Wednesday, April 19, 2017

Driving in the Slow Lane

Following the latest reports on housing starts (down 6.8% m/m during March) and manufacturing output (down 0.4% last month), the Atlanta Fed’s GDPNow model showed an increase of just 0.5% (saar) in Q1’s real GDP. As I noted recently, the auto industry is a major soft patch in the economy. Sure enough, auto output fell 3.6% during March. Auto assemblies are down 7.3% over the past five months to 11.1 million units (saar) from last year’s peak of 12.0mu. The weather can be blamed for the drop in housing starts, but not for the weakness in auto sales and production.

There are other soft patches in the economy. For example, the ATA Truck Tonnage Index dipped 1.0% m/m in March, and is up by only 0.7% y/y. In other words, it has stalled at a record high over the past year. Sales of medium-weight and heavy trucks dropped 8.0% m/m in March and 19.0% y/y.

So it comes as no surprise that the Citigroup Economic Surprise Index (CESI) has plunged from a recent high of 57.9 on March 15 to 6.6 on Tuesday. These developments are likely to put pressure on the Fed to hold off on another rate hike for now, and on the Trump administration to move forward with its fiscal stimulus agenda. Treasury Security Steve Mnuchin said on Monday that tax reform might not happen until after the summer. I think the weakness in the economy will prompt a faster response by Washington.

By the way, there is a reasonably good fit between the CESI and the 13-week change in the US Treasury 10-year bond yield. The actual yield has dropped from a recent peak of 2.62% on March 13 to 2.17% yesterday. It seems to be heading toward the bottom end of my predicted trading range of 2.00%-2.50% for the first half of this year.

Wednesday, April 12, 2017

Back to Slower, Longer Economic Growth?

In my meetings with some of our accounts recently, many were skeptical that the strength in the soft data in the US will trickle down to the hard data until the Trump administration actually succeeds in cutting taxes and in boosting infrastructure spending. The soft data consist mostly of surveys of consumers, CEOs, purchasing managers, small business owners, industry analysts, and investors. They all turned remarkably upbeat after Election Day, as I have been monitoring in our new Animal Spirits chart publication.

On the other hand, a few hard-data indicators are downright downbeat. Auto sales totaled 16.6 million units (saar) during March, down from a recent high of 18.4 million units at the end of last year. Payrolls in general merchandise stores have dropped 89,300 over the past five months through March as a result of widespread store closings due to competition from Amazon. Then again, employment in construction, manufacturing, and natural resources rose 175,000 during the first three months of this year. The sum of commercial and industrial bank loans and nonfinancial commercial paper has been flat since the start of the year.

A bigger question is whether there has been a structural decline in the potential growth of the economy that may defy both the animal spirits that seem to have been unleashed by Trump’s election as well as his “Make America Great Again” (MAGA) fiscal policies, assuming they get fully implemented. If so, then the long-term trend of growth for both the real economy and corporate earnings may be lower than in the past. The good news in this scenario is that it might mean that a boom is less likely, which obviously would reduce the risk of a bust.

While much has changed since Election Day, some things have not. Demography hasn’t changed. Neither has technology. Globalization might change, but for now the world remains very competitive as a result of relatively free (though not necessarily fair) trade. Productivity growth remains abysmal, and might improve as a result of MAGA policies, or might not. Consider the following:

(1) Potential output. The Congressional Budget Office (CBO) calculates a quarterly series for potential real GDP growth that starts in 1952 and is available through 2027. The outlook for this year and beyond is based on demographic projections used to estimate labor force growth and assumptions about productivity. From 1952 through 2001, potential real GDP grew in a range mostly between 2.5% and 4.0%, averaging 3.5%. Since then, growth has consistently been below 3.0%, and actually below 2.0% since Q1-2007.

(2) Real GDP. I constructed a series for the underlying growth in real GDP simply as the 40-quarter percent change in real GDP annualized. It tells more or less the same story as the CBO’s estimate for potential output. From 1960 through 1975, growth averaged 4.7%. From 1975 through 2007, it averaged 3.7%. It plunged during the Great Recession, and has remained consistently below 2.0% since Q3-2009.

(3) Labor force. Trump may or may not succeed with his MAGA plans. However, he certainly can’t Make America Young Again (MAYA). He can’t bring back the Baby Boom. There has been a dramatic slowing in the growth of the working-age population and the labor force, particularly of the 16- to 64-year-olds. The actual growth rates of this age segment of the working-age population and the labor force are down to only 0.5% and 0.3% over the past 10 years at annual rates.

(4) Productivity. The big unknown is whether Trump’s MAGA policies can revive productivity growth. That’s the only way that real GDP growth might finally exceed 2.0%. Getting it up to Trump’s 4.0% goal seems very unlikely. Nonfarm productivity growth has been below 1.0% since Q4-2014, based on the five-year percent change at an annual rate. Surprisingly, manufacturing has contributed greatly to this weakness, also rising less than 1.0% since Q4-2015.

Wednesday, April 5, 2017

Bull by the Tail

Stock market valuation measures are elevated across the board, for sure. The forward P/E of the S&P 500 is currently 17.7. It is highly correlated with the forward price-to-sales ratio (P/S) of the same stock market index. This valuation metric closely tracks the Buffett Ratio, which is equal to the market capitalization of the entire US equity market (excluding foreign issues) divided by nominal GNP. During Q4-2016, the Buffett Ratio was 1.67, not far below the record high of 1.80 during Q3-2000. The forward P/S rose from 1.58 in early 2016 to a record high of 1.93 in March.

These all are nose-bleed levels. However, they may be justified if Trump proceeds with deregulation and succeeds in implementing tax cuts. His policies may or may not do much to boost GDP growth and S&P 500 sales (a.k.a. revenues). Nevertheless, they could certainly boost earnings.

The risk is that Trump’s victory activated a melt-up mechanism that has nothing to do with sensible assessments of the fundamentals or valuation. Instead, structural market flows may be driving the market’s animal spirits. Consider the following:

(1) Lots of corporate cash is still buying equites. At the end of last week, we updated our chart publications with Q4-2016 data for S&P 500 buybacks. They remained very high at a $541 billion annualized rate. For all of last year, buybacks totaled $536 billion, a slight decline from the previous year’s cyclical high of $572 billion. S&P 500 dividends rose to a record high of $396 billion last year. Since the start of the bull market during Q1-2009 through the end of last year, buybacks totaled $3.4 trillion, while dividends added up to $2.4 trillion. Combined, they pumped $5.7 trillion into the bull market, driving stock prices higher without much, if any, help from households, mutual funds, institutional investors, or foreign investors.

(2) Passive is the new active. On the other hand, equity ETFs have been increasingly consistent net buyers of equities during the current bull market. Their net inflows totaled a record $281 billion over the past 12 months through February. Since the start of the bull market during March 2009, their cumulative net inflows equaled $1,167 billion, well exceeding the $179 billion trickle into equity mutual funds.

So there you have it: The bull may be chasing its own tail. I know that image doesn’t quite jibe with the bull charging ahead, but work with me here. The bull has been on steroids from share buybacks by corporate managers, who have been motivated by somewhat different and more bullish valuation parameters than those that motivate institutional investors, as we have discussed many times before. Most individual investors seemingly swore that they would never return to the stock market after it crashed in 2008 and early 2009. But time heals all wounds, and suddenly some of them may have turned belatedly bullish on stocks after Election Day. Add a buying panic of equity ETFs by individual investors to corporations’ consistent buying of their own shares, and the result may very well be a melt-up.

Wednesday, March 29, 2017

Many Happy S&P 500 Revenues

The global economy fell into a growth recession from mid-2014 through early 2016. It was caused by a severe recession in the global commodities sector, led by a collapse in oil prices. It was widely expected that the negative consequences of lower oil prices for producers would be more than offset by the positive ones for consumers. That was not the case. The former outweighed the latter because the commodity-related cuts in capital spending overshadowed the boost to consumer spending from lower oil prices. In addition, there was a brief credit crunch in the high-yield market on fears that commodity producers would default on their bonds and trigger a widespread financial contagion.

Now the worst is over for commodity producers, as their prices have rebounded. That’s because they scrambled to reduce output and restructure their operations to be more profitable at lower prices. More importantly, global demand for commodities remained solid. Now with commodity prices, especially oil prices, well below their 2014 highs, consumers are benefitting more than producers are suffering.

Voila! The global economy is showing more signs of improving in recent months. That’s already boosting revenues growth for the S&P 500, and should be increasingly obvious as corporations report their top-line growth rates for the Q1 earnings season during April. Let’s have a closer look:

(1) Commodity prices. The CRB raw industrials spot price index fell 27% from April 24, 2014 through November 23, 2015. The index is up 28% from the low. The price of a barrel of Brent crude oil plunged 76% from its 2014 high of $115.06 on June 19 to its 2016 low of $27.88 on January 20. It is up 84% from its low to $51.28 yesterday.

(2) Business sales. US manufacturers’ shipments of petroleum products plunged 58% from the end of 2013 through February 2016. That drop weighed heavily on US manufacturing and trade sales, which declined on a y/y basis each month from January 2015 through July 2016. Excluding petroleum shipments, this broad measure of business sales of goods barely grew during this energy recession.

(3) S&P 500 revenues. I am not surprised to see S&P 500 revenues tracing out the same pattern as business sales since I have been tracking the close relationship of the two for some time. The y/y growth rates of business sales and S&P 500 revenues (either on an aggregate or per-share basis) continue to be very close. The same goes for the relationship excluding Energy revenues from the S&P 500 aggregate and business sales excluding petroleum shipments.

I continue to monitor analysts’ expectations for the short-term (year-ahead) growth rates of S&P 500 revenues and earnings (STRG and STEG), as well as long-term (five-year-ahead) earnings growth (LTEG) on a weekly basis. STRG has rebounded from close to zero in early 2015 to about 5.5% currently. Since the start of last year, STEG has jumped from about 5% to over 10%. LTEG is around 12.3%, near the best reading of the current economic expansion.

I doubt that any of these improvements have much to do with Trump’s election victory. I have no doubts that the end of the global Energy sector’s recession accounts for much of the improvement.

(4) Business surveys. Another upbeat indicator for S&P 500 revenues is the M-PMI, which has a good correlation with the y/y growth rate in S&P 500 revenues (both in aggregate and per-share). The former jumped from a recent low of 49.4 during August 2016 to 57.7 during February, the best level since August 2014. That too is consistent with a manufacturing recovery following the end of the energy recession, and augurs well for revenues growth.

By the way, there is a similarly good correlation between revenues growth and the composite business indicators from the regional surveys conducted by five Fed districts. All five are available through March, with their average index jumping from last year’s low of -12.8 to 21.6 this month. The energy recession is clearly over.

Wednesday, March 22, 2017

Age-Old Adages for the Bull Market

There are plenty of age-old adages about the stock market that focus on the Fed’s impact on the market. They tend to be cautionary and are recited by old timers who’ve lived through some wicked bear markets and fearsome corrections. The basic message is that the Fed is your friend until it isn’t. Consider the following:

(1) Zweig. Martin Zweig was a highly respected analyst and investor who passed away in 2013. He famously often said “Don’t fight the Fed.” He started his newsletter in 1971 and his hedge fund in 1984. On Friday, October 16, 1987, in a memorable appearance on Wall Street Week with Louis Rukeyser, he warned of an imminent stock market crash. It happened the following Monday, and Zweig became an investment rock star. His newsletter, The Zweig Forecast, had a stellar track record, according to Mark Hulbert, who tracks such things.

In his 1986 book Winning on Wall Street, Zweig elaborated on his famous saying: “Monetary conditions exert an enormous influence on stock prices. Indeed, the monetary climate—primarily the trend in interest rates and Federal Reserve policy—is the dominant factor in determining the stock market’s major direction. … Generally, a rising trend in rates is bearish for stocks; a falling trend is bullish.” There are two reasons for this, he wrote: “First, falling interest rates reduce the competition on stocks from other investments, especially short-term instruments such as Treasury bills, certificates of deposit, or money market funds. … Second, when interest rates fall, it costs corporations less to borrow. … As expenses fall, profits rise. … So, as interest rates drop, investors tend to bid prices higher, partly on the expectation of better earnings. The opposite effect occurs when interest rates rise.”

(2) Martin. In 1949, President Harry Truman appointed Scott Paper CEO Thomas McCabe to run the Fed. McCabe pushed to regain the Fed’s power over monetary policy and did so with the Fed-Treasury Accord of 1951. He negotiated the deal with Assistant Treasury Secretary William McChesney Martin. McCabe returned to Scott Paper and Martin took over as chairman of a re-empowered Federal Reserve on April 2, 1951, serving in that position until January 31, 1970 under five presidents. The March 1951 Accord freed the Fed and marked the start of the modern Federal Reserve System. Under Martin, the Fed’s overriding goals became price and macroeconomic stability. He believed that the Fed’s job was to be a party pooper. His famous “punch bowl” metaphor seems to trace back to a speech given on October 19, 1955 in which he said:

“In the field of monetary and credit policy, precautionary action to prevent inflationary excesses is bound to have some onerous effects—if it did not it would be ineffective and futile. Those who have the task of making such policy don’t expect you to applaud. The Federal Reserve, as one writer put it, after the recent increase in the discount rate, is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.”

(3) Gould. According to the Market Technicians Association, the late technical analysis pioneer Edson Gould, who was active from the 1930s through the 1970s, observed that “whenever the Federal Reserve raises either the federal funds target rate, margin requirements, or reserve requirements three times without a decline, the stock market is likely to suffer a substantial, perhaps serious, setback.” This adage is widely known as “three steps and a stumble.” So far, investors are betting against it since stocks actually rose sharply last Wednesday after the Fed hiked the federal funds rate for the third time since the Great Recession.

What do the data show about the relationship between the Fed’s monetary policy cycle and the S&P 500? Monthly data for the index show that it tends to bottom during the beginning of easing phases of monetary policy, when the Fed is lowering the federal funds rate. It tends to continue rising through the end of the easing phases and even when the Fed starts raising interest rates. Three rate hikes may cause occasional stumbles, but it’s hard to see them in the data.

What does stand out is that the tightening phase of monetary policy often ends in tears because it tends to trigger financial crises. Forward P/Es have a tendency to peak before the crises hit as investors begin to fret that higher interest rates may be starting to stress the economy.