DJIA 20,000: Counting on Earnings

Today was another happy day for the bull market that started on March 9, 2009, when the DJIA was 6547.05. Today, it crossed 20,000. It closed above 1000 on November 14, 1972, 5000 on November 21, 1995, 10,000 on March 29, 1999, and 15,000 on May 7, 2013. I first joined Wall Street during January 1978 when EF Hutton hired me as an economist. The DJIA is up 2,314% since the start of my career on the Street. It is up 206.5% so far since March 9, 2009. It is up 9.5% since Election Day.

For a change, let’s ignore Washington. Let’s ignore the Republicans and the Democrats. Let’s ignore the White House, Congress, and K Street. That’s what the financial markets were doing for the past eight years. Investors were focusing most of the time on the Fed and the other central banks. Now we are all being forced to participate (in one way or the other, though mostly as observers) in the greatest circus of all times. I guess that is only fitting now that Ringling Brothers is going out of business. Instead it will be Cirque du Trump 24x7 for the next four years.

Of course, over the past eight years, stock market investors also have been focused on earnings, as they always are. While the 7.4% rally in the S&P 500 after Election Day through Wednesday’s record high might have had a lot to do with the results of that day, it helps that the earnings outlook has been improving. In our 8/22 Morning Briefing, I declared that the earnings recession was over, and that it was mostly attributable to the S&P 500 Energy sector as a result of the plunge in oil prices from mid-2014 through early 2016.

Let’s analyze the latest earnings data:

(1) Earnings. On a year-over-year basis, S&P 500 operating earnings, based on Thomson Reuters (TR) data, showed declines from Q3-2015 through Q2-2016. It rose 4.1% during Q3-2016, and probably rose around 6.0% during Q4-2016. Arguably, the earnings recession ended earlier than suggested by the growth rate based on the actual level of operating earnings (TR basis), which bottomed during Q1-2016, declining 11.7% from the previous record high during Q4-2014. It is up 15.8% from that recent bottom through Q3-2016 to a new record high.

(2) Revenues. On a year-over-year basis, S&P 500 revenues declined from Q1-2015 through Q4-2015. It edged up during the first half of 2016, and was up 2.5% y/y during Q3-2016. This too suggests that the earnings recession actually ended in early 2016.

(3) Q4 reporting season. So far this earnings-reporting season, i.e., through the 1/19 week, the blended earnings number (including both reported and estimated figures) shows a gain of 4.7%, up from 4.1% the previous quarter. Joe and I are expecting the traditional upward “hook” in actual earnings relative to expected earnings for the current earnings season, which is why we predict that the actual growth rate will be close to 6.0%.

(4) Forward ho! S&P 500 forward operating earnings per share, which is the time-weighted average of consensus expected earnings for the current and next year, rose to $133.65 during the 1/19 week. That’s a fresh record high and a good leading indicator for actual earnings as long as there is no recession coming over the next 12 months.

The consensus estimate for 2018 has been moving higher in recent weeks, which doesn’t usually happen, as optimistically biased analysts typically lower their distant forecasts as reality approaches. Analysts may be starting to incorporate tax cuts and less regulation into their 2018 estimates. They now expect that 2018 earnings will rise 12.0%, following this year’s gain of 12.3%.

The analysts may also be raising their economic growth expectations, as evidenced by the firming in their 2017 and 2018 estimates for S&P 500 revenues, which are showing gains of 5.8% this year and 4.9% next year. Forward revenues is also rising in record-high territory.

Earnings: Yes They Can Grow

A week after his election victory, I concluded that incoming President Donald Trump could succeed in stimulating economic growth, so I raised my real GDP forecast for 2017 from 2.5% to 3.0%. Since then, I’ve been keeping track of all the signs showing a revival of “animal spirits” in surveys of consumer and business confidence.

On Monday, the IMF raised its economic growth forecasts for the US, saying output could grow nearly a half-percentage-point faster than previously thought over this year and next, thanks to Trump’s plans to cut taxes and boost infrastructure spending. That would put US real GDP growth at 2.3% this year and 2.5% next year. The IMF’s move follows similar revisions by the World Bank last week.

If so, then the outlooks for the growth rates of S&P 500 revenues and earnings are improving. Both have recovered from the energy-led recession that started during the summer of 2014 and ended early last year, when the price of oil rebounded. Consider the following:

(1) Forward revenues and forward earnings of the S&P 500 have been rising rapidly since last spring into record-high territory. They are both good harbingers of actual revenues and earnings.

(2) Business sales are recovering from the energy recession. Manufacturing and trade sales rose 2.3% y/y during November, the best growth rate since October 2014. This series is highly correlated with the growth in S&P 500 aggregate revenues, which was 0.6% y/y during Q3-2016. It probably rose to about 2.0% during Q4-2016. Joe and I think the growth rate for revenues this year could be around 4%-5%.

Interestingly, the US M-PMI tends to be a leading indicator for the growth rate in S&P 500 aggregate revenues. During December of last year, the M-PMI rose to 54.7, the highest reading since December 2014.

(3) Retail sales rose 0.6% m/m during December. Chronic pessimists noted that it was essentially unchanged excluding gasoline and autos. Apparently, they weren’t impressed with December’s auto sales of 18.4 million units (saar), a cyclical high. Excluding gasoline but including autos, retail sales rose 0.2% to a new record high, and remain highly correlated with our Earned Income Proxy for private industry wages and salaries in personal income, which also rose to a fresh record high last month.

(4) Short-term leading economic indicators are upbeat. The Citigroup Economic Surprise Index rose to 40.7 on January 17. That’s near last year’s highest reading. The CRB raw industrials spot price index continues to recover from its cyclical low early last year. It was up 23.8% y/y on January 13.

My Boom-Bust Barometer continues to rise vertically in record high territory. The same can be said for the two Weekly Leading Indexes compiled by YRI and ECRI.

Animal Spirits

Just for fun, I compared the lyrics in the song “Physical” by Olivia Newton-John with Janet Yellen’s “Fiscal” lyrics during her press conference performance at the end of last year following the December 13-14 meeting of the FOMC. The word “physical” appears 20 times in Olivia’s song, and “fiscal” was mentioned 20 times during Janet’s press conference. In the minutes of the December meeting, the word “fiscal” appears 15 times, compared to just once during the previous meeting on November 1-2, which was before Election Day on November 8.

Prior to Election Day, a few Fed officials had called on Congress to step in to revive US economic growth with fiscal stimulus. They want to proceed with “normalizing” monetary policy so that they will have room to ease in the event of a future shock. They were looking for a way to continue to gradually raise rates without hampering economic growth, which has been slow. President-elect Donald Trump might just solve their problem with fiscal policy, included cuts in tax rates and more spending on infrastructure.

“Physical” starts with “Let’s get physical” and ends with “Let’s get animal, animal / I wanna get animal / Let’s get into animal.” That’s not appropriate or relevant language in a discussion about the Fed chair. However, President-elect Donald Trump is fair game.

After all, a Google search of “Trump and animal spirits” yields over 2 million links. They include lots of prim and proper ones such as a 1/5 FT article by Gillian Tett titled “Donald Trump unleashes business’s animal spirits.” She reported that Trump’s top eight officials (president, vice-president, chief of staff, attorney-general, and secretaries of State, Commerce, Defense, and Treasury) had only 55 years of government experience but 83 years in business. Obama’s comparable team had 117 years in government, but ONLY five years in business IN TOTAL.

As I’ve observed before, this is a radical change in governing regimes. As one of our accounts observed, government by dealmakers is about to replace government by community organizers. So far, this has all revived lots of animal spirits in the stock market. While the country may be split on Trump, his election has boosted overall consumer confidence. Purchasing managers were also more upbeat after the election, and so were small business owners.

December’s survey of small business owners by the National Federation of Independent Business (NFIB) was released on Tuesday. It was full of animal spirits. This group tends to be conservative. They generally don’t like government. When they are asked about the “most important problems small businesses face,” taxes and government regulation tend to be at the top of their list. They were still the top concerns in December, but Trump’s victory was clearly reflected in the extraordinary ascent in the Small Business Optimism Index from 98.4 during November to 105.8 in December, the highest since the end of 2004.

There’s more: The net percentage of firms expecting the economy to improve soared from 12% during November to 50% last month, the highest since March 2002. The percentage saying now is a good time to expand jumped from 11% to 23%, the highest since June 2005. The net percentage expecting to increase employment rose to 16%, the highest since January 2007.

So who cares? Aren’t these just a bunch of anti-government conservatives who are running minor little businesses and are looking forward to paying less than their fair share of taxes under the new Trump administration? Not so fast: Small businesses account for a very significant portion of jobs and hiring. Consider the following:

(1) Small business is big employer. ADP, the payroll processing company, compiles data series on employment in the private sector of the U.S. labor market by company size. At the end of 2016, the shares of employment attributable to small, medium-sized, and large firms were 40.5%, 37.7%, and 21.8%.

(2) Small business drives jobless rate. There has been a very high correlation between “poor sales” reported by small business owners and the national unemployment rate. If Trump succeeds in boosting their sales by cutting personal income tax rates, the jobless rate should remain low.

There is also a high correlation between the earnings of small businesses and the inverse of the poor sales. Trump’s proposed tax cuts would boost their earnings, which are inversely correlated with the national unemployment rate.

(3) A new problem for small business. Before I put any more twists in this pretzel, I expect that the biggest problem facing small business owners in 2017 is likely to be finding workers. Indeed, during December, 29.0% said that they have openings for jobs that they aren’t able to fill.

By the way, the term “animal spirits” was popularized by none other than John Maynard Keynes in The General Theory of Employment, Interest, and Money (1936) in the following passage:

Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits—a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

This passage has been widely discussed and interpreted. Cutting through the jargon, I think Keynes was saying that the business cycle is driven by the instability of human nature. He seemed to agree that booms might reflect “spontaneous optimism,” which cause instability in a similar fashion as speculation, setting the stage for a bust. Keynes added: “Thus if the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die;—though fears of loss may have a basis no more reasonable than hopes of profit had before.” Of course, his book heralded the idea that government spending could stabilize the business cycle by at least minimizing the downside of the cycle. How is that working out so far?

Who’s Afraid of the Big Bad Wolf?

The answer to the question posed in the title of this piece is certainly not “stock investors.” Hopefully, the complete answer is “lots of little piggies afraid of what President-elect Donald Trump might do to them.” Maybe they will cease and desist before they show up in one of the Big Bad Wolf’s tweets. He has already had some success in getting Boeing and Lockheed to review their costs so that they will lower the prices they charge the government for their high-end products.

Now let’s see if Trump can make some progress in reducing personal and corporate tax rates while eliminating many of the exemptions and deductions that make the tax code a slush fund for lobbyists and their patrons. Let’s see if he can reduce onerous regulations on businesses. Can he do all that while keeping a lid on federal spending given that there are so many little piggies feeding in the government trough? Let’s hope that the Progressive ones aren’t simply replaced by the crony capitalist variety.

The big question is whether he will succeed in bullying our trading partners to be fairer without instigating a trade war. An even bigger question is whether he can curb the nuclear ambitions of North Korea’s Lil’ Kim and Iran’s Supremes. Then there are China’s ambitions to turn the South China Sea into a secluded lake for their navy. We should also hope that Trump’s reset with the Russian Bear will be more successful than was Obama’s attempt to normalize relations with the beast.

This is a long wish list, and may be biased toward too much wishful thinking. However, we can’t rule out the possibility that Trump will succeed. He certainly has so far, upending the predictions of all his detractors. Betting against him has been a bad bet so far.

That seems to be the message of the stock market. The S&P 500 is up 4.6% from Trump’s Election Day (T-Day) through the end of 2016. That seems impressive, but it isn’t unprecedented. Here are the comparable performance figures for past presidents just elected to their first terms: Hoover (8.2%), Eisenhower (8.0), Kennedy (5.4), Reagan (5.2), Carter (4.2), Clinton (3.8), Bush I (0.9), Nixon (0.7), Johnson (-0.5), Roosevelt (-4.8), Bush II (-7.8), Truman (-9.0), and Obama (-10.2). So Hoover, Eisenhower, Kennedy, and Reagan trumped Trump. Perhaps Trump would have done better if the S&P 500 weren’t already nearly nine years into a bull market with valuation multiples at nose-bleed levels.

Then again, those valuations may not be too high if Trump delivers all the supply-side magic of personal and corporate tax cuts, and they work like a charm. Reagan did the same, but the economy was heading into a severe recession after his first 100 days. Back then, Fed Chairman Paul Volcker was intent on breaking the back of inflation by breaking everyone’s backs with burdensomely high interest rates, and Reagan supported Volcker’s tough love.

Now Trump might do what Reagan did, but with an economy that clearly is growing with no recession in sight. There certainly isn’t enough inflation to cause the Fed to precipitate a recession by tightening monetary policy too aggressively. Volcker raised the federal funds rate to over 20%. The FOMC’s dot plot suggests that the members of the committee expect to raise the federal funds rate this year three times at most, by 25bps each time, to 1.50%. The implications for corporate earnings could be awesome, as Joe and I discussed last month. If so, then valuation multiples are simply getting ahead of earnings, but rightly so.

Tuesday’s WSJ included an article titled “Earnings, Not Donald Trump, Are Stocks’ Best Friend in 2017.” That’s not news to us: Joe and I have been predicting since last summer that the end of the Energy-led earnings recession would boost stock prices. The subtitle of the article is “Continued rebound in corporate profits should prop up share prices regardless of Washington policies.” Actually, given that valuations were high before Election Day, and went higher after Trump’s sweeping victory (with his party winning control of both houses of Congress), we believe that his policies will matter a great deal.

If for some unanticipated reason he fails to implement his tax cuts and to cut regulations, stocks would take a dive. They might even crash if he manages to start a trade war. If he succeeds in his plans, then the S&P 500 earnings growth could more than double from 9% this year to 19%, as Joe and I explained last month. So Washington matters a great deal this year.

After Reagan was elected to his first term, the forward P/E of the S&P 500 rallied to 7.7 in February 1981 from a Jimmy (“Malaise”) Carter low of 7.0 during November 1979. During 1982, it dropped to a low of 6.3. During Reagan’s second term, it rose to a high of 14.8 during August 1987. On Tuesday, the S&P 500’s forward P/E was 16.9, well above the 13.8 average from September 1978 through December 2016. The forward P/Es of the S&P 400/600 were even closer to the sun at 18.7 and 19.8.

For the S&P 500, if the index price remains unchanged at the current level through the end of the year, a 10% increase in earnings this year would lower the multiple to 15.4, while a 20% increase in earnings would lower it to 14.1. So, yes, the multiples are high, as investors have gotten ahead of earnings. But earnings could do some significant catching up if Trump’s program boosts earnings as much as Joe and I expect. If the multiple stays put and earnings increase 20% as a result of tax cuts, then the S&P 500 would rise to 2700. For now, we are sticking with 2400-2500 as our target for this year.