The Fed, the Dollar, and Deflation (excerpt)

The woes of emerging economies could temper the Fed’s tapering in coming months by strengthening the dollar, which could push US inflation closer to zero. The JP Morgan Trade-Weighted Dollar Index has been trending higher since mid-2011. A strong dollar tends to depress inflation.

Indeed, the US import price index excluding petroleum has been falling over the past 10 months on a y/y basis through December, when it was down 1.3%. A stronger dollar would be bad news for commodity producers, especially in the emerging economies. When the dollar is rising, commodity prices tend to fall. Weak commodity prices have depressed the currencies of commodity-producers Canada and Australia over the past year.

The latest FOMC statement noted that near-zero inflation could be a problem for the US economy: “The Committee recognizes that inflation persistently below its 2 percent objective could pose risks to economic performance, and it is monitoring inflation developments carefully for evidence that inflation will move back toward its objective over the medium term.”

The emerging markets crisis, strength in the dollar, and weakness in commodity prices could frustrate the Fed’s expectations that inflation will rise back closer to 2%.

Today's Morning Briefing: The Fed & Emerging Economies. (1) Fed to EMs: “We wish you well.” (2) “Your problems are not our problem.” (3) A sanguine assessment. (4) Turkey and India act. (5) A scenario for tempering tapering. (6) EM crisis could boost dollar and depress US inflation. (7) US import prices deflating. (8) Weak stocks: Just a correction, or something worse? (9) From P/E-led to E-led bull market. (10) Both Cyclical and Defensive sectors hard hit ytd. (More for subscribers.)

Jobs Boosting Consumer Confidence (excerpt)

The Conference Board’s survey of consumer confidence does a good job of picking up trends in the jobs market. I particularly like to monitor the “jobs plentiful” response rate. It rose to 12.7% in January, the highest since August 2008. The “jobs are hard to get” response fell to 32.6%, the lowest since September 2008. The difference between the two is highly correlated with the “present situation” component of the Consumer Confidence Index, which rose to a new cyclical high in January.

We all know that the drop in the unemployment rate since 2010 has been partly attributable to a decline in the labor force participation rate. Nevertheless, the unemployment rate remains very highly correlated with the “jobs hard to get” response. The latter suggests that that jobless rate continued to fall in January from December’s 6.7% reading.

Today's Morning Briefing: State of the Union. (1) The state of emerging economies is not so good, but the crisis may be abating. (2) The state of the US economy is quite good. (3) The US carries a lot of weight. (4) Employment indicators are upbeat. (5) Jobs more plentiful. (6) Regional and small business surveys show hiring and job openings. (7) Factset survey shows no increase in capital spending. (8) R&D and software may be reducing need to expand physical capacity. (9) Orders for both industrial and metalworking machinery at record highs. (10) Focus on overweight-rated S&P 500 IT sector. (More for subscribers.)

History Lessons on the S&P 500 (excerpt)

The current emerging markets crisis didn’t just start last week. It’s been going on for a while, and should come as no surprise to investors. Argentina’s peso has plunged 18.9% y/y. South Africa’s rand is down 5.7%. Turkey’s currency has been a turkey since 2008. The following have been running trade deficits for the past year or longer (with the latest 12-month deficits in parentheses): India ($155 billion), Indonesia ($6 billion), Philippines ($8 billion), Turkey ($97 billion), and Ukraine ($14 billion).

During the emerging markets crisis of 1997, the S&P 500 rose 31.0% that year with only one brief correction amounting to 9.6% early that year. There was a more significant correction of 19.3% in 1998 after the Russian ruble crisis and mostly in reaction to the collapse of LTCM. Yet the S&P 500 rose 26.7% that year.

History doesn’t repeat itself, but it does rhyme. The notion that an emerging markets crisis is bearish for the US stock market isn’t confirmed by the experience of 1997. Recessions are bearish for stocks. So far, it’s hard to see how the current emerging markets crisis triggers a recession in the US.

Besides, aren’t great years like 2013, when the S&P 500 is up over 20%, bullish for the following year? History doesn’t confirm this notion either. During the 86 years since 1928, there have been 21 years when the S&P 500 rose by 20% or more. Excluding last year, the 20 were followed by 13 up years (averaging gains of 17.2%) and seven down years (averaging losses of 13.6%).

Today's Morning Briefing: Crises Now & Then. (1) 1929 and now. (2) So far, so good. (3) The previous emerging markets crisis wasn’t bearish for S&P 500. (4) Thailand in 1997 and Argentina now. (5) Emerging market crisis didn’t start last week. (6) No default allowed in China. (7) Disappointing earnings season. (8) Real GDP vs. GDP deflator. (9) Focus on market-weight-rated S&P 500 housing-related stocks. (More for subscribers.)

Year of the Charley Horse (excerpt)

The Chinese Lunar New Year starts on January 31. It is the Year of the Horse. For investors suffering in Chinese stocks, the pain makes it feel more like the Year of the Charley Horse. Many are wondering if this will be the year that China’s debt bubble bursts?

It’s hard to believe that global financial markets were roiled late last week by the release of the latest HSBC Flash China M-PMI on Thursday morning. The report showed that the overall index dropped from 50.5 in December to 49.6 in January, a six-month low. The output component edged down from 51.4 to 51.3, but that's above 50. At the same time, Markit reported that the Eurozone’s flash M-PMI jumped to 53.9 during January, the highest reading since June 2011. Furthermore, the US flash M-PMI remained solidly above 50 at 53.7, though that was down from December’s 55.0.

The outsized reaction to China’s weaker M-PMI reflects mounting concerns that decelerating growth in the country could lead to a financial crisis, which could then slam the brakes on growth. China’s forward profit margin is among the lowest in the world. I have data on it starting in 2004. It was 4.0% at its most recent cyclical peak during September 2009. In mid-January of this year, it was down to 3.5%. Slowing growth with such a low margin could squeeze corporate borrowers' ability to service their debts, creating problems for their lenders. That’s especially true for those companies that are borrowing from the shadow banking system.

On Friday, January 17, Chinese state media reported that China Credit Trust Co. warned investors that they may not be repaid when one of its wealth management products (WMP) matures on January 31, the first day of the Year of the Horse. The Industrial and Commercial Bank of China, the world’s largest bank by assets, sold the investment to its customers, and warned that it will not compensate investors for their losses.

The trust company loaned the proceeds of almost half a billion dollars to a coal company, which must have been charged more than 10% since that was the annual return promised to investors. There has never been a default of a WMP. Until now, perhaps. On Friday, Bloomberg reported that the China Banking Regulatory Commission ordered its regional offices to increase scrutiny of credit risks in the coal-mining industry and to closely monitor risks from WMPs, which are estimated to total $1.7 trillion.

Today's Morning Briefing: Something To Fear? (1) Nothing to fear but emerging economies and deflation. (2) Brewing since last spring. (3) More downside risk to the upside scenario. (4) Some EMs were up last week. (5) From most to least overbought sectors. (6) Finding support. (7) A cap on valuations. (8) Four challenges for EMs. (9) China’s Charley Horse. (10) China’s WMPs set to implode? (11) What will the Fed do? (12) “The Invisible Woman” (+). (More for subscribers.)

Fed Officials on Risk of Bubble in Emerging Economies

Could it be that the Fed’s ultra-easy monetary policy has already inflated yet another speculative bubble that is about to burst, or at least lose lots of air very quickly? If so, the obvious candidate is emerging economies, which borrowed lots of money (often in dollars) in recent years. They were able easily to attract foreign buyers, who were “reaching for yield” because interest rates were so low in the bond markets of the US, Europe, and Japan. The capital inflows boosted their currencies. That may have started to reverse during the spring and summer of 2013, when Fed officials began to talk about tapering QE, which boosted bond yields in the US and around the world, especially in the emerging economies.

If this bubble is about to burst, then once again Fed officials didn’t see it coming. They’ve been aware of the possibility, but minimized its likelihood. Obviously, they once again are failing to learn from history, which shows that easy credit conditions always lead to speculative bubbles that inevitably burst. Let’s review what Fed officials said (or did not say) on this subject:

1) FRB Vice Chair Janet Yellen. On April 16, 2013, Fed Vice Chair Janet Yellen spoke at a conference on monetary policy sponsored by the IMF. In her remarks, she briefly speculated about speculation, but concluded that there is nothing to worry about:

Some have asked whether the extraordinary accommodation being provided in response to the financial crisis may itself tend to generate new financial stability risks. This is a very important question. To put it in context, let’s remember that the Federal Reserve’s policies are intended to promote a return to prudent risk-taking, reflecting a normalization of credit markets that is essential to a healthy economy. Obviously, risk-taking can go too far. Low interest rates may induce investors to take on too much leverage and reach too aggressively for yield. I don’t see pervasive evidence of rapid credit growth, a marked buildup in leverage, or significant asset bubbles that would threaten financial stability. But there are signs that some parties are reaching for yield, and the Federal Reserve continues to carefully monitor this situation.

On March 4, in a speech titled, “Challenges Confronting Monetary Policy,” Yellen said that the Fed is watching out for risks in the financial system and that so far there is nothing to worry about:

At this stage, there are some signs that investors are reaching for yield, but I do not now see pervasive evidence of trends such as rapid credit growth, a marked buildup in leverage, or significant asset bubbles that would clearly threaten financial stability. That said, such trends need to be carefully monitored and addressed, and the Federal Reserve has invested considerable resources to establish new surveillance programs to assess risks in the financial system. In the aftermath of the crisis, regulators here and around the world are also implementing. a broad range of reforms to mitigate systemic risk. With respect to the large financial institutions that it supervises, the Federal Reserve is using a variety of supervisory tools to assess their exposure to, and proper management of, interest rate risk.

On January 4, 2013, Yellen spoke at a joint lunch of the American Economic Association / American Finance Association in San Diego. The word “risk” appears 82 times in her speech titled, “Interconnectedness and Systemic Risk: Lessons from the Financial Crisis and Policy Implications.” Her presentation was a general overview, without getting into any specifics. The risk of a bubble in emerging economies was not mentioned.

2) FRB Governor Jeremy Stein. In her March 4 speech, Yellen noted in a footnote that her colleague, Governor Jeremy Stein, had given a speech on February 7, 2013 in which he “discussed several areas in which a noticeable increase in risk-taking behavior has emerged.” He did not mention emerging economies. Rather, he focused on risks in the corporate bond market, but was reassuringly unconcerned about the potential adverse consequences for the financial system:

Putting it all together, my reading of the evidence is that we are seeing a fairly significant pattern of reaching-for-yield behavior emerging in corporate credit. However, even if this conjecture is correct, and even if it does not bode well for the expected returns to junk bond and leveraged-loan investors, it need not follow that this risk-taking has ominous systemic implications. That is, even if at some point junk bond investors suffer losses, without spillovers to other parts of the system, these losses may be confined and therefore less of a policy concern.

3) Fed Chairman Ben Bernanke. In his press conference on September 18, 2013, Fed Chairman Ben Bernanke was asked for his reaction to charges coming out of emerging economies that the Fed’s policies have been causing them financial distress. His initial response was that “we’re watching that very carefully.” Then, he went on to defend the Fed’s policies as good for everyone:

The main point, I guess, I would end with, though, is that what we’re trying to do with our monetary policy here is, I think, my colleagues in the emerging markets recognize, is trying to create a stronger U.S. economy. And a stronger U.S. economy is one of the most important things that could happen to help the economies of emerging markets. And, again, I think my colleagues in many of the emerging markets appreciate that--notwithstanding some of the effects that they may have felt--that efforts to strengthen the U.S. economy and other advanced economies in Europe and elsewhere ultimately redounds to the benefit of the global economy, including emerging markets as well.

Global Industrial Production (excerpt)

A review of the latest global economic indicators and analysts’ consensus expectations for the revenues of the major regional MSCI indexes confirms that the IMF latest world economic outlook is pointing in the right direction. World industrial production (excluding construction) rose to a record high during November. It increased 3.6% y/y, up from a recent low of 1.2% during February 2013, and the fastest since May 2012.

Industrial production in the advanced economies rose to a cyclical high during November, but remains 6.0% below the January 2008 record high. However, its growth rate is up to 3.3% y/y from a recent low of minus 1.4% during October 2012. The comparable series for the emerging economies has been rising to new record highs since September 2009. However, its growth rate was relatively weak at 3.9% during November.

Today's Morning Briefing: World Tour. (1) The consensus forecast. (2) No serious objections. (3) The IMF worries about deflation but doesn’t predict it. (4) Advice to Fed: Temper taper. (5) Advice to ECB: More liquidity. (6) Improving outlook. (7) Global production rising faster, led by advanced economies. (8) World MSCI revenues expected to grow 4%-5%. (9) US economy strong enough for more tapering. (10) UK is best in class. (11) Japan might grow faster than IMF expects. (12) Subpar recovery for Eurozone. (13) Severe profit margin compression in emerging economies. (More for subscribers.)

Earnings & Deflation (excerpt)

So far, the earnings season has been on the disappointing side. That’s somewhat surprising given the apparent strength of the economy at the end of last year. Yesterday’s Morning Briefing was focused on deflation. Perhaps this is becoming an issue for earnings. It certainly has for some retailers, as I noted yesterday. The big debate about earnings in recent months has focused on whether profit margins might get squeezed by more business spending on labor and capital. Perhaps we need to pay more attention to the pricing environment for signs of deflation. We intend to do just that in coming weeks.

Productivity is a wonderful thing. It usually boosts both corporate profits and labor incomes. Historically, there has been a strong correlation between productivity and real pay per worker. However, the technology revolution may be putting productivity on steroids, leading to the commoditization of more and more goods and services. Commoditization is always bad for profit margins because it is fundamentally deflationary. To stay in business in a commoditized business, you have to use more technology to lower your labor costs.

Let’s turn from theory to hard data:

(1) Earnings during Q4-2013. It’s not over yet, but this is turning out to be a very unusual earnings season. During each of the previous three earnings seasons last year, analysts lowered their estimates as the season approached. That set up investors to be pleasantly surprised as actual earnings turned out to be a bit better than expected.

So far, there has been no similar curve ball. Instead, during the week of 1/16, the blended actual/estimate for Q4 fell to a new low for the weekly series. The current projected growth rate for the quarter is just 6.6% y/y.

(2) Quarterly earnings during 2014. Previously, I’ve argued that Q4-2013 earnings don’t matter unless they significantly change expectations for 2014 and 2015, the current and the coming years that we use to calculate forward earnings. The latest consensus estimates for each of the four quarters of this year have been on downtrends since mid-2013. However, during the first two weeks of January, the Q1 and Q2 estimates have stabilized, while the Q3 and Q4 estimates have continued to fall. So, it’s not clear that the latest earnings season is having much of an impact on this year’s estimates.

Today's Morning Briefing: (1)Valuation, Earnings, & Deflation. A dull start to a dull year? (2) Good, not great expectations. (3) Stocks were a great buy during August 2011. Not so much now. (4) Slightly overvalued using forward P/E. (5) Some very pricey industries. (6) Earnings-driven stock market this year. (7) Earnings should be up 10% in 2014. (8) So why is Q4-2013 disappointing so far? (9) Deflation may be a problem for margins. (10) The commoditization challenge. (More for subscribers.)

Deflation, Bonds, & Stocks (excerpt)

All the recent chatter about deflation has been good for bonds, especially in the Eurozone’s peripheral economies. The 10-year government bond yield in Spain has declined 42bps since the end of last year to 3.7%. Italy’s comparable bond yield has done the same, falling to 3.8%. Both are back to the lows of 2010. That’s because the ECB is expected to inject more liquidity into the banking system in response to the decline in the Eurozone’s core CPI inflation rate below 1% since October. The core CPI inflation rate is higher in the US, at 1.7% through December. But the core PCED was lower, at 1.1% through November. Since the end of last year, Treasury, corporate, and muni bond yields all have edged lower by 15-23bps.

Initially, deflation might actually be bullish for stocks, even causing a melt-up. That’s because central bankers are already talking about the need to act decisively now to avoid it. Another round of ultra-easy monetary policies would surely cause stock prices to soar. If deflation prevails nonetheless, the melt-up would be followed by a meltdown, worsening the deflation. In general, falling consumer prices would be bad for corporate earnings. However, companies that are able to maintain some of their pricing power and earnings growth in a deflationary environment would certainly be highly valued.

Today's Morning Briefing: Deflation Scare. (1) The deflation mandate. (2) Long waves of inflation and deflation. (3) Why do central banks dread price deflation? (4) Can price deflation cause asset inflation? (5) The Rhythm of History. (6) Good vs bad deflation. (7) Bullish for bonds. (8) Asset classes and deflation. (9) Deflation hits retailers. (10) Disinflation bordering on deflation in Eurozone and US. (11) “Nebraska” (+ +) and “August: Osage County” (+ +). (More for subscribers.)

Companies Spending Plenty on R&D and Software (excerpt)

In the GDP accounts, capital spending includes Structures (23%), Equipment (45), and Intellectual Property Products (32), where the numbers in parentheses show the percent of the current-dollar total during Q3-2013. Equipment includes information processing equipment, industrial equipment, transportation equipment, and other equipment. Intellectual Property Products includes software, research & development, and entertainment, literary, and artistic originals.

On closer inspection, what stands out is the extraordinary increases in spending on R&D and software both in current dollars and adjusted for inflation. In current dollars, the total is at a record $578 billion (saar), doubling since the end of 1998.

Spending on R&D and software combined has been running around 30% of total capital spending in recent years, doubling since the mid-1980s. The two categories currently each account for about 15% of capital spending. Thirty years ago, R&D was 11% of the total, while software was just 4%.

Today's Morning Briefing: R&D Rocks. (1) Keeping a lid on costs and boosting margins. (2) Are record profit margins bad news for the bulls? (3) Profits not as wonderful on aggregate basis. (4) An upbeat assessment of capital spending. (5) R&D and software account for a third of capital spending. (6) Smart equipment. (7) More bang per R&D buck thanks to IT. (8) The Internet of Things. (9) Rockwell’s super-smart factories. (10) Obamacare creates more problems that private sector will solve. (11) Focus on overweight-rated S&P 500 Industrials. (More for subscribers.)

Small Business Survey Upbeat (excerpt)

I’m sure that Fed officials will closely examine the latest sales reports and conclude that they add weight to the evidence showing better economic growth. So they should give less weight to December’s surprisingly weak employment report. That doesn’t mean they will taper some more at the January 28-29 meeting of the FOMC. But they might signal that they will probably vote for another round of cuts in their bond purchases at the March 18-19 meeting.

The members of the FOMC might feel even better about the labor market and the economy if they look at December’s NFIB Small Business survey. Consider the following:

(1) More hiring and job openings. The survey shows that the outlook for the labor market is improving. The monthly data are very volatile, so I smooth them with 12-month averages. They show that the percent of firms expecting to increase employment rose to 6.3% in December. That may not seem like much, but it is the highest reading since October 2008.

Even more encouraging is that the percentage of firms with one or more job openings rose to 23%, the highest since January 2008. That’s up from the most recent cyclical low of 9% during November 2010.

(2) More capital-spending plans. Another upbeat reading from the survey is that 24% of firms have capital-spending plans over the next three to six months, the highest level since November 2008. Those capital-spending plans are highly correlated with the percent of firms reporting that earnings were higher minus those reporting that they were lower over the past three months. The up/down balance of earnings has recently rebounded back close to the June 2012 cyclical high, and is consistent with more upside to capital-spending plans by small businesses.

(3) Better sales, but too much government. From October 2008 through July 2012, the #1 problem reported by small business owners was poor sales. The percent reporting this as their #1 problem fell to 16.2% in December (based on the six-month average), the lowest reading since July 2008. Now the #1 problem according to the NFIB survey is government regulation (21.7%), followed by taxes (20.7%). In other words, the economy is improving for small businesses, but Big Government is a drag for them.

Today's Morning Briefing: Picking Up Steam. (1) Business sales growing at slow pace in current dollars, at faster pace adjusted for inflation. (2) Retail sales surprisingly strong during Q4. (3) Q4 GDP now looking to be up 3%-4%. (4) Fed should give less weight to December’s weak jobs report, but hold off next tapering step ‘til March. (5) Small business survey confirms improving labor market. (6) Small business owners have more capital-spending plans. (7) NFIB survey shows that Big Government is the #1 problem. (8) Focus on market-weight-rated S&P 500 Retailers. (More for subscribers.)

Challenges Facing Emerging Markets (excerpt)

Last year, I identified two fundamental problems confronting EMs: (1) the end of the commodity super-cycle, and (2) rising labor costs and social unrest. The commodity producers bet on a commodity super-cycle that started in late 2001, when China joined the World Trade Organization. They spent lots of borrowed money to expand their mining operations, roads, railroad, and ports. That led to increasing supplies of commodities, which put an end to the super-cycle around 2011, when European growth started to stagnate.

As I previously noted, there is a remarkably close fit between the EM MSCI (in dollars) and the CRB raw industrials spot price index. They both peaked at the start of 2011, fell sharply early that year, and have been fluctuating in flat trends since then.

In recent years, rapid growth in the EMs has increased not only standards of living but also income inequality. The result has been social unrest. The response by employers and governments has been to increase wages. Both problems have squeezed profit margins. The forward margin of the EM MSCI dropped from 8.4% at the start of 2011 to 6.4% at the start of this year.

There’s a third problem for emerging markets. The EM MSCI is also highly correlated with the inverse of the trade-weighted foreign-exchange value of the dollar. The dollar has been on a strengthening trend since early 2011, which coincided with the underperformance of the EM MSCI.

It is likely to remain on that course if the US economy continues to grow fast enough to allow the Fed to taper QE and terminate it by the end of this year, as Debbie and I expect. In addition, the euro is likely to weaken if the ECB responds to recent deflationary risks by injecting more liquidity into the Eurozone banking system. Furthermore, the Bank of Japan will most likely continue to pursue ultra-easy monetary policy aimed at weakening the yen. (Yesterday’s FT had an excellent article explaining why “a strengthening US currency spells calamity once again for emerging market.”)

Today's Morning Briefing: Advancing & Submerging Markets. (1) OECD leading indicators predicting better global growth ahead. (2) Better for advanced than emerging economies. (3) Good news for revenues. (4) Japan’s leading indicator gives thumbs up to Abenomics. (5) Eurozone’s peripheral countries leading upturn in region’s leading index. (6) BRICs remain below par. (7) Will EMs underperform again this year? (8) Margin squeeze as commodity super-cycle ends and labor costs rise. (9) EMs need a weak dollar to outperform, but may not get it. (More for subscribers.)

The Paradox of Progressivism (excerpt)

If the rich are getting richer, and no one else is doing the same, then why are consumer stocks doing so well? There simply aren’t enough of the “1%” to explain the growth in consumer spending, which has boosted the forward revenues and forward earnings of the S&P 500 Consumer Discretionary sector by 51% and 339% since June 2009 and March 2009, respectively. What does the market know about consumers that the “progressives”--the populist proponents of income redistribution--don’t get? Consider the following:

(1) Income before entitlements. The Paradox of Progressivism is that all of the government’s spending on redistributing income and fighting poverty doesn’t seem to be working, requiring even more spending to win the war on poverty and income inequality. That’s because progressives tend to measure progress by focusing on measures of income that exclude the government’s spending to boost the standard of living of people with low incomes!

So they invariably focus on inflation-adjusted mean and median household and family incomes. These measures have stagnated for the past 15 years, but they don’t include entitlement payments and benefits. According to the official source of the data “money income does not reflect the fact that some families receive noncash benefits” such as food stamps, health benefits, and subsidized housing.

(2) Income after entitlements. The monthly measure of personal income includes “government social benefits to persons,” which totaled a record $2.4 trillion during November, doubling since the end of 2001. They account for 17.0% of personal income and 16.5% of total National Income, which includes compensation of employees, corporate profits, rents, interest, and dividends.

So while wages and salaries are down to a record low of 49.0% of National Income--with total compensation to employees (including supplements) back down near its record low at 60.8%--total personal income continues to fluctuate around 100% of National Income, as it has been doing since the early 1980s thanks to entitlements. Furthermore, inflation-adjusted pre-tax compensation in personal income per payroll employee has been on an upward trend for the past 15 years, and rose to a record high during November of last year.

Today's Morning Briefing: The Paradox of Progressivism. (1) Will consumers continue to lead the bull market? (2) Fluky employment report. (3) Earned Income Proxy remains on solid uptrend. (4) Progressives want more income redistribution. (5) Measuring incomes before and after entitlements. (6) Consumer Discretionary stocks aren’t cheap, but should benefit from more discretionary spending. (7) Tempering tapering after December jobs report. (8) Will Europe continue to outperform? (9) “The Wolf of Wall Street” (+ +). (More for subscribers.)

Tolerating Tapering (excerpt)

Yesterday, when I accentuated the positives on the outlook for the US economy and the stock market, I listed “tolerating tapering” as a likely upbeat development. It didn’t take long before I received a few emails from our accounts noting that the S&P 500 had a 16.0% correction lasting 69 days after QE1 was terminated, and a 19.4% drop lasting 154 days after QE2 was terminated.

Stocks recovered decisively after the first correction following a speech at Jackson Hole by Fed Chairman Ben Bernanke on August 27, 2010. He suggested that the FOMC could implement QE2, which was announced November 3, 2010. Stocks recovered again after the second correction when the Fed implemented Operation Twist during September 2011 and followed it up with QE3 and QE4. (See QE & the Markets.)

The question is whether QE5--i.e., the tapering of QE4--will cause another significant correction or even kill the bull if tapering leads to the termination of quantitative easing. Yesterday’s minor 0.4% drop in the S&P 500 suggests that stock investors might be ready to tolerate more tapering, which was implied in the minutes released yesterday of the December 17-18 FOMC meeting.

Today's Morning Briefing: Tolerating Tapering. (1) Stock prices: 10% per year for another four years? (2) Looking down on tapering. (3) Terminating QE1 and QE2 led to big corrections. (4) From QE1 to QE5 and beyond. (5) FOMC sees more of QE’s downside for financial stability. (6) Diminishing returns. (7) Not sure if and how it works. (8) A good trade: More growth less QE. (9) Ideal for Rational Exuberance scenario, with earnings rather than P/Es driving stock prices higher. (10) They’ve had enough of QE. (More for subscribers.)

Fracking Dividend (excerpt)

Following the end of the Cold War, there was much talk about the coming Peace Dividend. It probably did contribute to growth during the 1990s, but then the 9/11 attacks led to America’s wars in Afghanistan and Iraq. Now we can look forward to the Fracking Dividend. It is already having a dramatic impact on lowering America’s dependence on foreign oil.

In fact, there is mounting industry pressure on the government to permit the export of crude oil, which has been banned since the energy crisis of the mid-1970s. There is no ban on the export of petroleum products. The result has been a surge in such exports recently, while imports of both crude oil and petroleum products remain on a downward trend.

All this is starting to have a significant impact on reducing the US merchandise trade deficit, as evidenced by yesterday’s report with November data. US imports of crude oil and petroleum products dropped to the slowest pace since November 2010, while such exports rose to a record high.

The Fracking Dividend has already narrowed this US petroleum trade deficit from a recent peak of $359 billion (saar) during January 2012 to $182 billion during November 2013. The deficit could go to zero over the next couple of years. That would provide a big dividend to real GDP growth, as well as more purchasing power for Americans. Building the infrastructure to export crude oil would be another benefit, especially for capital goods manufacturers.

Today's Morning Briefing: Looking Up. (1) No end to the endgame. (2) Awesome 2013. (3) Still keen on Consumer Discretionary, Financials, and Industrials. (4) Year # 6 for charged-up bull. (5) Investors more upbeat, less anxious than a year ago. (6) Back to “Old Normal” growth? (7) Less fiscal drag. (8) More US oil. (9) The Fracking Dividend. (10) Learning to tolerate tapering. (11) Europe’s tepid recovery. (12) China issuing bonds. (13) Focus on overweight-rated S&P 500 Transportation. (More for subscribers.)

January’s Effect & Earnings Season (excerpt)

It’s early January 2014. So it’s time for the Q4-2013 earnings season to begin. At the end of the month, it will be time for the financial press to analyze the so-called “January Effect.” As goes January, so goes the year--so they say. We’ve set up a little publication to track this relationship.

A scatterplot of the performance of the S&P 500 during each January and its full year from 1947 through 2013 shows that there is something to the effect. Over the past 67 years covered by our analysis, January and its full year have been up 55% of the time. During only four years (1966, 1994, 2001, and 2011) were up Januarys followed by full-year declines. Down Januarys aren’t necessarily bearish given that they were preceded by 11 years that were up. There were 14 down Januarys followed by full-year declines.

While we are waiting to see how the month ends, there will be plenty of earnings news to digest. Most of it won’t matter much since it will be for the final quarter of last year, which has dropped out of the calculation of forward earnings.

Forward earnings is the time-weighted average of the current and next years’ consensus expected earnings. It is the "E" that I use in my P/E x E analysis of the market. Right now, it is identical to the expectations just for this year, but it will give less weight to this one and more to the next as the year progresses. Q4-2013 results will matter only if they significantly alter analysts’ expectations for 2014 and 2015, which seems unlikely to me.

Today's Morning Briefing: Earnings, Revenues, & Margins. (1) The “January Effect” is coming. (2) A scatterplot. (3) Another earnings season is starting. (4) Why it may not matter. (5) Analysts forecasting double-digit earnings growth. (6) Can 5% revenues growth produce 10% earnings growth? (7) Global PMIs confirming moderately upbeat outlook for revenues. (8) Emerging Markets PMI is rebounding. (9) However, NERIs are still negative. (10) Analysts predicting rising margins. (11) Margins could suffer if companies expand payrolls and capacity more rapidly. (12) For now, business spending on labor and capital lowest relative to GDP since early 1950s. (More for subscribers.)

Buybacks, Great Rotation, and Melt-Up (excerpt)

Until last year, retail investors didn’t believe that the bull market in stocks was sustainable. Instead, they chose to buy bonds. From 2009-2012, bond mutual funds attracted $1,372 billion in net inflows. Over that same period, equity mutual funds had net outflows of $75 billion.

During the first 11 months of 2013, bond funds had net inflows of only $16 billion (with $111 billion in outflows from June through November), while equity funds had net inflows of $193 billion. This may be the start of the so-called “Great Rotation” from bonds to stocks by retail investors. By the way, over the past 12 months through November, the combined net inflows into equity mutual funds and ETFs totaled a record $388 billion.

The WSJ ran an article at the end of last year (12/25) titled, “Companies Binge on Share Buybacks.” For the past couple of years, this has been a story I’ve often told to explain what’s driving the bull market. Recently released data show that S&P 500 companies repurchased $128 billion of their shares during Q3. They paid out $79 billion in dividends during that quarter and a record $85 billion during Q4. The $207 billion sum of buybacks and dividends for Q3 is just shy of the $233 billion record high during Q3-2007.

Since the start of the bull market during Q1-2009 through Q3-2013, share buybacks totaled $1.6 trillion and dividends totaled $1.2 trillion, summing to a whopping $2.8 trillion! Corporate cash flow rose to a new record high of $2.3 trillion (saar) during Q3. Yet nonfinancial corporate net bond issuance totaled a record $665 billion over the past four quarters through Q3, with issuers using some of the proceeds to buy back their shares.

Buybacks are likely to remain strong in 2014. Now imagine the melt-up potential of the stock market if the Great Rotation by retail investors from bonds into stocks continues to build momentum. And by the way, January has a history of being a good month for inflows into equity mutual funds.

Today's Morning Briefing: Anatomy of a Melt-Up. (1) Updating three scenarios. (2) And the 2013 winner is: Rational Exuberance. (3) Will Irrational Exuberance get the 2014 award? (4) A year to pack our bags in May? (5) Stampeding bulls. (6) The Great Rotation is picking up steam. (7) Buybacks approaching record highs. (8) Forward P/Es could head into the high teens. (9) Fed may have to speed up tapering. (10) No soft patch in latest US economic data. (11) “American Hustle” (+ +). (More for subscribers.)