Expectations have changed, but expectations are not always met. Even if expectations are met, some have rapid feedback loops and some have slow feedback loops. The economic sphere is mostly slow, but sentiment does impact near term business decisions. The financial sphere has rapid feedback loops which explains the rapid movements of the markets since the elections.
Tipping Points and Targets
The global central banks had already reached a tipping point this summer determining ever-lower interest rates were having the opposite effect than planned. They started walking back expectations of ever-lower interest rates hoping to find a way to keep the bond markets from blowing up. Then came Trump.
Inflation expectations were also already hitting the Fed’s targets. As pointed out previously in Inflation, COLAs and the Economy, higher inflation was already baked into the inflation formulas. The Fed’s arbitrary 2% inflation target was going to be exceeded without much effort. The Fed knew it and started talking about running a “high pressure” economy which is a politically correct way of saying “financial repression”- letting inflation run higher than interest rates.
Trumped
While Hillary said “me too” on infrastructure spending, she rarely mentioned it. Trump made it one of the main themes of his campaign. When he was elected, inflation expectations surged based on his large fiscal stimulus plans and Republican control of both chambers. Interest rates surged on expectations of higher inflation and higher government borrowing. The interest rate sensitive financial sector stock prices surged. The industrial stocks surged on expectations the industrial recession would be coming to an end.
The small cap indexes and the Dow Jones Industrial Averages have a higher weighting of financial and industrial stocks. These indexes outperformed the SP500 post-election and will probably continue to during this rally. The large cap companies in the SP500 have significant overseas earnings exposure and this will weigh on these companies while the dollar surges.
Buybacks and Tax Cuts
The weakness in the stock market the last two years corresponds to the slowing of corporate buy-backs. The 2nd quarter of 2016 saw the lowest level of buybacks. Corporations have hit debt limits that will not allow them to take on new debt to waste on buybacks. Twenty-five percent of the SP500 companies doing buybacks in the 2nd Quarter spent more on buybacks than they had earnings.
One of the rapid feedback loops in expectations is the belief that Trump will push the Republican plan for a tax holiday on corporate savings from overseas operations. The last time they got a tax holiday most of the repatriate funds went to stock buybacks and very little to investing in future economic production or job creation.
During the post-election surge, the companies engaged in buybacks significantly outperformed the broader index. This is one expectation that may fall short next year but the effect has already been priced in.
Corporate tax cuts could come into effect in 2017 and this would lead to a one-time jump in reported earnings-per-share without any growth in the economy. This expectation is partially being priced in today, but what is missing from the analysis is the plan also eliminates many deductions. It is all a numbers game and I do not like to value stocks based on manufactured earnings statements or forward guessing. But those who use financially engineered earnings-per-share are buying it.
The Economy
After the financial crisis we have slowly replaced high paying manufacturing jobs with low paying service jobs or part-time employment. While the unemployment rate looks good, there is plenty of room for bringing back higher paying jobs but this is a slow process and any fiscal stimulus if properly used will not be seen until 2018. The way our tax code is set up, low wage earners pay little in federal income tax. When we lost the high paying jobs we lost tax revenue.
Meanwhile three of the main drivers for economic growth have already plateaued. Auto sales plateaued in 2015 at the same ceiling seen before the financial crisis and will add little if any growth going forward. With mortgage rates climbing one would expect another decline in home prices or slowing in the housing market or both. The oil shale industry is mostly built out and again plateaued in terms of job creation.
Global trade has been in steep decline. Trump should accelerate the decline over the next few years based simply on being himself. Emerging markets are under severe stress again. Europe is holding up, but they are on economic life support with significant central bank interventions. There are few global economic drivers. The most profitable US company – Apple – is rapidly losing market share in China which provided much of its recent growth. It will take a lot to replace those SP500 earnings.
Fiscal stimulus will be good for the economy, but its effects will not be seen for some time. In the meanwhile, the economy faces many headwinds: higher interest rates, higher dollar, slowing global trade to name a few. The economy has been at stall speed the last couple of years and it will need all the stimulus it can get just to maintain slow growth and not dip into recession.
Only fiscal stimulus paid for from money created out of thin air will lead to significant economic growth. But my guess Trump’s grand plans will come from cuts to spending in other areas that will offset growth and may actually slow the economy. The Republicans remain fiscally conservative and while they had no problem with QE for bailing out balance sheets, they are not inclined to vote for large spending packages without offsetting cuts. As for deficit spending, we are already there and merely maintaining flat growth.
At least Reagan started with painfully high tax rates (70% on high earners) to cut, high unemployment and bear market valuations. In 1980 interest rates were over 10% and the Shiller Price-to-Earnings ratio was only 6.5. Today the Shiller PE is 24.5 and interest rates in the US are coming off historical lows with rising inflation expectations. To put that into perspective, the SP500 index would have to drop 70% to equal the market’s valuation levels when Reagan took office.
After Reagan was elected the stock market initially traded higher but then sold off into a recession as earnings dropped and the Fed was forced to hike interest rates due to wage-push inflation. It took time for the deficit spending and lower taxes to have an effect. But again, Reagan was starting at the end of a secular bear market. Trump is starting at the end of a secular bull market. Today, neither high taxes nor high interest rates are the economic constraint they were in 1980. On the contrary, rising interest rates may become the constraint.
The Tug-of-War
While the Federal Reserve stopped any new QE programs in late 2014 – the same time the SP500 started trading sideways – the rest of the world’s central banks increased their free money creation game and interest rate manipulation. Most of the money creation found its way into the financial markets detaching financial asset prices from underlying fundamentals. Today, this global money creation out-of-thin-air is still finding its way into the US financial markets. As global financial stress increases money flows from the risky and periphery to the core – the US financial system – causing a possible melt-up at the core.
With interest rates rising and bond prices falling, the only game left has been the US stock market. My view is we are seeing a final melt-up in the US stock market that often occurs at the end of a bubble. Except this time, we are near the end of an epic global credit bubble like no other. The central banks are not going to roll over and allow the markets to return to free market price discovery. This would lead to another financial crisis. The tug-of-war continues but the forces are getting stronger requiring ever larger monetary interventions to just hold ground.
What’s Changed?
Expectations. Trump is not even in office yet. Expectations may change by then. I am trading the melt-up but I am under no illusions that we are starting a new bull market. We are still in the process of ending a secular bull market.
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Categories: Perspectives, The Smart Bird