Saturday, August 11, 2018

US Economy Slowing? Not So Fast!


Real GDP rose 4.1% (saar) during Q2 (Fig. 1). That was good, but not surprisingly good. Actually, given that taxes were cut at the end of last year, it’s surprising that it wasn’t better. In fact, GDP growth was temporarily boosted by exports as US exporters scrambled to beat Trump’s tariffs. Exports of goods and services contributed 1.12 percentage points to Q2’s real GDP growth, the most since Q4-2013 (Fig. 2).

I like to look at the y/y growth rate of real GDP to assess whether the trend growth rate of the economy is changing (Fig. 3). It was up 2.8% y/y during Q2. That’s not a new high for the current expansion, and remains in the 1.0%-3.8% range it has spanned since 2010. In other words, real GDP growth still may be fluctuating around 2.0%, as it has been doing since 2010.

Consumer spending in real GDP rose 4.0% (saar) during Q2, the best since the end of 2014. Again, on a y/y basis, the growth rate for the monthly series was 2.8% during June, just about where it has been since late 2015 (Fig. 4). Real capital spending rose solidly by 7.3% (saar) during Q2, but the 6.7% y/y growth rate was nothing out of the ordinary (Fig. 5).

Could the US economy actually be slowing already despite the fiscal stimulus provided by the tax cuts enacted at the end of last year and the fiscal spending increases passed at the start of this year? If it is, we can blame the Fed for raising interest rates and the Trump administration for imposing tariffs. Both developments have also contributed to a stronger dollar, which may also start to weigh on exports and profits.

I don’t see a recession coming, but I am looking out for signs of weakness. There have been more of them recently, with the obvious exception of the all-important and booming labor market. Now consider the following:

(1) Economic surprises downbeat. The big surprise is that the Citigroup Economic Surprise Index (CESI) has dropped from a recent high of 84.5 on December 22, 2017 to -13.9 on Monday (Fig. 6). That doesn’t jibe with the strength in real GDP, particularly during Q2. Then again, the CESI tends to be weak during Q1 and sometimes during Q2, before rebounding during the second half of the year. In any event, it is a trendless cyclical indicator, which means that after it goes down for a while, it goes up for a while.

Notice that the CESI dropped sharply on the weaker-than-expected payroll employment gain of 157,000 during July, reported on Friday. However, it obviously didn’t reflect the significant upward revisions in May (24,000 to 268,000) and June (35,000 to 248,000)! Nor did it capture the 389,000 jump in the household measure of employment, led by a whopping 453,000 in full-time jobs!

(2) NM-PMI drops. The NM-PMI fell from 59.1 during June to 55.7 last month (Fig. 7). That’s the lowest since last August. The new orders component dropped from 63.2 to 57.0. I am not alarmed, because the series is very volatile and the latest readings remain relatively high. Keep in mind that this is another trendless cyclical indicator. It was so good earlier this year that it couldn’t get much better. Instead, it got a little worse, but still remains upbeat!

(3) Residential construction flattening. Private residential investment in real GDP fell 1.1% (saar) during Q2, and was up only 1.4% y/y (Fig. 8). The weakness has been concentrated in multi-family housing construction, which is down 4.9% y/y (Fig. 9).

Household formation among homeowners has been increasing in recent quarters, while the number of households who rent has been falling. That should be good for single-family residential investment, though it fell 4.7% (saar) during Q2 (but was up 3.5% y/y), as rising mortgage rates may be starting to curb some enthusiasm for buying a home. That’s not confirmed by mortgage applications for new purchases, which remain near recent cyclical highs (Fig. 10).

(4) Auto sales looking toppy. The 12-month sum of US motor vehicle sales peaked at 17.7 million units during February 2016, falling to 17.3 million units last month (Fig. 11). While both domestic light truck and imported auto sales remain on uptrends, domestic car sales have crashed to the lowest since November 2010 (Fig. 12).

I suspect that the Millennials may be causing home and auto sales to top out. They are mostly minimalists. Many are single and city dwellers, renting apartments, which are no longer in short supply after the multifamily housing boom of the last few years. They don’t have much use for a car, let alone a light truck. Instead, they rely on Uber and Lyft or rent bicycles.

The bottom line on all the above is that the US economy isn’t as weak as it seems according to the recent signs of slowing. On the other hand, it isn’t as strong as supply-siders had hoped it would be in response to their tax cut, but the jury may still be out on that score.

Thursday, August 2, 2018

Tug of War In the Bond Market


Helping stocks to recover from the year’s lows in early February is the eerie calm in the US bond market. The Bond Vigilante Model suggests that the 10-year Treasury bond yield tends to trade around the growth rate in nominal GDP on a y/y basis (Fig. 1). It has been trading consistently below nominal GDP growth since mid-2010. The current spread is among the widest since then, with nominal GDP growing 5.4% while the bond yield is around 3.00% (Fig. 2).

Why isn’t the bond yield closer to 4.00% or even 5.00%? After all, the Tax Cuts & Jobs Act enacted at the end of last year and additional fiscal spending passed by Congress earlier this year are projected by the Congressional Budget Office to result in federal budget deficits averaging about $1 trillion per year for the next 10 years (Fig. 3). Furthermore, the FOMC commenced tapering its balance sheet last October and plans to continue doing so through the end of 2024 (Fig. 4). The Fed is on track to slash its holdings of Treasuries and MBSs by $2.5 trillion and $1.7 trillion, respectively, over the next seven years! Oh and by the way, the FOMC is on track to raising the federal funds rate to 3.00% by the end of next year from 1.75%-2.00% currently.

Let’s review some possible explanations for the nonchalant performance of the bond market. Is it the calm before the storm or the calm that calmly continues? Consider the following bullish offsets to the bearish factors just mentioned above:

(1) Near-zero yields in Germany and Japan. The 10-year German government bond yield has dropped from this year’s high of 0.77% on February 2 to 0.45% 0n Tuesday (Fig. 5). Germany may have been hit by uncertainty created by Trump’s trade war. The IFO Business Confidence Index has been falling all year, with its expectations component the lowest since March 2016 (Fig. 6). In any event, the ECB has indicated that the bank’s key interest rates will remain at historical lows at least through the summer of next year!

Meanwhile, there was some anxiety last week about a rumored change of course by the BOJ. The 10-year Japanese bond yield jumped from 0.035% on Friday, July 20, to 0.104% on Monday of this week. It was back down to 0.048% on Tuesday after the BOJ kept its policy steady. It maintained its target for the 10-year government bond yield at around 0.00% and the short-term interest rate target at minus 0.1%. The bank announced one minor tweak: In a statement, it explained that the yields may move up or down “to some extent mainly depending on developments in economic activity and prices.”

Wow, lots of agita about nothing! The BOJ also acknowledged that it will take “more time than expected” to achieve its inflation target of 2%. You think? The BOJ’s monetary base has more than quadrupled since April 2013, when Haruhiko Kuroda, the new head of the bank back then, slammed on the monetary accelerator and never took his foot off of it (Fig. 7). Most of the time since then, through June of this year, Japan’s CPI inflation rate has remained closer to zero than 2.0% (with the exception of 2014, when the sales tax was raised significantly) (Fig. 8).

(2) Subdued inflation. Back in the USA, the latest inflation figures remain relatively benign: Not too hot, not too cold, just warm enough to allow the Fed to proceed with the gradual normalization of monetary policy. The headline PCED rose 2.2% y/y through June, while the core increased 1.9% over the same period (Fig. 9).

The wage component of the Employment Cost Index held at 2.9% y/y during Q2 (Fig. 10). That’s the highest pace since Q3-2008, but still relatively low given the tightness of the labor market.

(3) Record wealth, with lots set on risk off. That still leaves an important question: Why aren’t bond yields rising in anticipation of all the debt that will need to be financed? There is already a record amount of debt everywhere, and more coming can’t be good for bonds. There is also a record amount of wealth in the world. Some of it tends to be managed with a risk-off bent. Ironically, people who expect that “this will all end badly” tend to buy government bonds because they are deemed to be among the safest assets.

Friday, July 27, 2018

Weekly Fundamental Stock Market Indicator Remains Bullish, So Far


So far, the escalating trade and currency wars aren’t weighing on the weekly stock market fundamentals that I track and discuss below. That’s because the US economy received a big boost from the Tax Cuts and Jobs Act (TCJA) at the end of last year. Federal tax receipts as a percentage of nominal GDP dropped from 18.2% during Q4-2017 to 17.5% during Q1-2018 (Fig. 1 and Fig. 2). That’s the lowest reading since Q4-2012. Normally, this ratio drops during recessions, not during expansions. So the TCJA is giving a big boost to an economy that is already at full employment. Let’s have a closer look:

(1) Individual tax receipts still growing after TCJA. The y/y growth rate of income taxes in personal income fell to 3.6% during May, down from a recent peak of 7.1% at the end of last year (Fig. 3). The ratio of personal income taxes to personal income has been in a flat trend around 12.5% since 2015. It edged down to the bottom of the range in May (Fig. 4). In other words, it’s hard to see the tax cut in these data because personal income has been growing, boosting individual income tax receipts even after TCJA-reduced tax rates. I suppose supply-siders can take credit (perhaps prematurely) for this development.

By the way, also contributing to the strength of consumer spending is the downtrend in the personal savings rate, which started in late 2015 (Fig. 5). Incredibly, the 12-month sum of personal saving has been nearly halved from a recent high of $829 billion during November 2015 to $458 billion during May (Fig. 6).

(2) Corporate profits jumped after TCJA. Corporate profits also received a big boost from the TCJA. In the GDP accounts, corporate profits taxes plunged from $446 billion (saar) during Q4-2017 to $332 billion during Q1 of this year (Fig. 7).

Industry analysts have raised their 2018 consensus estimate for S&P 500 earnings per share by $13.35 since late last year through the first week of July (Fig. 8). That’s a 9.0% increase that is mostly attributable to the slashing of the corporate tax rate. Soaring earnings is the bullish signal that is offsetting all the bearish noise coming out of Washington.

(3) Boom-Bust Barometer near recent record high. The recent weakness in some key commodity prices, such as the price of copper, hasn’t weighed heavily on the CRB raw industrials spot price index (Fig. 9). Meanwhile, initial unemployment claims remains at its lowest readings since early December 1969 (Fig. 10). As a result, my Boom-Bust Barometer (BBB), which is the ratio of the CRB index to jobless claims, remained in record-high territory during the 7/14 week (Fig. 11).

(4) Forward earnings soaring. The BBB is highly correlated with S&P 500 forward earnings, which soared to yet another record high of $170.21 per share during the July 19 week (Fig. 12). (As I explain in Chapter 13 of my book, Predicting the Markets, forward earnings is the time-weighted average of industry analysts’ consensus estimates for earnings during the current year and the coming year. It tends to accurately lead actual earnings during expansions. However, it consistently fails to anticipate recessions.)

(5) FSMI remains bullish. My Fundamental Stock Market Indicator (FSMI) is simply the average of the BBB and the weekly Consumer Comfort Index (Fig. 13). It remains at record highs, and has been highly correlated with the S&P 500 since 2000. The FSMI isn’t a leading indicator of the stock market, but it is useful for either confirming or raising some doubt about the direction of stock prices. In any event, it is still bullish, and helps to explain why stock prices have held up so well in the face of Trump’s escalating trade war with our major trading partners.

Monday, July 23, 2018

CFA Institute's Review of My Book, Predicting the Markets

Financial Analysts Journal
Book Reviews
2018, Volume 13 Issue 1

Predicting the Markets: A Professional Autobiography (a review)
Reviewed by Janet J. Mangano

Edward Yardeni’s (“Dr. Ed’s”) Predicting the Markets: A Professional Autobiography is a massive, entertaining, and enlightening work that captures the reader’s imagination and challenges established investment and analytical processes. The title only begins to suggest what is inside. Beyond “predicting the markets,” the book encompasses decades of intense, thoughtful research that shows there is no single simple—or even complex—way to predict the markets, the economy, or any sector within them. Solid research goes a long way, however, toward blazing a trail, creating new insights, and hypothesizing about the future.

To some extent, Predicting the Markets is more retrospective than predictive. Yardeni reviews past and present Federal Reserve Bank monetary policy and certain aspects of its implementation, such as setting interest rate and inflation targets and quantitative easing. He also addresses how valuation methods have changed from dividend-driven approaches to earnings-driven approaches and beyond.

The actual professional autobiography is charmingly presented in Chapter 1. It is so extensive that it could stand as a book on its own. In these pages, Yardeni recounts his four decades in the investment business, primarily as an economist but also in a breakthrough position he attained at C.J. Lawrence as chief economist/chief investment strategist. In 2007, he founded his own firm, Yardeni Research, where he continues to serve in the dual function of president and chief investment strategist.

Certain details of the book’s autobiographical component will probably strike current CFA candidates as quaint. Computers and databases were not easily available 40 years ago, but Yardeni and his contemporaries delved into time series and corporate filings while enjoying access to great thinkers and to corporate management in an era prior to Regulation Fair Disclosure. Yardeni grew professionally in a time when corporate buybacks were considered poor practice, if not borderline illegal.

The heart of the book is simultaneously professional and personal, as well as both retrospective and predictive. Yardeni addresses, in an economic setting, the critical issues driving the markets, considering current and hypothetical conditions. History always influences—and demographics invariably guide—his work. Readers will be rewarded for the effort required to understand the specific workings of the models and relationships that Yardeni explains not only through backtesting but also by observing how they are likely to perform in the future under different conditions.

Does anyone stress to the extent Yardeni does the need to study the Federal Reserve Bank’s “Financial Accounts of the United States” on a regular basis to gain a sense of where investors are investing? Economists will recognize the legacy he shares with Janet Yellen as a former student of James Tobin at Yale University. His neo-Keynesian focus is clearly on growth in real income and investment.

Among the chapters, “Predicting the Fed” is a standout. It is the lengthiest and the most comprehensive in revisiting the reasoning behind policies and the actions that result from them. Readers will perceive in a new light why certain monetary actions (such as deactivating the gold standard) were taken at specific points in time. Thanks to the questions Yardeni poses about quantitative easing, they will begin to comprehend why it has been as massive and has lasted as long as it has over the past decade. The discussions in this chapter make the reader feel like a member of the Federal Open Market Committee. Readers will also improve their understanding of inflection points in the economy, provided they are willing to put in the necessary time to perform the required analysis. This learning is also facilitated by reviewing the book’s excellent charts, along with timely updates that Yardeni makes available online.

The chapter titled “Predicting Valuation” is informative for individuals engaged in capital investments for businesses, corporate finance, and asset management. Its clarity rests in the applicability of particular valuation methods at different points in time and their lack of validity at others. Yardeni mentions CFA candidates in this chapter and the necessity that they understand the Fed’s Stock Valuation Model of 1997 and the 1999 Yardeni extension of it. Recall that Alan Greenspan was the first Fed chair to comment about the impact of monetary policy on the interaction between the inflation rate and the valuation of equities. (How could any of us then working as analysts and investors forget Chair Greenspan’s assertion that low price inflation was boosting valuation multiples to levels of “irrational exuberance”?) The importance of this exercise is to understand why such models were used, how the inflection points were measured, and how useful or useless they may be now and in the future. The tried and true dividend discount model cannot be applied in all situations, nor can earnings-centric models when real interest rates—or earnings—are at or below zero.

Predicting the Markets differs from the autobiographical works of other economists and investors (such as Henry Kaufman, Andrew Lanyi, and Michael Steinhardt) in its humor and occasional boasting. It is also grounded in disciplined study and analysis over decades, while providing clear, meaningful narrative and graphs. Yardeni demonstrates that his well-informed conclusions and insights are derived from hard data and facts and states that they remain subject to change as new conditions emerge. His mega-book will inspire both novice and seasoned economists and investors to use common sense, coupled with an intellectual edge.

Thursday, July 19, 2018

Donald Trump vs Blanche DuBois

Much like Blanche DuBois in Tennessee Williams’ play “A Street Car Named Desire,” the US has “always depended on the kindness of strangers,” or at least it has for a very long time. That’s because foreigners have been big buyers of bonds issued by Americans. They’ve helped to finance the US federal budget deficit. They’ve also bought lots of mortgage-backed and corporate bonds.

Trump’s escalation of the trade war between the US and all our major trading partners has raised concerns that foreigners will respond to Trump’s “America First” protectionism by cutting back on their purchases of US debt. Furthermore, Trump’s tariffs may boost inflation in the US by increasing the cost of imports. Both possibilities should be bearish for bonds. Yet bond yields remain eerily subdued. Let’s consider why, and also whether tariffs are necessarily inflationary:

(1) Bond yields and expected inflation. The 10-year US Treasury bond yield peaked this year at 3.11% on May 17, and has been trading below 3.00% most of the time since then (Fig. 1). The comparable 10-year TIPS yield has mirrored the nominal yield so far this year.

Expected inflation, as implied by the spread of the two yields, has been relatively stable around 2.00% after mostly rising during the second half of 2017 from a low of 1.66% on June 21, and jumping after passage of the Tax Cuts and Jobs Act (TCJA) on December 22 (Fig. 2).

The escalating trade war hasn’t boosted the expected inflation spread, so far, despite Trump’s threat to impose tariffs on lots of Chinese imports. So far, there is no sign that foreigners are bailing out of US debt securities. On the contrary, the outbreak of protectionist saber-rattling, and now jousting, has boosted the trade-weighted dollar (Fig. 3). This suggests that some global investors are taking sides in the trade war, betting that the US will win, if there is a winner, or at least will emerge the least bloodied.

Meanwhile, despite the potential of an escalating trade war to cause a global recession, the credit-quality yield spread between high-yield corporate bonds and the 10-year Treasury bond also remains eerily serene. It’s been in a tight range around 350bps since early 2017 (Fig. 4).

(2) Dr. Copper. The price of copper (a.k.a. “the metal with the PhD in economics”) has been falling since it peaked this year at 329.3 cents per pound on June 8 (Fig. 5). It continued to move lower last week, closing at 277.0 cents, down 15.9% from the recent peak. Since this says more about the economy of China than that of the US, it’s not surprising to see that Chinese stocks are getting hammered (Fig. 6).

Meanwhile, the S&P 500/400/600 are up 8.5%, 10.8%, and 17.1% since their lows on February 8. My switch back to a Stay Home from a Go Global investment strategy on June 4 was well timed, so far, as evidenced by the ratios of the US MSCI to the All Country World ex-US MSCI in both dollars and local currency terms. Both soared to record highs last week (Fig. 7).

(3) Flow of funds. As I discuss in my book, Predicting the Markets, I use the Fed’s quarterly report Financial Accounts of the United States to monitor the flow of funds in the capital markets. The data are currently available through Q1-2018. They show that the “rest of the world” acquired $674 billion in US fixed-income securities over the past four quarters (Fig. 8). That’s among the highest readings since the 2008 financial debacle. The figure includes $332 billion in US Treasuries and $267 billion in corporate bonds (Fig. 9 and Fig. 10).

The consensus view among economists is that Trump is wrong about trade wars. They aren’t “good, and easy to win,” as he tweeted on March 2. It is also widely believed that if he continues to escalate the trade war, everyone will lose because the result is most likely to be stagflation or worse. Weakening global trade will depress global growth, while higher tariffs will boost inflation. I am not dismissing this widely believed narrative. However, while Trump has opened up lots of fronts in his battle for fair trade with America’s major trading partners, the major fight is with China. Will China put up the white flag and make major concessions to get a cease fire out of Trump?

Currently, that seems to be an unlikely scenario. However, that’s exactly the story being told by the financial markets. As noted above, while Chinese stocks are falling, US stocks are rising. The weakness in the price of copper is a better economic indicator for the economy of China than for that of the US.

While the Fed continues to gradually normalize monetary policy, the People’s Bank of China cut reserve requirements sharply in recent weeks (Fig. 11). That undoubtedly contributed to the 6.2% plunge in the yuan from its mid-April peak (Fig. 12).

If Trump does raise the ante by slapping a 10% tariff on $200 billion of imports from China, a stronger dollar relative to the yuan might very well offset most of the inflationary consequences for the US. To add insult to injury, Trump could revive his attacks on China as a “currency manipulator.” However, in my opinion, it is US trade policies, not Chinese intervention, that is weakening the yuan.

Trump knows that a weak yuan could cause the Chinese some real pain, by increasing the yuan cost of buying dollar-priced commodities, especially oil. China’s PPI inflation rate, which was 4.7% on a y/y basis in June, could go higher and put upward pressure on the CPI inflation rate, which was 1.9% last month (Fig. 13).

Meanwhile, in the US, the year-to-date (through 7/13) performances of the S&P 500 sectors suggest that investors are more concerned about rising interest rates resulting from a strong economy than about a trade war depressing the economy (Fig. 14): Information Technology (15.3%), Consumer Discretionary (14.1), Health Care (5.8), Energy (5.7), S&P 500 Index (4.8), Real Estate (-0.1), Utilities (-0.3), Industrials (-2.8), Materials (-3.1), Financials (-3.5), Consumer Staples (-7.8), and Telecom Services (-10.3). Cyclical stocks are mostly outperforming interest-rate sensitive ones.

Sunday, July 15, 2018

Predicting the Markets

May I suggest you take my recently published book Predicting the Markets: A Professional Autobiography along to the beach this summer? If you like reading biographical histories that focus on financial markets and the economy, you should enjoy my book. If you prefer thrillers, then The President Is Missing by Bill Clinton and James Patterson might be a better choice.

I wrote my book to share what I have learned over the past 40 years as an economist and investment strategist on Wall Street. My hope is that investors in my age bracket find it to be an enjoyable and thought-provoking walk down Memory Lane and that younger folks find plenty of insights they can put to good use in their financial life. In writing the book, I’ve avoided jargon for a narrative that appeals mostly to one’s common sense.

My career has provided me with lots of opportunities for testing theories, and for learning from both successes and mistakes. I started my career on the Street at EF Hutton in 1978. The Dow Jones Industrials Average was around 1000 at the time. Now it is over 25000. I’ve been bullish most of that time. However, I also stumbled a few times along the way.

For example, I didn’t foresee the flash crash on Black Monday October 19, 1987. But I argued that it was a buying opportunity because the outlook for earnings remained solid. During 1999, I turned negative on tech stocks because they seemed significantly overvalued. I also warned that the Y2K problem might cause a recession. It did, but I was right for the wrong reason: Computer systems continued to work just fine after the stroke of midnight 2000; however, so much money had been spent on fixing the problem that sales of information technology hardware and software plummeted, depressing the economy.

From 2003 through 2007, I grew increasingly bullish owing to the positive implications I saw for commodity prices—and for the Materials, Energy, and Industrial sectors of the S&P 500—when China emerged as a major driver of the global economy. I turned bearish on the S&P 500 Financials sector on June 25, 2007, but I wasn’t bearish enough on the overall market because I never expected that the federal government would let Lehman fail, as it did on September 15, 2008. I did better at calling the major market bottoms in August 1982 and March 2009.

Along the way, I learned lots of lessons that I hope will be helpful to investors, many of whom don’t pay enough attention to the big picture. Without further ado, here are some of the major lessons I’ve learned and why they are relevant to investors today:

(1) Getting inflation right is imperative. In my book, I observe: “Accurately predicting price inflation is one of the most important prerequisites for predicting the outlook for the stock and bond markets. A bad inflation forecast almost certainly will result in bad investment choices in all the major financial markets.”

During my career so far, inflation has trended downward. Fortunately, I was an early proponent of “disinflation.” I never bought the idea promoted by Milton Friedman that inflation is solely a monetary phenomenon that can be controlled by the Fed or any other central bank. Instead, my view has been that price inflation is also determined by more microeconomic factors, particularly the competitiveness of markets. Globalization, deregulation, and the advance of information technologies have been major forces heightening competition, in the US and abroad, over the past few decades.

Following the Great Recession of 2008, the major central banks sought to avoid deflation and adopted 2.0% inflation targets. They lowered their official interest rates close to zero and pumped liquidity into their economies with quantitative easing programs, i.e., by purchasing bonds in the capital markets. Yet inflation remains remarkably subdued, with relatively lackluster economic growth among the major industrial economies. Much of the liquidity seems to have gone into the financial markets, driving bond yields lower and stock prices higher. Real estate also has benefited from the ultra-easy policies of the central bankers.

(2) The Phillips curve isn’t working. In the US, Fed officials have been expecting that their policies would lower the unemployment rate and boost wage inflation, which would be marked up into price inflation. They based that on the Phillips Curve Model, which posits an inverse correlation between the inflation rate and unemployment rate. The jobless rate dropped below 4.0% recently, the lowest in decades. Yet wage inflation remains subdued. Globalization and technological innovation may account for much of the “flattening” of the Phillips curve. Globalization is currently being challenged by President Donald Trump’s protectionist saber-rattling, while technological innovation seems to be happening at a faster and faster pace. The jury is out, but I expect that the net effect will be that inflation remains subdued.

(3) No boom, no bust. Inflation is a key driver of the business cycle. In the past, recessions were followed by recoveries, with GDP regaining what was lost during the downturn. During the subsequent expansion phase, GDP rose to record highs. Along the way, excesses developed as businesses scrambled to add capacity and to hire more workers at higher wages. The good times encouraged more borrowing to finance the expansion. Debt-to-income ratios rose rapidly. The Fed was clearly behind the curve, and raced to get ahead of rising inflationary pressures. Rapidly rising short-term rates triggered a financial crisis as some borrowers failed to service their debts when their sales disappointed. That triggered a widespread credit crunch as even good borrowers were denied refinancing by their lenders, who were plagued by mounting bad loans. The yield curve inverted as investors in Treasury bonds started to anticipate that the boom soon would be followed by a bust, which invariably happened.

This time may or may not be different. But for now, business managers are remaining relatively cautious. Many of them faced a near-death experience during the Trauma of 2008. Ever since, they seem to have been focusing on increasing their profit margins, which rose to a record high for the S&P 500 during the fourth quarter of 2017, before Trump’s tax cut, and even higher during the first quarter of this year, after the tax cut.

Also different this time, so far, is that the flattening yield curve may reflect investors’ perceptions that the Fed is ahead of the inflation curve, which explains why Treasury bond yields aren’t rising as rapidly as the federal funds rate. Furthermore, the US bond market has been globalized in recent years, with record-low yields in the Eurozone and Japan keeping US yields lower than otherwise.

(4) Profits drive the economy. Economists and investors tend to focus on the business cycle, which I believe is driven by the profits cycle. While politicians pat themselves on the back for creating jobs, it is businesses that actually do the hiring, especially small ones that aspire to grow into bigger ones. Profitable companies expand their capacity and increase their payroll head count. Unprofitable companies retrench across the board. Record-high profit margins show no signs of fulfilling bearish market prognosticators’ warnings throughout the bull market that they are bound to revert to their means.

(5) Forward earnings drive the stock market. Forecasting the stock market should be easy since it involves forecasting just two variables—namely, earnings (E) and the valuation multiple (P/E). Getting them right is the hard part. In my book, I explain why I favor tracking the industry analysts’ consensus expectations for the operating earnings of the S&P 500 on a weekly basis. In my opinion, the market discounts forward earnings, which is a time-weighted average of the consensus forecasts for the current year and the coming year. S&P 500 forward earnings rose to a record high at the end of last year, before Trump’s tax cuts took effect. They shot up in January when the tax cuts became effective.

Yet stock prices have been zigzagging since late January on fears that the Fed’s interest-rate hikes and balance-sheet tapering might cause a financial crisis, as happened during previous tightening rounds. There’s mounting evidence that the normalization of monetary policy in the US may be stirring up an emerging markets crisis. Trump’s protectionist saber-rattling is another source of concern, though most cyclical sectors of the S&P 500 have been outperforming the overall index so far this year, while the “safe” interest-rate-sensitive sectors have been hard hit by the rising bond yield.

With forward earnings continuing to rise into record territory, the zigzagging stock market has been driven by the zigs and zags in the forward P/E. Valuation multiples that were awfully high in January are closer to their long-run fair values based on forward P/Es. I devote a chapter of my book to all the widely followed valuation metrics. P/Es based on forward earnings tend to be too optimistic, especially just before recessions; that’s because industry analysts collectively don’t see recessions coming and must slash their forecasts as recessions unfold. On the other hand, P/Es based on trailing earnings (like Shiller’s CAPE, which is based on 10-years-trailing earnings) tend to be overly and prematurely bearish during bull markets.

(6) The end is far. Lots can go wrong in the foreseeable future. Trump’s protectionist saber-rattling could trigger a global trade war. The Fed could trigger another financial crisis, especially among emerging market economies. In the intermediate term, say the next 12 months, inflation could make a surprising comeback (at least surprising to me), forcing the Fed to tighten more aggressively. In the long term, say the next one to three years, swelling federal government budget deficits combined with the Fed’s balance-sheet tapering could push up bond yields to levels that cause trouble.

I might be overstaying my welcome in the bullish camp, but I believe that strong earnings will remain the signal that the market heeds. I’ve noted since the start of the bull market that it was prone to panic attacks on fears of another trauma like the 2008 calamity. I’ve consistently argued that they would pass, followed by relief rallies. One day, there will be a recession and a bear market. But as long as inflation remains subdued, the Fed is unlikely to raise interest rates to levels that precipitate these events. I expect that the current economic expansion will continue through at least July 2019, when it will become the longest one since the end of World War II.

(7) Technology is often a pleasant surprise. By now, you may have concluded that I am an optimist. Guilty as charged. I’m looking forward to writing a book about the next 40 years of my career, and I’m counting on biotech innovations to keep me going that long. Technological innovations are mostly ignored by economists, particularly of the pessimistic variety. They often fail to foresee, let alone to see, that the inexorable advance of technology is a major source of productivity, which keeps a lid on inflation and boosts both profits and standards of living.

(8) Economics is the study of abundance, not scarcity. In the book, I write: “The latest (19th) edition of Economics (2010) by Paul Samuelson and William Nordhaus teaches students that economics ‘is the study of how societies use scarce resources to produce valuable goods and services and distribute them among different individuals.’ This definition hasn’t changed since the first edition of this classic textbook was published in 1948. I’ve learned that economics isn’t a zero-sum game, as implied by the definition. Economics is about using technology to increase everyone’s standard of living. Technological innovations are driven by the profits that can be earned by solving the problems posed by scarce resources. Free markets provide the profit incentives to motivate innovators to solve this problem. As they do so, consumer prices tend to fall, driven by their innovations. The market distributes the resulting benefits to all consumers. From my perspective, economics is about creating and spreading abundance, not about distributing scarcity.”

(There are more than 700 charts referenced in the book. All are automatically updated and posted on the book’s website, yardenibook.com. If you teach economics or finance courses, please inquire about my partnership program to motivate students to major in these subjects. Send me a message at info@yardenibook.com.)

Tuesday, July 10, 2018

Is the Yield Curve Bearish for Stocks?

The yield curve is commonly measured as the spread between the 10-year US Treasury bond yield and the federal funds rate (Fig. 1). This spread has narrowed significantly since the start of this year, raising fears of an imminent recession and bear market in stocks (Fig. 2). That’s because in the past, the yield curve spread has flattened (i.e., narrowed) and then inverted (i.e., the bond yield was below the federal funds rate) immediately preceding the past seven recessions.

Recessions cause bear markets in stocks, which is why the yield curve has received lots of buzz in recent weeks (Fig. 3). Do a Google Trends search on “yield curve” for the past five years, and you’ll see a trendless series through the end of last year, followed by an upward-trending series so far this year with a spike in June.

The Federal Open Market Committee (FOMC), the entity that sets the Federal Reserve’s monetary policy, raised the federal funds rate by 25 basis points (bps) on June 13 to a range of 1.75%-2.00%, following a similarly sized hike on March 21 (Fig. 4). Yet the 10-year US Treasury bond yield peaked so far this year at 3.11% on May 17 and fell to 2.82% in early July. The spread, which had been just over 150 bps earlier this year, has narrowed to just below 100 bps now. The yield curve spread between the 10-year and 2-year Treasuries has triggered even wider concern, as it has narrowed from over 75 bps earlier this year to almost 25 bps recently, i.e., closer to zero (Fig. 5).

A higher short end of the yield curve than long end suggests that investors expect interest rates to decline, which usually happens just before recessions. Is the yield curve about to invert? If it does, will that mark the eighth time in a row that this indicator accurately predicted a recession and a bear market in stocks?

It’s hard to argue with success. It’s always unsettling when arguments are made for why “this time is different.” Nevertheless, let’s go there. Consider the following:

(1) One of 10. In my new book Predicting the Markets, I observe that the yield curve spread is actually one of the 10 components of the Index of Leading Economic Indicators (LEI), which is deemed to provide a recession warning roughly three months before one starts. A list of the 10 can be found on The Conference Board’s website. Among the 10 are the S&P 500, initial unemployment claims, and measures of consumer and business confidence. Collectively, they’ve pushed the LEI up by 6.1% over the past 12 months to yet another new record high during May (Fig. 6). So the LEI certainly isn’t sounding a recession alarm.

(2) Credit crunches. In the past, the Fed would raise the federal funds rate during economic booms to stop an acceleration of inflation. Fed officials did so aggressively, perhaps in no small measure to shore up their credibility as inflation fighters. Tightening credit market conditions often triggered a credit crunch—particularly during the 1960s and 1970s, when interest-rate ceilings on bank deposits were set by Regulation Q—as even the credit-worthiest of borrowers found that bankers were less willing and able to lend them money (Fig. 7).

Sensing this mounting stress in the credit markets and expecting the credit crunch to cause a recession and a bear market in stocks, investors would pile into Treasury bonds (Fig. 8). The yield curve inverted, accurately anticipating the increasingly obvious chain of events that ensued—i.e., rising interest rates triggered a credit crisis, which led to a widespread credit crunch and a recession, causing the Fed to lower short-term interest rates.

(3) No boom, no bust. So how can we explain the flattening of the yield curve during the current business cycle? Inflation remains relatively subdued, having risen to the Fed’s 2.0% target (measured by the personal consumption expenditures deflator excluding food and energy on a year-over-year basis) during May—for the first time since the target was explicitly established by the Fed on January 25, 2012 (Fig. 9)!

The Fed has gradually been raising the federal funds rate since late 2015, yet few critics charge that the Fed is behind the curve on inflation and needs to raise interest rates more aggressively. The economy is performing well, but there are few signs of an inflationary boom or major speculative excesses that require a more forceful normalization of monetary policy.

(4) Globalized bond market. In my opinion, the flattening of the US yield curve is mostly attributable to the negative interest policies of the European Central Bank (ECB) and the Bank of Japan (BOJ) (Fig. 10). The ECB first lowered its official deposit rate to below zero on June 5, 2014. The BOJ lowered its official rate to below zero on January 29, 2016. Those rates, which remain slightly below zero, have reduced 10-year government bond yields to close to zero in both Germany and Japan since 2015 (Fig. 11).

Such yields certainty make comparable US Treasury bonds very attractive to investors—especially when the dollar is strengthening, as has been the case this year (Fig. 12). When investors turn defensive and want to park their money in a safe asset, the US Treasury bond clearly offers a more attractive return than bunds and JGBs.

(5) Bond Vigilantes. In other words, the US bond market has become more globalized, and is no longer driven exclusively by the US business cycle and Fed policies. In my book, I discuss the close correlation between the 10-year Treasury bond yield and the growth rate of nominal GDP, on a year-over-year basis (Fig. 13 and Fig. 14). The former has always traded in the same neighborhood as the latter. I call this relationship the “Bond Vigilantes Model.” The challenge is to explain why the two variables aren’t identical at any point in time or for a period of time. Nominal GDP rose 4.7% during the first quarter of 2018 and is likely to be around 5.0% during the second quarter, on a year-over-year basis. Yet the US bond yield is below 3.00%.

During the 1960s and 1970s, bond investors weren’t very vigilant about inflation and consistently purchased bonds at yields below the nominal GDP growth rate. They suffered significant losses. During the 1980s and 1990s, they turned into inflation-fighting Bond Vigilantes, keeping bond yields above nominal GDP growth. Since the Great Recession of 2008, the Wild Bunch has been held in check by the major central banks, which have had near-zero interest-rate policies and massive quantitative easing programs that have swelled their balance sheets with bonds. Meanwhile, powerful structural forces have kept a lid on inflation—all the more reason for the Bond Vigilantes to have relaxed their guard.

As noted above, a global perspective certainly helps to explain why the US bond yield is well below nominal GDP growth. So this time may be different than in the past for the bond market, which has become more globalized and influenced by the monetary policies not only of the Fed but also of the other major central banks.

(6) Another Fed Model. The latest minutes of the June 12-13 FOMC meeting offers another reason not to worry about the flattening yield curve. During the meeting, Fed staff presented an alternative “indicator of the likelihood of recession” based on research explained in a 6/28 FEDS Notes titled “(Don't Fear) The Yield Curve” by two Fed economists. In brief, they question why a “long-term spread” between the 10-year and 2-year Treasury notes should have much power to predict imminent recessions. As an alternative, they’ve devised a 0- to 6-quarter “near-term forward spread” based on the spread between the current level of the federal funds rate and the expected federal funds rate several quarters ahead, derived from futures market prices (Fig. 15).

The note’s authors stress that the long-term spread reflects the near-term spread, which they argue makes more sense as an indicator of a recession that is expected to occur within the next few quarters. They also observe that an inversion of either yield spread does not mean that the spread causes recessions.

Their current assessment is that “the market is putting fairly low odds on a rate cut over the next four quarters,” i.e., 14.1% (Fig. 16). “Unlike far-term yield spreads, the near-term forward spread has not been trending down in recent years, and survey-based measures of longer-term expectations for short term interest rates show no sign of an expected inversion.”

What a relief! So now, all we have to worry about is a recession caused by a trade war!

Thursday, July 5, 2018

Mother of All Credit Bubbles?


A 6/8 article in The Washington Post was ominously titled “Beware the ‘mother of all credit bubbles.’” Author Steven Pearlstein is a Post business and economics writer and the Robinson Professor of Public Affairs at George Mason University. The article has been “trending,” with 555 comments since it was posted on the Post’s website. I received several emails from accounts asking me to comment on it. So here goes:

(1) The end is coming. Pearlstein concluded his article as follows: “It’s hard to say what will cause this giant credit bubble to finally pop. A Turkish lira crisis. Oil prices topping $100 a barrel. A default on a large BBB bond. A rush to the exits by panicked ETF investors. Trying to figure out which is a fool’s errand. Pretending it won’t happen is folly.”

I agree that there will be another credit crisis—eventually. In my book Predicting the Markets, I show that most of the post-war recessions were triggered by rising interest rates. Here’s how that typically happened: Rising interest rates triggered a financial crisis when some borrowers couldn’t service their debts at the higher rates. The jump in bad loans forced lenders to cut lending across the board, even to borrowers with good credit scores. A widespread credit crunch resulted, taking on crisis proportions. The crisis grew into a contagion, and recession ensued (Fig. 1). The stock market naturally fell into a bear market (Fig. 2). It bottomed once the Fed started easing credit conditions to end the crisis.

(2) Corporations will lead the next meltdown. Pearlstein correctly observed that the previous credit bubble was inflated by “households using cheap debt to take cash out of their overvalued homes.” This time, in his opinion, the epicenter of the coming debacle is “giant corporations using cheap debt—and a one-time tax windfall—to take cash from their balance sheets and send it to shareholders in the form of increased dividends and, in particular, stock buybacks.” This is where we part ways.

Pearlstein calls it the “Buyback Economy,” where future growth is sacrificed for current consumption. The article quickly turns into a liberal progressive rant claiming that corporations are “diverting capital from productive long-term investment.” Instead of investing for the long term, they are engaging in “financial engineering” by converting equity into record debt. And needless to say, this is all making the rich richer. And who are the rich? Round up the usual suspects: They are corporate executives, wealthy investors, and Wall Street financiers.

It’s true that nonfinancial corporations’ (NFCs) debt—both debt securities and loans—is at a record high, having risen from $6.0 trillion at the end of 2010 to $9.1 trillion during Q1-2018 (Fig. 3). But NFCs’ liquid assets ($2.7 trillion during Q1-2018) and cash flow ($1.8 trillion over the past four quarters) continue to set new highs. The ratio of NFC debt to liquid assets is matching its lowest readings since the mid-1960s (Fig. 4).

The ratio of NFC short-term debt to total debt has been falling since the 1980s (Fig. 5). It is down from 40%-45% during the 1980s and 1990s to roughly 28% during the current economic expansion. This confirms that NFCs have been extending the maturity of their debt to lock in lower interest rates.

(3) Corporate bond debt at record high. It is also true that NFCs’ corporate bonds outstanding was at a record high of $5.4 trillion during Q1-2018, having doubled since the mid-2000s (Fig. 6). But again, this may partly reflect opportunistic lengthening of NFC debt maturities. The spread between gross and net NFC bond issuance rose to a record high slightly exceeding $600 billion last year (Fig. 7 and Fig. 8).

(4) Buybacks are troubling. Pearlstein claimed that buybacks amount to “corporate malpractice,” observing that companies have been spending more than 100% of their net profits on dividends and share repurchases. That’s true. Historically, however, corporations collectively have paid out roughly 50% of their profits in dividends rather than investing for the long term; that use of profits has never been viewed as malpractice (Fig. 9).

The sum of buybacks plus dividends has been running around 100% of S&P 500 after-tax earnings (Fig. 10). That means that buybacks have been 100% funded by retained earnings (i.e., after-tax profits less dividends). Even so, Pearlstein claimed without supporting evidence: “The most significant and troubling aspect of this buyback boom, however, is that despite record corporate profits and cash flow, at least a third of the shares are being repurchased with borrowed money, bringing the corporate debt to an all-time high, not only in an absolute sense but also in relation to profits, assets and the overall size of the economy.”

Not so fast: Retained earnings are just one portion of NFCs’ cash flow, which is also determined by the capital consumption allowance (CCA), i.e., depreciation reported to the IRS (Fig. 11). I like to think of the CCA as a huge tax shelter for corporate earnings.

(5) Corporations have been eating their seed corn. Progressives like Pearlstein are most incensed about how corporations aren’t investing in the future. Instead of buying back their shares with 100% of retained earnings and even borrowing to do so, the thinking goes, they should be spending more on plant and equipment. They should be paying their workers more and providing them with the skills they need to make their companies more productive, so that real incomes can grow.

What are the facts? The data show that NFCs’ gross capital expenditures are at a record high (Fig. 12). These outlays continue to be funded predominantly by cash flow in general and the CCA in particular (Fig. 13). Net fixed investment broadly has matched the spending pattern of the past two expansions (Fig. 14).

The data also show that net bond issuance has been relatively small compared to cash flow (Fig. 15). Cash flow has been ample, financing lots of capital spending and share buybacks. So buybacks haven’t come at the expense of capital spending. Furthermore, as noted above, corporations have refinanced and extended the maturities of lots of their debt at lower and lower interest rates (Fig. 16).

(6) Corporate borrowing is increasingly risky. Pearlstein claimed: “In recent years, at least half of those new bonds have been either ‘junk’ bonds, the riskiest, or BBB, the lowest rating for ‘investment-grade’ bonds. And investor demand for riskier bonds has largely been driven by the growth of bond ETFs—or exchange traded funds—securities that trade like stocks but are really just pools of different corporate bonds.”

Furthermore, Pearlstein said he is troubled that “a greater part of corporate borrowing has come in the form of bank loans that are quickly packaged into securities known as CLOs, or collateralized loan obligations, which are sliced and diced and sold off to sophisticated investors just as home loans were during the mortgage bubble.”

This may be Pearlstein’s most credible concern. Lots of junk has been piling up in the corporate credit markets, just as it did in housing’s subprime credit calamity during the 2000s. However, there was a significant stress test from the second half of 2014 through the end of 2015 in the high-yield market. The collapse of the price of oil caused credit quality spreads to blow out, especially for the junk bonds issued by oil companies. With the benefit of hindsight, that was an amazing opportunity to buy junk bonds.

My working hypothesis is that future credit crunches may be mitigated by all the distressed asset and debt funds that are around these days, with billions of dollars just waiting to scoop up distressed assets and debt at depressed prices. They may be the credit market’s new shock absorber. I believe that’s why the recent calamity in the oil patch was patched up so quickly without turning into a contagion and a crunch.

(7) Dangerous excesses abound. At the tail end of his article, Pearlstein covered all the bases with the usual litany of other credit market excesses. Rising interest rates and defaults could send ETF prices into a “tailspin.” The “global economy is now awash in debt.” The US budget deficits will exceed $1.0 trillion per year on average over the next 10 years. Household balance sheets are in worse shape than widely recognized. Margin debt is at a record high. He did concede that “[While] banks are in better shape than in 2008 to withstand the increase in default rates and the decline in the market price of their financial assets, they are hardly immune.”

Pearlstein deserves credit for having cogently presented the dangers lurking in the credit markets, which have almost always been the epicenter of potential trouble for the economy and the stock market. However, writing as an alarmist, he ignored lots of evidence that doesn’t support his alarming points. I don’t disagree that there may be another crisis—eventually. As I observed in my book, “I’ll go out on a limb and predict that there will be another financial crisis in our lifetimes. However, like previous ones, it probably will offer a great opportunity for buying stocks.”

(8) Accentuating the negatives. Pearlstein is an experienced financial journalist writing for a reputable publication, so I am not disputing all his assertions. My beef is that he accentuates the negatives and ignores the positives for NFC debt discussed in the reports he cited from the US Treasury, International Monetary Fund (IMF), and Moody’s. Trouble may be brewing for NFC debt, but there really aren’t any indications of stress yet.

Pearlstein notes: “‘Flashing red’ is how this buildup of corporate debt was characterized by the U.S. Treasury’s Office of Financial Research [OFR] in its latest annual report on the stability of the financial system.” I agree that it is hard to ignore the red boxes in Figure 20 in the OFR’s report. The red represents high “potential vulnerability” for US NFC credit risk based on corporate leverage ratios, which compare debt to assets and earnings. On the other hand, the same figure in the OFR report also shows green boxes, which represent low potential vulnerability—i.e., ample ability for US NFCs to cover their interest obligations, based on the ratio of earnings to interest.

The OFR reported: “On the positive side, many companies have rolled over existing debt at lower interest rates, while also lengthening maturities of their debt. These steps make servicing the outstanding debt less costly and boost these companies’ creditworthiness. In 2017, almost 60 percent of high-yield bond deals, by count, included repayment of debt as a use of proceeds. This is the highest level since at least 1995.” The OFR added: “Excluding commodities-related companies, the default rate for non-investment-grade, nonfinancial corporations has held steady at about 2 percent in recent years.”

“The International Monetary Fund recently issued a similar warning” about the level of NFC debt, noted Pearlstein. But notwithstanding the high level of NFC debt, one of the IMF’s key findings was that the allocation of corporate credit isn’t nearly as risky as it was before the 2008 financial crisis. In the IMF’s April Global Financial Stability Report, Chapter 2 focused on the IMF’s new global measure of the riskiness of credit allocation as an indicator of financial vulnerability. The IMF found that “a period of high credit growth is more likely to be followed by a severe downturn or financial sector stress over the medium term if it is accompanied by an increase in the riskiness of credit allocation.”

The riskiness of credit allocation at the global level has rebounded since its post-global-financial-crisis trough back to its historical average at the end of 2016, observed the IMF. Yet it is not nearly as high as it was when it peaked at the onset of the global financial crisis (see Figure 2.4.1. on page 63 in Chapter 2 of the IMF’s report). “The relatively mild credit expansion in recent years, combined with postcrisis regulatory tightening, contributed to a softer rebound in the riskiness of credit allocation than might be expected given the very loose financial conditions,” explained the IMF.

“Mariarosa Verde, senior credit officer at Moody’s, the rating agency, warned in May that ‘the record number of highly-leveraged companies has set the stage for a particularly large wave of defaults when the next period of broad economic stress eventually arrives,’” observed Pearlstein. Indeed, Moody’s May report contended that “the non-financial corporate debt burden today is higher than its peak before the 2008-09 financial crisis.” However, Moody’s also found that “the near-term credit outlook is benign and the speculative-grade default rate remains low.”

(9) Hedge clause. Needless to say, I've accentuated the positives to counter Pearlstein's comprehensive litany of negatives. The most obvious risk for stocks these days is trade protectionism rather than the bursting of a credit bubble. That's a subject for another day.

Wednesday, June 27, 2018

Buyback Bonanza

S&P 500 buybacks are back. Actually, they never left the current bull market despite recurring chatter that the buyback binge was over. Since 2014, they’ve fluctuated around an annualized rate of roughly $550 billion. They jumped during Q1-2018 to an annualized $756 billion. That’s a record high, exceeding the previous record high of $688 billion during Q3-2007.

Obviously, buyback activity was boosted by repatriated earnings following the passage of the Tax Cuts and Jobs Act at the end of last year. It lowered the corporate tax rate on such earnings from the 35.0% statutory rate to a one-time mandatory tax of 15.5% for liquid assets and 8.0% for illiquid assets payable over eight years. Odds are that corporations will continue to buy back their shares at a solid pace through the end of this year, though not at the record set during Q1.

I’ve often argued during the current bull market that the Fed’s Stock Valuation Model makes more sense to explain corporate buyback decisions than it does to explain investors’ stocks-vs-bonds asset allocation decisions. As I explain in Chapter 14 of Predicting the Markets:

“[C]orporate finance managers have a big incentive to buy back their companies’ shares when the forward earnings of their corporations exceeds the after-tax cost of borrowing funds in the bond market. Using the pretax corporate bond yield composite overstates the after-tax cost of money borrowed in the bond market. The spread between the forward earnings yield and the pretax cost of funds did widen after 2004 and remained wide well into the next decade. Obviously, it did the same on an after-tax basis. … The bottom line is that as corporate managers have increased their buyback activities, their version of the Fed’s Model has probably had more weight in the valuation of stocks. In theory, this means that valuation should be determined by the corporate version of the model.”

Meanwhile, S&P 500 dividends set a record high of $436 billion (annualized) during Q4-2017 and remained there during Q1 of this year. Together, trailing four-quarter buybacks and dividends jumped to $1.0 trillion during Q1. Since the start of the bull market during Q1-2009, buybacks have totaled $4.1 trillion, while dividends totaled $2.8 trillion. The grand total has been $6.9 trillion, so far!

While the bull market stopped charging ahead ever since the 1/26 record high, it continues to zigzag in record-high territory. The bears can continue growling about a potential trade war. Meanwhile, the bulls are taking a break and grazing on share buybacks and record corporate earnings. S&P 500 forward earnings rose to $168.56 per share during the 6/21 week, rapidly approaching my $170 target for year-end. Barring a trade war, that number should easily be achieved. Now multiply it by forward P/Es of 14, 16, and 18 to get the year-end S&P 500 potential levels of 2390, 2720, or 3060. Take your pick. I pick 3100. Again, that’s barring a trade war.

Wednesday, June 20, 2018

Trade War Noise vs Earnings Signal

President Donald Trump’s protectionist saber-rattling has led to multi-front trade skirmishes with America’s major trading partners. Now Trump threatens to up the tit-for-tat ante with an incremental 10% tariff on $200 billion of Chinese imports. He did so Monday evening. The Chinese immediately said that they would retaliate in kind.

This may all be Trump’s art of the deal-making. However, bullying the Chinese in public rather than negotiating with them in private is risky. The longer that the noisy dispute continues, the more it could harm global economic growth as businesses postpone spending until the smoke clears. The biggest risk, of course, is that the smoke is actually the fog of war. Trump’s approach risks escalating the trade skirmishes into an all-out trade war, which would depress global economic activity. Now let’s try to tune out the noise of war and find some peace and quiet:

(1) Forward earnings. Notwithstanding all of the above, I continue to focus on the strong signal coming from S&P 500/400/600 forward earnings. All three rose to record highs in mid-June. The forward earnings of the S&P 500 is up to $168.40 per share, quickly approaching my target of $170 for the end of this year. Barring an all-out trade war, that level seems easily achievable, since forward earnings will equal the consensus expectation for 2019 by the end of this year. That expectation has been rising ever since the cut in the corporate tax rate at the end of last year. It was $176.94 in mid-June. (For a thorough explanation of forward earnings, see Chapter 13 on "Predicting Corporate Earnings" in my new book Predicting the Markets.)

(2) Forward revenues. I guess that industry analysts haven’t gotten the trade-war memo yet. Their forward revenues estimates for the S&P 500/400/600 continued to climb to fresh record highs in mid-June. The upward slope is particularly steep for both the forward revenues and forward earnings of the S&P 600 SmallCaps.

(3) Profit margins. The S&P 500 forward profit margin continues to rise in record-high territory. It was 12.2% in mid-June, up from 11.1% during the December 14 week, just before Trump’s tax cut.

(4) Bottom line. My bottom line is that the noise hasn’t drowned out the signal, which remains strong enough so that stocks have held up quite well despite the noise of war. I expect that investors will tune out the noise and focus on the signal over the rest of the year.

Thursday, June 14, 2018

Red Hot SmallCaps

SmallCap stocks remain on a bullish trend, with the Russell 2000 flying to new record highs in recent weeks. The widespread explanation is that their outperformance reflects investors coming back to a Stay Home investment strategy from a Go Global one. That makes sense to me given the challenges to the global economy posed by the Fed’s tightening, the strengthening dollar, and Trump’s protectionist saber-rattling.

Also boosting SmallCaps are Trump’s deregulation and tax cuts for business. The forward earnings of the S&P 600 SmallCaps has been soaring to record highs since the enactment of the Tax Cut and Jobs Act late last year.

The National Federation of Independent Business’ May survey of small business owners showed they were ecstatic last month. The percent reporting higher minus lower earnings over the past three months soared to 3% in May. That might not seem like a big deal, but it is because that’s the highest reading on record going back to 1974! The percent who said that taxes are their most important problem was at 16.0%, based on the three-month average, holding around April’s record low. The three-month average in the percent saying that government regulation is their number-one headache dropped to an eight-year low of 13.3%.

Thursday, June 7, 2018

US Economy: Pedal to the Metal

While the global economy is being rattled by Trump’s protectionist stance on trade, renewed uncertainty about the future of the Eurozone, and capital outflows from some emerging markets, the US economy is barreling along. Real GDP may be starting to do so at a faster speed now, exceeding the so-called 2% “stall speed,” which was the so-called “New Normal” from mid-2010 through Q1-2018. Consider the following:

(1) A supercharged quarter. On Friday, the Atlanta Fed’s GDPNow model boosted the Q2-2018 real GDP growth rate to 4.8%. That’s up from 4.7% on May 31. Here are the details: “The nowcasts for second-quarter real consumer spending growth and second-quarter real private fixed investment growth increased from 3.4 percent and 4.6 percent, respectively, to 3.5 percent and 5.4 percent, respectively, after the employment report from the U.S. Bureau of Labor Statistics, the construction spending report from the U.S. Census Bureau, and the Manufacturing ISM Report On Business from the Institute for Supply Management were released this morning.”

(2) Truckers lost and found. The ATA Truck Tonnage Index rose solidly by 9.5% y/y to a record high in April. It’s been rising into record territory consistently since 2013. Its y/y growth rate is a good coincident indicator of real GDP growth, though the former is much more volatile than the latter.

Could it be that all the chatter about the shortage of truck drivers is misguided? How else to explain the record high in truck tonnage? There is a good correlation between the ATA index and payroll employment of truckers. Friday’s employment report showed that payroll employment in the truck transportation industry has been stuck just below 1.5 million for the past six months, but it is at a record high and up 24,200 y/y.

Starting at the end of last year, a new federal rule requires all interstate truck drivers to install an electronic logging device, or ELD, that logs their hours. Truck drivers are required to reduce their overtime hours because fatigued ones have been involved in major crashes on the highways. That could exacerbate the perceived shortage of workers. The y/y growth rate in the average hourly earnings of truckers is very volatile, but April’s increase of 2.5% was relatively subdued and belies the shortage-of-truckers chatter.

(3) Earned Income Proxy rising. There has also been lots of chatter about a shortage of workers in other industries. Yet overall wage inflation remained moderate at 2.7% y/y during May. However, it continues to exceed price inflation, currently running around 2.0% recently.

According to the payroll survey, employers in the private sector managed to find 218,000 net new hires last month, a solid increase for sure. According to the household survey, the number of full-time employees rose a whopping 904,000 last month to a new record high. Manufacturers have increased average overtime weekly hours from 3.2 hours a year ago to 3.5 hours during May.

Aggregate weekly hours worked for all private industries rose to a record 4.36 billion hours during May, up 2.2% y/y. Our Earned Income Proxy, which closely tracks wages and salaries in private industries, rose to yet another record high last month. This augurs well for consumer spending in particular and GDP in general.

Friday, June 1, 2018

Italy’s Swan Dive

Italy always seems to be in a political crisis. Governments don’t last very long there, as the ruling party’s coalition tends to splinter rapidly, requiring yet another election and another effort to form a government by the mostly incompatible coalitions. This time, after the March 4 election, the latest popular coalition is dominated by so-called “Eurosceptics,” who believe that Italy’s problems might be solved by dropping out of the Eurozone.

This development isn’t a black swan. Rather, it is more like a gray swan. It doesn’t come as a big surprise, yet it wasn’t widely expected either. The question is whether this problem will be contained or whether the latest political mess will trigger the next global financial crisis, which could trigger a global credit crunch and recession. The short answer is that I don’t think it will trigger a global credit crunch and recession.

During the various Greek debt crises that started in 2010, there were similar concerns. Yet the problem was contained as the IMF and EU worked out bailout deals with the Greeks. When the ongoing Greek crisis first started, pessimistic pundits predicted that even if Greece didn’t cause the next global calamity, Italy certainly could do so if push ever came to shove over that country’s messed up financial situation. That didn’t happen because the European Central Bank (ECB) bailed out all the PIIGS by providing ultra-easy monetary policy that allowed these highly indebted “peripheral” Eurozone countries to stay afloat as the ECB purchased their dodgy debts. (The PIIGS are Portugal, Ireland, Italy, Greece, and Spain.) Consider the following implications of the latest development:

(1) ECB stuck in an easing place. I think it’s safe to say that the Italian crisis will force the ECB to postpone any plans for normalizing monetary policy in the near future. After all, it was the bank’s president, Mario Draghi, who famously declared in a 7/26/12 speech: “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” That set the stage for a dramatic drop in government bond yields in the Eurozone through mid-2016. The yield spread between Italian and German bonds narrowed significantly, as did the spread between Spanish and German bonds. However, on Monday the former spread jumped sharply. The Spanish-German spread also widened.

Draghi’s ultra-easing monetary policies included a massive QE program, which increased the ECB’s balance sheet from €2.0 trillion at the end of 2014 to €4.6 trillion in late May, led by purchases of “securities of Euro Area Residents in euro.” In addition, the ECB’s official borrowing rate has been slightly below zero since June 2014.

All that huffing and puffing by Draghi has revived Eurozone lending activity since 2015, but not by a lot. However, the same cannot be said of Italy, where private-sector net lending by MFIs (monetary financial institutions excluding the ECB) has been mostly negative since the second half of 2011, and increasingly so since mid-2017.

(2) TARGET2 divergences widening. The weak link in the Eurozone financial structure may be that despite all of Draghi’s efforts to balance the inherent imbalances among the economies of the region, the imbalances are worsening, according to TARGET2 data. TARGET2 is an interbank payment system for the real-time processing of cross-border transfers throughout the EU. (“TARGET,” or the Trans-European Automated Real-time Gross Settlement Express Transfer System, was replaced in November 2007 by TARGET2.) The data show that the cross-border transactions within the region were relatively well balanced during the second half of 2008 through the end of 2009. But then the Greek crisis hit in 2010 and threatened to spread to the other PIIGS during 2011. As a result, money poured out of Italy and Spain. It went mostly to Germany.

The imbalances diminished significantly following Draghi’s July 2012 speech. But now they are bigger than ever, with surpluses totaling €1.3 trillion during March in Germany, Finland, Luxembourg, and Netherlands. The rest of the Eurozone has a net deficit of €1.0 trillion.

Hans-Werner Sinn, president of the Munich Ifo Institute, first warned about the increasing TARGET2 balances in a 2/21/11 article in Wirtschaftswoche. He drew attention to the enormous increase in TARGET2 claims held by Germany’s Bundesbank, from €5 billion at the end of 2006 to €326 billion at the end of 2010. He also noted that the liabilities of Greece, Ireland, Portugal, and Spain totaled €340 billion at the end of February 2011. He added that in the event that any of these countries should exit the Eurozone and declare insolvency, Germany’s liability would amount to 33% of their unpaid balances. Wikipedia reports that before Sinn made them public, the deficits or surpluses in the Eurozone’s payments system were usually buried in obscure positions of central bank balance sheets.

(3) Good for US bonds and the dollar. The Italian political crisis helps to remind us why the 10-year US Treasury bond yield has continued to trade well below the growth of nominal GDP in the US, despite the deteriorating outlook for the US fiscal deficit. When global investors are spooked and decide that it’s time to move from a risk-on to a risk-off strategy, they tend to buy US Treasury bonds, which means that they also have to buy US dollars to do so. The US Treasury bond yield has clearly been globalized rather than normalized. In normal times, it should be trading around the growth rate of nominal GDP, which is about 4.0%-4.5% currently. Instead, it is back below 3.00% because comparable German and Japanese yields are close to zero.

The trade-weighted dollar has appreciated 5% since February 1. That strength seemed to be fueled by Trump’s protectionist threats. Now the strength is likely to be driven by a weaker euro while we all are waiting to see whether the Italian political upheaval morphs into a more serious economic crisis.

(4) More gradual Fed? The latest FOMC minutes show that several participants of the FOMC are concerned about the flattening of the yield curve. They noted that it’s been a very reliable indicator of recessions when it has inverted in the past. Until recently, the yield curve has flattened as the Fed raised the federal funds rate more than bond yields rose in response to the Fed’s hikes. Now several Fed officials might argue for an even more gradual normalization of US monetary policy if the US bond yield falls in reaction to the Italian crisis.

(5) One more thing. Business Insider reports that “Article 75 of the Italian constitution forbids referendums dealing with international treaties. That means that the country's constitution would need to be changed before a referendum could be held on EU and euro membership. A two-thirds majority in the lower house of Italy's parliament is needed to change the constitution. Such a majority looks highly unlikely right now, even if the Northern League and Five Star Movement increase their vote share in any future election.”