation rate was back below 2.0% during June, with the headline rate down to 1.6% y/y and the core rate down to 1.7% (Fig. 5). This suggests that the core PCED rate, which was 1.4% during May, might have been even lower in June, since it tends to fall consistently below the core CPI inflation rate (Fig. 6).

Meanwhile, wage inflation remains remarkably subdued around 2.5% even though the unemployment rate has been below 4.5% for the past three months through June (Fig. 7). Job openings are plentiful (Fig. 8). When the labor market was this tight by these measures during the past three business cycles, wage inflation was around 4.0%.

(3) Neutral interest rate lower. In her latest speech, Brainard said, “the neutral level of the federal funds rate is likely to remain close to zero in real terms over the medium term.” Considering that, there would not be “much more additional work to do on moving to a neutral stance” from the moderately accommodative stance now. She added that the FOMC “decided to delay balance sheet normalization until the federal funds rate had reached a high enough level to enable it to be cut materially if economic conditions deteriorate.”

The FOMC hiked the federal funds rate again twice this year so far to a target range of 1.00%-1.25%. The federal funds future market is anticipating one more hike over the next 12 months (Fig. 9). We agree, but expect the federal funds rate to flatten out around 2.00% at the end of next year through 2019. Meanwhile, the real interest rate in the 10-year Treasury TIPS market continues to fluctuate between 0.00% and 0.80%, as it has since late 2013 (Fig. 10).

The Fed II: Yellen’s Dovish Testimony. Fed Chair Janet Yellen still knows how to sprinkle the fairy dust. When the Fairy Godmother of the Bull Market speaks, investors listen and get more bullish. The Dow Jones hit a new record high following her semi-annual testimony to Congress on Wednesday, and the S&P 500 did so on Friday. On numerous previous occasions, we have observed that stock prices tend to rise after Yellen speaks (Fig. 11 and Fig. 12).

Confirming Brainard’s comments, Yellen said that her goal is to reach a neutral level of interest rates, which is lower than it was historically and not so far off from where the federal funds rate is set now. Later this year, the FOMC is also expected to begin normalizing its balance sheet, she said, as Brainard discussed a few days before.

(1) Balance sheet. In her opening remarks, Yellen rehashed the outline for the plan for balance-sheet normalization, which was previously provided in greater detail in an addendum with the 6/14 FOMC policy statement. Yellen’s testimony on the subject seemed rather subdued. She said: “The Committee intends to gradually reduce the Federal Reserve's securities holdings by decreasing its reinvestment of the principal payments it receives from the securities held in the System Open Market Account. Specifically, such payments will be reinvested only to the extent that they exceed gradually rising caps. Initially, these caps will be set at relatively low levels to limit the volume of securities that private investors will have to absorb.” She added: “[W]e do not intend to use the balance sheet as an active tool for monetary policy in normal times.”

Brainard had suggested a similarly easy-does-it approach toward balance-sheet normalization in her speech: “In light of recent policy moves, I consider normalization of the federal funds rate to be well under way. If the data continue to confirm a strong labor market and firming economic activity, I believe it would be appropriate relatively soon to commence the gradual and predictable process of allowing the balance sheet to run off.”

(2) Balanced view. Inflation continues to be the sticking point for the Fed’s approach to accommodation in terms of its dual mandate to maintain its stability and maximum employment. The headline unemployment rate has dropped substantially since the Great Recession. At the same time, inflation has remained remarkably low.

In her written testimony, Yellen observed: “It appears that the recent lower readings on inflation are partly the result of a few unusual reductions in certain categories of prices; these reductions will hold 12-month inflation down until they drop out of the calculation.” During the Q&A with lawmakers, Yellen cited temporary influences holding down prices including mobile-phone plans and prescription drugs. She added: “It is premature to reach the judgment that we are not on the path to 2% inflation over the next couple of years.”

Yellen’s remarks on inflation seemed slightly more dovish than during her 6/14 press conference when she harped on temporary influences holding down prices, including mobile-phone plans and prescription drugs. Bloomberg observed that Yellen used the word “partly” to describe the impact of the temporary effects this time versus the word “significantly” last time. Balancing out her remarks, however, Yellen said: “[Several] developments should increase resource utilization somewhat further, thereby fostering a stronger pace of wage and price increases.” That effect is uncertain, though, in her view.

The Fed III: A Dove’s Swan Song. Commencing the balance-sheet unwinding while potentially raising interest rates closer to neutral at the same time could be Yellen’s final act as Fed chair. For now, the markets don’t seem too concerned about who will replace the Fed chair when her term is up in February 2018 if she isn’t reappointed.

Politico reported on 7/11 that National Economic Council Director Gary Cohn could be Trump’s top choice to replace Yellen. But Cohn might not want the job. Also, Cohn’s nomination might encounter resistance from the Senate given his close ties to the banking industry as a former Goldman Sachs executive. No matter what, Trump will probably look to nominate a Fed chair who will maintain stimulative policies at least until fiscal policies can take over. Politico observed that Cohn is “viewed as closer to Yellen’s preference for gradual rate hikes.”

By the way, though Fed officials proclaim their independence from politics, Brainard is a Democrat with a history of working for and contributing to the Democratic party. She doesn’t seem to be going anywhere soon, as her term doesn’t end until 2026, but her influence could be overshadowed by a new boss. It sure would be interesting to see Cohn step into the Fed chair role. Despite his current role in the Trump administration, Cohn is a registered Democrat, and he has no academic, economic, or monetary policy background. In any case, Yellen is the boss for now, and she seems to highly value Brainard’s opinion, which coincides with her own.

The Fed IV: Dove’s Rule. The FOMC’s projections support the views of Yellen and Brainard. On June 14, the FOMC set the federal funds rate in a target range of 1.00% to 1.25%. According to the Taylor Rule, the federal funds rate should be set at about 2.90%, as of Q2 based on the default inputs into the Atlanta Fed’s utility on its website. That figure happens to approximate the Fed’s latest median projection for the federal funds rate by 2019. For 2017, the median projection is just 1.40%.

The Fed’s 7/7 Monetary Policy Report (MPR), which accompanied Yellen’s congressional testimony, included a section titled “Monetary Policy Rules and Their Role in the Federal Reserve’s Policy Process.” The basic message is that the FOMC pays attention to models like the Taylor Rule, which prescribe the level of the federal funds rate, but the Fed’s policymakers believe that these models ignore too many “considerations” that require their judgment when setting the federal funds rate. In the “rules versus discretion” debate, they clearly favor the latter approach. Here are some key points from the MPR:

(1) Too simple. “Each rule takes into account two gaps—the difference between inflation and its objective (2 percent as measured by the price index for personal consumption expenditures [PCE], in the case of the Federal Reserve) as well as the difference between the rate of unemployment in the longer run (u^LR) and the current unemployment rate. … The small number of variables involved in policy rules makes them easy to use. However, the U.S. economy is highly complex, and these rules, by their very nature, do not capture that complexity.”

(2) Measuring slack. “[W]hile the unemployment rate is an important measure of the state of the labor market, it often lags business cycle developments and does not provide a complete measure of slack or tightness. In practice, Federal Open Market Committee (FOMC) policymakers examine a great deal of information about the labor market to gauge its health; this information includes broader measures of labor underutilization, the labor force participation rate, employment, hours worked, and the rates of job openings, hiring, layoffs, and quits, as well as anecdotal information not easily reduced to numerical indexes.” A footnote makes reference to the Fed’s Labor Market Conditions Index, which includes 19 components.

(3) Measuring inflation. “[T]here are many measures of inflation, and they do not always move together or by the same amount. … For example, inflation as measured by the consumer price index (or CPI) has generally been somewhat higher historically than inflation measured using the PCE price index (the index to which the FOMC’s 2 percent longer run inflation objective refers). Core inflation, meaning inflation excluding changes in food and energy prices, is less volatile than headline inflation and is often used in estimating monetary policy rules because it has historically been a good predictor of future headline inflation.”

(4) Broader considerations. “Finally, monetary policy rules do not take account of broader risk considerations. For example, policymakers routinely assess risks to financial stability. Furthermore, over the past few years, with the federal funds rate still close to zero, the FOMC has recognized that it would have limited scope to respond to an unexpected weakening in the economy by lowering short-term interest rates.”

(5) Different strokes. “Different monetary policy rules often offer quite different prescriptions for the federal funds rate; moreover, there is no obvious metric for favoring one rule over another.”

 

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There’s an App for That

July 13, 2017 (Thursday)

 

Industry Focus: Construction in 3D. When you think of 3D printing, manufacturing airplane parts may come to mind. Or perhaps manufacturing kids’ toys does. But it’s time to think bigger, much bigger. 3D printing is being used to build homes and buildings around the world.

Sometimes, the printers are housed in a factory where portions of the building are manufactured and then shipped to the construction site. Sometimes, the 3D printer is sent to the construction site, and it is used to make the building right there and then. Typically, a computer program tells the “printer” where to squirt a fast-drying liquid concrete material. It does so repeatedly, in many layers, until the structure is built, often in under a day.

If widely adopted, the benefits to the industry—and humanity—could be huge. Construction would be much less wasteful as well as faster and cheaper to help those in need. Or it could be used in very high-end designs, because anything you create in a computer can be turned into reality via 3D printing. Curved walls or domed ceilings are no problem. That said, the new technology will result in fewer construction jobs. Then again, there certainly is a shortage of construction workers in the US currently.

I asked Jackie to take a tour around the world (on her PC) to see what some of the bigger players in the industry are accomplishing. Some of the sources she references below are unfamiliar to us, so we can’t vouch for their accuracy. That said, there’s enough activity in the space that a trend seems to be solidly underway. If just some of what these articles report is true, the future of 3D construction is building quickly. Here for your wonderment is Edifice Rex:

(1) 3D in the desert. Last year, Dubai launched the Dubai 3D Printing Strategy, which focused on additive printing of medical products, consumer products, and construction. The city aims to have 25% or more of its buildings built using 3D printing technology by 2030.

“The future will depend on 3D printing technologies in all aspects of our life, starting from houses we live in, the streets we use, the cars we drive, the clothes we wear and the food we eat,” said Vice President and Prime Minister of the UAE and Ruler of Dubai, His Highness Sheikh Mohammed Bin Rashid Al Maktoum, according to a 4/27/16 article in Gulf Today. He added, “This technology will create added economic value and benefits worth billions of dollars during the coming period. We should have a share in this growing global market. This technology will restructure economies and labour markets as the use of unskilled labour will come down compared to the current situation, especially in the construction sector. It will also redefine productivity because the time needed for 3D printing of buildings and products will be 10% of the time taken in traditional techniques.”

Just about a year later, a laboratory building, the R&Drone Laboratory, was constructed in Dubai using a 3D printer created by CyBe Construction, a Dutch company, according to a 6/2 article on 3ders.org. CyBe’s 3D printer, dubbed the “RC 3Dp,” moves on caterpillar tracks and built the foundation and walls of the 168-square-meter building in three weeks. Another contractor built the roof, stairs, doors, and bathrooms.

One of Dubai’s next projects is a 3D-printed skyscraper by US startup Cazza Construction. The firm plans to use cranes, concrete, and steel rebar, according to a 3/12 article in ConstructionWeekOnline. Cazza’s CEO, 20-year old Chris Kelsey, had previously told ConstructionWeekOnline that the firm’s manufacturing process was capable of providing labor cost savings of up to 90% and could build a 3D-printed, three-story house in two days.

(2) 3D in China. Chinese construction company Winsun made headlines in 2013 for 3D printing 10 standalone houses in China. It followed up by printing a five-story apartment building and an 11,840-square-foot villa. Most recently, Winsun agreed to print 17 office buildings in Dubai and entered into a $1.5 billion contract with Saudi Arabian company, AI Mobty Contracting, to print “at least 30 million square meters of 3D construction projects in Saudi Arabia. The new project is said to have been made to relieve a national housing crisis that has escalated lately,” according to a 3/22 article on 3Dinsider.com.

Winsun’s “ink” is made of cement, sand, fiber, and an additive. About half of the materials come from construction waste or mine tailings. The company makes the walls in a factory and assembles the building onsite. Its technology can make hollow structures to accommodate piping, wiring, and insulation.

3D construction cuts down on both labor and the time needed to build a structure. “For example, construction of a two-story 1,100 (square meter) mansion took one day of printing, two days of assembly, with internal bar structures erected in advance, requiring three workmen only,” according to a case study attributed to the Boston Consulting Group as part of the Future of Construction Project at the World Economic Forum. Therefore, the technology can benefit emerging countries, where there can be a shortage of skilled construction workers.

Winsun has also constructed an office in Dubai, on which it claims to have saved about 80% on construction costs, 60% on labor, and 60% on waste. “To date, the company has sold more than 100 houses of various types, many of them in Dubai, the largest with a floor space in excess of 5,000 square meters,” the case study noted.

(3) 3D in outer space. One of the US deans of 3D printing is Dr. Behrokh Khoshnevis, a professor of engineering at the University of Southern California and director of its Center for Rapid Automated Fabrication Technologies (Craft). His printing construction method, called “Contour Crafting,” can build a house in a day and cut down on the construction cost by 30%, according to a 7/20/16 NYT article.

Khoshnevis is also working with NASA to build structures using Contour Crafting on the moon from materials available there. In a 2012 TEDx Talk, he discussed what 3D manufacturing of buildings will mean for the world, including the ability to provide inexpensive housing to folks now living in slums.

(4) Home in a day. Apis Cor, a San Francisco-based company headed by Nikita Cheniuntai, claims to have built a 400-square-foot home in Russia in just 24 hours using 3D printing, at a cost of about $10,000.

According to a 3/7 article on Engadget.com: “The company used a mobile 3D printer to print out the house’s concrete walls, partitions and building envelope. Workers had to manually paint it and install the roofing materials, wiring, hydro-acoustic and thermal insulation, but that didn’t take much time.” Don’t miss the video in the link above!

Sector Focus: Retail Reeling. Earlier this week, while Amazon captured upbeat headlines with Prime Day deals, a number of retailers reported dismal news. So while Amazon.com shares were up 4.2% for the week ended Tuesday, the S&P 500 Specialty Stores index fell 6.3%, Apparel Retail dropped 7.4%, and Department Stores lost 7.7% (Fig. 1). Here are some of the low lights of the past week:

(1) The wedding is off. News that Abercrombie & Fitch was unable to sell itself sent the teen-retailer’s shares tumbling 21% to $9.59 on Monday. The company had told the market in May that it was in “preliminary” discussions, and its shares topped $14 for a brief period. Abercrombie is in good company. Neiman Marcus Group and Macy’s have also been unable to find buyers. But things could be worse. Competitors Aéropostale, Wet Seal, and American Apparel have filed for Chapter 11 bankruptcy protection, a 7/10 WSJ article reminds us.

(2) Lipstick on a pig. In an effort to lure shoppers into their stores, department stores are doing the unthinkable: discounting lipstick. Last month, Lord & Taylor offered 15% off almost all cosmetics and fragrances, Bloomie’s gave shoppers a $25 reward card for every $100 beauty purchase, and Macy’s offered 15% off cosmetics, the 7/10 WSJ reported. The news slammed Ulta Beauty’s high-flying stock, which fell 7.6% over Monday and Tuesday. Ulta, a cosmetics retailer, had previously proven immune to competition from Amazon. But investors weren’t anticipating that Amazon’s pressure on department stores would push the department stores to discount cosmetics, which could hurt Ulta.

(3) Piranhas attacking geeks. Best Buy’s Geek Squad service—where employees go to customers’ homes to answer tech questions—was one way the company differentiated itself from Amazon. But Amazon is showing its ability to emulate, in addition to innovate. “Over the last few months, Amazon has quietly been hiring an army of in-house gadget experts to offer free Alexa consultations as well as product installations for a fee inside customer homes,” according to a 7/10 Recode article citing multiple anonymous sources and job postings. “The new offering, which has already rolled out in seven markets without much fanfare, is aimed at helping customers set up a “smart home”—the industry term used to describe household systems like heating and lighting that can be controlled via apps, and increasingly by voice. While Amazon has a marketplace for third parties to offer home services, like TV mounting and plumbing, these new smart-home-related services seem important enough to Amazon that it is hiring its own in-house experts.” Best Buy shares fell 7.2% over Monday and Tuesday.

(4) Shorting bricks & mortar. ProShare Advisors is offering three new ETFs that allow investors to bet against retailers. According to a 7/10 Bloomberg article: “The ProShares UltraShort Bricks and Mortar Retail fund and ProShares UltraPro Short Bricks and Mortar Retail fund will seek to use derivatives to generate daily returns of two or three times the inverse of an index comprising the most at-risk U.S. retailers. … Meanwhile, the ProShares Long Online Short Bricks & Mortar Retail ETF will track an equal-weighted benchmark that includes U.S. and overseas stocks, the filings show.”

(5) Desperate numbers. The damage done to department store stocks can’t be understated. The S&P 500 Department Stores stock price index is down 57.7% from its 2015 peak (Fig. 2). The industry’s forward earnings multiple has shrunk to 10.2, from 16.1 in 2015 (Fig. 3). And analysts expect earnings to fall 2.2% over the next 12 months (Fig. 4).

The S&P 500 General Merchandise Stores index hasn’t fared much better, down 31.8% from its 2016 peak (Fig. 5). The industry’s forward P/E has shriveled from almost 20 in 2015 to a recent 13.6 (Fig. 6). Here too, analysts see earnings dropping 0.4% over the next 12 months (Fig. 7). Investors wisely have avoided the sale on retail stocks.

Brazil: Doing the Bossa Nova. Please welcome Sandy Ward as a Contributing Editor to Yardeni Research. Sandy, like Jackie, was formerly a senior editor for Barron’s. I asked her to start off by bringing us up to speed on a couple of major emerging economies. Here is her piece on Brazil:

While the MSCI Emerging Markets Latin America index has turned in a more-than-respectable performance so far this year, climbing 11.7% in US dollars through Tuesday’s close vs ­­8.3% for the S&P 500, Brazil barely contributed. Argentina delivered blistering gains, posting the top performance among all emerging markets at 40.8%, while Mexico is up 25.6% ytd. Even Chile and Peru have posted double-digit ytd increases.

In contrast, Brazil was the laggard, gaining 5.0% ytd, with 3.7% of that coming on Monday and Tuesday. Only the emerging markets of South Africa, Jordan, Pakistan, and Russia have performed worse than Brazil ytd (Fig. 8). Besieged by the worst recession in 25 years amid a collapse in commodities and beset by political turmoil, it’s no wonder that Brazil has struggled. Still, it was the top performer in 2016, soaring 61.3%, and a look behind the numbers shows encouraging signs that the worst may be over for Latin America’s largest economy.

Indeed, big U.S. multinational firms with sizable business interests in Brazil, such as International Paper and Schlumberger, have said they believe the economy has bottomed. Since late June, Brazil’s MSCI stock market index has turned in a scorching performance, vaulting into positive territory (5.0% ytd as of Tuesday’s close) after being down as much as 18% between its February high and June low. Forward earnings has been climbing, driving share prices higher (Fig. 9). Earnings is forecast to jump by 26.5% this year, yet Brazil’s stock market is trading at 10.8 times earnings (Fig.10).

Bossa Nova, one of Brazil’s best-known musical genres, means “new trends” in Portuguese. In the universal language of the stock market, there clearly are some new positive trends taking place in this Latin American country at long last. Consider the following:

(1) GDP growth. Real GDP continues to recover smartly, boosted by a rise in exports (Fig. 11 and Fig. 12). The 0.4% y/y contraction during Q1 was the best showing in two years.

(2) Real exports and imports. Exports jumped 4.8% in Q1 into positive territory despite a tainted-meat and corruption scandal that has led to widespread bans of Brazilian poultry and meat around the world. The scandal threatens to bring down President Michael Temer, the structural reformer who also has been indicted on charges of taking bribes from meatpacking giant JBS SA after only a year in office. Brazil is the world’s largest exporter of beef and poultry. Powering exports to their biggest gain in two years were sales of oil, iron ore, and soybeans. Imports rose sharply.

(3) Gross fixed capital formation. Capital spending remained in negative territory during Q1 but showed marked improvement as investors continued to gain confidence. During Q2, there’s been a series of deals that suggest a new level of optimism, despite the political turmoil. In late May, Buenos Aires-based venture capital firm Kaszek Ventures said it raised $200 million for a fund that will invest in Internet start-ups focused on agriculture technology, education, and health care. It is Kaszek’s third fund; about two-thirds of the investments across its funds are in Brazil, and that will continue.

“We believe that Brazil will still be the largest recipient of our capital and where we invest the most,” said one of the founding partners, according to the 6/30 NYT article linked above. American investors in the new fund include Sequoia Heritage, a fund of funds connected to Sequoia Capital, and the Dietrich Foundation of Pittsburgh. Another investor: Accel’s Kevin Efrusy, responsible for that firm’s early bet on Facebook. Kaszek’s first two funds focused on financial technology and software services.

Other recent deals: Softbank of Japan said in late May it would contribute $100 million to the privately held 99, a competitor to Uber. And a China-backed $20 billion fund announced last year to help finance the construction of railroads to link agricultural areas to ports started taking investment pitches in late June.

(4) IPOs. More companies have launched IPOs in Brazil this year than in all of 2016, when only one company went public, according to a 4/18 Leaders League post. Azul, the Brazilian airline started by the founder of JetBlue, raised R$2 billion in an early April IPO—the biggest IPO in the country since 2013. That followed on the heels of two other public debuts: Movida, the car rental company, and Instituto Hermes Pardini, a health care company.

Investment bankers estimate that activity will pick up sharply in the year’s second half, and up to 15 or more firms could go public. XP Investimentos, which bills itself as “the Charles Schwab of Brazil,” is expected to go public this month, and Grupo Notre Dame Intermedica, a dental and health care insurer, is also considering a public offering later this year. A sign of things to come: The family that owns Latin America’s largest construction group—Oldebracht SA, known for building airports, highways, and hydroelectric plants around the world—plans to bring all its businesses public in the next three to four years as it seeks to recover from a bribery scandal, reported an article in the 6/30 WSJ.

(5) Foreign direct investment. Regulatory reforms enacted in 2016 to attract more foreign investment are working. In the first two months of this year, US$16.8 billion flowed into Brazil from abroad, a record for the timeframe and up 57% from the same period in the year-ago period. The money flowed to all sectors of the economy, according to the Brazilian government, with the industrial sector topping the list, followed by services and agribusiness & mining. This follows the US$15.4 billion that flowed into Brazil in December 2016, the highest amount since 2010, according to the government. On 4/4, the WSJ reported that Exxon Mobil was in talks to expand in Brazil through joint ventures with the state-controlled Petrobras, gaining access to deep-water oil reserves, as well as with U.S.-based producer Hess.

Economic conditions in Brazil are far from perfect—unemployment is at record highs, and the charges against Temer cast uncertainty on pension and other reforms—but the trends are encouraging enough to dance the Bossa Nova.

 

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Steady Does It

July 12, 2017 (Wednesday)

 

Earnings & Revenues: Upbeat Forward Guidance. Earnings seasons are when industry analysts often revise their earnings estimates based on the latest quarterly results reported by their companies. They are also influenced by managements’ conference calls discussing those results as well as their forward guidance on their business prospects. We will see how the Q2-2017 season plays out over the next few weeks.

Joe and I aren’t expecting any significant downside surprises. Au contraire, as the French say, we remain impressed by the recent steadiness of the S&P 500/400/600 consensus earnings expectations for this year (Fig. 1). Industry analysts are currently projecting growth rates of 10.3%, 7.0%, and 6.2% on a pro forma basis for the three S&P indexes. Even more impressive is the steadiness, since last September, of their S&P 500/600 estimates for 2018, while the estimate for the S&P 400 has been on a modest uptrend. The analysts are estimating 2018 growth rates of 12.0%, 14.2%, and 19.3%.

It is quite unusual to see such steadfastness since the coming year’s estimates for the S&P 500 typically tend to fall over time, though there remains plenty of time for them still to do so (Fig. 2). The quarterly estimates for the S&P 500 are also holding up relatively well for the remainder of this year (Fig. 3).

This steadiness, despite a long history of overly optimistic estimates being revised downward more often than not, might be attributable to expectations of a corporate tax cut effective in 2018. A couple of months ago, as Washington’s swamp turned murkier, Joe and I changed our minds about a retroactive cut starting in 2017. But we still expect one for 2018.

Perhaps a more likely explanation for the steadfastness of earnings estimates so far this year is that the global economy is showing signs of improving. This certainly explains why both S&P 500/400/600 forward earnings (which would be directly boosted by a tax cut) and forward revenues (which wouldn’t be directly impacted) all are continuing to rise to record highs (Fig. 4).

So while we await the conference calls and managements’ guidance, the forward guidance provided by S&P 500/400/600 forward earnings and revenues—which are based on analysts’ consensus expectations for this year and next year—remains upbeat.

Our Blue Angels analysis for the S&P 500/400/600 stock price indexes shows that while valuation multiples are high for all three, forward earnings seems to be rising at a faster pace into record territory (Fig. 5).

Global Economy: Growing Steadily. Just about every month, Joe and I note that there is a decent correlation between S&P 500 revenues and the US M-PMI and NM-PMI measures of domestic economic activity. Both were solid in June, which augurs well for revenues. So do the solid PMIs for the global economy during June, with the global composite remaining steady around 54.0 for the past six months (Fig. 6).

Yesterday, Debbie reviewed May’s OECD leading indicators report, which tracks indexes for 32 of the 35 OECD advanced economies, as well as 6 of 15 OECD non-member economies, which include Brazil, Russia, India, and China. They also were mostly on a steady course, confirming that the current slow-but-steady growth of the global economy should continue. On the other hand, if you are looking for somewhat better economic growth than slow-but-steady, then take a European vacation this summer. Here are some of the sights you’ll enjoy:

(1) Pretty PMIs. The Eurozone’s M-PMI rose to 57.4 in June, while the region’s NM-PMI dipped to a still-solid reading of 55.4 (Fig. 7 and Fig. 8). Germany led the way on the M-PMI with a very strong 59.6, while the NM-PMI was led by Spain (58.3) and France (56.9).

(2) Shopping galore. France is also leading the Eurozone in the volume of retail sales (excluding autos). The region’s sales are up 2.6% y/y through May, with solid gains in France (4.2%), Spain (2.9), Germany (2.3), and Italy (1.0) (Fig. 9). New passenger car registrations remain on solid uptrends in the major European economies (Fig. 10).

(3) Lots of oomph. The strongest economy in the Eurozone is Germany’s, where industrial production rose 5.0% y/y during May to a fresh record high (Fig. 11). The country is benefitting from booming exports, which also confirms that the global economy is doing well.

US Economy: Steady Drags. We’ve been bullish since the start of the bull market in equities during March 2009. One day, we will be bearish. That will happen when we believe that a recession is imminent. Hopefully, we will figure that out either before or at least at about the same time as the stock market does so. Meanwhile, to maintain our credibility (and maybe our sanity too), we continue to do the best we can to balance our optimism with a realistic assessment of the risks. For now, we continue to see many more white swans than black swans. Nevertheless, here are a couple of recent concerns:

(1) Labor shortage. One of my daughters recently opened a very successful breakfast and lunch bistro in Petaluna, located in Sonoma County, California. Sarah’s Eats & Sweets has a five-star rating on Yelp with 74 reviews already. The only problem that Sarah has so far is getting help to meet all the demand for her culinary delights. She reports that it doesn’t make sense to try paying more to attract workers. She simply can’t find qualified workers. She is not alone. This is a nationwide problem and may put a lid on economic growth.

The latest survey of small business owners conducted by the National Federation of Independent Business (NFIB) found that 32.3% reported job openings that could not be filled on average over the past three months through June, the highest reading since January 2001 (Fig. 12). This series starts in January 1986 and is highly correlated with the JOLTS data on the national job openings rate, which is available since December 2000, and is in record-high territory.

(2) Subdued wages. So far, the big surprise is that despite all the job openings, wage inflation remains around 2.5%. During the previous three cyclical peaks in jobs openings, wage inflation was around 4.0% (Fig. 13). Even more puzzling is that the national quits rate rose to a new cyclical high in May. Workers usually leave and take another job for better pay (Fig. 14).

If job growth is restrained by a shortage of qualified workers and wages remain subdued, then the probability of faster economic growth is low. Previously, we’ve suggested that wage inflation is being held down by even lower price inflation. That means that real wages are still growing, but not by much, since they are determined by productivity, which isn’t growing by much.

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Outbound & Inbound

July 11, 2017 (Tuesday)

 

US Economy: America’s Trade Is Great. There’s lots more data covering the US economy than other economies. There are even fewer economic series that add up all the national sources to provide a good picture of the global economy. Given the size and importance of the US economy in global trade, it isn’t surprising that some of our homegrown trade indicators provide excellent insight into the performance of the global economy. Currently, their signals are very upbeat, which might explain why the S&P 500 Transportation Index is at a new record high. Let’s have a look:

(1) Real exports & imports. According to the CPB Netherlands Bureau for Economic Policy, the volume of world exports edged down during April from March’s record high (Fig. 1). The growth rate of this series is highly correlated with the growth of the sum of US inflation-adjusted exports plus imports (Fig. 2). The former was up 3.2% y/y in April, while the latter was up 4.5% in May. Both were closer to zero a year ago.

This augurs well for US industrial production, which is also highly correlated on a y/y basis with both measures of trade growth (Fig. 3). Indeed, US industrial output was up 2.1% y/y through May, the best reading since January 2015. It had been negative from April 2015 through November 2016, mostly as a result of the rolling recession in the global oil industry.

(2) West Coast ports. According to the Beach Boys, the West Coast has the sunshine and hippest girls. It also has ports that do lots of business with Asia. Debbie and I monitor the monthly stats on 20-foot-equivalent containers that go in and out of the ports of Los Angeles and Long Beach (Fig. 4 and Fig. 5). The series are volatile, so we track the 12-month sums. The sum of the outbound and inbound traffic is highly correlated with the sum of real US exports and imports (Fig. 6). Both series are on uptrends and at or near recent record highs.

(3) Rail & truck traffic. Not surprisingly, intermodal container railcar loadings (on a 52-week average basis) is highly correlated with both measures of US trade activity (Fig. 7 and Fig. 8). All those exports and imports need to be moved by rail. Some of them must also be keeping the truckers busy. The ATA truck tonnage index jumped to a record high in May, confirming the recent upturn in intermodal container railcar loadings (Fig. 9).

The bad news for the economy is that railcar loadings of motor vehicles has stalled since late last year (Fig. 10). Motor vehicle sales have dropped from a cyclical peak of 18.4 million units (saa) during December to 16.5 million units during June, the lowest pace since February 2015.

(4) Oil exports & imports. The rebound in US oil field production since late last year has slightly boosted railcar loadings of chemicals and petroleum products in recent weeks (Fig. 11). US exports of crude oil and petroleum products have roughly tripled since the start of the current economic expansion (Fig. 12). Net imports have been cut by about two-thirds since 2007!

Larry Kudlow’s 7/8 commentary on CNBC’s website was spot on concerning how the Trump administration is aiming to undermine both Russia’s Vladimir Putin and Iran’s Mullahs by enabling more oil and gas production in the US. He notes that Trump’s speech in Warsaw included the following key line: “We are committed to securing your access to alternative sources of energy, so Poland and its neighbors are never again held hostage to a single supplier of energy.” That was a direct slap at Russia.

Kudlow explained: “Trump wants America to achieve energy dominance. He withdrew from the costly Paris climate accord, which would have severely damaged the American economy. He directed the EPA to rescind the Obama Clean Power Plan, which would have led to skyrocketing electricity rates. He fast-tracked the Keystone XL pipeline. He reopened the door for a modernized American coal industry. He’s overturning all the Obama obstacles to hydraulic fracturing, which his presidential opponent Hillary Clinton would have dramatically increased. And he has opened the floodgates wide to energy exports.”

Love him or hate him, Trump’s initiatives could push oil prices lower. The geopolitical benefits of defunding and defanging Russia and Iran, both of which are extremely dependent on oil revenues, could be significant. So could the positive impact of lower oil prices on US consumers. There could be a negative impact on energy capital spending in the US, but that might be offset by the new exploration projects that Trump’s policies are enabling.

Strategy I: Transports Flying. All the above provides good fundamental support for the record high in the Dow Jones Transportation Average, which in turn is providing solid confirmation of the bull market in the Dow Jones Industrials Average. There are also lots of upbeat and improving indicators for the fundamental stats on the S&P 500 Transportation stock price index. Consider the following:

(1) Forward revenues. The sector’s forward revenues remain on a solid uptrend, rising to fresh record highs in June (Fig. 13).

(2) Forward earnings. Apparently, the S&P 500 Railroad industry’s forward earnings was hard hit by the energy recession during 2015 (Fig. 14). However, it has been making a comeback since early 2016. The forward earnings of the S&P 500 Airlines industry also has been recovering this year. Meanwhile, Air Freight & Logistics has been rising faster in record territory so far this year.

(3) NERI. The Net Earnings Revisions Index (NERI) of the Transportation sector turned increasingly positive over the past five months through June, following 21 consecutive months of negative readings (Fig. 15). The rebound in NERI has been led by an impressive turnaround in NERI for the Railroad industry (Fig. 16).

Strategy II: Another Earnings Season. Joe reports that as the Q2-2017 earnings season is starting, industry analysts are expecting S&P 500 earnings to be up 7.9% y/y. We are expecting about the same, though the result could be a bit better given that analysts tend to lower their estimates too much in the weeks approaching earnings reporting seasons. They’ve lowered their estimate for Q2 by 3.8% since the start of this year (Fig. 17). Here are the analysts’ current earnings growth expectations for the 11 sectors of the S&P 500: Consumer Discretionary (0.9%), Consumer Staples (3.5), Energy (660.2), Financials (7.5), Health Care (2.3), Industrials (2.4), Materials (4.3), Real Estate (1.9), Tech (11.2), Telecom (1.1), and Utilities (-2.8).

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More of the Same

July 10, 2017 (Monday)

 

US Employment: Same Old, Same Old. This is starting to get dull. There just isn’t much happening other than more of the same. In the US, private-sector payroll employment has increased 170,800 per month on average during the first six months of the year. Sound familiar? Here are the average gains for 2016, 2015, 2014, 2013, and 2012: 160,700, 216,700, 235,700, 210,200, and 186,800 (Fig. 1). Although the unemployment rate has been below 5.0% for the past 14 months and below 4.5% for the past three months, wage inflation, as measured by average hourly earnings, remains around 2.5% on a y/y basis, as it has since the end of 2015 (Fig. 2). When the unemployment rate got this low during the previous two economic cycles, wage inflation rose to around 4.0%. Here are a few related developments:

(1) Jobs. Interestingly, payroll employment among general merchandise stores, which dropped 63,800 during the first three months of the year, rose during two of the past three months by a total of 19,800 (Fig. 3). In the natural resources industry, payroll employment has increased 56,000 since bottoming during October of last year (Fig. 4). The recovery in construction employment seems to have stalled in recent months, probably reflecting a shortage of workers rather than of work (Fig. 5).

(2) Wages. Helping to keep a lid on wage inflation is that price inflation remains subdued below wage inflation. The PCED headline and core inflation rates were both 1.4% y/y during May, well below the Fed’s 2.0% target (Fig. 6). Using the headline PCED, real average hourly earnings rose to a record high during May (Fig. 7). That’s up 5.7% since the start of the current economic expansion during June 2009, and 13.0% since May 2002. The notion that real wages have stagnated for the past 15 years is an urban legend!

(3) Earned income. It all adds up to yet another new high in our Earned Income Proxy (EIP) for private-sector wages and salaries (Fig. 8). It rose 0.6% m/m during June and 4.5% y/y. Adjusted for the headline PCED, we reckon that the EIP rose 0.7% m/m and 3.3% y/y. This augurs well for consumer spending.

(4) Confidence. The strength of the labor market is buoying consumer confidence. The Consumer Optimism Index (COI), which is an average of the Consumer Sentiment Index and the Consumer Confidence Index, edged down in June, but remained near the recent cyclical high (Fig. 9). The COI’s current conditions component rose to a new cyclical high last month.

The increases in real wages and payrolls and the recent decreases in gasoline prices are boosting confidence. Uncertainty about the fate of the Trump administration’s health care and tax reform policies doesn’t seem to be weighing on overall confidence so far.

US Economy: Staying on Course. Friday’s better-than-expected news on employment followed two solid readings for June’s M-PMI (57.8) and NM-PMI (57.4). Both registered very high readings for their new orders components, at 63.5 and 60.5, while their employment components were also quite good, at 57.2 and 55.8 (Fig. 10). The M-PMI augurs well for the growth rate in S&P 500 revenues since they are positively correlated (Fig. 11).

As Debbie and I have noted before, we don’t get too excited when the Citigroup Economic Surprise Index takes a dive, as it did during the first half of the year (Fig. 12). That’s because it is extremely volatile and cyclical. After it falls, it always rebounds, until it falls again. It may be starting to rebound again. While the latest economic indicators are looking up, there’s no reason to believe that real GDP won’t continue to increase at a relatively leisurely pace of 2.0% on a y/y basis, as it has since the second half of 2010.

Stocks: Still Fundamentally Good. The latest ascent into record-high territory for the S&P 500, with historically high P/Es, naturally has raised fears of a correction, or worse. It seems to Joe and me that the market is doing a very good job of correcting internally on a regular basis without giving up the high ground. The latest example is the recent selloff in technology stocks and rebound in financial ones. That might continue without triggering a market-wide selloff.

Meanwhile, two of our favorite weekly fundamental stock market indicators continue to support the bull market trend. Here is an update:

(1) Our Boom-Bust Barometer (BBB) is simply the ratio of the CRB raw industrials spot price index and weekly initial unemployment claims (Fig. 13). It remains in record-high territory, with a whopping y/y gain of 21%.

(2) Our Weekly Leading Index (WLI) averages our BBB and the Bloomberg weekly Consumer Comfort Index (Fig. 14). WLI tracks the S&P 500 even better than our BBB. It is also up in record territory, with a gain of 13% y/y.

(3) Forward earnings. Both measures have been highly correlated with the S&P 500 since 2000. That’s because both have been highly correlated with the forward earnings of the S&P 500, which rose to yet another record high during the 6/29 week (Fig. 15 and Fig. 16).

Fed’s Fischer: Yada, Yada, Yada. FRB Vice Chairman Stanley Fischer has been a particularly active Fed governor this summer, having given three formal speeches in the past month. Fischer is an important voice on the FOMC whose opinion tends to carry weight across the Committee, especially with Fed Chair Janet Yellen. Though wordy, none of the speeches discussed the direction of monetary policy. Rather, the focus was on Fischer’s concerns regarding the health of the US economy and financial markets.

Importantly, however, there was nothing in Fischer’s recent speeches to suggest that he is wavering from his previous comments on the need for the gradual pace of monetary normalization to stay on course. During April, he said that a continued gradual increase in interest rates (about one more this year) would be appropriate and unaffected by the start of the slow unwinding of the Fed’s balance sheet. Below, we summarize Fischer’s latest speeches, all of which seem to indicate that he expects more of the same:

(1) More melt-up. On June 27 at an IMF workshop in Washington, D.C., Fischer outlined four areas of cyclical vulnerability related to financial stability, including financial-sector leverage, nonfinancial-sector borrowing, liquidity and maturity transformation, and asset valuation pressures. Summarizing his assessment, Fischer said: “[O]verall, a range of indicators point to vulnerability that is moderate when compared with past periods: Leverage in the financial sector is at historically low levels, and ... vulnerabilities associated with liquidity and maturity transformation appear to have decreased. However, the increase in prices of risky assets in most asset markets over the past six months points to a notable uptick in risk appetites, although this shift has not yet led to a pickup in the pace of borrowing or a sizable rise in leverage at financial institutions.”

(2) More low-productivity. “How much does productivity growth matter? The basic answer: simple arithmetic says it matters a lot,” according to Fischer’s concluding remarks at a July 6 forum in Massachusetts. “[T]he U.S. economy has been in a low-productivity growth period since 1974 [except for the mid-1990s]. The record for the past five years has been particularly dismal.” Fischer attributed the recent decline in productivity growth to several factors, including weak private-sector investment, which “may in part reflect uncertainty about the [fiscal] policy environment.”

On the public front, Fischer presented a chart showing that government-funded R&D as a share of GDP is at a record low, which in his words is “disturbing.” Nevertheless, he optimistically concluded: “Governments can take sensible actions to promote more rapid productivity growth.” In other words, Fischer seems to be expecting more of the same productivity growth until fiscal policymakers save the day, a sentiment he has reiterated before.

(3) More to be done. On June 20, at a macroprudential conference in the Netherlands, Fischer homed in on housing and financial stability. Interestingly, he attributed vulnerabilities in housing to low interest rates: “With the recent crisis fresh in mind, a number of countries have taken steps to strengthen the resilience of their housing finance systems. ... But memories fade. Fannie, Freddie, and the Federal Housing Administration are now the dominant providers of mortgage funding, and the FHLBs have expanded their balance sheets notably. House prices are now high and rising in several countries, perhaps as a result of extended periods of low interest rates.”

(4) More communication. How can we be sure that Fischer hasn’t changed his tune? Because he hasn’t given us reason to believe otherwise. In an April 17 speech, Fischer directly informed the markets about his thinking on the Fed’s communication strategy. He asked: “How can the Fed avoid surprising markets?” Then answering his own question, he said: “Clear communication of the Federal Open Market Committee’s (FOMC’s) views on the economic outlook and the likely evolution of policy is essential in managing the market’s expectations.”

Specifically, Fischer spoke about the FOMC’s desire to avoid a repeat of the mid-2013 “taper tantrum.” In his view, such an event is unlikely to happen again because the Fed has given its clear guidance that the unwinding of its asset purchases is likely to begin this year in a slow and painless fashion. So far, he noted, the markets have had a muted reaction to that prospect.

Movie. “The Beguiled” (- - -) (link) is a dark movie directed by Sofia Coppola and starring Colin Farrell and Nicole Kidman. Most of it was filmed at night by candle light, so bring a flash light. It is a remake of a 1971 movie featuring Clint Eastwood and Geraldine Page, and set in an all-girl boarding school in the rural South during the American Civil War. The movie is very slow moving, and all too predictable. There is a subliminal message for stock investors: Beware of a wounded bull that seems to be recovering, only to turn on you.

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Fireworks

July 06, 2017 (Thursday)

 

Strategy I: IPO Extravaganza. The Fourth of July is a great day for Americans. We celebrate our independence by going to the beach or enjoying a barbeque in the backyard with family and friends. Then we go to see fireworks at the end of the day. Firecrackers come with some great names and can be surprisingly pricey. The Wickedly Awesome 115 shot retails for $199.99, while the Swashbuckler 72-shot is $149.99, according to Fireworks.com. So perhaps it should be no surprise that the US fireworks industry had $1.2 billion in revenue last year, according to the American Pyrotechnics Association, or Americanpyro.com—we kid you not.

In our business, there have been some impressive fireworks in the IPO market so far this year. The Renaissance IPO index has returned 20.5% ytd through June 30, surpassing the S&P 500’s 8.2% return over the same period. Likewise, the average IPO gained 11% in Q2, compared to the S&P 500’s 2.3% return. But it’s the top performing IPOs priced in 2017 that have really been on fire, in some cases returning north of 60%. Let’s take a look at what’s been heating up the IPO market so far this year.

(1) Healthy returns. In the first half of 2017, there were 77 IPOs raising $20.5 billion, the best result in the market since 2015, Renaissance Capital reports. With the year only halfway done, the IPO market has raised more than was raised in all of 2016.

The largest number of IPOs in the first half were done in the Health Care sector, which saw 18 deals, according to Renaissance. The sector was also home to the top performing IPO, BeyondSpring, which enjoyed a 141.8% return since its March offering through July 3. The biotech company, which generates no revenue, is testing drugs that it hopes will reduce infection in chemotherapy patients and will treat certain lung cancers. Other Health Care names among the top 10 best performing IPOs priced this year through July 3 are AnaptysBio, up 66.7%, Biohaven Pharmaceutical Holding, up 53.0% and Athenex, up 51.4%, according to IPOScoop.com. The recent upturn in the S&P 500 Biotechnology stock price index suggests that investors are looking for healthy returns from this sector again.

But the Health Care sector also housed a number of the IPO market’s biggest clunkers. Notably, Zymeworks, a biotech company, is down 36.3% from its April IPO and ObsEva S.A., a biotech company developing drugs to increase women’s reproductivity, has lost 50.1% since its January offering.

(2) Home sweet home. Benefitting from the boom in home purchases and renovation, the IPO of Floor & Décor Holdings has gained 82.5% since its April IPO, making it the second best performer of the IPOs priced this year. The company’s “same-store sales have grown by double-digit percentages for eight consecutive years, fueling investor appetite for its initial public offering…” a 5/3 WSJ article reported. The company has 72 locations, but would like to grow to 400 stores by increasing its store base by about 20% a year.

Another consumer goods company, Canada Goose Holdings, was the fourth best performing IPO priced this year. Since its March IPO, shares of the maker of very pricey winter coats have gained 54.8%. Another sign that times are good: Canada Goose returned to the well last Tuesday, selling $259.4 million of shares that were owned by investors in and managers of the company.

(3) Snap, crackle, pop. The Tech sector had the largest dollar-volume of deals in the first half, $5.6 billion, according to the Renaissance report. The tally was boosted by the year’s largest IPO, the $3.4 billion deal from Snap. However bigger doesn’t necessarily mean better. Snap shares have risen only 3.5% since its March IPO. Shares have come under pressure as Facebook has become increasingly competitive in the same space through its Instagram division.

Tech companies developing software to sell to corporations have fared better in the IPO market this year. Shares of Appian, which makes software for developing enterprise applications, are up 47.6% from its May IPO. Shares of MuleSoft, which sells companies software to integrate their applications, have gained 47.2% since a March offering. And SMART Global Holdings, a semiconductor company, has shares that climbed 42.8% just since its May 24^th IPO.

This year’s second largest IPO has fared a bit better than the year’s largest offering. Altice USA’s $1.9 billion IPO has gained 6.3% since June 22 offering. A subsidiary of the Netherland’s-based Altice NV, the US company was formed by last year’s merger of Cablevision Systems and Suddenlink Communications.

(4) No energy. With the price of Brent down 13% ytd, it’s not surprising that IPOs in the Energy sector have had a tough time. Shares of Antero Midstream GP, the general partner of Antero Midstream, which owns assets like gathering pipelines and compressor stations, are down 6.8% since its May IPO. The IPO of Select Energy Services, which provides water solutions to US frackers, has dropped 13.4%, and the January IPO of Keane Group, which provides well completion services to fracking companies, fell 14.3%.

(5) Up and down. The Fed’s tally of new nonfinancial corporate equity issuance, which includes initial and secondary stock offerings, has also had a solid rebound, with companies raising $43.1 in the first five months of this year, compared to the $32.4 raised last year over the same period. Activity is slowly climbing back to the elevated levels enjoyed in 2014 and 2015, before the volume of stock offerings dropped sharply last year (Fig. 1).

Despite the elevated IPO and secondary issuance, outstanding equities continue to shrink thanks to share buyback activities. Nonfinancial corporate equities outstanding have shrunk by $550 billion over the past four quarters through Q1-2017 (Fig. 2).

Strategy II: Shifting Sands. As the first half of the year wrapped up, sector leadership took a dramatic turn: The S&P 500 Financials sector suddenly surged ahead and the S&P 500 Tech sector stumbled badly. It’s quite a reversal from earlier in the year. Let’s take a closer look at what’s causing these changes just as the year enters its second half.

(1) Financials gaining. Over the four weeks through July 3, the S&P 500 Financials sector gained 6.8%, making it the best performing S&P 500 sector, while the Tech sector dropped 4.9%, making it the worst performer.

The change in momentum has reduced the ytd (through July 3) return for the Tech sector to 15.4%, but it remains the best performing sector so far this year. Likewise, the Financials sector’s return this year has improved to 7.4%, but it continues to lag behind the S&P 500’s 8.5% ytd performance. The sector that has shown the steadiest returns is the Health Care sector, which is the second best performing sector both ytd—up 15.2%—and over the past four weeks—up 3.1% (Fig. 3).

(2) Passing the test. The industries propelling Financials to the top of the heap over the past four weeks include Diversified Banks (9.8%), Regional Banks (7.9), Investment Banking & Brokerage (7.7), Consumer Finance (7.4), and Asset Management & Custody Banks (6.8). Diversified Banks is the third best performer among the 100 industries that we track and the other Financial industries are among the top 10 performing industries (Fig. 4).

The S&P 500 Financials stock price index was boosted by news last Wednesday that all of the banks taking the annual Federal Reserve stress test passed it and many were given permission to increase their dividends and stock repurchases. It also didn’t hurt that the Federal Reserve raised interest rates by a quarter point on June 14 and has indicated it plans to reduce its balance sheet in the coming months. Fed officials have implied an announcement laying out their plans could come as soon as September, the 7/4 WSJ reported. Financials also improved as the spread between the fed funds rate and the 10-year Treasury yield widened from 98 bps on June 26 to 119 bps on Monday.

The Financials sector remains at the top of the heap on a y/y basis through July 3, up 35.3%, with a nice lead over the Tech sector, which is up 30.6%. Both have far outpaced the S&P 500’s 15.5% return over the same period (Table 1).

Earnings in the S&P 500 Financials sector are expected grow 12.1% over the next 12 months and the sector has a forward P/E of 13.9 (Fig. 5 and Fig. 6). Meanwhile, analysts forecast S&P 500 Tech sector earnings will grow by 11.6% over the next year and it has a forward P/E of 18.1 (Fig. 7 and Fig. 8). Looked at side by side, it’s easy to understand why investors may be willing to give the underperforming Financials sector a go as the year enters the home stretch.

(3) Chips with salsa. Some of the highest flying industries in the Tech sector have fallen the hardest over the past four weeks. The S&P 500 Semiconductor Equipment industry index, which was up 44.4% ytd through June 2, has fallen 12.8% since then. Likewise, the Semiconductors index, which climbed 13.4% ytd through June 2, has fallen 7.3% in the four subsequent weeks. And after climbing 27.7% from the start of the year through June 2, the Internet Software & Services index has dropped 6.0% (Fig. 9).

The recent downward move may be just what some of the Tech industries need to consolidate their gains before moving higher in step with above-average earnings growth. Worldwide semiconductor sales continue to hit new record highs, most recently in April (Fig. 10). The Semiconductor Equipment industry is expected to grow earnings 15.6%, higher than the industry’s forward 13.7 price-to-earnings ratio. And Semiconductors is expected to grow earnings 11.0%, has a forward P/E of 14.9.

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The Third Mandate

Jun 29, 2017 (Thursday)

 

Strategy I: Benign Neglect. Like most of us, Fed officials don’t like to be ignored. A few of them crave attention. That’s why Fed officials love giving speeches and appearing on CNBC. However, over the past year or so, investors have moved on. They seem to have lost their interest in the Fed. That was not the case at the beginning of 2016 when two Fed officials—namely, Fed Vice Chairman Stanley Fischer and FRB-SF President John Williams—warned investors that four rate hikes were likely over the rest of the year. They were hammering home the message of the December 15-16, 2015 meeting of the FOMC, when the committee hiked the federal funds rate for the first time during the current expansion and released a dot plot indicating four rate hikes in 2016.

The S&P 500 plunged 13.3% early last year from its high on November 3, 2015 to a low of 1829.08 on February 11, 2016 (Fig. 1). The two Fed officials realized that they were getting too much attention and backed off, toning down their market-rattling rhetoric in subsequent clarifications of what they really meant. The 25bps rate hike at the end of 2015 to 0.25%-0.50% was followed by another “one-and-done” hike in 2016 to 0.50%-0.75% at the end of 2016, a third hike on March 15 this year to 0.75%-1.00%, and a fourth to 1.00%-1.25% on June 14.

However, there were no tightening tantrums in the financial markets. Investors simply lost interest in the Fed and adopted an attitude of benign neglect, much to the consternation of attention-needy Fed officials. Consider the following:

(1) Stocks. The stock market mostly ignored all those hikes, proceeding to melt up from last year’s low by 34.1% to a record high of 2543.46 on June 19. Yesterday, It closed only 1.4% below that level on Tuesday. The forward P/Es of the S&P 500/400/600 rose from 14.8, 14.8, and 15.2 in early on February 2016 to 17.4, 18.0, and 19.2 on Tuesday (Fig. 2).

The Buffett ratio, which is the market value of US stocks traded in the US divided by GNP, rose to 1.72 during Q1, nearing its record high of 1.80 during Q1-2000 (Fig. 3). The similar ratio of the S&P 500 market capitalization divided by the composite’s revenues rose to 2.00 during Q1, matching the previous record high. A comparable weekly measure using the S&P 500 stock price index divided by forward revenues per share rose to a record 1.95 during the week of June 22 (Fig. 4).

(2) Bonds. Initially, the reaction in the bond market to the Fed’s rate hikes was also extremely benign (Fig. 5). The US Treasury 10-year bond yield plunged 93 bps from 2.30% on December 16, 2015 to a record low of 1.37% on July 8 of last year. The yield curve spread narrowed from 215 bps to 97 bps over this period (Fig. 6). Last year’s lows in both were made on July 8, a few days after the Brexit vote. Yields fell and the yield curve narrowed during the first half of last year because the economy looked weak according to the Citigroup Economic Surprise Index (CESI) (Fig. 7). In addition, inflationary expectations over the next 10 years remained subdued around 1.5% (Fig. 8).

From last year’s low, the bond yield jumped to this year’s high (so far) of 2.62% on March 13. The yield curve spread widened to 196 bps on the same day. The Brexit vote didn’t precipitate a financial crisis as was feared by many. The CESI rebounded smartly from last summer’s low of -25.4 to peak at 57.3 on March 15 of this year as the economy recovered from the energy industry’s rolling recession. Of course, much of the surge in the bond yield and the yield curve spread occurred after Election Day when Donald Trump’s ambitious and stimulative agenda of tax cuts and infrastructure spending suddenly looked possible. Animal spirits soared according to surveys of consumer and business confidence. So did stock prices.

However, the CESI, which peaked on March 15 at 57.9 proceeded to plunge to the most recent low of -78.6 on June 16. The 10-year yield was down to 2.21% on Tuesday, and the yield curve spread was 105, near Monday’s 98, which was the narrowest since right after the Brexit vote! Expected inflation over the next 10 years was 1.73% yesterday, down from the recent peak of 2.08%.

(3) Currencies & commodities. The currency markets have also mostly ignored the Fed. Despite the March and June rate hikes, the JP Morgan trade-weighted dollar peaked on January 6, and fell 17% through yesterday (Fig. 9). The FOMC’s latest Summary of Economic Projections shows that the Committee is aiming to raise the federal funds rate maybe three to four more times to achieve the median projection of 2.1% by the end of next year. Yet the dollar remains weak. Usually, a weak dollar should be bullish for commodities. Instead, the price of a barrel of Brent crude oil has fallen from a recent high of $57.10 to $47.23 yesterday (Fig. 10). Over this same period, the CRB raw industrials spot price index has stalled after rising smartly since late 2015.

Strategy II: Fed Raid. Fed officials may be coming around to believe that further rate hikes may be a mistake given the weakness in the CESI, the drop in bond yields, the flattening of the yield curve, and the decline in expected inflation. However, they may be increasingly concerned that if they signal a halt to rate hikes, stock prices might continue to melt up. Their congressional mandate is to aim for full employment with price stability. Their third, though unofficial, mandate is to maintain financial stability. This would explain the recent spate of comments by Fed officials on this subject. They are clearly trying to get our attention. Consider the following:

(1) Williams. “The stock market seems to be running pretty much on fumes,” FRB-SF President John Williams said in an interview in Sydney, as Reuters discussed on Tuesday. “It’s something that clearly is a risk to the U.S. economy, some correction there—it's something we have to be prepared for to respond to if it does happen,” he said. On the one hand, the bank president said that he is concerned about the “complacency in the market,” citing low measures of market volatility. On the other hand, Williams doesn’t foresee a major crash coming because the market is underpinned by a fundamentally sound US economy, in his opinion.

For Williams, the bottom line seems to be that the course of reducing monetary stimulus will continue to be slow and steady. That would be in keeping with his concerns about the market and remarks he made in a speech in Sydney on Tuesday that the US economic expansion will be sustained, but slow. During his speech, Williams focused on long-term demographic drivers weighing on growth, productivity, and inflation. Prior to his speech, Williams told reporters that just three rate hikes this year and three to four hikes next year would be fine. Williams gets to participate in FOMC meetings this year, but he doesn’t get a vote.

(2) Fischer. FRB Vice Chairman Stanley Fischer has more weight than Williams because he gets a permanent vote on the Committee given his position on the Fed’s Board of Governors. Fischer too warned against market complacency in a 6/27 speech. Fischer’s broad assessment is that leverage and liquidity risk in the financial markets is “relatively low.” However, Fischer seemed to be most worried about the market’s nonplussed attitude toward perceived risks inherent in elevated asset valuations.

Fischer concluded: “Prices of risky assets have increased in most major asset markets in recent months even as risk-free rates also rose. In equity markets, price-to-earnings ratios now stand in the top quintiles of their historical distributions, while corporate bond spreads are near their post-crisis lows. Prices of commercial real estate (CRE) have grown faster than rents for some time … The general rise in valuation pressures may be partly explained by a generally brighter economic outlook, but there are signs that risk appetite increased as well. For example, estimates of equity and bond risk premiums are at the lower end of their historical distributions, and, relative to some non-price-based measures of uncertainty, the implied volatility index VIX is particularly subdued.”

For what it’s worth, as of April, Fischer seemed to be in the three-rate-hikes-this-year camp along with Williams. During mid-June, Fischer spoke about his concerns over assets prices, specifically global housing, but made no mention of the path of rate hikes. Fischer’s most recent speech didn’t mention his thoughts on the course of rate hikes either.

(3) Yellen. Of course, Fed Chair Janet Yellen carries the most weight in the FOMC. Like Fischer, she too spoke on Tuesday, describing asset valuations as “somewhat rich if you use some traditional metrics like price earnings ratios,” according to Bloomberg. She said so when answering audience questions at an event in London. The good news is that she doesn’t foresee another financial crisis “in our lifetime,” reported CNBC. She is a bit older than me, but much older than Melissa.

Fed: The Great Unwinding. Besides rates, several Fed officials have taken a position on what Melissa and I have referred to as the inevitable “great unwinding” of the Fed’s $ 4.4 trillion in assets on the balance sheet. Last month, for example, Williams indicated that the balance sheet will be “much smaller” in about five years than it is today. Tempering the possibility of a repeat 2013 “taper tantrum” when global markets panicked at the mere mention of a possible tapering of asset purchases, Williams said that the Fed will start with a “baby step” likely later this year and be quite “boring” and in the “background.”

FRB-SL Fed President James Bullard, not a voter this year, also said that he has been an advocate for getting started on balance-sheet reduction, in a 6/22 interview with the WSJ. “We’re going to do it in a very controlled and passive way that I think will be easy for markets to digest, and so I’m not expecting anything too dramatic. But I think it is important to create some policy space for the future,” he said.

Melissa and I think that the Fed will probably commence the great unwinding this year, or at least outline a plan for doing so. That insight is based not only on recent comments from Fed officials, but also the latest Statement on Monetary Policy. Depending on the Fed’s approach to the great unwinding, the pace of rate hikes could slow even further, because the Fed will want to avoid a “great unravelling” of markets should the great unwinding unnerve otherwise complacent investors.

Consumer Discretionary I: Furniture Is Flying. Overlooked amid all the gloom and doom in retail is the boom going on in the home furnishings category. It reflects positive trends in housing and the economy, in general, and parallels the favorable fundamentals of the home improvement category. And so far, home furnishings has continued to defy even the Great Disruptor that is Amazon. Fundamentals are expected to stay strong for the industry for the foreseeable future on expectations for higher household formations, increasing home sales, and continued low unemployment. Consider the following:

(1) Sales. US furniture and home furnishings sales have risen every year since 2010 (Fig. 11). During April, they totaled a record $193 billion (saar), with furniture at $110 billion and furnishings at $83 billion. The inflation-adjusted total rose to a record $1,965 (saar) on a per household basis, doubling since November 1999 (Fig. 12).

(2) Orders. New orders in the home furnishings market have been strengthening since August 2016, and a recent survey by accounting and consulting firm Smith Leonard shows that new orders in March were up by 12% y/y, a significant advance from February’s 4% y/y gain.

(3) Online. While online furniture sales—from the likes of Wayfair (W) and Amazon (AMZN) and Williams-Sonoma’s (WSM) West Elm units—still represents only about 10% of total U.S. furniture sales, it’s a swiftly growing segment.

A 5/12 WSJ article quoted a CEO whose trucking company makes large e-commerce deliveries saying “Just in the last year, furniture has taken off.” Furniture is his company's number-one business-to-consumer shipment item, recently usurping TVs.

(4) Hot stuff. What’s flying off stores’ floors? Demand for sofas and bedding is high, in particular, while outdoor furniture and vintage furniture are also popular. The vintage trend is new and noteworthy: Vintage Ikea furniture is fetching big bucks at auctions, and virtually all furniture websites now feature a vintage selection.

(5) Amazing Amazon. Amazon has been turning more attention to its online furniture business. “Furniture is one of the fastest-growing retail categories here at Amazon,” furniture general manager Veenu Taneja told the WSJ in the article cited above. He said the company is expanding its furniture-related offerings, adding custom-furniture design services as well as Ashley Furniture sofas to its lineup. Amazon also has been speeding up delivery to one or two days in some cities.

One well-known furniture retailer has decided that joining forces with Amazon is a better strategy than trying to beat the world’s biggest retailer at its own game: Ethan Allen Interiors (ETH) announced in April that it will launch the Ethan Allen Design Studio on Amazon to sell its furniture.

(6) Good performance. The strong showing hasn’t gone completely unnoticed by investors: Through Tuesday’s close, the S&P 500 Home Furnishings industry, representing manufacturers, is up 16.9% ytd and 26.9% y/y. That’s in line with the performance of the S&P 500 Home Improvement Retail industry (home- and garden-related stores), up 11.8% ytd and 15.4% y/y. In contrast, the S&P 500 Homefurnishing Retail industry (which has home furnishing retailer Bed Bath & Beyond as its sole member) hasn’t fared as well: It’s down 24.4% ytd and 26.6% y/y.

Consumer Discretionary II: Lots of Shoppers. News from many of the publicly traded furniture retailers bears out the positive top-down trends. To furnish some details:

(1) Big Lots (BIG) posted record earnings in its Q1, its sixth straight quarter of positive earnings, and gave an upbeat forecast for the year. It has been expanding its furniture offerings this summer. Company executives recently said that customers are buying higher-quality and higher-priced goods in bed and bath, and the store is selling out items at prices that are higher than it ever carried before, e.g., a $1,000 patio set. As a result, Big Lots is expanding certain departments, including furniture. A newly remodeled Columbus, OH store will feature a new “Store of the Future” format emphasizing its strongest categories—furniture, soft home goods, and décor.

(2) Bassett Furniture (BSET) saw Q1 sales rise 4% y/y, on the strength of products made domestically. Domestically made or finished and assembled products represented 71% of its wholesale shipments. US-made furniture is increasingly perceived as better made and available for faster delivery, a critical feature in an increasingly Amazon Prime-driven one-day shipping world.

(3) TJX Companies (TJX)—parent of off-price retailers TJ MAXX and Marshall’s and one of the few retailers to navigate successfully the wrenching changes in retail—plans to expand its Home Goods chain and launch a related concept called “HomeSense,” which already operates in Canada and Europe but will have a different format in the US.

(4) RH (RH), formerly known as “Restoration Hardware,” is pursuing an “un-Amazonable” strategy and totally redefining its approach to selling furniture. While it posted a 23% Q1 revenue gain, its stock plunged recently on the negative earnings impact from liquidating merchandise and adding restaurants to some of its stores.

(5) Bed Bath & Beyond (BBBY), one of the retailers included in Bespoke Investment Group’s “Death by Amazon” index, bought online furniture seller One King’s Lane last fall as a way to deflect the Amazon threat: The younger shoppers attracted to One King’s Lane tend to shop less at Amazon. It plans to open a pop-up seasonal shop in Southampton, NY this summer, the first brick-and-mortar presence for One King’s Lane, and in a former library no less. Take that, Amazon!

(6) Wayfair (W), the only pure-play online furniture seller, is benefiting doubly from both hot demand for furniture and the online channel’s increasing popularity as a furniture outlet. Furniture is one of the fastest-growing segments of US online retail, growing 18% in 2015, second only to groceries, according to Barclays. Wayfair’s direct retail revenues popped more than 32% in Q1. The S&P 500 Internet and Direct Marketing Retail industry has been a sweet spot, rising 45.9% y/y through Tuesday.

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Puzzling Productivity & Profitability

Jun 28, 2017 (Wednesday)

 

Germany: Oomph! The word “oomph” sounds like it might be of German origin. In fact, it is an American expression dating back to 1935-40. It is imitative of the sound made during physical exertion, as when lifting a heavy object. Then again, Oomph! is a German industrial metal band formed in Wolfsburg, Germany in 1989. Today, the industrial metals business is booming in Germany, and so are many other industries. June’s Ifo Business Confidence Index soared to a new record high, led by its current situation component (Fig. 1). The series is available since 1991. The diffusion indexes for the German manufacturing, construction, wholesale trade, and retail trade components all were very strong this month (Fig. 2).

The German MSCI stock price index (in euros) is up 7.4% ytd and 29.3% y/y, compared to the US MSCI index, which is up 9.1% ytd and 18.8% y/y (Fig. 3 and Fig. 4).

It’s too early for Octoberfest, but not too early to have a couple of steins of beer in a Bavarian Biergärten while listening to an oompah band. If you start dancing, try to avoid the slapdancers.

Perversely, this happy story has yet to show up in Germany’s productivity statistics, which are just as puzzlingly weak as those in the US (Fig. 5 and Fig. 6). Over the past 20 quarters, the German measure was up at an annual rate of 0.4%, while the US rate was 0.7%.

US Productivity: Why the Long Face? Something just doesn’t add up: Despite the weak pace of productivity growth in the US, inflation is very low. Inflation-adjusted pay per worker is at a record high. Measures of corporate profit margins are at record highs. There’s a lot of anecdotal evidence that productivity-enhancing technological innovations are proliferating in many industries. The cloud allows for a much more efficient use of high-tech hardware and software across the economy. Automation and robotics have been integrated over the Internet to communicate and to interact seamlessly. The Great Disruptors—including Alphabet, Amazon, Microsoft, Tesla, and Uber—are forcing all their competitors to boost their efficiency or risk going out of business. Perhaps no industry has made more progress in increasing its productivity than the oil and gas producers, thanks to fracking technologies.

Yet none of these productivity-boosting developments are showing up in the official productivity numbers. Lots of explanations have been proffered by economists and technologists. Economists are well known for making assumptions. The optimists among them assume that the data are wrong, and will eventually be revised higher. That happened in the late 1990s. The optimists say that the government’s bean counters may be underestimating the economy’s output.

The pessimists say we are in a period of secular stagnation. Some of them claim that all the latest and future technological innovations are unlikely to boost productivity to the extent that the truly revolutionary technologies of the past had done—such as the steam engine, electricity, indoor plumbing, automobiles, air conditioning, and computers. They even question whether computers have done much to increase productivity beyond boosting the production of computers.

That’s an interesting point because, after growing rapidly during the 1980s and 1990s, inflation-adjusted capital spending on both information processing equipment and software has slowed significantly (Fig. 7). Yet in current dollars, they now account for 28.4% of total capital spending, up from 17.0% during 1980 and 8.5% during 1960 (Fig. 8).

Could it be that technological innovation aimed at complementing (or un-employing) the brain has a different impact on productivity than innovations that replace brawn? The proliferation of the cloud certainly explains why spending on IT hardware and software has slowed, since we can all rent just what we need from the cloud vendors, who are using their resources much more efficiently than we did when we owned our own software and servers, housed them at server farms, and woefully underutilized them. UBER is undoubtedly increasing the efficiency of the auto fleet while it must be weighing on car sales. How will we even measure the impact of self-driving cars on productivity? Now consider the following related notions:

(1) Inflation & profit margins. Weak productivity growth is boosting labor costs, which is defined as compensation divided by productivity. Over the past four quarters through Q1-2017, productivity in the nonfarm business (NFB) sector rose just 1.2%, while hourly compensation rose 2.3%. The NFB price deflator rose only 1.7% over this period. Yet the S&P 500 profit margin remained in record-high territory above 10.0% for 12 of the past 13 quarters, even as five-year trend productivity growth slowed from 1.5% to 0.7% over this period (Fig. 9 and Fig. 10).

(2) Real wages. In a competitive market economy, nominal wages are determined by the value of marginal productivity. That’s one of the basic principles taught in courses on microeconomics. Sure enough, the data confirm the close relationship between inflation-adjusted hourly compensation and productivity, though it’s very important to use the price deflator of the nonfarm business sector, which determines the value of the marginal product produced by workers, rather than the CPI or PCED when deflating the measure of wages (Fig. 11 and Fig. 12).

Over the past five years, both productivity and real compensation growth rates in the nonfarm business sector have been very weak, averaging 0.7% and 0.9% per year through Q1. However, the widespread view that real wages have stagnated for the past 15-20 years is just dead wrong. Over the past 20 years, real compensation in the NFB sector is up roughly 30% (Fig. 13). The laggard has been manufacturing, yet real compensation is up about 20% over the past 20 years in this sector.

Over this period, real average hourly earnings (using the NFB price deflator) for production and nonsupervisory workers, who currently account for 82% of total private payroll employment, rose 30%, continuing to closely track productivity (Fig. 14 and Fig. 15). Nominal wages are growing remarkably slowly given the tight labor market. However, adjusted for inflation they are keeping pace with productivity, which still has an uptrend. Wages are rising faster than prices, but prices are rising very slowly for reasons that may not have much to do with productivity. Global competition, disruptive technology, and aging demographics may be playing a much greater role in keeping a lid on prices, which is also keeping a lid on wages.

US Corporate Finance: Show Me the Money. Yesterday, we wrote that S&P 500 operating earnings totaled $958 billion over the past four quarters, with buybacks and dividends accounting for 95% of this total. The dividend payout ratio of the S&P 500 remains around 50%. This implies that corporations are spending all their extra cash on buybacks rather than capital spending and wages.

We noted: “The problem with this widely circulated myth is that profits are not the same as cash flow.” The latter is equal to retained earnings (i.e., after-tax profits less dividends) plus the depreciation allowance. When we add the cash flow plus net bond issuance of nonfinancial corporations (NFCs), the resulting series is more often than not very close to capital expenditures plus buybacks (Fig. 16). Here are a few round numbers for 2016 based on data compiled in the Fed’s Financial Accounts of the United States (Table F.103):

(1) Sources of cash. NFCs had reported pre-tax profits of $1,271 billion. They paid $322 billion in taxes and $617 billion in dividends. They had $1,307 billion in capital consumption allowances (CCA). Their internal cash flow, i.e., the sum of their retained earnings and CCA, was $1,639 billion. Their net bond issuance was $268 billion. These sources of cash sum to $1,907 billion.

(2) Uses of cash. Capital expenditures (including inventory investment) totaled $1,670 billion last year. Buybacks totaled $586 billion. These two categories of spending sum to $2,256 billion.

The discrepancy between the sources and uses of cash seems large, but it tends to average out over time. Besides, the analysis above excludes lots of other items in the Fed’s accounting for this sector. The main point is that cash flow is much bigger than after-tax profits less dividends. Companies have been spending a record amount on capex, including on technology, which is cheaper and more powerful than ever.

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A Matter of Some Interest

Jun 27, 2017 (Tuesday)

 

Corporate Finance: Buybacks & Interest Expense. The 6/25 WSJ included an article titled “The $1.5 Trillion Business Tax Change Flying Under the Radar.” It noted: “Republicans looking to rewrite the U.S. tax code are taking aim at one of the foundations of modern finance—the deduction that companies get for interest they pay on debt. … Thanks in part to the deduction, the U.S. financial system is heavily oriented toward debt, which because of the tax code is often cheaper than equity financing—such as sales of stock. … Getting rid of the deduction for net interest expense, as House Republicans propose, would alter finance. It also would generate about $1.5 trillion in revenue for the government over a decade, according to the Tax Foundation, a conservative-leaning think tank.”

Eliminating the deductibility of interest expense would be paired with the immediate deductions for capital spending. Dividend payments are not deductible as an expense, but they are subject to personal income taxation. This amounts to the double taxation of dividends. With the subsidization of borrowing, the tax code clearly favors debt over equity financing by corporations. It also favors borrowing money by corporations to buy back their equites, particularly if their after-tax cost of funding is less than their forward earnings yield. Joe and I figure that’s been the case since late 2004, when S&P 500 buybacks took off (Fig. 1). The S&P 500 forward earnings yield has exceeded the pre-tax AA-AAA corporate bond yield since then. The former is currently 5.7%, while the latter is 4.0%.

Almost since the start of the current bull market, we have argued that from a flow-of-funds perspective, it has been driven by corporate cash used to buy back shares and pay out dividends, which often are reinvested in stocks. The correlation between the S&P 500 and the sum of the two corporate cash flows back into the stock market has been very high since 2004 (Fig. 2). Eliminating interest expensing could pose a threat to debt-financed buybacks as a driver of the bull market. However, that hasn’t happened yet, and it might not happen at all. We are monitoring developments in Washington’s sausage factory as best we can.

As Joe reports below, Q1 data for S&P 500 buybacks were released late last week. Here are some top-line observations on this and other corporate finance matters:

(1) Buybacks & dividends. Over the past four quarters through Q1, buybacks totaled $508.1 billion, down 13.8% from the record high of $589.4 billion through Q1-2016 (Fig. 3). Dividends totaled a record $400.0 billion through Q1. S&P 500 operating earnings totaled $958.1 billion over the past four quarters. So buybacks and dividends accounted for 94.8% of this total. The dividend payout ratio of the S&P 500 remains around 50.0% (Fig. 4). The implication is that corporations are spending all their extra cash on buybacks rather than capital spending and wages.

The problem with this widely circulated myth is that profits are not the same as cash flow, which is the sum of after-tax profits and depreciation expense. Capital spending by nonfinancial corporations (NFCs) has been hovering at a record high over the past year because corporate cash flow has been doing the same (Fig. 5). In other words, there has been enough cash for buybacks, dividends, and capital spending!

The effective corporate tax rate for the S&P 500 was 26.4% during 2016 (Fig. 6). S&P 500 companies had pre-tax interest expense of $22.90 per share during 2016 (Fig. 7). This implies that the after-tax interest expense was $16.85 per share during 2016. Their after-tax reported earnings was $101.06 per share, with the expensing of interest benefitting S&P 500 corporations $6.05 last year.

(2) Debt. The Fed’s Financial Accounts of the United States shows that NFCs had a record $8.6 trillion in debt at the end of Q1-2017 (Fig. 8). That included $2.7 trillion in loans and a record total of $5.2 trillion in bonds (Fig. 9). Data available annually show that NFCs had monetary interest expense of $487 billion during 2015, implying that the pre-tax interest rate paid on all their debts was 6.1%, the lowest since 1966 (Fig. 10 and Fig. 11).

(3) Bond issuance. Monthly data compiled by the Fed show that NFCs borrowed at a near-record $855.7 billion during the 12 months through April (Fig. 12). However, quarterly data through Q1 show net issuance of $244.6 billion. We calculate that NFCs refinanced a record $599.5 billion in their bonds over the past four quarters at record-low interest rates (Fig. 13). The resulting reduction in interest expense certainly boosted earnings over this period.

(4) Dividend yield. The dividend yield of the S&P 500 was 1.96% during Q1 (Fig. 14). It has been hovering around 2% since the mid-1990s. This means that the S&P 500 has been growing at the same trend as dividends, which is around 7.0% per year (Fig. 15). Interestingly, the dividend yield has been about the same as the US Treasury 10-year bond yield in recent years for the first time since the late 1950s. In between, the bond yield has always been higher. The higher yield reflected a premium for inflation, which erodes bond coupons but not dividends. That’s because dividends tend to grow along with nominal GDP, while coupons are fixed. Apparently today, investors believe that inflation is dead, so they don’t need an inflation premium in the bond yield relative to the dividend yield. With both yielding around 2.00%, stocks are cheap relative to bonds, since dividends grow while coupons remain fixed.

(5) Forward ho! Meanwhile, as Joe reports below, forward earnings of the S&P 500/400/600 rose to new record highs last week.

Global Demography: Japan’s Carebots. Yesterday, Melissa and I wrote about the inverse correlation between urbanization and fertility rates. As populations become more urbanized around the world, families have fewer children. People are also living longer. So populations are getting older, and there are fewer primary working-age people (15-64 years old) to support seniors (65+).

Among modern industrial economies, Japan is the poster child for the economic impact of aging demographics. Japan’s overall population is now declining at the fastest rate globally. The country sells more adult diapers than baby diapers, and its dearth of workers to support an aging population is depressing economic growth.

Japan’s fertility rate fell below the replacement rate of 2.1 children per woman during 1978 (Fig. 16). Over the past 12 months through November, marriages totaled just 52,000, the lowest on record (Fig. 17). The number of deaths has exceeded the number of births since July 2007 (Fig. 18). The working-age population peaked at a record 87.8 million during 1995 (Fig. 19). It fell to 78.1 million during 2015, and is projected be down to 55.6 million by 2050. In 1955, there were almost 12 workers per senior. Now the ratio is just barely above 2.0.

The good news is that robots may not extinguish lots of jobs done by humans. Instead, they may be vitally important to pitch in as shortages of working human stiffs become more prevalent. Japan is the most automated economy in the world, with a proliferation of robots doing all sorts of jobs, yet the jobless rate in Japan is down to 2.8%. The country is suffering from a chronic labor shortage.

Business Insider reports: “Carebots are robots specifically designed to assist elderly people, and it’s an industry that’s growing in a big way. One-third of the Japanese government’s budget is allocated to developing carebots. The global personal robot market, which includes carebots, could reach $17.4 billion by 2020, according to the Merrill Lynch report.”

There is increasing buzz about the need for Basic Universal Income to support people who can’t compete with robots. Maybe what we need instead is a Basic Fertility Income. We need to subsidize having children. That would provide an incentive for couples to make babies for fun and profit. Otherwise, we are on the road to self-extinction. Remember: Demography is destiny!

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Voluntary Self-Extinction

Jun 26, 2017 (Monday)

 

Global Demography: Birth Dearth & Urbanization. The Voluntary Human Extinction Movement (VHEMT) was founded in 1991 by Les U. Knight, a high-school substitute teacher who lives in Portland, Oregon. He and his followers believe that human extinction is the best solution to the problems facing the Earth’s biosphere and humanity. The VHEMT website shows that the group’s motto is “May we live long and die out.” Their Facebook page sells tee-shirts declaring: “When You Breed, the Planet Bleeds.” Another declares: “Thank You for Not Breeding.” Sure enough, the pace of human breeding has slowed, but for reasons that have nothing to do with VHEMT.

All around the world, humans are not having enough babies to replace themselves. There are a few significant exceptions, such as India and the continent of Africa. Working-age populations are projected to decline along with populations in coming years in most of Asia (excluding India), Europe, and Latin America. The US has a brighter future, though the pace of population growth is projected to slow significantly in coming years.

There are many explanations for the decline in fertility rates around the world to below the replacement rate, which is estimated to be 2.1 children born per woman in developed countries. It is higher in some developing countries that have higher mortality rates.

Melissa and I believe that the most logical explanation is urbanization. The United Nations estimates that the percentage of the world population that has been urbanized rose from 29.6% in 1950 to just over 50.0% during 2008 (Fig. 1). This percentage is projected to rise to 66.4% by 2050. The world fertility rate was around 5.0 births per woman in the mid-1950s (Fig. 2). It fell to 2.5 in 2015. The UN projects it will fall to 2.0 by the end of this century.

In our opinion, families are likely to have more children in rural communities than urban ones. Housing is cheaper in the former than in the latter. In addition, rural populations are much more dependent on agricultural employment. They are likely to view every child as contributing to a family’s economic well-being once he or she is old enough to work in the field or tend the livestock. Adult children also are expected to support and to care for their extended families by housing and feeding their aging parents in their own huts and yurts.

In urban environments, children tend to be expensive to house, feed, and educate. When they become urban-dwelling adults, they are less likely to welcome an extended-family living arrangement, with their aging parents living with them in a cramped city apartment. A UN report titled “World Urbanization Prospects: The 2014 Revision,” noted, “The process of urbanization historically has been associated with other important economic and social transformations, which have brought greater geographic mobility, lower fertility, longer life expectancy and population ageing.”

In our opinion, the urbanization trend since the end of World War II was attributable in large part to the “Green Revolution,” the term coined by William Gaud, the former director of the US Agency for International Development, a.k.a. USAID, to give a name to the spread of new agricultural technologies: “These and other developments in the field of agriculture contain the makings of a new revolution. It is not a violent Red Revolution like that of the Soviets, nor is it a White Revolution like that of the Shah of Iran. I call it the Green Revolution.”

In 1970, Norman Borlaug—often called “the Father of the Green Revolution”—won the Nobel Peace Prize. A January 1997 article about him written by Gregg Easterbrook in The Atlantic was titled “Forgotten Benefactor of Humanity.” Easterbrook wrote that the agronomist’s techniques for high-yield agriculture were “responsible for the fact that throughout the postwar era, except in sub-Saharan Africa, global food production has expanded faster than the human population, averting the mass starvations that were widely predicted.” Borlaug may have prevented a billion deaths as a result.

The resulting productivity boom in agriculture eliminated lots of jobs and forced small farmers to sell their plots to large agricultural enterprises that could use the latest technologies to feed many more people in the cities with fewer workers in the fields. Ironically, then, the Green Revolution provided enough food to feed a population explosion. Instead of working the land on family farms, much of the population moved to the cities and had fewer kids! Good old Tommy Malthus, the dismal scientist of economics and demographics, never anticipated ag tech and urbanization. Now consider the following related developments:

(1) China. The fertility rate in China has plunged from 6.0 in the mid-1950s to below 2.0 during 1996 (Fig. 3). It remains below that level and is projected to do so through the end of the century. Initially, the drop had less to do with urbanization than with the government’s response to the country’s population explosion, which was to introduce the one-child policy in 1979. That did slow the 10-year growth rate in China’s population from a peak of near 3.0% at an annual rate during 1968 to 0.5% in 2016. However, it also led to a shortage of young adult workers and a rapidly aging population. So the government reversed course, with a two-child policy effective January 1, 2016.

Meanwhile, urbanization has proceeded apace, with the percentage of the urban population rising from 10.0% in 1950 to 50.0% during 2010 and reaching 57.3% in 2016 (Fig. 4). The urban population increased by 21.8 million that year, which is truly extraordinary, as this category has been increasing consistently by around 20 million per year since 1996 (Fig. 5). To urbanize that many people requires the equivalent of building one Houston, Texas per month! I first made that point in a 2004 study.

In our opinion, the move to a two-child policy is coming too late. China’s primary working-age population (15-64 years old) peaked at a record high of 1.02 billion during 2014 and is projected to fall to 815 million by 2050 (Fig. 6). By 2050, the primary working-age population in China will represent 59.7% of the total population, below the peak of 73.8% during 2010 (Fig. 7). Over the same time span, the elderly dependency ratio, which we define as the primary working-age population divided by the number of seniors (65+), will fall from 8.8 workers/senior to 2.3 by 2050; even more eye-popping is the drop from its peak of 16.2 during 1965 (Fig. 8).

In any event, the fertility rate is unlikely to rise in response to the government’s new policy. Young married couples living in cities are hard-pressed to afford having just one child. An 10/30/15 article in the Washington Post titled “Why many families in China won’t want more than one kid even if they can have them,” observed:

“[F]or many couples, it has become very costly to have kids in China. To prepare a child to succeed in the country’s competitive schools and workplaces, parents must invest lots of time and money in a child—for schooling, extracurricular activities, and outside tutoring, often for college-entrance and English proficiency exams.” Another problem is that most “Chinese of child-bearing age are single kids, and they may forgo having another kid in order to better support their aging parents.” As is written in the Bible, “As you sow, so shall you reap.”

(2) US. The fertility rate in the US was over 3.0 during the second half of the 1950s (Fig. 9). It fell just below 2.0 during 2013, and been hovering around that level since then. The percent of Americans living in rural areas fell from 30.0% during 1960 to 18.4% during 2015 (Fig. 10). The UN projects that the primary working-age population will continue to grow through 2050, though the growth rate will be very low (Fig. 11 and Fig. 12).

(3) Europe. The fertility rate in Europe fell from 2.7 during the late 1950s to below 2.0 during 1980, and has remained below that level ever since; it’s projected to remain below the replacement rate through the end of the century (Fig. 13). Europe’s primary working-age population peaked at a record 503 million during 2010 and is expected to decline to 361 million by the end of the century (Fig. 14).

(4) Africa & India. During 2015, among the highest fertility rates were in India (2.5) and Africa (4.7). They are projected to decline to 1.9 and 3.1 by 2050. India’s primary working-age population is projected to rise from 860 million during 2015 to peak at 1.12 billion during 2050 before heading lower over the remainder of the century. Africa’s primary working-age population stands out, as it is projected to rise from 663 million during 2015 to 1.57 billion during 2050 and 2.84 billion by the end of the century. India and Africa remain predominantly rural.

(5) Latin America. The fertility rate in Latin America was 2.2 during 2015 and is expected to fall to 1.8 by 2050. The region’s working-age population was 422 million during 2015 and is projected to peak during the early 2040s at 500 million before heading downwards to 390 million by the end of the century.

(6) Study guide. The UN also has a report titled “World Fertility Patterns 2015.” Nearly half the world lives in countries with below-replacement levels of fertility. According to the report: “Today, 46 per cent of the world’s population lives in countries with low levels of fertility, where women have fewer than 2.1 children on average. Low-fertility countries now include all of Europe and Northern America, as well as many countries in Asia and Latin America and the Caribbean. Another 46 per cent of the world’s population lives in ‘intermediate-fertility’ countries that have already experienced substantial fertility declines and where women have on average between 2.1 and 5 children.”

Melissa, Mali, and I are working on creating a bunch of global demography chart books for our website’s Global Demography section. So far, we have Global Population, Global Working-Age Population, and Global Elderly Dependency Ratios.

US Economy: Leading the Way. As Debbie reports below, both the Index of Leading Economic Indicators (LEI) and the Index of Coincident Economic Indicators (CEI) rose to fresh record highs during May (Fig. 15). Here are a few top-line impressions:

(1) Previously, we’ve reported that a benchmark analysis of the previous five cyclical upturns in the CEI shows that the average duration of the expansion phase (once the index had recovered to the previous cyclical peak) was 65 months, which would put the next peak during March 2019 (Fig. 16). The average increase during the past five expansions (from the latest peak to the previous one) was 18.6%. The current one is up only 7.8%, so it might have a ways to go on this benchmark.

(2) For the here and now, the CEI is up 2.1% y/y through May (Fig. 17). This growth rate has been highly and closely correlated with the y/y growth rate in real GDP. Both have been hovering around 2.0% since mid-2010.

(3) The ratio of the LEI to CEI is remarkably well correlated with the Resource Utilization Rate, which is the average of the capacity utilization rate and the employment rate (i.e., 100 minus the unemployment rate) (Fig. 18). They’ve both recovered smartly since their 2009 troughs but remain well below their previous cyclical peaks, supporting our No-Boom-No-Bust (NBx2) scenario for now.

(4) The big worry, of course, has been the significant narrowing of the yield curve spread, which is one of the 10 LEI components, in recent weeks. It has been a reliable indicator of recessions when it has turned negative. Keep in mind, though, that it hasn’t turned negative, and that it is only one of the components of the LEI. There are nine others, including the S&P 500, which is at a record high. (See our Leading & Coincident Indicators.)

Movie. “My Cousin Rachel” (+) (link) is based on a novel by the late English author Dame Daphne du Maurier. She wrote romances that rarely had conventional happy endings. At least Romeo and Juliet had a few good moments together before they met their tragic end. For the romantic couples in Daphne’s novels, there are fewer happy moments before it all ends badly. Her novels have been described as “moody.” She spent much of her life in Cornwall, where most of her works are set. This movie, starring Rachel Weisz as the moody “Rachel” of the title, is also set in Cornwall, and has an unsettling beginning, middle, and ending too. It reminds me of our relationship with politicians these days: We want to love them, but they always let us down. Let’s hope they don’t kill us.

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Sheik Up

Jun 22, 2017 (Thursday)

 

Energy: Crude Reality. Oil investors don’t like what they see: too much supply and not enough demand. They don’t like the growing number of barrels being produced in America, Libya, and Nigeria. Nor are they comforted by the sluggish growth in demand caused by the lackluster pace of global economic activity, increased energy efficiency, and alternative fuels. This one-two-three punch has sent the price of Brent crude oil into its latest bear market, down 21% to $44.92 as of yesterday’s close (Fig. 1).

Energy is the worst-performing S&P 500 sector ytd, down 13.5%, and many of the sector’s industries are doing even more poorly: Oil & Gas Drilling has lost 36.4% ytd, Oil & Gas Exploration & Production has lost 20.5%, and Oil & Gas Equipment & Services is down 19.3% (Fig. 2 and Fig. 3).

Most other S&P 500 sectors have been enjoying much better ytd performances through Tuesday’s close: Tech (18.2%), Health Care (14.4), Utilities (11.0), Consumer Discretionary (10.3), Materials (9.0), Industrials (8.9), S&P 500 (8.9), Consumer Staples (8.8), Real Estate (5.5), Financials (4.6), Telecom Services (-10.5), and Energy (-13.5) (Table). Let’s take a look at the push and pulls affecting the price of black gold:

(1) The US is pumping. In Q1, the amount of oil being produced and the amount of oil being consumed weren’t that far out of whack. Total world demand was 96.5 mbd in Q1, and total supply was 96.6 mbd, according to the International Energy Agency’s (IEA) 5/16 Oil Market Report. That’s a significant improvement from Q4-2016, when demand was 97.7 mbd and supply was 98.3 mbd. OPEC’s production cut of about 1.8 mbd, which began last year and is expected to continue through March 2018, looked like it was balancing the market until recently.

However, continued supply growth out of the US and production rebounds in Libya and Nigeria subsequently have overshadowed OPEC cuts. US crude production hit 9.35 mbd after rising by 20,000 barrels during the week of June 16. As a result, production is not far from the peak amount produced during the week of June 5, 2015, 9.6 mbd (Fig. 4). Production never fell as dramatically as the US oil rig count, as producers managed to coax more oil out of existing wells. And after bottoming in late May 2016 at 316, the number of US rigs has increased to 747 (Fig. 5).

Those rigs have been awfully busy. At the end of May, there were 5,946 drilled-but-uncompleted wells, the most in at least three years, according to estimates by the US Energy Information Administration (EIA). “In the last month alone, explorers drilled 125 more wells in the Permian Basin than they would open, meaning production could surge when they turn on the spigots,” a 6/19 Bloomberg article reported.

The US isn’t the only country increasing production. Libya is producing 902,000 bpd, up about 200,000 barrels since April because two fields returned to production. It’s the most the country has produced since 2013, when production hit 1.13 million bpd, another 6/19 Bloomberg article reported. Libya is exempted from the OPEC production cuts.

(2) Brimming inventories. Excess production has kept US inventories stubbornly high. For the week ending June 16, US crude oil inventories (excluding those in the Strategic Petroleum Reserve) decreased by 2.5 million barrels to 509.1 million barrels, according to yesterday’s EIA report. That still leaves inventories slightly above where they stood last year, at 500.0 million barrels, and far above where they stood in the three years prior to that (Fig. 6).

High inventories in other countries around the world are prompting oil traders to store increasing amounts of oil at sea. “The amount of oil stored in tankers reached a 2017 high of 111.9 million barrels earlier this month, according to Paris-based tracking company Kpler SAS. Higher volumes of storage in the North Sea, Singapore and Iran account for most of the increase,” yet another 6/19 Bloomberg article reported. “As recently as May 1, the average volume was about 74 million barrels, according to Kpler.”

(3) Sluggish demand. Global demand growth for oil in Q1 was only 0.9 mbd, according to an IEA report. However, the agency expects demand to pick up in the second half of the year, bringing full-year demand growth to 1.3 mbd in 2017 and 1.4 mbd in 2018, as worldwide demand reaches a record of 99.3 mbd.

Those projections may be tough to hit if the recent drop in demand for gasoline doesn’t go into reverse. Gasoline usage has dropped to 9.23 mbd during the week of June 16 from a peak of 9.37 mbd last fall. The drop in gasoline usage is of note because the number of vehicle miles traveled has continued to climb to record highs (Fig. 7). It could have much to do with the improved fuel efficiency of US cars. By our calculation, the average miles per gallon is 22.4, near the record hit in October 2013 when gas prices were much higher and there was more demand for smaller cars (Fig. 8).

The number of electric vehicles on the road also bears watching, as it may be affecting demand on the margin. For the year ending November 2016, more than 130,000 hybrid or battery-powered vehicles were sold in the US, almost double the 73,000 vehicles sold in 2012, notes a 12/21 Recode article. That’s still far from the average 17 million total cars sold in each of the past three years in the US. But the number may be about to jump once again, as Tesla’s $35,000 Model 3 is expected to hit the market this year.

(4) Prince of Arabia & Vision 2030. According to Time: “Undoing decades of royal tradition, Saudi Arabia’s King Salman appointed his 31-year-old son Mohammed Bin Salman to be next in line for the throne on Wednesday, signaling a historic political shift in one of the Middle East’s key regional powers.

“A rising star within the Saudi royal family, Mohammed Bin Salman was already one of the kingdom’s most powerful leaders. He advocates a forceful Saudi foreign policy and is also leading a massive overhaul of the Saudi economy. As the country’s defense minister, he is in charge of Saudi Arabia’s two-year-old air war in Yemen, where more than 10,000 people have died in one of the world’s most dire humanitarian crises.”

In 2016, the prince-in-waiting implemented Vision 2030, a plan to restructure the economy away from its dependence on oil exports. It states: “Diversifying our economy is vital for its sustainability.” On Monday, we advised OPEC countries with large oil reserves as follows: “Rather than propping up the price, maybe OPEC should sell as much of their oil as they can at lower prices to slow down the pace of technological innovation that may eventually put them out of business.” That’s so obvious that a smart young man like Mohammed Bin Salman probably gets it.

(5) Less influence. The S&P 500’s ability to remain near record levels given the selloff in the Energy sector is reasonable—so far. The S&P 500 Energy sector’s market weighting in the S&P 500 has shrunk to 6.0% from its peak of 16.1% in July 2008. Likewise, the amount of earnings it contributes to the broader index is now 4.3%, down from 21.3% then (Fig. 9). So while crude has entered a bear market, its influence on the broader index has fallen as the S&P 500 has continued to hit new highs, Bloomberg rightly noted on 6/20.

The question will be whether the oil bear market will lead many energy companies to shut down production if drilling becomes uneconomic at these lower prices. A 6/19 WSJ article said many shale producers had lowered their production costs so that they could be profitable when oil fetched $50 to $60 a barrel, and a handful could even turn a profit if the price fell to $40. That certainly isn’t good news for the upcoming Saudi Aramco IPO. Saudi Arabia’s ruling family undoubtedly is watching. There is usually an obvious reason for selling the family jewels.

Restaurants: Tech on Tap. In our 3/24 Morning Briefing last year, we took a trip down Memory Lane and wrote about Horn & Hardart’s Automat, where in the early 1900s, customers could find their prepared meal behind small glass windows and buy it for under $1 by placing coins in a slot. Today, many restaurants are taking a page out of the Automat’s playbook, often in an effort to reduce labor costs.

We mentioned Eatsa, a California eatery where customers order on an iPad, then visit a wall to retrieve their meal. Panera Bread and McDonald’s have been rolling out kiosks where customers can order and pay, avoiding the line—and the human—at the register. Jackie reports that her local TCBY has a wall of soft-ice-cream dispensers that lets customers take as much ice cream as they can fit into oversized cups. It’s a disastrous format for dieters but brilliant for business, she notes.

Now there’s a new twist on wall dispensers for the 21-and-over crowd. Instead of a wall of soft-serve ice cream, Randolph Beer in Brooklyn is offering a wall of beer taps. Customers hand over a credit card and receive an ATM card that can activate 24 self-service taps, according to a 6/9 article in Metro, brought to our attention by ZeroHedge. A screen over each tap displays the beer’s name, brewer, and country of origin as well as notes on how the beer tastes.

Randolph Beer hasn’t abandoned the “Cheers” model altogether; however, its traditional bar and bartender can only serve one customer at a time, not 24. A “Norm” might not like the change, but the easily accessible taps mean that Randolph Beer can serve many more beverages during Happy Hour without having to hire another “Sam.”

The S&P Restaurant index, up 17.9% ytd as of Tuesday’s close, has risen twice as much as the S&P 500 (Fig. 10). Much good news is priced into the industry, which sports a forward P/E of 24.4, close to the highest P/E the industry sported in 2015 and 2016, 25.3, and not far from its highest P/E ever, 28.5 in April 1999 (Fig. 11).

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Earnings Boom

Jun 21, 2017 (Wednesday)

 

Earnings I: Diverging from GDP. The current economic expansion has been among the weakest on record. More specifically, of the seven cyclical upturns in real GDP since 1961, it has been the second weakest (Fig. 1). The big drag has been consumer spending (Fig. 2). Interestingly, real consumer outlays on goods has been the third weakest, while real consumer expenditures on services has been the weakest among these seven expansions (Fig. 3 and Fig. 4). Weighing on services this time are spending on health care services, housing & utilities, and financial services & insurance.

Capital-spending growth also has been subpar during the current expansion, led by weakness in technology equipment, structures, and intellectual property (which includes software). On the other hand, spending on transportation equipment has been the strongest among all the expansions since 1961. Government spending on goods and services in real GDP has been the weakest. (See our GDP Expansion Cycles.)

During most of the current bull market, Debbie and I have argued that subpar economic growth should be bullish for stocks. In our opinion, the Trauma of 2008 was a major contributor to the subsequent slow pace of growth. Both consumers and businesses were traumatized by the event, and were likely to proceed with much more caution than in the past. Such conservative behavior reduced the inflationary potential of the current expansion. It also lowered the odds of speculative excesses. We’ve dubbed this our “NBx2” scenario, i.e., No Boom, No Bust. This implies that the expansion could be among the longest. It already is the third longest since World War II. It only has to keep going another 25 months through July 2019 to surpass the longest one from March 1991 to March 2001.

Yet despite the subpar pace of nominal GDP, corporate profits have performed remarkably well. The rise in the GDP price deflator during the current expansion is the weakest since 1961 (Fig. 5). The expansion in nominal GDP is also the weakest over this same period (Fig. 6). Now consider the remarkable performance of various measures of corporate profits:

(1) Trends. From 1960 through 2008, nominal GDP and corporate profits as measured in the National Income & Product Accounts (NIPA) rose together along a trendline of 7% (Fig. 7). They’ve diverged since then, with profits continuing to grow along the 7% trendline while nominal GDP growth has fallen below it. Other measures of profits such as S&P 500 reported, operating, and forward earnings are still tracking the 7% trendline. The first two are available quarterly and arguably aren’t tracking quite as well as forward earnings, which is available monthly and weekly (Fig. 8).

(2) Cycles. Comparing the profits expansions since 1961, using the profit-cycle troughs as the starting points, we see that the current one is the third best so far of the seven (Fig. 9). Granted, that’s not a fair comparison, because it says more about the depth of the profits recession during 2008 than the strength of the profits expansion.

(3) Profit margins. Nevertheless, there’s no denying that the current profits upturn has been boosted not only by the cyclical rebound in profit margins to record highs, but also their ability to maintain those highs for so long. In the past, the forces of reversion-to-the-mean would have started to erode margins by now as boom-time conditions fed on themselves by stimulating more (margin-reverting) business spending than we are seeing this go-round (Fig. 10 and Fig. 11).

(4) Boom-Bust Barometer. While there is neither a boom nor a bust in the overall economy, our Boom-Bust Barometer (BBB) continues to boom (Fig. 12). It’s gone vertical since early 2016. We calculate it simply as the weekly average of the CRB raw industrials spot price index divided by the four-week average of initial unemployment claims. The numerator is a gauge of global economic activity, while the denominator is a measure of labor market tightness in the US.

Previously, we have shown that our BBB is highly correlated with S&P 500 forward earnings, i.e., the time-weighted average of analysts’ consensus earnings expectations for the current year and the coming year (Fig. 13). They are still highly correlated and rising together in record-high territory.

Earnings II: Where Eagles Dare. Jackie, Joe, and I regularly monitor our S&P 500 Sectors & Industries Forward Earnings (Indexed). This chart publication compares the performances of the forward earnings of the 10 S&P sectors and numerous industries since the start of the current bull market. We find it to be a handy way to pick out where industry analysts are seeing outperformance and underperformance in their estimates of earnings. Here are some of our latest findings:

(1) Sectors. Excluding autos (because the industry lost so much money during the Great Recession), S&P 500 forward earnings is up 95.3% since the week of March 5, 2009 (Fig. 14). Leading the way higher, especially since early 2016, is the IT sector, which is now up 209.6%. Coming from behind since September 22, 2016 is the Financials sector, which now ties the Consumer Discretionary (ex-Autos) sector for second place, with a gain of 157.7%. It was boosted last year when REITs were removed to create an 11^th sector for the S&P 500. The laggard and only loser is Energy, with a decline of 33.9%.

(2) Consumer Discretionary. Among the big winners in this sector that continue to show plenty of upside forward earnings momentum are Hotels, Resorts, & Cruise Lines; Home Improvement Retail; Movies & Entertainment; and Restaurants. The clunkers are Apparel, Accessories & Luxury Goods; Department Stores; and Specialty Stores.

(3) Consumer Staples. Tobacco has been on fire since early 2015. Drug Retail has been making a comeback this year after slipping last year from record highs. Packaged Foods & Meats has been making new highs at a leisurely pace since last summer. Soda has lost its fizz.

(4) Financials. Leading the sector’s rebound since early last year are Diversified Banks, Investment Banking & Brokerage, and Asset Managers. They all are at record highs.

(5) Health Care. This sector’s standout winner since the start of the bull market is the Managed Health Care industry (Fig. 15). It has gone nearly parabolic since the start of 2014. Health Care Equipment has resumed its climb to new record highs this year, while Pharmaceuticals has stalled since last year. Biotech seems to be recovering from its freefall earlier this year.

(6) Industrials. The standouts in this sector are Industrial Conglomerates, Industrial Machinery, and Aerospace & Defense. All three are on uptrends and making new highs. Rebounding from weakness over the past couple of years are Railroads and Construction Machinery & Heavy Trucks.

(7) Information Technology. Leading the way higher in this sector have been the Semiconductor Equipment and Semiconductor industries (Fig. 16). That’s been especially so since early 2016. Making an impressive comeback after a brief fall in late 2015 is Technology Hardware, Storage & Peripherals.

(8) Materials. In this sector, among the hot industries have been, and continue to be, Diversified Chemicals and Specialty Chemicals. Steel has been making a comeback of sorts over the past year. Fertilizer & Agriculture Chemicals remains in the dumps.

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Second Thoughts

Jun 20, 2017 (Tuesday)

 

US Economy: Animals Dispirited? Following Election Day, there was a widespread jump in consumer and business confidence. It was widely deemed that this reflected the unleashing of “animal spirits” when Donald Trump won with majorities in both houses of Congress. Suddenly, his campaign promises, which included tax cuts for individuals and businesses, seemed quite doable. So did his plan to repatriate $2.5 trillion of corporate cash stashed overseas, as well as his commitment to slash business regulations. Debbie and I argued that, perhaps most significantly, the election marked a remarkable regime change. Over the past eight years, we’ve had government by community organizers, who were mostly lawyers with lots of government experience but almost no business experience. Trump and his Cabinet are dealmakers with lots of business experience but very little government experience.

A 1/5 FT article by Gillian Tett titled “Donald Trump unleashes business’s animal spirits” reported that Trump’s top eight officials (president, vice-president, chief of staff, attorney-general, and secretaries of State, Commerce, Defense, and Treasury) had only 55 years of government experience but 83 years in business. Obama’s comparable team had 117 years in government, but ONLY five years in business IN TOTAL.

Debbie and I argued that some of the aroused animal spirits might be reflecting the regime change, with many of the optimists excited about simply having a very pro-business administration. If so, then actually implementing the full Trump economic agenda might not be crucially important for sustaining animal spirits. After all, the economy is at full employment, and more economic stimulus is not an urgent priority. The stock market has been moving into record-high territory since July 11, 2016. The Fed started to normalize monetary policy by raising the federal funds rate in late 2015 at a gradual pace. Fiscal stimulus would most likely be offset by a more aggressive normalization of monetary policy.

So here we are with an administration full of dealmakers and very few deals to show for it so far. Perhaps some are in the works. Trump also promised to “drain the swamp.” So far, it looks like the swamp is deeper than he thought, and he seems to be sinking in it. In any event, animal spirits mostly remain elevated, as evidenced by the latest “soft data” that we continue to monitor in our Animal Spirits chart book. However, the hard economic data remain relatively soft. Consider the following:

(1) Real GDP. After Trump’s election, Debbie and I raised our real GDP forecast for this year from 2.5% to 3.0%. That’s on a Q4-to-Q4 basis. Now we are lowering it to 2.1%. It’s been growing around 2.0% since Q2-2010 (Fig. 1). Even during Q1-2017, which was up just 1.2% (q/q saar), it rose 2.0% y/y! If it continues to do so, that would imply q/q growth rates for Q2-Q4 of 1.8%, 3.5%, and 2.1% (Fig. 2).

Previously, we’ve observed that from H2-2010 to H1-2015, real GDP was growing around 3.0% excluding spending by federal, state, and local governments (Fig. 3). Government spending in real GDP is on goods and services, not on entitlement programs, which redistribute income. These programs may now be so large that they are putting a lid on government spending on goods and services, which certainly explains the awful condition of infrastructure in the US. In any case, the weakness in government spending in real GDP has been an unusual drag on the current expansion (Fig. 4). The good news is that it turned positive on a y/y basis from Q4 2014 through Q4-2016, though it was down again during Q1-2017 by a modest 0.5%. The bad news is that excluding government, real GDP growth seems to have slowed from 3.0% closer to 2.0% since mid-2015.

By the way, on Friday, the Atlanta Fed’s GDPNow reported: “The GDPNow model forecast for real GDP growth (seasonally adjusted annual rate) in the second quarter of 2017 is 2.9 percent on June 16, down from 3.2 percent on June 14. The forecast for second-quarter real residential investment growth decreased from 1.8 percent to 0.4 percent after this morning's housing starts release from the U.S. Census Bureau. The forecast of the contribution of net exports to second-quarter growth declined from -0.23 percentage points to -0.34 percentage points after yesterday's Import/Export Price Index release from the U.S. Bureau of Labor Statistics.”

(2) Economic surprise index. Among the softest of the hard data indicators is the Citibank Economic Surprise Index (Fig. 5). It continued to plunge last week, falling from a recent high of 57.9 on March 15, 2017 to -78.6 last Friday. That’s the lowest since August 19, 2011. The good news is that this is a highly cyclical series with lots of short-term swings. In the past, when it has dropped this much this fast, it has tended to rebound strongly.

For now, it is showing that expectations that the rebound in animal spirits would boost the actual economy haven’t been realized. As expectations turn more moderate, they are more likely to be realized or exceeded.

(3) Housing starts. As Debbie discusses below, housing permits and starts have been weaker than expected recently for both single-family and multi-family units (Fig. 6). Single-family housing starts remain on an upward trend. However, so far, they have recovered only to previous cyclical lows.

Contributing to the slow housing recovery is that fewer individuals than ever before are building their own homes. We can track the do-it-yourself trend by monitoring the difference between new single-family home completions and new single-family home sales (Fig. 7). The 12-month moving sum of this volatile series has remained below 200,000 since the start of the current recovery. That’s the lowest pace on the record, which starts in 1968!

(4) Retail sales & production. The good news is that the recent spate of bad news wasn’t so bad. While retail sales fell 0.3% m/m during May, the three-month change in the three-month average of inflation-adjusted retail sales was 3.9% (saar), the best pace since September 2016 (Fig. 8). Industrial production was unchanged during May, yet the three-month change in the three-month average was 3.8% (saar), the best since July 2014! This augurs well for a pickup in real GDP growth during the current quarter.

(5) Animated animal spirits. Meanwhile, animal spirits haven’t retreated much even though Trump seems to be thrashing about in Washington’s swamp waters. The latest reading we have on business conditions comes from the June district surveys conducted by the Federal Reserve Banks of NY and Philly. The average of their general business conditions indexes rose to 23.7 during June, up from 18.9 last month (Fig. 9).

The Business Round Table reports that the CEO Economic Outlook Index was 93.9 during Q2, exceeding Q1’s 93.3 reading, with both well above Q4’s 74.2 tally (Fig. 10). That augurs well for capital spending.

(6) Forward revenues & earnings. Debbie and I are big fans of the soft data that Thomson Reuters I/B/E/S compiles of forward revenues and forward earnings for the S&P 500 (Fig. 11). These series are time-weighted averages of industry analysts’ consensus forecasts for the current year and the coming year. Both tend to be very good leading indicators for S&P 500 revenues and earnings. They are highly correlated with numerous business-cycle indicators. Their only flaw is that they don’t see recessions coming. However, if there isn’t likely to be one over the next 52 weeks, then they are signaling that the economy continues to expand into record-high territory.

(7) Bonds & stocks. Finally, we need to consider the mixed message coming out of the bond and stock markets. The recent decline in bond yields and narrowing of the yield curve spread suggest weaker economic growth. That doesn’t seem to be fazing the stock market, which continues to make new record highs.

Our interpretation is that they are both consistent with our NBx2 scenario for the economy, i.e., No Boom, No Bust. In this scenario, inflation is likely to remain subdued. If so, there might be only three more 25bps hikes in the federal funds rate, to 2.0% by the end of next year, then that might be it for a while.

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Wonder Men & Women

Jun 19, 2017 (Monday)

 

US Economy: Inflation, RIP? No one knows whether Amazon women ever existed. These warrior women were first mentioned by ancient Greek poet Homer in the Iliad, set during the Bronze, or Heroic, Age. He referred to them as “antianeirai,” meaning “those who go to war like men.” Ancient Greek historian Herodotus describes them as “androktones,” meaning “killers of males.” The name “Amazon” is believed to come from the Greek word “amazoi,” which means “breast-less,” as young female warriors’ right breasts were removed to facilitate their drawing of the bow, according to legend. Besides bows and arrows, their main weapon, Amazons wielded swords and double-sided axes while carrying a distinctive crescent-shaped shield. Most of their fighting was done from horseback.

Could Jeff Bezos be Amazon Man? He certainly has the killer instinct, and continues to slaughter his competitors. Jackie and I have been following his exploits for some time and have concluded that he is also killing inflation. He has brought deflation to the book industry, mall retailers, and the cloud. Now he is doing the same to grocery stores, with the biggest losers likely to be their vendors, i.e., manufacturers of consumer brands, particularly staples.

Bezos is not alone in his battle to disrupt and destroy business models, with deflationary consequences. Elon Musk is also an Amazon Man, who intends to harvest solar energy on the roofs of our homes, storing the electricity generated in large batteries while also charging up our electric cars. Meanwhile, the frackers are using every frick in their book to reduce the cost of pumping more crude oil. Pharmaceutical companies are under lots of political pressure to stop hyper-inflating drug prices. Telecom services prices are falling as a result of intense competition. With price inflation remaining subdued, it’s no wonder there isn’t a lot of upward pressure on wage inflation even though the labor market is obviously very tight. Consider the following:

(1) Disinflation. On a y/y basis, the headline and core CPI inflation rates both fell back below 2.0% (the Fed’s target for the PCE price deflator) in May to 1.9% and 1.7% (Fig. 1). On a three-month basis and annualized, they were -1.0% and 0.0% through May (Fig. 2). Showing outright deflation on a y/y basis are wireless telephone services fees (-12.3%), used car prices (-4.3), airfares (-2.9), and furniture & bedding (-1.4) (Fig. 3 and Fig. 4). Even the medical-care CPI inflation rate has dropped from a recent high of 4.9% to 2.7% in May, led by falling inflation rates for physician services and even drugs (Fig. 5).

(2) Food fight. Online shopping now accounts for a record 29.7% of GAFO sales (i.e., sales of goods typically found in department stores) (Fig. 6). That’s up from about 5% in 1992. It was 9.0% when Amazon went public during May 1997. The company clearly has taken lots of growth and market share away from the department stores. It’s been doing the same to the warehouse clubs and super stores since 2009.

Now Bezos is going after the grocery business. It’s a huge one, with sales totaling a record $939 billion (saar) during April. The warehouse clubs and super stores have increased their share of this business from 7.0% in 1992 to a peak of 27.2% during June 2008 (Fig. 7). That share was down to 23.8% during April, and is likely to continue falling as Amazon Man enters the fray. Bezos plans to do so by purchasing Whole Foods and using its stores as fulfillment centers for food sold by his company online, with the assistance of voice-activated Alexa.

(3) Drowning in oil. OPEC oil producers continue to put a lid on their output in an effort to prop up prices. Yet the price of a barrel of Brent crude oil is back down to $47.37, below its recent high of $57.10 on January 6 (Fig. 8). That’s comfortably in the $40-$50 price range that Debbie and I have been expecting for this year. Despite the 76% plunge in the price of oil from June 19, 2014 to January 20, 2016, US crude oil production fell just 12% from the week of June 5, 2015 through the week of July 1, 2016 (Fig. 9). Since then, it is up 10% to 9.3mbd.

Interestingly, weekly production held up relatively better in Texas and North Dakota than in the rest of the country when total output was declining (Fig. 10). However, the rebound in US oil production has been led by the rest of the country, excluding Texas and North Dakota. Could it be that frackers figured out how to lower their costs in the two states where they’ve been most active, and taken their innovations to the other states? Maybe.

Meanwhile, the 52-week average of gasoline usage in the US is down 0.7% y/y (Fig. 11). This may or may not be a sign of a slowing economy. It is undoubtedly a bearish development for oil prices.

Saudi Arabia, Russia, Iran, and other major oil producers, with large reserves of the stuff, should be awfully worried that they are sitting on a commodity that may become much less needed in the future. As long as the sun will come out tomorrow (as Little Orphan Annie predicted), solar energy is likely to get increasingly cheaper and fuel a growing fleet of electric passenger cars. Rather than propping up the price, maybe they should sell as much of their oil as they can at lower prices to slow down the pace of technological innovation that will eventually put them out of business.

(4) Bond vigilantes. The bond market certainly confirms that the disinflation story remains a credible one. The yield spread between the US Treasury 10-year bond and its comparable TIPS is deemed to be a measure of inflationary expectations over the next 10 years. It soared following Election Day, from 1.73% on that day to a recent peak of 2.08% on January 27 (Fig. 12). It was back down to 1.67% on Friday, the lowest since October 24. The yield curve spread between the 10-year bond yield and the federal funds rate has narrowed from a recent high of 213bps on December 14, 2016 to 100bps near the end of last week, the lowest since July 8, 2016 (Fig. 13).

There is mounting concern that the bond market may be signaling that even slower economic growth is ahead. Perhaps. More likely, in our view, is that long-term bond investors are coming around to our view that inflation may be dead. There are some very powerful structural forces that should continue to keep it from rising from the dead. If so, then the bond vigilantes can relax.

(5) Deflationary drivers. Intensifying competition, technological innovation, and aging demographics are the structural forces that are keeping inflation in check. They’ve done so despite the ultra-easy monetary policies of the major central banks. Here is a brief list of some of the main events that have broken the back of inflation, which is likely to remain flat on its back: Walmart goes public (August 1972), Volcker clobbers inflation (October 1979), Reagan fires PATCO (August 1981), the end of the Cold War (November 1989), Amazon goes public (May 1997), China joins the WTO (December 2001), Amazon Web Services opens the cloud (August 2006), the oldest Baby Boomers turn 65 (January 2011) (Fig. 14).

The Fed: Wonder Woman. In her press conference last week on Wednesday, Fed Chair Janet Yellen confirmed in her prepared remarks that the Fed believes that the economy’s weakness during Q1 and recent easing of inflation are likely temporary developments, which is why the FOMC proceeded with a 25bps hike in the federal funds rate to a range of 1.00%-1.25%. She noted that consumer and business spending seem to be firming. She expects that labor market indicators will continue to improve.

Yellen said, “The recent lower readings on inflation have been driven significantly by what appear to be one-off reductions in certain categories of prices, such as wireless telephone services and prescription drugs.” She added, “Finally, the median inflation projection is 1.6 percent this year and rises to 2 percent in 2018 and 2019.” In other words, the FOMC is sufficiently comfortable with the underlying strength in the economy in general and the labor market in particular that the committee had no qualms about raising the federal funds rate for the fourth time since the end of 2015, even though inflation remains below its 2.0% target.

Yellen reiterated that more rate hikes are likely, but “the federal funds rate would not have to rise all that much further to get to a neutral policy stance.” She observed, “The median projection [of the FOMC] for the federal funds rate is 1.4 percent at the end of this year, 2.1 percent at the end of next year, and 2.9 percent at the end of 2019, about in line with its estimated longer-run value.”

Melissa and I reckon that Yellen & Co. are aiming to raise the federal funds rate to 2.0% by the end of next year. If so, that would take only three more hikes to get there. That certainly would be consistent with their pledge to normalize monetary policy at a gradual pace. There’s already some pushback from Fed watchers who say that the FOMC is making a mistake tightening further given the slow pace of growth and subdued inflation. We don’t agree. So far, the Fed’s normalization hasn’t caused any “tightening tantrums” in financial markets. The Fed should take this opportunity to proceed with normalization.

The big question is whether President Donald Trump will reappoint the Fed’s Wonder Woman for another term when her current one expires on February 3, 2018. He might.

Stocks: Mr. Wonderful. Anyone who invested in Amazon since it went public must think of Jeff Bezos as Mr. Wonderful. The stock price is up a whopping 50,293% from its offering price on May 15, 1997. His competitors must see him as the Grim Reaper. Of course, there is another Mr. Wonderful. That is the nom de guerre of Kevin O’Leary, who is one of the sharks on “Shark Tank.” I appeared with Mr. Wonderful on CNBC on June 9. When I said that ETFs are attracting lots of money away from mutual funds, which might explain why the FAANG stocks were leading the stock market to new highs, he chortled, “Wonderful, wonderful.” During July 2015, O’Leary offered a menu of five exchange-traded funds to the public. They’ve attracted lots of funds and performed wonderfully.

While flow-of-funds analysis is important for understanding what’s driving the stock market, so are earnings. As Joe reviewed last week, the forward earnings of the S&P 500/400/600 all rose to fresh record highs during the first week of June (Fig. 15). That’s quite impressive given the powerful forces of disinflation.

Movie. “Wonder Woman” (++) (link) is one of the better action hero flicks. That’s partly because it isn’t all carnage all the time. There is actually some dialogue. Most of it is hokey, but some of it is mildly amusing. In any event, it was good to see Wonder Woman coming around to realize that utopian visions of peace on Earth can’t be achieved simply by killing the God of War. However, she does conclude that love conquers all, which may work in bilateral relationships but is less reliable otherwise.

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Healthier

Jun 15, 2017 (Thursday)

 

Business Sales: Not Bad. Yesterday, we learned that business sales of goods by manufacturers and distributors rose 5.6% y/y through April. This augurs well for aggregate S&P 500 revenues, which rose 5.1% y/y through Q1-2017 (Fig. 1). So does the retail sales component of total business sales of goods, which is available through May, when it was up 4.0% y/y (Fig. 2).

As Debbie explains below, while May’s retail sales report seemed weak, the three-month average adjusted for inflation rose 3.9% (saar). Real core retail sales—excluding autos, gasoline, building materials, and food services—jumped 7.5% (Fig. 3). The Atlanta Fed’s GDPNow forecast for Q2 real GDP growth was raised from 3.0% to 3.2% yesterday on the news: “The forecast for second-quarter real consumer spending growth increased from 3.0 percent to 3.2 percent after this morning’s retail sales report from the U.S. Census Bureau and this morning’s Consumer Price Index release from the U.S. Bureau of Labor Statistics.”

Meanwhile, consumers continue to shop online from the comfort of their homes and/or with the ease of their smartphones from wherever they might be. Online shopping accounted for a record 29.7% of in-store GAFO (i.e., the kind of merchandise typically sold in department stores) and online retail sales (Fig. 4). They continue to take share away from both department stores as well as warehouse clubs and super stores.

As Jackie updates below, the grocery business is facing competition not only from online vendors but also from foreign ones entering the US market. The great disruption in the grocery business occurred during the 1990s and 2000s, when the market share of warehouse clubs and super stores rose from 8.1% in 1992 to 27.2% during June 2008 (Fig. 5). Amazon is entering the fray for consumer grocery bucks. So are foreign grocers such as Aldi and Lidl. The sure winners will be consumers. The sure losers are likely to be consumer staples companies that depend on branded product sales.

Health Care: Revival Time. The Health Care sector is suffering from many ailments. Last year, new drug approvals were scant and the high price of existing drugs drew critical scrutiny. Insurers are dropping out of the Patient Protection and Affordable Care Act (ACA) like flies. And if the House of Representatives’ plan to revamp the ACA succeeds, there will be 23 million fewer patients covered under the ACA. That might be good for the federal budget, but bad for the bottom line of health insurance companies and providers.

But despite the bevy of bad news, Health Care stocks are showing signs of life. The S&P 500 Health Care sector is the second-best-performing sector ytd. Here’s how the S&P 500 sectors stack up since the start of the year through Tuesday: Tech (18.6%), Health Care (12.2), Consumer Discretionary (11.4), Materials (10.4), Utilities (9.6), Consumer Staples (9.3), S&P 500 (9.0), Industrials (8.6), Real Estate (4.9), Financials (4.7), Telecom Services (-9.6), and Energy (-11.1) (Fig. 6).

Health Care’s performance this year is quite a reversal from 2016, when it was the worst-performing sector, falling 4.4% compared to the S&P 500’s 9.5% return (Fig. 7). Its revival may continue because the Health Care sector kicks in 15.5% of the S&P 500’s earnings but represents only 14.0% of the S&P 500’s market capitalization (Fig. 8). Only three of the 11 S&P 500 sectors have earnings contributions that are well above their market-cap representation in the S&P 500. The other two sectors: Financials, which historically doesn’t garner a market cap greater than its earnings contribution, and Telecom, which has the smallest capitalization in the S&P 500, at 2.2%.

Here’s a quick look at some of the Health Care sector’s vitals:

(1) Fewer new drugs. The sector’s strong returns this year are notable because two of its largest constituents are underperforming. The S&P 500 Pharmaceuticals index is up 6.9% ytd, and the Biotechnology index is 6.5% higher so far this year, but both lag behind the S&P 500’s 9.0% ytd return (Fig. 9). The two industries represent just over half of the Health Care sector’s total market capitalization.

These two industries may be lagging because fewer new drugs passed inspection last year, according to the FDA’s website. Twenty-two new drugs were approved in 2016, down from 45 drugs in 2015, 41 in 2014, 27 in 2013, 39 in 2012, and 29 in 2011. The slowdown last year can be blamed on fewer applications (36, down from 40 in 2015) and the delayed approval or outright rejection of more drugs last year, a 1/9 article in FierceBiotech explained. Approvals may pick up this year, as there already are 21 drugs approved with six more months left to go in 2017.

(2) Bitter pills. Pharma and Biotech also have a PR problem. Investors may be excited that Pfizer raised the US price of nearly 100 drugs by an average of 20% so far this year (as reported by a 6/2 FT article), but that headline doesn’t play well in Peoria or in the halls of Congress.

President Trump said earlier this year that his administration plans to push for lower drug prices, implying that it could do so by negotiating better prices for Medicare and Medicaid. More recently, his FDA commissioner said he plans to do what’s possible to “facilitate entry of lower-cost alternatives to the market, and increase competition,” the 5/25 WSJ reported. That translates into making it easier for generic drugs to enter the market and compete with existing drugs.

(3) Growth challenges & opportunities. Earnings growth in the S&P 500 Pharma industry has come down sharply, but so too has its earnings multiple. The industry’s forward earnings growth estimate stands at 7.5%, up from its post-recession low of -1.3% but a far cry from the 14%-15% earnings growth it enjoyed from 1998 through 2001 (Fig. 10). Its forward P/E ratio has followed a similar path, peaking at 34.4 in March 1999, bottoming around the time of the recession at 8.8, and recovering to the current 15.3 (Fig. 11). Because the industry’s earnings growth and forward P/E have moved in tandem, the industry’s PEG ratio is at 2.0 today, just about where it was when Pharma’s P/E was much higher in 1999 (Fig. 12).

The Biotechnology industry looks extremely interesting given that its forward P/E has fallen to 13.3, close to the lows it hit in the wake of the recession (Fig. 13). There’s also a very large gap between the industry’s forward earnings growth estimate of 2.4% and the 13.8% earnings growth that analysts are calling for over the next five years (Fig. 14). If the dearth of drug approvals is a blip rather than a trend, investors could return to the industry.

(4) ACA blues. Washington has not managed to come up with a replacement to the ACA, also known as “Obamacare.” The House proposal would result in 23 million fewer Americans having health care coverage by 2026, and the Senate has yet to formulate a bill. While the politicians dither, insurers are dropping out of the ACA, claiming that they’re unable to make profits under the current system in certain locations.

Surprisingly, Managed Health Care stocks have fared fabulously so far this year. The S&P 500 Managed Health Care index (AET, ANTM, CI, CNC, HUM, and UNH) is up 18.3% ytd. Standouts include Centene, up 38.1% ytd through Tuesday’s close; Anthem, up 30.2%; and Cigna up 24.9%.

Centene, an insurer that focuses on Medicaid, has been able to make profits in the ACA and has announced plans to expand its offerings in three new states—Kansas, Missouri, and Nevada—and within states where it already does business. The company is dropping out of Massachusetts due to low enrollment.

Centene’s ACA plan enrollment grew to 1.2 million as of the end of March, up from 537,000 at the end of 2016, the 6/13 WSJ reported. That runs counter to UnitedHealth Group, Aetna, and Humana, which have pulled back sharply from ACA business or plan to exit next year. Investors appear to be discounting the fact that President Trump’s proposed budget would cut Medicaid by more than 40% over a decade.

Over the next 12 months, the Managed Health Care industry is expected to grow revenues by 6.1% and earnings by 13.2%, which is below the sector’s forward P/E of 17.0 (Fig. 15 and Fig. 16).

(5) Picture of health. Beyond Managed Health Care, the other industries driving the Health Care sector’s strong performance include Health Care Technology (CERN), up 40.3% ytd and the third-best-performing industry in the S&P 500 so far this year, and Life Sciences Tools & Services (A, ILMN, PKI, TMO, and WAT), up 29.3% and the sixth-best-performing S&P 500 industry that we track. Not far behind are Health Care Equipment (22.9%) and Health Care Supplies (XRAY) (20.6). It looks like rumors of the sector’s death have been greatly exaggerated.

Consumer Staples: Another Foreign Elephant. Last week, we observed that investors looking for safety in the Consumer Staples sector might be disappointed as competition in the grocery business heats up, putting pressure on prices (6/8 Morning Briefing). Our case was bolstered earlier this week by news that German grocery chain Aldi plans to open 900 stores in the US, to bring its total up to 2,500 by 2022. Doing so would make it the country’s third-largest grocer, the 6/11 WSJ reported. The news comes after Lidl, another German discount grocery store, said it would open its first 10 stores in the US this month.

Aldi has been in the US since 1976, focusing on lower-income shoppers, but last year it started pushing into suburban, middle-income, or higher-income neighborhoods, the 10/16 WSJ wrote. It described Aldi’s stores as “no frills” with skimpy in-store marketing. It stocks fewer items, about 1,300 versus 30,000 in an average grocery store, and roughly 90% of its products sold are private label.

The company runs its operations quite differently to save on labor. Items are displayed in the cardboard boxes in which they were shipped, and customers can take empty boxes to carry home their groceries. Customers bag their own groceries in bags they’ve brought from home or they pay to buy new bags in the store. In addition, consumers pay a quarter to take a shopping cart, which is returned if the cart is returned to its holding area.

Aldi stores are typically open during peak shopping hours, not 24 hours a day. And employees are trained to do many jobs, so cashiers stock shelves. In addition, items may have many barcode labels so that they can be scanned faster at checkout. Although Aldi pays its employees above-market wages, the grocer is still able to offer prices that are 25% to 40% lower than traditional grocers’, the WSJ article explained.

While time will tell whether US consumers will adapt to save money, those in the UK certainly did. Aldi entered the UK market roughly four years ago, and it is now the country’s fifth-largest supermarket. “Rivals trying to compete on price have seen margins on earnings before interest and taxes fall from 5 percent to 2 percent in four years,” the 6/12 FT explained. In the wake of increased competition, Tesco has shut poorly performing stores, ended night shopping, and sold its South Korean business, Homeplus. US grocers and the companies that fill their shelves with goods should be on high alert.

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Small Is Beautiful

Jun 14, 2017 (Wednesday)

 

Small Business I: SmallCaps Are Big Employers. The S&P 1500 stock price index has 1,500 companies. On June 12, it had a total market capitalization of $23.3 trillion. Remarkably, this index’s market cap is up 251.9% since March 9, 2009, by a whopping $16.7 trillion from a low of $6.6 trillion (Fig. 1). It is up 48.5% from the previous bull market’s peak. Weighing in at $20.9 trillion currently, the S&P 500 accounts for nearly 90% of the S&P 1500’s market cap (Fig. 2).

The S&P 400 MidCaps and S&P 600 SmallCaps currently have market values of $1.7 trillion and $0.7 trillion, respectively. They account at present for just 7.2% and 3.1% of the S&P 1500 (Fig. 3). The S&P 500 comprises corporations with market caps of at least $6.1 billion. MidCaps represent those with market caps of $1.6-$6.8 billion, and Small Caps $450 million-$1.8 billion.

Yet small and medium-sized companies are disproportionately big employers according to ADP’s monthly tally of payrolls. In May, the former accounted for 41.3% of private-sector payrolls, while the latter accounted for 36.0% (Fig. 4). So large companies employed just 22.7% of all private-sector employees.

The ADP data by company size start in 2005. So there isn’t much history. Since then, total employment is up 13.0 million, led by gains of 6.3 million and 5.4 million among small companies and medium-sized ones (Fig. 5). Employment at large companies rose only 1.3 million over this period.

This might be one plausible explanation for the significant slowing in productivity growth in the US. Consider the following:

(1) Smaller outfits that are growing probably can do so mostly by hiring more workers, while larger companies may have access to more productive ways of expanding their capacity and output. It’s hard to test this hypothesis since we don’t know whether smaller firms were outsized employers or not prior to 2005, when productivity was growing at a faster clip.

(2) ADP data are available since 2001 for employment by goods-producing and service-producing companies (Fig. 6). The former is actually down 4.2 million over this period through May of this year, while the latter is up 16.8 million. This suggests that productivity has weakened in recent years mostly because service companies with small and medium-sized payrolls have done all of the hiring. The big problem with this theory is that manufacturing productivity growth has averaged zero for the past five years (Fig. 7)!

Small Business II: Profits Cycle Booming. Debbie and I believe that the profits cycle drives the business cycle. Profitable companies expand their payrolls and capacity, while unprofitable ones are forced to retrench. Obviously, during economic expansions, there are many more profitable than unprofitable companies.

The forward earnings data for the S&P 1500 and its three major components show that all are rising in record-high territory (Fig. 8). Since the start of the weekly data at the beginning of 1999 through early June of this year, the forward earnings of the S&P 500/400/600 are up 168.1%, 349.6%, and 327.7% (Fig. 9).

The monthly survey of small business owners conducted by the National Federation of Small Business (NFIB) includes a question on whether earnings are higher or lower over the past three months. The resulting net earnings series is volatile from month to month, with the 12-month average very much driven by the ups and downs of the business cycle (Fig. 10). The series starts during September 1974, and has been negative since then. In other words, on balance more small business owners lose than earn money!

Nevertheless, the 12-month average of this series is highly correlated with the 12-month average of the percent of small business owners who plan to increase employment (Fig. 11). In May, the former rose to the highest since May 2007, while the latter rose to the highest since September 2007.

Small Business III: Help Wanted. The problem with all this wonderful news is that the economy is running out of warm bodies to employ as Debbie and I have been arguing of late. May’s NFIB survey found that 34.0% of small business owners had one or more job openings, the highest since November 2000 (Fig. 12). Furthermore, 51.0% said that there were few or no qualified applicants for the positions.

The three-month average of the NFIB job openings series is highly inversely correlated with both the unemployment rate and the jobs-hard-to-get series included in the monthly consumer confidence survey (Fig. 13 and Fig. 14). The bottom line is that the labor market is tight, and may pose a challenge for the expansion plans of small businesses and dampen the growth rate of the overall economy.

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Tech Now & Then

Jun 13, 2017 (Tuesday)

 

Strategy I: Hard-Charging Bull. Bulls tend to live 18-22 years. The average age of the past 22 equity bull markets since 1928 has been 1,007 days, or 33 months (Fig. 1). (See our S&P 500 Bull & Bear Markets Table.) The current one has lasted for 3,007 days, or 99 months. So far, it is the second-longest bull market since 1928. The previous longest ones lasted for 4,494 (150 months) and 2,954 days (98 months).

Bulls die of old age, unless they are prematurely killed by a matador in a bull ring. Bull markets don’t die of old age. Instead, they terminate when the economy falls into a recession (Fig. 2). So far, while the current economic expansion has been among the slowest on record, it has lasted 96 months, which makes it the third-longest one since 1928. (See NBER US Business Cycle Expansions and Contractions.) The previous longest expansions lasted 120 and 106 months.

As Debbie and I discussed yesterday, using the average of the past five business expansions to benchmark the current one, we pinpoint the next recession to start during March 2019. That doesn’t come with a money-back guarantee. It is simply a benchmark based on the average experience of recent business-cycle history. However, we will guarantee that the next recession will kill the current bull market.

Meanwhile, the old bull continues to age and to charge ahead despite his advanced age. For example, here is the performance derby of the S&P 500 and its 11 sectors since last year’s low on February 11, 2016 through Friday of last week (Fig. 3 and Table 1): Financials (51.1%), IT (50.3), Materials (40.0), Industrials (36.9), S&P 500 (33.0), Consumer Discretionary (32.1), Health Care (22.0), Energy (19.8), Real Estate (19.3), Utilities (17.0), Consumer Staples (14.9), and Telecom Services (1.5). That’s an impressive performance for an old-timer.

Of course, the charge since March 9, 2009, when the current bull market began, is truly superb (Fig. 4 and Table 2): Consumer Discretionary (471.2%), Financials (380.3), Information Technology (379.8), Industrials (336.6), S&P 500 (259.4), Health Care (253.0), Materials (214.2), Consumer Staples (191.0), Utilities (137.8), Telecommunication Services (81.5), and Energy (56.5).

Strategy II: Relative Exuberance. Is it 1999/2000 all over again for the S&P 500 Information Technology sector? Not so far. Consider the following:

(1) First vs third place. During the bull market from October 11, 1990 through March 24, 2000, the sector soared 1,697.2%, well ahead of the 417.0% gain in the S&P 500 and all the other sectors (Fig. 5). During the current bull market, it is in third place.

(2) Market-cap and earnings shares. At the tail end of the bull market of the 1990s, the S&P 500 IT sector’s share of the overall index’s market capitalization rose to a record 32.9% during March 2000 (Fig. 6). However, its earnings share peaked at only 17.6% during September 2000. This time, during May, the sector’s market-cap share rose to a cyclical high of 22.9%, while its earnings share, at a cyclical high of 22.0%, was much more supportive of the sector’s market-cap share. As a rule of thumb, Joe and I get nervous when a sector’s shares of either or both rise close to 33%. We aren’t nervous yet about IT, though we are just a little twitchy.

(3) No contest on valuation basis. During the second half of the 1990s through the early 2000s, the forward P/E of the Tech sector soared relative to the broad index (Fig. 7). The former peaked at a record 48.3 during March 2000. That same month, the forward P/E of the S&P 500 was 22.6. Both then proceeded to trend lower through 2008, when they finally converged. During the current bull market, the Tech sector’s forward P/E hasn’t diverged much at all from that of the overall index. Last month, the former was 18.1, while the latter was 17.3.

(4) Less irrational exuberance about long-term growth. Joe and I regularly monitor LTEG for the S&P 500 and its 11 sectors and 100+ industries. LTEG is analysts’ consensus long-term earnings growth expectations over the next five years at an annual rate. It soared to a record high of 18.7% during August 2000 for the S&P 500, up from 11.5% at the start of 1995 (Fig. 8). Keep in mind that the historical trend growth in the S&P 500 during economic expansions tends to be around 7% (Fig. 9)! The ascent in this growth expectation trend for the S&P 500 during the second half of the 1990s was led by an even more wildly irrational rerating of expected LTEG for the Tech sector from 16.6% at the start of 1995 to a record high of 28.7% during October 2000.

Since those peaks, both LTEGs have come back down closer to the Planet Earth. During April, they were 12.3% for the S&P 500 and 12.7% for the IT sector. Those are still more optimistic than what is likely to be delivered, but at least they are back to the rationally exuberant normal bias of analysts.

(5) Less air in this bubble so far. All of the above suggests that the Tech sector is trading much closer to realistic expectations for fundamentals than during the bubble of the 1990s. The S&P 500 IT stock index nearly exceeded its March 27, 2000 high for the first time just last week on June 8 (Fig. 10). The sector’s forward earnings rose to a record high at the start of June, exceeding the 2000 peak by 168.6% (Fig. 11).

The sector has the highest forward profit margins among the S&P 500 sectors. It has been at a record high around 20% since late last year, up from a cyclical low of around 12% at the start of 2009 (Fig. 12).

(6) Chips with salsa. Among the 10 top-performing S&P 500 industries since last year’s February 11 low are Semiconductor Equipment (#1 with a gain 142.9%) and Semiconductors (#9, 67.4%) (Fig. 13 and Fig. 14). The forward earnings of the former has gone vertical, doubling since early last year (Fig. 15). As a result, the forward P/E of this high-flying but cyclical industry was only 14.7 at the beginning of June.

The forward earnings of the Semiconductors industry has also been like eating chips dipped in salsa with extra hot jalapenos. Not surprisingly, it is highly correlated with worldwide sales of semiconductors, which rose to a record $376 billion (saar) during April (Fig. 16).

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White Swans

Jun 12, 2017 (Monday)

 

Strategy I: New England Is Bullish. I visited with some of our institutional accounts in New England last week. I am sensing that a consensus is emerging among them and our other accounts in the US and abroad. They are less concerned about frothy valuation multiples in stocks, and less bearish on bonds than they were earlier this year. They are much less concerned about the Fed too, figuring that rate hikes will remain very gradual and that the central bank won’t shrink its balance sheet for a while. In any event, they see better values in European and EM stock markets. They have mixed views on the FAANGs.

No one was able to come up with any new and credible black-swan event that might trip up the bull market in stocks. I observed that white swans typically outnumber black ones over time. We all agreed that one possible perverse black swan might be a melt-up that leads to a meltdown. Investors increasingly are either irritated or bored with the daily swamp opera in DC, and mostly tuning it out. There usually aren’t any swans of any color in swamps, just too many swamp people and alligators. Investors aren’t betting the farm on Trump’s economic agenda. If a significantly downsized version is eventually enacted, that’s okay. If nothing changes, so be it. There’s plenty to keep the bull charging ahead.

Investors seem to be coming around to our long-held view that this economic expansion could last for a very long time. In other words, they are considering the possibility that the biggest surprise might be how long the current bull market lasts. In this scenario, both inflation and interest rates would remain surprisingly low for a surprisingly long time. Valuation multiples might stay high for a long time too. Again, historically speaking, white swans tend to outnumber black swans.

Debbie and I have been arguing that the Trauma of 2008 reduced the likelihood of a boom-bust scenario for the economy as both consumers and businesses remained relatively cautious and conservative in their spending and borrowing activities. Among the most telling confirmations of our hypothesis is that wage inflation, as measured by the yearly growth rate in average hourly earnings, remains around 2.5%. In the past, the current record number of job openings and the cyclical low in consumers reporting that jobs are hard to get was associated with wage inflation of 3.0%-4.0% or higher (Fig. 1 and Fig. 2). This is consistent with our NBx2 scenario, i.e., No Boom, No Bust.

About two and a half years ago, back on October 27, 2014, Debbie and I first discussed the possibility that the current economic expansion might last until March 2019. That was based on a simple benchmark model of the business cycle. We noted that during the previous five business cycles, the recovery periods lasted 26 months on average, measured from the trough of the Index of Coincident Economic Indicators back to the previous cyclical peak (Fig. 3). The remaining expansion phases lasted 65 months on average after the recovery phase. That would put the next cyclical peak during March 2019.

Traditional business-cycle economists have been expecting tighter labor market conditions to boost wages, which would lift price inflation. This is based on the classic demand-pull and cost-push models of inflation, including the Output Gap and Phillips Curve. These inflation models don’t recognize the possibility that there may be powerful secular forces keeping a lid on price inflation, which keeps a lid on wage demands even in a tight labor market. These forces include competition resulting from globalization, inherently deflationary technological innovations, and demographic drag from aging populations. The proof is in the numbers: Since the mid-1990s when the three forces started to kick in, price inflation remained below, and tended to act as an anchor for, wage inflation, which has been much more sensitive to the business cycle (Fig. 4).

Strategy II: Are Bonds Bearish? In my meetings last week, one of the concerns we discussed was the drop in the US Treasury 10-year bond yield from a recent high of 2.62% on March 13 to last week’s low of 2.14% on Tuesday (Fig. 5). That’s the lowest since November 9, the day after Election Day. A related concern was frequently expressed about the flattening of the yield curve from a recent high of 213 bps on December 14 to last week’s low of 123 bps on Tuesday (Fig. 6). That’s the narrowest since October 3. Both suggest a much weaker assessment of economic growth than in the weeks following Election Day. On a short-term basis, both are responding to the plunge in the Citigroup Economic Surprise Index from a recent peak of 57.9 on March 15 to Friday’s reading of -43.4, near last Monday’s -44.7, which was the lowest since February 18, 2016 (Fig. 7).

According to the Bond Vigilante Model, the 10-year bond yield is the fixed-income market’s assessment of the current growth rate in nominal GDP on a y/y basis (Fig. 8). The former is currently about half as much as the latter, which was 4.1% during Q1 of this year. There are alternative possible explanations for the drop in the bond yield other than the bond market predicting a significant drop in already weak economic growth. Consider the following:

(1) Falling inflationary expectations. It may be that some investors see much more risk in stocks, given their historically high valuations, than in bonds. However, bonds certainly don’t look cheap, unless bond investors are reassessing the long-term outlook for inflation. As noted above, competition, technology, and demography are powerful secular forces subduing inflation. Sure enough, expected inflation, as embedded in the yield spread between the US Treasury 10-year bond and its comparable TIPS, dropped from a recent high of 2.08% on January 27 to 1.78% at the end of last week (Fig. 9).

(2) Near-zero yields abroad. Of course, the US bond yield, at 2.21%, still looks awfully attractive compared to the 10-year government bond yield in Germany at 0.26% and Japan at 0.07% (Fig. 10). Last Thursday, the ECB dropped its downside risk warning for economic growth, saying the risks were now “broadly balanced.” It also dropped its guidance that interest rates might be cut again, while scaling back its inflation forecasts for the next two years. Nevertheless, ECB President Mario Draghi remained very dovish, saying that the ECB will continue its quantitative easing program of bond-buying for the foreseeable future and adding that it “will be in the market for a long time.”

The Fed ended its QE program at the end of October 2014. Since then, it has rolled over its maturing securities so that the Fed’s assets have remained around $4.4 trillion since then (Fig. 11). Meanwhile, over the same period, the ECB has increased its assets by $2.0 trillion to $4.6 trillion, while the BOJ’s assets are up $1.8 trillion to $4.5 trillion. So the total of the three major central banks is up $3.8 trillion since October 2014 to a record $13.5 trillion (Fig. 12).

Last Thursday, BOJ Governor Haruhiko Kuroda said, “While the policy approach has steered Japan’s economy in the right direction, our intellectual journey has not yet been completed. The rate of change in the consumer price index recently has been around 0 percent and there is still a long way to go until the price stability target of 2 percent is achieved.” Now in the fifth year of its unprecedented quantitative easing, the BOJ has expanded its balance sheet to nearly the same size as Japan’s economy.

(3) Fed’s balance sheet. In Boston last week, I was asked a couple of times about when the Fed might start to reduce its balance sheet. It seems to me that in normalizing monetary policy, Fed officials are probably most interested in raising the federal funds rate back closer to 2.00%. It is currently 0.88%. If so, then they are likely to signal that they are in no hurry to reduce their balance sheet since that might make it tougher to raise rates. Melissa and I will be paying close attention, along with everyone else, to the Fed’s communication on this subject following the FOMC meeting on Wednesday, June 14.

We do expect a quarter-point rate hike at this meeting. While it is true that payroll employment has been surprisingly weak in recent months (averaging just 162,000 per month from March-May), that may be because the economy is at full employment. In other words, employment is weak because we’ve run out of warm bodies to hire rather than because of weak demand for workers.

Perhaps the best way to think about full employment is this: Full employment occurs when the number of job openings equals the number of unemployed workers. During April, the former was a record 6.0 million during April, while the latter was 7.1 million. The ratio of unemployed workers to job openings was 1.17, the lowest since January 2001. April’s unemployment rate of 4.4%, therefore, mostly reflected so-called “frictional” unemployment caused primarily by geographic and skills mismatches. Besides, the financial markets were very calm about the rate hike earlier this year. Fed officials would be foolish to let this opportunity to normalize some more slip by.

The bottom line is that the US Treasury bond yield mostly remained in our 2.00%-2.50% range during the first half of 2017. We still expect a range of 2.50%-3.00% during the second half of the year. That’s because we expect that the Fed remains committed to gradually raising the federal funds rate.

Strategy III: Quarterly Valuation Ratios. The Fed updated its Financial Accounts of the United States publication last week with Q1-2017 data. It shows that the value of all equities in the US rose to a record $40.8 trillion (Fig. 13). That’s up a whopping $27.4 trillion since the bear market low during Q1-2009. The Q1-2017 total includes $33.1 trillion in US equities and $7.7 trillion in foreign issues. US residents held 18.7% of their equity portfolios in foreign stocks during the first quarter (Fig. 14). By the way, the S&P 500 rose to a record-high market capitalization of $20.7 trillion at the end of May, up $13.8 trillion since March 2009. Now consider the following valuation metrics:

(1) The Buffett Ratio, which divides the market cap of all stocks less foreign ones by nominal GNP, rose to 1.72 during Q1-2017 (Fig. 15). That’s the highest since Q1-2000, and is fast approaching that quarter’s record high of 1.80. Meanwhile, the comparable ratio for the S&P 500 using the market cap of the index divided by its aggregate revenues rose to 2.00 during Q1-2017, matching its record high during Q4-1999.

(2) The Laffer Ratio is similar to the Buffett Ratio but uses after-tax corporate profits from current production in GNP rather than GNP (Fig. 16). It edged up to 21.1 during Q1-2017. That’s the highest since Q4-2015, but well below its record high of 36.5 during Q1-2000. (For more on Laffer’s valuation measure, see Jon Laing’s 1/5/2004 Barron’s article titled “Altitude Adjustment.”)

(3) The Tobin Ratio is also relatively subdued on the valuation question (Fig. 17). It is the ratio of the market value of equities to the net worth of corporations, including real estate and structures at market value and equipment, intellectual property products, and inventories at replacement cost. It edged up to 1.04 during Q1-2017, still well below the record high of 1.61 during Q1-2000.

(4) The forward P/S is available weekly and is highly correlated with the Buffett Ratio (Fig. 18). This is the forward price-to-sales ratio of the S&P 500. It was awfully high at 1.93 at the start of June.

The bottom line is that stocks are extremely overvalued based on the Buffett Ratio. The same can be said of stocks using both the S&P 500 market-cap-to-revenues ratio and the forward price-to-sales ratio. On the other hand, stocks seem somewhat more reasonably priced using the Laffer Ratio and Tobin Ratio.

In our opinion, the longer that the current expansion continues with inflation and interest rates remaining subdued, the more bullish it is for stocks.

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Beware of Fighting Elephants

Jun 08, 2017 (Thursday)

 

Consumer Staples: Getting Trampled. Proverbs are great at conveying big ideas simply but colorfully. Consider this African proverb: “When elephants fight, it is the grass that suffers.” Simple, yet colorful.

Fighting elephants came to mind when Amazon announced this week its plans to offer folks on government assistance a reduced rate to become Prime members. It’s the latest salvo in the battle between Amazon and Walmart to dominate Internet shopping. While the two have been tusking for years, the fight has intensified in recent months, and their suppliers and competitors alike are likely to get trampled in the grass beneath them.

You’d never know the elephants are fighting by looking at the industries in the S&P 500 Consumer Staples sector, where many of the suppliers and competitors are housed. Many of them have outperformed in recent weeks and trade at lofty multiples relative to low-single-digit earnings growth expectations. Investors may be turning to the sector because it has historically been a safe haven during times of turbulence, and offers dividends that look attractive in today’s low-interest-rate environment. Could this be the quiet before many of the Consumer Staples industries get trampled? Let’s look:

(1) The grocery showdown. There’s no mistaking it: Amazon and Walmart are making a big push to dominate Internet grocery shopping. They’ve both introduced a laundry list of new programs in an effort to woo customers. Personal outlays on food consumed at home totaled $939 billion (saar) during April (Fig. 1). Retail sales of food and beverage stores totaled $713 billion (saar) the same month. The difference between the two series is likely to be mostly the grocery sales of the warehouse clubs and super stores (Fig. 2). In other words, it’s a huge and natural arena for fighting elephants.

Amazon earlier this week offered a reduced rate for Prime membership—$5.99 a month instead of $10.99 a month—to customers on government assistance. The move comes as Amazon, Walmart, and seven additional retailers are participating in a pilot program that will allow food stamps to be used to purchase groceries online beginning next year, according to the US Department of Agriculture.

In addition, Amazon opened two grocery pickup locations in Seattle recently, and it lowered its free shipping threshold to $25—after Walmart lowered its threshold to $35, Recode reported on 6/6. Meanwhile, Walmart bought Internet retailer Jet.com for $3.3 billion last year, and it added discounts for anyone picking up packages in the store. Walmart is also testing a program where its workers are paid if they drop off packages ordered online on their way home from work.

The rapid succession of new initiatives gives the impression that both companies are throwing food at the wall to see what sticks. In the meantime, other retailers—whether they be grocery stores like Kroger, larger-format stores like Target and Costco, or dollar stores—have to be wondering what the grass will look like after the elephants finish fighting.

(2) Price slashing. Margins are already notoriously thin in the grocery business. But as Walmart and Amazon get even more competitive, they reportedly are asking suppliers to cut prices. According to a 3/30 Recode article, Walmart told some of its largest suppliers that it wants to have the lowest price on 80% of its sales.

“To accomplish that, the brands that sell their goods through Walmart would have to cut their wholesale prices or make other cost adjustments to shave at least 15 percent off. In some cases, vendors say they would lose money on each sale if they met Walmart’s demands,” the Recode article stated. “Brands that agree to play ball with Walmart could expect better distribution and more strategic help from the giant retailer. And to those that didn’t? Walmart said it would limit their distribution and create its own branded products to directly challenge its own suppliers.”

Amazon is also twisting arms. The Recode 3/30 article reports that Amazon has software that finds the lowest price online for an item and then matches it on Amazon, even if it means the sale is unprofitable. “Unprofitable items are known inside Amazon as [CR*P] products—the acronym stands for ‘Can’t Realize a Profit.’ … When Amazon warns suppliers that a product is pre-[CR*P], meaning it’s in jeopardy of being kicked off the site for profitability issues, it makes demands. Oftentimes, to lower wholesale prices. But that doesn’t always work, especially if a brand has the leverage of also selling into Walmart, which is still the biggest retail customer for many manufacturers.” So Amazon may move the product to a different part of its site that charges an additional shipping fee or prevent advertisement of the product on its website.

(3) Safety sells. Despite the upheaval in the retail space, the S&P 500 Consumer Staples index has turned in a strong performance over the past four weeks along with Utilities as defensive sectors have outperformed and Treasury yields have dropped. Here’s the performance derby of the S&P 500 sectors for the four weeks through Tuesday’s close: Utilities (4.7%), Consumer Staples (3.9), Tech (3.4), Materials (1.8), Health Care (1.7), Real Estate (1.6), S&P 500 (1.4), Telecom Services (0.9), Industrials (0.5), Consumer Discretionary (0.2), Financials (-1.6), and Energy (-2.3) (Table).

During the past four weeks, numerous industries in the Staples sector have outperformed the broader market, including: Tobacco (7.6%), Soft Drinks (5.0), Distillers & Vintners (4.8), Personal Products (4.5), Packaged Foods & Meets (4.1), Hypermarkets & Super Centers (3.8), Household Products (3.7), and Brewers (3.5). Meanwhile, the S&P 500 has returned 1.4% over the same four-week period from May 9 through Tuesday.

Before jumping into Consumer Staples, remember that the elephants are fighting and the sector’s forward P/E, at 20.5, is almost three times the 7.2% earnings growth analysts are expecting over the next 12 months (Fig. 3 and Fig. 4). That’s pricier than the multiple of earnings that investors are paying for stocks broadly: The S&P 500 sports a lower forward P/E of 17.6 yet higher forward earnings growth of 11.3%.

(4) Food retailers. Given the battle between Walmart and Amazon, it’s ironic that one of the Consumer Staples’ industries with the most stretched valuation is S&P 500 Food Retail (KR, WFM). It has forward earnings growth of only 3.4%, yet the shares trade with a forward multiple of 15.4 (Fig. 5 and Fig. 6). Its earnings growth rate has come down from north of 10%, where it routinely stood from 2012 to 2014. The last time earnings growth was this low was in 2009, when the P/E was much lower at 8.7.

In addition to the Amazon/Walmart battle, there’s a new company entering the fray. German grocer Lidl is opening its first 10 stores in the US this month. Over the next year, the company plans to open a total of 100 stores, and its ultimate goal is to have 600 stores in the US to complement the 10,000 stores it has in 27 European countries, according to a 5/17 Business Insider article. Food retailers have been slashing prices in response to increased competition. Declining prices led Kroger to report its first earnings decline in 13 years for Q4-2016, the 3/2 WSJ reported.

Hypermarkets & Super Centers (COST, WMT), which is expected to grow earnings by 5.0% over the next 12 months, sports a forward P/E of 20.8 (Fig. 7 and Fig. 8). Dollar stores and Target are in the Consumer Discretionary sector, but we thought we’d mention them anyway. They’re in the S&P 500 General Merchandise Stores industry (DG, DLTR, and TGT), which has already fallen 12.4% ytd. Analysts are calling for forward earnings in the industry to fall 1.4%, and the industry’s P/E has dropped to 14.6 from a recent high of 19.6 in 2015 (Fig. 9 and Fig. 10).

(5) Pricing pressures? As Walmart and Amazon race to offer Internet shoppers products with the lowest prices, their suppliers’ profits are at risk of being squeezed. Yet investors in the S&P 500 Consumer Staples Household Products index (CHD, CL, CLX, KMB, PG) don’t appear concerned. The industry has a forward P/E of 22.1, even though it’s expected to grow earnings by only 6.6% over the next year (Fig. 11 and Fig. 12).

Along the same lines, the S&P 500 Soft Drinks industry (DPS, KO, MNST, PEP) is projected to boost earnings by 4.8% over the next year, but it has a forward P/E of 22.8 (Fig. 13 and Fig. 14).

(6) Better prospects. There are some Consumer Staples industries that offer faster growth and lower multiples than the ones mentioned above. Not surprisingly, many of them don’t sell their products through Walmart or Amazon. Agricultural Products (ADM), for example, has a forward P/E below its earnings growth rate. The industry is expected to grow earnings by 16.6% over the next year and has a forward P/E of 14.6 (Fig. 15 and Fig. 16).

Similarly, the S&P 500 Brewers (TAP) is expected to grow earnings by 23.8% over the next 12 months because Molson Coors Brewing acquired SABMiller’s 58% stake in MillerCoors. The industry has a forward P/E of 14.2 (Fig. 17 and Fig. 18). As the deal is anniversaried, the industry’s earnings growth rate is expected to decelerate to 6.5% in 2018. Shares of Molson Coors fell 6.5% yesterday after the company said costs would rise this year and its EBITDA margin estimate disappointed investors, the FT reported.

Two other industries with lower valuations are Drug Retail and Tobacco. The S&P 500 Drug Retail index (CVX, WBA) peaked in 2015 and has fallen 25.0% since then (Fig. 19). When the shares were at their peak, the industry’s forward P/E was roughly 21. Today, its forward P/E has fallen to 13.6, and earnings growth has tumbled to 6.8%, down from double digits in years past (Fig. 20 and Fig. 21).

The best-performing Consumer Staples industry is Tobacco, up 22.5% ytd, followed by Distillers & Vintners (20.1%) and Personal Products (18.5) (Fig. 22). Tobacco companies have had strong results in the US because they’ve increased prices to more than offset declining volumes of cigarettes sold. “The number of cigarettes sold in the U.S. fell by 37% from 2001 to 2016, according to Euromonitor. Over the same period, though, companies raised prices, boosting cigarette revenue by 32%, to an estimated $93.4 billion last year. An average pack in the U.S. cost an estimated $6.42 in 2016, up from $3.73 in 2001, according to TMA, an industry trade group,” the 4/23 WSJ reported.

In addition, Tobacco stocks have been helped by M&A activity. There is speculation that Philip Morris International will buy Altria, and Reynolds American is in the midst of being acquired by British American Tobacco. Companies are also developing products that heat tobacco and release nicotine in a vapor. “Philip Morris says its internal studies have shown that by avoiding combustion, the product prevents or reduces the release of many harmful compounds. The company has asked the FDA for authorization to market IQOS as less harmful than cigarettes through a partnership here with Altria,” the WSJ article stated. Even though vaping products are not marketed to kids, kids are vaping, presumably drawn to the practice by fruity flavors and the desire to be like their friends. Hopefully, history isn’t about to repeat.

The S&P 500 Tobacco industry (MO, PM, RAI) is expected to boost earnings 9.4% over the next year, and its forward P/E has climbed to 23.0, the highest it has been over the past 22 years (Fig. 23 and Fig. 24).

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All-Consuming Questions

Jun 07, 2017 (Wednesday)

 

US Labor I: Help Wanted. Is the US economy running out of warm bodies to hire? The answer is no, yes, and maybe; it depends on the data series used to answer this question. Last week on Thursday, ADP reported that private-sector payrolls rose by 253,000 during May, averaging a solid monthly gain of 240,000 since the start of the year (Fig. 1). Then on Friday, the Bureau of Labor Statistics (BLS) reported that private-sector employment increased 147,000 during May, averaging just 161,000. Yesterday, the BLS JOLTS report showed that hirings less separations totaled 78,000 during April, with the monthly gain averaging only 150,500 since the start of the year.

Debbie and I are big fans of the ADP series since it is based on actual paychecks data. It also doesn’t get revised as much as the BLS payroll data. It suggests that companies are hiring at a rapid clip and are finding workers to keep up the impressive pace. However, one out of three isn’t a winning combination. The other two measures of employment clearly suggest that more help is wanted than there are helpers who want jobs, or have the skills that match the open positions. Consider the following:

(1) Job openings. As Debbie discusses below, job openings rose to a record 6.04 million during April (Fig. 2). The ratio of unemployed workers to job openings fell to 1.17, the lowest since January 2001! In other words, there’s a job out there somewhere for every jobless American wherever they might be. Of course, for various reasons, job seekers aren’t matching up with the available jobs.

The JOLTS job openings rate, which is job openings as a percent of the sum of employment plus job openings, is highly correlated with the percentage of small business owners reporting they have one or more job openings, both as 12-month moving averages (Fig. 3). The former has leveled out at a record high around 4.0% for the past two years. This series starts during December 2001. The small business series, which is compiled by the National Federation of Independent Business (NFIB), is available since December 1986. In May, it rose to 29.8%, the highest since July 2001.

Using the monthly NIFB data, we see that during May the percent of firms with one or more job openings rose to 34%, the highest since November 2000 (Fig. 4). This series is highly correlated with the percent of small business owners who say that there are few or no qualified candidates for their job openings. This percentage rose to 51% in May, which slightly exceeds the past two cyclical peaks.

(2) Hiring. According to the latest JOLTS report, total new hires fell sharply during April (Fig. 5). Given the abundance of job openings this drop is more likely to reflect the shortage of employable workers rather than a sudden weakening in the labor market. However, the monthly data are quite volatile. On a 12-month-sum basis, new hires have been very stable around 63.0 million since last summer, while separations have also stabilized around 60.5 million (Fig. 6).

This implies that the labor market is aligned to provide 2.5 million jobs at an annual rate, or a bit over 200,000 per month. It hasn’t been doing that recently, suggesting that past performance is no guarantee of future performance. In other words, if it is getting harder to find warm bodies, then lots of employers may have more unfilled openings.

US Labor II: The Wage Question Again. A shortage of employables could slow consumer spending and the economy. In the past, tight labor markets boosted wages, which sustained the growth of consumer incomes and spending, at least in nominal terms. The surprise this time is the subdued pace of wage inflation.

In the past, there was a strong correlation between the growth rate of average hourly earnings of production and nonsupervisory workers, on a y/y basis, and job openings (Fig. 7). There are lots of possible explanations that Melissa and I have discussed in the past. In fact, we did it again on Monday, when we examined the latest BLS employment report. In any event, the fact remains that wage inflation remains around 2.5%. It isn’t 3.0%-4.0%, as suggested by the past relationship between wages and measures of labor market tightness.

US Consumers: Driving Less. While we are worrying about consumers, let’s go for a drive with them. The good news is that over the past 12 months through March, vehicle miles traveled in the US rose to a record high of 3.18 trillion miles (Fig. 8). The bad news, at least possibly, is that gasoline usage has been falling since the week of October 28 based on the 52-week series for millions of barrels per day. In fact, this series is down 0.5% y/y, the lowest since mid-July 2013 (Fig. 9).

I’m hearing more chatter recently about a significant drop in foreign tourism so far this year. Many would-be tourists from abroad might have been turned off by Trump’s “America First” rhetoric. Spring and summer tend to be the months when foreign tourism is especially strong. Tourists tend to drive a lot to see the sites. So it’s possible that the recent drop in gasoline usage reflects the weak-tourism phenomenon rather than anything more worrisome about the US consumer.

A 5/25 USNews.com story reported: “A new study finds international tourism to the U.S. has dropped in the Donald Trump era. America's share of international tourism saw a 16 percent decline in March when compared to the same month last year, according a data analysis released on Wednesday by Foursquare, a technology company with a focus on location intelligence.

“The decline dates to October 2016, one month before the U.S. presidential election that pitted Republican President Donald Trump against Democratic challenger and former U.S. Secretary of State Hillary Clinton, according to the study. The decline has been steady with leisure tourism-related traffic to the U.S. falling an average of 11 percent between October and March, compared to the same period a year before.

“Conversely, Foursquare analysts found tourism in the rest of the world increased 6 percent year-over-year during that same period.”

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Chirping Canaries

Jun 06, 2017 (Tuesday)

 

US Economy: Thin Air. Since Election Day, there has been lots of chatter about “animal spirits.” The evidence of animated animal spirits has come mostly in the form of “soft data” based on surveys of consumers and businesses that showed remarkable jumps in confidence following the election. So far, the euphoria hasn’t trickled down to the US economy’s hard data, as most recently evidenced by May’s weaker-than-expected employment report released last Friday. May’s Consumer Optimism Index, which averages the Consumer Sentiment Index and Consumer Confidence Index, remained near its recent cyclical high during March (Fig. 1). So did April’s Small Business Optimism Index (Fig. 2).

Yet the Citigroup Economic Surprise Index (CESI) dropped to -40.9 on Friday (Fig. 3). That’s down sharply from a recent peak of 57.9 on March 15, and the lowest reading since February 18, 2016. That has helped to bring the US Treasury 10-year bond yield down from a recent high of 2.42% on May 9 to 2.18% yesterday (Fig. 4). The 13-week change in this yield tends to be highly correlated with the CESI (Fig. 5). The Treasury yield curve spread has narrowed from a recent high of 213bps to 124bps at the end of last week, the lowest since October 3 (Fig. 6).

Yet the S&P 500 continues to chalk up new record highs, rising to 2439.07 on Friday, already putting it comfortably within our yearend target range of 2400-2500! Yesterday, Joe and I chalked this accomplishment up to “Hannibal spirits,” which is the relentless drive to scale the Alps even with a herd of elephants. More specifically, we observed that money is pouring into ETFs at a record pace.

The biggest elephants in the stock market are the five FAANG stocks, which now account for 11.9% of the S&P 500’s market capitalization, up from 5.8% on April 26, 2013. Collectively, over this period, they’ve accounted for $1.6 trillion of the $6.9 trillion increase in the S&P 500! Their collective forward P/E is now 27.1 and 42.8 with and without Apple, respectively. The S&P 500’s forward P/E is 17.7 and 16.9 with and without the FAANGs. These elephants continue to sprint up mountains, leading the market’s bulls, even though the air is getting thinner.

Yesterday, we wrote that money coming out of actively managed equity mutual funds into passive equity ETFs might be more bullish for the largest-cap stocks, like the FAANGs, than for the rest of the market. One of our accounts told us that only makes sense if money is coming out of mutual funds that have underperformed because they’ve underweighted FAANGs. That’s certainly a possibility.

Global Economy: Fresh Air. Today, we would like to bring “sentinel animals” into our discussion of financial-markets zoology. They are used to detect risks to humans by providing warning of a danger. The classic example is canaries in a coal mine. While a few canaries in the US seem to be having trouble breathing, most of them continue to chirp without a care in the world. The ones in other parts of the world are especially chirpy. This might explain why the major stock indexes in the US and Europe are rising in record-high territory. Global economic growth seems to be improving, while inflation remains subdued. Central bankers may be looking for ways to unwind their ultra-easy monetary policy, but they are likely to do so very gradually. This is a very bullish scenario for stocks.

So far this year, that’s been especially so for the outperforming EMU MSCI and EM stock price indexes because their forward P/Es are lower than the one for the US MSCI (Fig. 7 and Fig. 8). Here is the performance derby ytd of the major MSCI stock price indexes in dollars through Friday: EMU (18.4%), Emerging Markets (17.7), All Country World (11.3), Japan (11.1), UK (10.1), and US (9.2). Now consider the following:

(1) Commodity prices. There’s no boom in our trusty CRB raw industrials spot price index, nor is there a bust. It has stalled in recent weeks, but remains 27% above its most recent cyclical low at the end of 2015.

(2) PMIs. As Debbie reviews below, the global composite PMI was 53.7 during May, remaining between 53.0 and 54.0 since October (Fig. 9). The M-PMI of the advanced economies has been especially steady at a robust level around 54.0 for the past six months. The same can be said for the NM-PMI of the advanced economies. Emerging economies have shown some weakness in recent months for the M-PMI, while the NM-PMI has been rising.

(3) Eurozone business. Eurozone M-PMIs were exceptionally strong last month, with the following readings: Germany (59.5), Eurozone (57.0), Spain (55.4), Italy (55.1), and France (53.8). So were the region’s NM-PMIs during May as follow: Spain (57.3), France (57.2), Eurozone (56.3), Germany (55.4), and Italy (55.1).

(4) World trade. Debbie and I believe that among the most reliable indicators of global economic activity are the ones based on merchandise trade data. The CPB Netherlands Bureau for Economic Policy compiles a monthly composite of the volume of world exports. Its growth rate on a y/y basis is highly correlated with the comparable growth rate in the sum of inflation-adjusted US exports plus imports (Fig. 10). The former was up 6.1% during March, the best performance since April 2011. The latter was up 4.4% during April, which was well ahead of the 2.0% decline recorded a year ago.

(5) Asian trade. Debbie and I closely monitor and compare the exports data coming out of Asia, in dollars and on a y/y basis. Many of the region’s economies have become highly integrated with one another. China, obviously, ties them all together given the size of its imports and exports. Among the most closely tied to China are South Korea, Taiwan, and Singapore. Their exports have been mostly on uptrends since early 2016 (Fig. 11). The same can be said about the exports of India, Indonesia, Malaysia, and Thailand (Fig. 12).

(6) Forward earnings. Confirming the global happy-canaries scenario is our analysis of forward earnings for the All Country-World ex-US MSCI stock price index in local currency (Fig. 13). It was mostly flat to down from mid-2011 through early 2016. It was gasping for air for sure, while forward earnings for the US MSCI continued to rise to new record highs before stalling during the second half of 2014 through 2016, as a result of the recession in the energy sector.

Since early 2016, both measures of forward earnings have been rising. The US is back in record territory, while the overseas measure is the highest since November 2008. It’s more or less the same story for the Developed Countries ex-US MSCI and the Emerging Markets MSCI, both in local currencies (Fig. 14 and Fig. 15).

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Hannibal Spirits

Jun 05, 2017 (Monday)

 

Strategy: Mountain Climbing. Hannibal, the Carthaginian general, was one of the greatest military strategists of all times. The city of Carthage in ancient Roman times was in the spot of modern-day Tunis, in Tunisia. Hannibal was so feared by the Romans that a common Latin expression to express anxiety about an impending calamity was “Hannibal ante portas!,” which means “Hannibal is at the gates!” He studied his opponents’ strengths and weaknesses, winning battles by playing to their weaknesses and to his strengths.

One of Hannibal’s most remembered achievements was marching an army that included war elephants over the Pyrenees and the Alps to invade Italy at the outbreak of the Second Punic War. He occupied much of Italy for 15 years but was unable to conquer Rome. A Roman general, Scipio Africanus, counter-attacked in North Africa, forcing Hannibal to return to Carthage, where he was decisively defeated by at the Battle of Zama. Scipio had studied Hannibal’s tactics and devised some of his own to defeat his nemesis.

So far, the current bull market has marched impressively forward despite 56 anxiety attacks, by my count. (See our S&P 500 Panic Attacks Since 2009.) They were false alarms. At the annual gathering of investment strategists and portfolio managers hosted by Gary Bahre last week, the other strategists were mostly concerned about the overvaluation of stock prices and believed that “something bad” always unexpectedly brings an end to bull markets. No one expects an imminent recession. One rather lame scenario offered by the bears was a massively disruptive cyberattack. Most of them have been bearish on stocks since the beginning of the bull market.

I remain bullish. However, when asked for my what-could-go-wrong scenario, I said that my long-held concern is that the bull market might end with a melt-up that sets the stage for a meltdown. Indeed, on March 7, I raised my subjective odds of a melt-up from 30% to 40%. I lowered the odds of a sustainable bull run from 60% to 40%. So I increased the odds of a meltdown from 10% to 20%. In my mind, a melt-up would set the stage for a meltdown. However, in this scenario, the meltdown might be a 10%-20% correction or a short bear-market plunge of 20%+, but it would not necessarily cause a recession. So the bull market could resume relatively quickly.

The latest valuation and flow-of-funds data certainly suggest that the melt-up scenario may be imminent, or actually underway. Consider the following:

(1) Valuation melt-up. The Buffett Ratio is back near its record high of 1.81 during Q1-2000 (Fig. 1). It is simply the US equity market capitalization excluding foreign issues divided by nominal GDP. It rose to 1.69 during Q4-2016. It is highly correlated with the ratio of the S&P 500 market cap to the aggregate revenues of the composite (Fig. 2). This alternative Buffett Ratio rose to 2.00 during Q1 of this year, matching the record high during Q4-1999. It is also highly correlated with the ratios of the S&P 500 to both forward revenues per share and forward earnings per share (Fig. 3 and Fig. 4). All these valuation measures are flashing red.

(2) ETF melt-up. The net fund flows into US equity ETFs certainly confirms that a melt-up might be underway. Over the past 12 months through April, a record $314.8 billion has poured into these funds (Fig. 5). That was led by funds that invest only in US equities, with net inflows of $236.4 billion, while US-based ETFs that invest in equities around the world attracted $78.4 billion in net new money over the 12 months through April.

Some of the money that went into equity ETFs came out of equity mutual funds (Fig. 6). Over the past 12 months through April, net outflows from all US-based equity mutual funds totaled $155.3 billion, with $163.7 billion coming out of US mutual funds that invest just in the US and $8.4 billion going into those that invest worldwide.

So the net inflows into all US-based equity mutual and indexed funds totaled $159.4 billion over the past 12 months, $72.7 billion going into domestic funds and $86.7 billion into global ones (Fig. 7). These totals don’t seem to be big enough to fuel a melt-up. However, the shift of funds from actively managed funds to passive index funds is significant and could be contributing to the melt-up. That’s especially likely since money is pouring into S&P 500 index funds, which are market-cap weighted. This certainly explains why big cap stocks, like the FAANGs, are outperforming.

(3) FAANG-led melt-up. Since the start of the year, the market-cap weighted S&P 500 is up 8.9%, while the equal weighted index is up 7.2% (Fig. 8). Joe calculates that the market cap of the FAANGs is up 41.4% y/y to a record $2.49 trillion, while the market cap of the S&P 500 is up 14.3% to $20.95 trillion over the same period (Fig. 9). In other words, the FAANGs account for 27.8% of the $2.6 trillion increase in the value of the S&P 500 over the past year.

US Economy: Warm Bodies. Is the US economy running out of warm bodies to employ? The unemployment rate is down to 4.3%. Job openings are at record highs. Payroll employment gains have slowed significantly over the past three months. Demographic trends may be exacerbating the situation.

The Baby Boomers are retiring. At the start of their careers, they mostly expected to work for one company over their entire careers. Of course, that was not the case for many of them, but they did mostly have a “careerist-materialist” attitude about their jobs and lives. The Millennials aren’t rushing into the labor force as did the Baby Boomers. More of them are going to college, especially the women among them. When they land a job, they aren’t as committed to keeping it for the rest of their careers. They may be willing to accept lower wages in exchange for more flexible (and less demanding) work. They have a more “lifestyles-minimalist” attitude. Melissa and I have been studying these trends. Let’s analyze the latest employment report with this perspective in mind:

(1) Earned Income Proxy. First, let’s not get too carried away by the weakness in May’s payrolls. They were up only 138,000, and the previous two months were revised down by 66,000 in total, as Debbie reports below. Private-sector payrolls are up only 126,300 per month on average from March through May. Yet over this same period, the ADP measure of private-sector payrolls is up 227,300 per month on average (Fig. 10).

Our Earned Income Proxy, which tracks private-sector wages and salaries in personal income, rose 0.3% m/m during May to a new record high (Fig. 11). It is up solidly by 4.3% y/y, auguring well for consumer spending.

(2) Labor force. Again, the actual data belie some of the concerns about a shortage of warm bodies to hire. The y/y growth of the labor force, based on the 12-month average, has exceeded 1.0% for the past 10 months (Fig. 12). That’s holding around its best performance since the fall of 2007. Workers are still dropping out of the labor force. However, the y/y growth of NILFs (i.e., the working-age population not in the labor force), based on the 12-month average, fell to 0.5% in May, the lowest since March 1998 (Fig. 13). The growth of NILFs who are 55 years old and older was 2.4% over the past 12 months, while younger NILFs fell 1.8% (Fig. 14).

The percent of the labor force with a college degree was a record 34.5% during May (Fig. 15). That’s up from 25.1% when the oldest Millennials (born in 1981) turned 18 years old during January 1999. This certainly implies that more young adults are going to college and adding to the number of NILFs while they are doing so.

(3) New normal. Despite the cyclical improvement in the growth of the labor force recently, the new normal in the labor market may be slower growth in both the labor force and employment, as low as 50,000 to 110,000 added per month. According to a FRB-SF paper from last October, such a pace would maintain a near-natural rate of unemployment around 5%, taking into account lower labor force participation rates resulting from retiring Baby Boomers over the next decade.

(4) Wages. Given that the job market appears to be so tight, the puzzle is that the pace of wage growth has remained so slow. Average hourly earnings for all employees on private nonfarm payrolls has risen just 2.5% y/y through May. It seems plausible that wages could be suppressed as retiring Baby Boomers with a lot of experience, and, thus higher salaries, are handing off the baton to younger less experienced workers. At the same time, job openings are at record highs. And small businesses, which make-up the lion’s share of the US economy in terms of jobs, are complaining that good employees are hard to find.

So employers are probably being forced to hire some employees that are not totally qualified, or just not that good. And employers might not be willing to pay those sorts of folks the big bucks. Thinking out loud, something else that could be at play is that Millennials who are entering the workforce now as the Baby Boomers retire might also not be demanding the big bucks. Some may prefer a more balanced lifestyle to a high-paying, high-stress job. Millennials and their inclination for minimalism and life experiences over “stuff” is a trend we have spotted and discussed previously.

In any event, employers are reporting that lots of low-wage workers today aren’t very loyal and don’t even show up, according to a 6/2 WSJ article. In it, the owner of a staffing agency was paraphrased as saying that “workers who skip out of jobs, whether to hang out with friends or care for family members, face little repercussion. With the unemployment rate so low, they can quickly find another low-wage job when they are ready to work.”

Nevertheless, the article observed that the “national tilt toward low-wage job growth now shows signs of shifting, which could lead to bigger increases in national pay raises.” During the past year, better-paying fields like health care and professional & business services have increased payrolls, while lower-wage retail payrolls have been cut. For example, payroll employment at all retail stores fell 80,100 over the past four months through May.

Movie. “Get Out” (+) (link) is not explicitly about the stock market. However, it is a movie worth watching as a cautionary tale. Sometimes, it is just so obvious that it’s time to go. For example, if you are meeting your girlfriend’s parents in their rural home for the first time, and you notice something odd about the maid and the caretaker…get out. Or, if her psychologist mom hypnotizes you involuntarily…get out. Or, if a bunch of old couples show up for a Sunday cocktail party to admire your physique…get out. We may be starting to see similar clues in the stock market. So why are we all still staying?

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United Tech, Divided Transports

Jun 01, 2017 (Thursday)

 

Technology Sector: FAANG Fans. Large, round numbers make for eye-catching headlines. They may not be as infamous as the New York Post’s “Headless Body in Topless Bar,” but as the bull market climbs ever higher, index milestones garner their fair share of attention. The fanfare continued in May as the S&P 500 broke through 2,400 for the first time.

The latest leg up in the market owes much to the FAANG stocks, including Amazon, which landed in the headlines because its stock price briefly crossed past $1,000 on Tuesday. That 10-Benjamins threshold brought into sharp focus the stock’s impressive 50,920% return since its IPO at a split-adjusted $1.96 on May 15, 1997. Amazon is the stock every investor would like to say they were smart enough to buy and hold through good times and bad.

Amazon’s ascendancy also reflects the enthusiasm that has returned to the S&P 500 Tech sector. Yes, we know that Amazon is officially in the Consumer Discretionary sector. However, it’s easily argued that the stock—with its focus on the Internet, software, and cloud services—looks, swims, and quacks more like a Tech stock.

The S&P 500 Tech sector index has risen 20.0% ytd through Tuesday’s close, far outpacing its fellow S&P 500 sectors: Consumer Discretionary (11.4), Health Care (9.6), Utilities (9.6), Consumer Staples (9.1), S&P 500 (7.8), Industrials (6.9), Materials (6.1), Real Estate (3.3), Financials (0.5), Telecom Services (-10.4), and Energy (-13.2) (Fig. 1).

The tech trade certainly isn’t undiscovered. “Funds tracked by Bank of America Corp. own the highest percentage of technology stocks on record compared to their benchmark. … And it’s giving active managers a boost they haven’t seen in more than two years,” a 5/30 Bloomberg article reported.

The article went on to say that 71% of active fund managers are now overweight the FAANG stocks. The returns of Facebook (up 27.6% y/y through Tuesday’s close), Amazon (39.9), Apple (53.1), Netflix (58.0), and Google (33.2) account for more than a quarter of the S&P 500’s 15.0% y/y return through Tuesday’s close.

But even the strong FAANG stock returns understate the enthusiasm that investors have had for the true go-go stocks in the Tech sector. Leading the pack are semiconductor stocks like Nvidia, up 215.6% over the past year, Micron Technology (149.4%), and Advanced Micro Devices (141.7), to name a few of the industry’s most impressive returns.

The stock of Autodesk, which develops software to create things, gained 90.7% over the past year. And straggling behind are the gaming software companies Electronic Arts and Activision Blizzard, which have posted 49.1% and 48.9% one-year gains.

The S&P 500 Tech sector (which, again, does not include amazing Amazon) sports a forward P/E of 18.5, slightly above the S&P 500’s forward P/E of 17.7 (Fig. 2). However, both the Tech sector and the S&P 500 are expected to have earnings growth of 11.2% on average over the next 12 months (Fig. 3). Nervous bulls might be glad to learn that the S&P 500 Tech sector’s share of the S&P 500’s market capitalization, at 23.1%, is only slightly above the sector’s share of the S&P 500’s earnings, 22.0%. At the peak of the 2000 bubble, the Tech sector’s market-cap share was 32.9%, and its contribution to S&P 500 earnings was only 15.4% (Fig. 4).

Transportation Industry: Taking Different Roads. The Dow Jones Industrial Average also found itself in the headlines last month as it crossed past 21,000 once again. The index reached its highest price of 21,115 on March 1, and it has edged down 0.4% since then. Dow Theory adherents undoubtedly were happy to see that on the same day, the Dow Transports hit a new high of 9,593, confirming the move in the DJIA. The Transports have also fallen back a bit—by 4.5%—since then (Fig. 5).

The new high in the Transports is impressive given the bifurcated performance of the industries in the index. While the airlines and rails have enjoyed stellar performances over the past year, the truckers and marine companies have dropped or simply underperformed, holding the index back. I asked Jackie to have a look at why the Transport industries are producing such different returns:

(1) Rails on fast track. In 2010, Warren Buffett made a $26 billion bet on the rails by buying Burlington Northern Santa Fe. So far, so good. The S&P 500 Railroads industry is one of the best-performing industries in the S&P 500, up 18.1% ytd and 48.4% over the past year (Fig. 6).

The industry has recovered nicely from sharp declines in coal shipments that ran from 2009 through last year (Fig. 7). With coal volumes bottoming and shipments of chemicals, plastics, and petroleum on the rise, overall rail shipments should start growing again. Excluding coal, railcar loadings have plateaued (Fig. 8).

Shares of CSX have been the best performer in the railroad industry, up 50.9% ytd and 108.4% y/y, as Hunter Harrison was brought in by an activist investor to be CEO. Harrison is known as a turnaround pro and has already instituted a plan to improve the railroad’s efficiency by idling 550 locomotives and 25,000 railcars, the 3/6 WSJ reported.

The S&P 500 Railroad industry is expected to post strong results this year. Revenue is expected to grow 5.6% in 2017, compared to the 7.1% decline last year. Likewise, this year’s earnings are expected to grow 13.6%, following last year’s 15.9% gain (Fig. 9). Analysts’ earnings expectations for the rails have been improving all year long (Fig.10). However, the industry’s valuation bears watching: While its forward P/E has come down from a record high of 20.2 during January to 18.0, the multiple remains higher than it has been going back to the mid-1990s (Fig. 11).

(2) Airlines flying high. Airlines should be wary of the turbulence that analysts are expecting this year and next. While revenues are expected to climb 4.7% over the next 12 months, earnings are expected to grow only 1.9% (Fig. 12).

But despite that tepid forecast, S&P 500 Airlines’ shares have gained 6.5% ytd, perhaps because earnings growth is expected to pick up next year to 15.5% (Fig. 13). Recently, American Airlines and United indicated that the supply of seats in the industry remains tight relative to the number of customers looking to book tickets. United Airlines, which recently found itself in the headlines after a customer was dragged off a plane, said it expects passenger revenue for each seat flown a mile to rise by 1%-3% y/y. Likewise, American Airlines predicted passenger revenue per seat would increase 3.5%-5.5%.

“The new forecasts signal increased confidence by American that it will post unit-revenue gains for a third straight quarter, after a 2015 discount war and excess capacity had forced ticket prices down for about two years. Higher average fares and lower estimated fuel prices led to the improved outlook, American said,” according to a 5/9 Bloomberg article.

(3) Truckers stopped. The trucking industry has hit a pothole. The S&P 500 Trucking index has risen only 1.4% y/y, and it has fallen 11.3% ytd (Fig. 14). Investors may be somewhat concerned that trucking volumes have plateaued at a high level over the past year after soaring from 2009 through 2015 (Fig. 15). Additionally, the declining price of used trucks is hurting the value of trucking companies’ assets, all while the long-running lack of drivers is forcing companies to increase wages.

A few years ago, when volumes were growing strongly, trucking companies went on a truck-buying spree. Large, long-haul trucking companies typically use a truck for three to five years and then trade it in before the warranty expires. Now, as they’re ready to trade in the trucks, overcapacity is causing the price of used trucks to decline, putting pressure on the overall value of the companies’ truck portfolios (Fig. 16).

“Over the past two years, the average retail price for a used Class 8 sleeper, the heavy-duty tractor used for long-haul routes, has plunged about 22% to about $49,000 in March, according to J.D. Power Valuation Services. That translates into a decrease of some $140 million across a fleet of 10,000 trucks,” the 5/12 WSJ reported. The number of new trucks sold never rose as high as it did in previous cycles, and truck sales may have bottomed out at a higher level as well.

Perhaps smelling opportunity, Swift Transportation and Knight Transportation announced in April plans to merge. At the time, both companies had similar market caps, however, Swift is the fifth largest trucking company by revenue, and Knight is the 22^nd largest, the 4/10 WSJ reported. Knight’s CEO will lead the merged company, as Knight is considered a better operator with better margins.

The trucking industry has also been increasing wages in an effort to ease a driver shortage. But it’s tough to see why someone would consider making truck driving a career if autonomous trucks are in the industry’s future. Tesla has said it plans to unveil in September an electric truck, which analysts believe will be at least partially autonomous, Bloomberg reported on 4/13. And they’re not alone. Starsky Robotics is a startup working on the problem, and Uber bought Otto last summer to get a jumpstart in the industry, according to a 3/30 FT article.

The S&P 500 Trucking industry is expected to grow revenues by 6.4% over the next 12 months, but earnings expectations have come down sharply over the past year, leaving growth estimates for the next 12 months at 3.0% (Fig. 17 and Fig. 18). Despite the below-market earnings growth, the industry’s forward P/E, at 17.7, remains near the highs of this cycle, and not far from the S&P 500’s multiple (Fig. 19).

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