Tuesday, October 3, 2017

Message to Buffett: Thanks a Million!

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. 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. 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. Let’s have a closer look at the numbers:

(1) I have a monthly series for the DJIA starting December 1920. I can put it on a ratio scale and compare it to alternative compounded annual growth rate (CAGR) lines. 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 around the 6% CAGR trend.

(2) Starting from the last trading day of 2016, when the DJIA was at 19,763, I calculate 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%).

(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%. 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. I derived that yield by subtracting the CPI inflation rate from the S&P 500’s earnings-price ratio.

Tuesday, September 26, 2017

Janet in Wonderland

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). Yet over that same period, wage inflation has remained around 2.5% and price inflation has remained below 2.0%. 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.

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.

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.”

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.

(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%.

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”.

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.

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.”

Wednesday, September 20, 2017

Valuation Debate: 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. 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 on the valuation question:

(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.” My 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. 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. 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) Rule of 20. The Rule of 20 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. In August, the CPI inflation rate was 1.9% y/y. According to the Rule of 20, that meant that the P/E should be around 18.1. 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.

(5) Misery-Adjusted P/E. Another valuation metric that 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. I’ve observed an inverse relationship between the forward P/E and the Misery Index. 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. 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.

(6) Real earnings yield. There’s an alternative valuation measure that is adjusted for inflation in a more rigorous fashion than is reflected in the two rules of thumb above. Let’s flip the P/E over and focus 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. The real earnings yield is the nominal yield less the CPI inflation rate.

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.

Thursday, September 14, 2017

Another Seinfeld Episode for Stocks

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. It has been highly correlated with the S&P 500 since 2000. Its two components declined slightly in early September.

Our Boom-Bust Barometer has been rising in record-high territory since late September 2016. 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. 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). It has been highly correlated with the S&P 500 since 2000.

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. 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. 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.

(3) Forward earnings. The forward earnings of the S&P 500/400/600 continue to trend higher in record-high territory. During the first week of September, forward earnings for the S&P 500/400 both rose to record highs.

For more on this extraordinary bull market, see “Obama-Trump bull market is now up 268%,” a 9/13 post on CNN Money:
The S&P 500 would have to more than double its gains to surpass the 582.15% surge experienced during that bull market [from 1987-2000]. And it would need to keep going for almost four more years to take the title of the longest in history. "That's asking for a lot -- but I wouldn't rule it out," said Yardeni.

Wednesday, September 6, 2017

Global Synchronized Growth: Why Now?

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.

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) 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.

(2) Europe. The Eurozone’s Economic Sentiment Index rose to 111.9 during August, the highest since July 2007. 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.

(3) 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.

(4) Japan. Japan’s real GDP rose 4.0% (saar) during Q2, the fastest such pace since Q1-2015.

(5) Global manufacturing. Last month, the global M-PMI rose to 53.1, the highest since May 2011. Solid increases were registered for both the developed economies and the emerging ones.

Tuesday, August 29, 2017

Stocks Are Fundamentally Sound

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. 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 I watch show plenty of solid rocket fuel:

(1) The Fundamental Stock Market Indicator (FSMI) rose to a new record high during the week of August 19. It has been very highly correlated with the S&P 500 since 2000.

The FSMI 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. My 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.

The FSMI 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. 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.

(3) The Boom-Bust Barometer (BBB) is simply the ratio of the CRB raw industrials spot price index divided by initial unemployment claims. To smooth it out, I 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. That’s not surprising since it is highly correlated with another very procyclical indicator, namely S&P 500 forward earnings.

(4) Consumer confidence is the third component of the FSMI, which averages the Weekly Consumer Comfort Index (WCCI) and the BBB. 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. The WCCI has recovered sharply since late 2011, and so has the P/E.

Thursday, August 24, 2017

S&P 500 Earnings: The Shining

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. Growth resumed during the second half of 2016 and first half of 2017.

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.

That put the S&P 500 operating profit margin (based on TR data) at a record high of 10.8%. “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.

(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. 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 per share 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: 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: 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).

Tuesday, August 8, 2017

Four Deuces Scenario

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, I described my 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 my accounts suggested the Four Deuces (2-2-2-2) scenario, adding the unemployment rate to the Three Deuces scenario. 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. The low for this series was 2.5% during April and May 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 my “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. The stock market also does well when the Misery Index, which is the sum of the unemployment rate and the inflation rate, is falling. Indeed, there is an inverse correlation between the Misery Index and the S&P 500 P/E since 1979. Consider the following:

(1) The sum of the forward P/E and the Misery Index has averaged 23.9 since 1979. 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).

Wednesday, August 2, 2017

Investors Hearing Call of the Wild

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.

Over the past 12 months through June, a record $357.8 billion has poured into equity exchange-traded funds (ETFs), led by $236.2 billion going into domestic ETFs and $121.6 billion going into ETFs that invest globally. 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. 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 August 1. The average expenses across Fidelity’s stock and bond index fund lineup will decrease to 9.9 basis points, down from 11.0 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 my 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 me. I started to argue back then that the bull market was more likely to end with a melt-up before there was any meltdown.

Today, I am 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.

Sunday, July 23, 2017

Summertime Lullaby

“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. Consider the following:

(1) Vix. The S&P 500 VIX fell to a record low 9.36 last Friday. 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. 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. 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. This series is also highly correlated with the VIX. The Bull/Bear Ratio was back above 3.00 last week.

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, 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?

Wednesday, July 19, 2017

China: The Xi Dynasty’s Debt Extravaganza

China’s real GDP rose 6.9% y/y during Q2. 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, I am not among China’s doomsayers. I 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 near-record US$2.8 trillion. 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. Astonishingly, bank loans have more than tripled since the end of 2008, soaring by 280% to a record $16.8 trillion during June.

The good news—I 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—I guess—is that the authorities seem to be making a bit of progress throttling back the shadow banking system. I estimate shadow banking activity by subtracting bank lending from total social financing. Doing so suggests that on a 12-month basis, the shadow banks accounted for a record 55.1% of social financing through May 2013. 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) Industrial production & trade. Just for fun, I compare the growth rates of China’s bank loans to industrial production and track the ratio of the former to the latter. The ratio of bank loans to industrial production confirms my 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. The y/y growth rates for these categories were strong at 16.9% and 22.6%. 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.

(5) 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. The growth rate of the population is projected to turn negative during 2033. 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.

Monday, July 10, 2017

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 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 my favorite weekly fundamental stock market indicators continue to support the bull market trend. Here is an update:

(1) My Boom-Bust Barometer (BBB) is simply the ratio of the CRB raw industrials spot price index and weekly initial unemployment claims. It remains in record-high territory, with a whopping y/y gain of 21%.

(2) My Fundamental Stock Market Indicator (FSMI) averages the BBB and the Bloomberg weekly Consumer Comfort Index. FSMI tracks the S&P 500 even better than my 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.

Wednesday, July 5, 2017

US Corporate Finance: Show Me the Money


S&P 500 operating earnings totaled $958 billion over the past four quarters through Q1-2017, 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.

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. 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 plenty on capex, including on technology, which is cheaper and more powerful than ever.

Wednesday, June 28, 2017

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.

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. 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. It fell to 2.5 in 2015. The UN projects it will fall to 2.0 by the end of this century.

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 my 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.

Wednesday, June 21, 2017

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 $45.89, below its recent high of $57.10 on January 6. That’s comfortably in the $40-$50 price range that 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. 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. 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. 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. Elon Musk 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. 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. Meanwhile, the frackers are using every frick in their book to reduce the cost of pumping more crude oil. 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.

Thursday, June 15, 2017

Tech Now and Then

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. During the current bull market, it is in third place with a gain of 379.8% through last Friday.

(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. 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, I get nervous when a sector’s shares of either or both rise close to 33%. I’m not nervous yet about IT, though I am 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. 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. 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. Keep in mind that the historical trend growth in the S&P 500 during economic expansions tends to be around 7%! 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. The sector’s forward earnings rose to a record high at the start of June, exceeding the 2000 peak by 168.6%.

(6) Fat margins. 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.

Thursday, June 8, 2017

Hannibal Spirits: S&P 500 Climbing Mountains

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. They were false alarms. I remain bullish. My long-held concern is that the bull market might end with a melt-up that sets the stage for a meltdown. The latest valuation and flow-of-funds data certainly suggest that the melt-up scenario may be imminent, or underway. Consider the following:

(1) Valuation melt-up. The Buffett Ratio is back near its record high of 1.81 during Q1-2000. 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. 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. 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. 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. 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. 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 may partly explain why big cap stocks, like the FAANGs, are outperforming assuming that money is coming out of mutual funds that are underweight the outperforming FAANGs.

(3) FAANG-led melt-up. 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. The FAANGs account for 27.8% of the $2.6 trillion increase in the value of the S&P 500 over the past year. The FAANG stocks 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.

Wednesday, May 31, 2017

A Memorable Earnings Season

Q1 revenues, earnings, and margins are now available for the S&P 500. Revenues per share dropped 2.7% q/q during Q1. Earnings per share, based on Thomson Reuters I/B/E/S (TR) data, fell 1.3% q/q. So in what sense was the Q1 reporting season “memorable,” as stated in the title of today’s commentary?

For starters, the S&P 500 rose to a new record high of 2415.82 on May 26. The S&P 400 and S&P 600 stock price indexes continued to mark time at their recent record highs. Industry analysts remained upbeat about earnings for this year and next year, as reflected by the record highs in the S&P 500/400/600 forward earnings.

This all happened despite a growing realization that President Trump’s economic agenda is likely to be slowed by Washington’s swampy ways. I came to that epiphany on May 18 and adjusted my earnings estimates accordingly, pushing the corporate tax cut into 2018 from 2017. Without a tax cut, I estimate that S&P 500 earnings per share will be $130.00 this year and $136.75 next year. With the tax cut in 2018, my estimate for next year gets raised to $150.00. Let’s have a closer look at the results of the latest reporting season:

(1) Good growth. Of course, the apparent weakness in Q1’s revenues and earnings on a q/q basis is mostly seasonal in nature. The first quarter of the year tends to be the weakest one of the year. On a y/y basis, revenues per share rose 6.9%, the fastest since Q4-2011. Earnings per share rose 14.5% y/y, the best growth since Q3-2011.

I argued that the S&P 500 revenues recession during 2015—when y/y growth rates were down each quarter—was mostly attributable to the plunge in the revenues of the energy sector. The revenue growth rates, which turned slightly positive during Q1-2016, have been increasing since then. It was last summer that I declared the end of the earnings recession. The y/y growth rate of earnings turned positive during Q3-2016 at 4.2%, rose to 5.9% during Q4-2016, and chalked up 14.5% at the start of this year.

(2) High & stable margin. The profit margin of the S&P 500, based on TR data, rebounded sharply from a record low of 2.4% during Q4-2008 back to its previous cyclical peak of 9.6% during Q3-2011. There was lots of growling by the perma-bears that it would soon revert to its mean. Instead, it continued to rise to a new record high of 10.7% during Q3-2016. It has remained around there since then, registering 10.5% during Q1.

I argued that following the Trauma of 2008, company managements would do whatever they could to raise and maintain their profit margins by remaining conservative in their spending plans despite record profits. I’m not saying that the profit margin will never revert again. It will do so come the next recession. But that downturn may not come for a while because companies are being conservative.

In the past, the profit margin would often peak before recessions as companies went on hiring and capacity expansion sprees. The resulting boom would create the borrowing and inflationary excesses that set the stage for the inevitable bust. This time, the economy isn’t booming the way it often has at this late stage of an expansion. No boom, no boost … at least not in the foreseeable future.

(3) Correlations. I’m not surprised by the solid rebound in S&P 500 revenues because its y/y growth rate tends to be nearly the same as the comparable growth rate for manufacturing and trade sales, even though this series is limited to goods and does not include services. Aggregate (not per-share) revenues was up 5.2% y/y during Q1, while business sales rose 6.4% through March. Revenues per share on a y/y basis tends to lag the US M-PMI. The latter remains relatively high and consistent with revenue growth around 5%. Not surprisingly, there is a decent correlation between the y/y growth rate in nominal GDP and aggregate S&P 500 revenues.

Wednesday, May 24, 2017

Valuation: A Less Miserable Measure

Almost all valuation multiples are flashing that stocks are dangerously overvalued. Are there any valuation models suggesting that the danger signals might be false alarms? There is one. It shows the inverse relationship since 1979 between the S&P 500 forward P/E and the Misery Index, which is the sum of the unemployment rate and the CPI inflation rate. Let’s have a look at it and compare it to a few of the other valuation indicators:

(1) Misery Index very bullish. During April, the Misery Index was down to 6.6%, near previous cyclical lows. That’s down 6.3ppts from its most recent cyclical peak of 12.9% during September 2011. Over this same period, the forward P/E has risen from roughly 10 to 17, well above its average of 13.8 since September 1978.

The theory is that less misery should justify a higher P/E. A low unemployment rate should be bullish for stocks unless it is accompanied by rising inflation, which could cause the Fed to tighten to the point of triggering a recession and driving the jobless rate higher. Nirvana should be a low unemployment rate with low inflation, which seems to be the current situation. In this happy state, a recession is nowhere to be seen, which should justify a higher valuation multiple.

I construct a “misery-adjusted” P/E simply by summing the S&P 500 forward P/E and the misery index. It has been trendless and highly cyclical since September 1978, with an average of 23.9. Its low was 18.5 during November 2008, and its high was 33.0 during March 2000. During April, it was 24.3, in line with its average. That’s somewhat comforting.

(2) Rule of 20 no longer a buy signal. Less comforting is the Rule of 20, which tracks the sum of the S&P forward P/E plus the CPI inflation rate. So it is the same as the misery-adjusted P/E less the unemployment rate. I moved to CJ Lawrence in 1991. My mentor there was Jim Moltz, who devised the Rule of 20, which states that the stock market is fairly valued when the sum of the P/E and the inflation rate equal 20. Above that level, stocks are overvalued; below it, they are undervalued.

The rule was bearish just prior to the bear market at the start of the 1980s. It was wildly bullish for stocks in the first half of the 1980s. It turned very bearish in the late 1990s and bullish again a couple of years later in mid-2002. Those were all good calls. However, like most other valuation models, it didn’t signal the bear market that lasted from October 9, 2007 through March 9, 2009. At the end of 2008, the Rule of 20 was as bullish as it was in the early 1980s. That was another very good call. By early 2017, it was signaling that stocks were slightly overvalued for the first time since May 2002.

(3) Buffett ratio sees no bargains. Another valuation gauge I follow is the price-to-sales (P/S). The S&P 500 stock price index can be divided by forward revenues instead of forward earnings. However, the forward P/S ratio is very highly correlated with the forward P/E ratio. So it doesn’t add much to the assessment of valuation.

A variant of the P/S ratio is one that Warren Buffett said he favors. It is the ratio of the value of all stocks traded in the US to nominal GDP. The data for the numerator is included in the Fed’s quarterly Financial Accounts of the United States and lags behind the GDP 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 forward P/S ratio, which is available weekly, has been tracking Buffett’s ratio very closely. In an interview he did 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 Sage of Omaha. His ratio was at 1.69 during Q4, while the P/S was 1.90 in mid-May, suggesting that we are playing with fire.

On the other hand, a year ago in a 5/2 CNBC interview, Buffett said, “If you had zero interest rates and you knew you were going to have them forever, stocks should sell at, you know, 100 times earnings or 200 times earnings.” He was speaking hypothetically, of course. More recently, this year in a 2/27 CNBC interview, Buffett said that US stock prices are “on the cheap side,” and added, “We are not in a bubble territory.” He also announced at the time that he had more than doubled his stake in Apple since the new year and before the tech giant reported earnings on January 31.

(4) Fed model still bullish. To round out the discussion, I should mention that the Fed’s Stock Valuation Model showed that the S&P 500 was undervalued during April by 61.9% using the US Treasury 10-year bond yield and 24.9% using a corporate bond yield composite. This confirms Buffett’s assessment that stocks are relatively cheap compared to bonds. If more investors conclude that economic growth (with low unemployment) and inflation may remain subdued for a long while, then they should conclude that economic growth and inflation may remain historically low. That’s a Nirvana scenario for stocks, and would be consistent with valuation multiples remaining high.