Wednesday, April 18, 2018

Weekly S&P 500 Earnings & Valuation Report

S&P 500 consensus expected operating earnings for both 2018 and 2019 flattened out over the past few weeks after rising sharply in January and February during the Q4-2017 earnings season thanks to the Tax Cuts & Jobs Act (TCJA) enacted on December 22. They will probably resume their climb as companies start to report the initial positive impact of the TCJA during the current earnings season for Q1-2018. Forward earnings, i.e., the time-weighted average of consensus expected earnings for this year and next year, edged up to a fresh record high during the week of April 12. The Blue Angels chart shows that at the same time as forward earnings soared earlier this year, the forward P/E dropped sharply, resulting in a 10% correction. The market seems to have found support around a forward P/E of 16.0. (For more on forward earnings and Blue Angels, see Chapter 13 of my new book Predicting the Markets: A Professional Autobiography.)

Tuesday, April 17, 2018

Fed Still on Gradual Normalization Course

The word “inflation” appears 106 times in the minutes of the latest FOMC meeting, held March 20-21 and released on April 11. By contrast, the word “unemployment” appears 45 times. Does this suggest that Fed officials are increasingly concerned about a rebound in inflationary pressures given that the jobless rate was at a cyclical low of 4.1% during March? There were still 6.6 million unemployed workers, according to the Bureau of Labor Statistics (BLS). However, the latest data, also from the BLS, showed that there were 6.1 million job openings during February. That implies that virtually all the remaining unemployment can be described as “frictional,” resulting from geographic and skills mismatches.

Actually, Fed officials have been rooting for inflation to rise to their 2.0% target for the yearly percent change in the personal consumption expenditures deflator. They first publicly announced this target at the start of 2012. Yet much to their chagrin, they have failed ever since then to boost inflation on a sustainable basis to 2.0% despite their ultra-easy monetary policies following the Great Recession.

Nevertheless, the FOMC started to normalize monetary policy, first by ending quantitative easing at the end of October 2014, then by gradually raising the federal funds rate in 25-basis-point baby steps—starting from around zero at the end of 2015 to 1.50%-1.75% at the March meeting.

They are likely to remain on this gradual course through next year, since the latest economic projections of the FOMC participants show median inflation expectations of 1.9% this year and 2.0% next year. Anticipating finally accomplishing their mission of hitting their inflation target, the committee’s median projections for the federal funds rate are 2.1% at the end of this year and 2.9% at the end of next year.

Financial markets started to fret about a more aggressive normalization of monetary policy on February 2, when January’s employment report showed a higher-than-expected 2.9% gain in wages, as measured by average hourly earnings for all workers. That’s a bit ironic given that during Janet Yellen’s first press conference as Fed chair during March 2014, she suggested that the Fed’s easing-does-it policies would bring wage inflation back up to a range of 3.0%-4.0%.

Four years later, following last month’s FOMC meeting, Fed Chair Jerome Powell signaled in his first press conference that monetary normalization would remain on a gradual course. March’s wage inflation rate eased to 2.7%. The minutes released last week sent a message to financial market participants to chill out about inflation.

The message seemed to be a response to the observation in the minutes that “a steep” albeit temporary “decline in equity prices and an associated rise in measures of volatility” resulted from market participants’ reaction to “incoming economic data released in early February—particularly data on average hourly earnings—as raising concerns about the prospects for higher inflation and higher interest rates.”

FOMC participants do expect that inflation will rise as “transitory” factors that had weighed on inflation last year dissipate this year. Furthermore, the stronger economic growth is expected to push inflation up toward the FOMC’s 2.0% objective, according to the minutes. But such an increase is not expected to change the FOMC’s gradual course of raising interest rates. Nor would a temporarily overshoot of the inflation target: “A few participants suggested that a modest inflation overshoot might help push up longer-term inflation expectations and anchor them at a level consistent with” the FOMC’s 2.0% objective.

If inflation should rise much faster than expected and stay consistently above 2.0%, however, then the FOMC might decide to raise rates at a “slightly” faster pace over the next few years. One risk to inflation discussed in the minutes could come from fiscal stimulus. Depending on the timing and magnitude of the effects of fiscal stimulus, it could push output above its potential and further tighten resource utilization.

Fed policy isn’t likely to veer much from the current course of normalization. President Donald Trump seemed to signal his endorsement of this course by promoting Fed Governor Powell to replace Yellen. The President just announced his intention to nominate Richard Clarida for the No. 2 position of Fed vice chairman. He is widely viewed as a solid economist, with experience in the financial industry. Trump also plans to nominate Kansas State Bank Commissioner Michelle Bowman as a Fed governor, representing the interests of community banks. Meanwhile, the Federal Reserve Bank of New York recently named John Williams as its next president. He had the same position at the Federal Reserve Bank of San Francisco. The new Fed team is shaping up to be one of pragmatic centrists with few, if any, obvious dissenters.

So far, Chairman Powell hasn’t been fazed by the volatility of the stock market. He and his colleagues could be thrown off course if inflation makes a major comeback. That would force them to raise interest rates faster and higher, which certainly would worsen the outlook for the federal deficit. That would push bond yields much higher and cause serious concerns for stock investors.

The key will be inflation. While Fed officials continue to believe that it is a monetary phenomenon, they may come around to recognize, and even to appreciate, that there are other forces such as global competition and technological innovations keeping a lid on inflation. If so, then the Fed’s current game plan will be realized. (For more on the Fed and inflation, see Chapter 9 in my new book, Predicting the Markets: A Professional Autobiography.)

Wednesday, April 11, 2018

Real GDP Growth: Hard To Get Back to Old Normal

In a 4/6 speech, newly appointed Fed Vice Chairman John Williams matter-of-factly stated: “Last year real gross domestic product, or GDP, increased 2.6 percent. This is a solid performance. Importantly, it’s above the trend growth rate, which I peg at about 1¾ percent.”

I was surprised by his comment that the trend in real GDP is only 1.75%. That certainly is at odds with the predictions of President Donald Trump and his supply-side advisers, who believe that their policies will boost real GDP growth up to the old normal of 3.0% and even 4.0%. I have been expecting more of the same, i.e., 2.0%-2.5%.

Williams referenced a 10/11/16 FRBSF Economic Letter titled “What Is the New Normal for U.S. Growth?” by John Fernald. Sure enough, the article starts by stating: “Estimates suggest the new normal for U.S. GDP growth has dropped to between 1½ and 1¾%, noticeably slower than the typical postwar pace.” The article explains the reasoning behind this lackluster outlook for real GDP as follows:

“This estimate is based on trends in demographics, education, and productivity. The aging and retirement of the baby boom generation is expected to hold down employment growth relative to population growth. Further, educational attainment has plateaued, reducing the contribution of labor quality to productivity growth. The slower forecast for overall GDP growth assumes that, apart from these effects, productivity growth is relatively normal, if modest—in line with its pace for most of the period since 1973.” Here’s more:

(1) Labor force growth. “[T]he population is now growing relatively slowly, and census projections expect that slow pace to continue. Second, these projections also suggest the working-age population will grow more slowly than the overall population, reflecting the aging of baby boomers. Of course, some of those older individuals will continue to work. Hence, the Congressional Budget Office (CBO) projects the labor force will grow about ½% per year … over the next decade—a little faster than the working-age population, but substantially slower than in the second half of the 20th century.”

(2) Productivity growth. The article is much more pessimistic (or perhaps realistic) about the outlook for productivity growth than are today’s supply-siders. Fernald concedes: “The major source of uncertainty about the future concerns productivity growth rather than demographics. Historically, changes in trend productivity growth have been unpredictable and large.” Nevertheless, he estimates that the new normal trend growth rate in real GDP is 1.6%, implying that productivity won’t grow much faster than 1.0%.

(3) Information technology. But won’t the IT revolution boost productivity? It hasn’t been doing so in recent years. Fernald observes: “Starting around 1995, productivity growth was again exceptional for eight or nine years. Considerable research highlighted how businesses throughout the economy used information technology (IT) to transform what and how they produced. After 2004, the low-hanging fruit of IT had been plucked.”

Again, he concedes: “Looking ahead, another wave of the IT revolution from machine learning and robots could boost productivity growth. ... But, until such a development occurs, the most likely outcome is a continuation of slow productivity growth.”

For more on technology and productivity, see Chapter 3 of my new book, Predicting the Markets: A Professional Autobiography.

Sunday, April 8, 2018

Excerpt from Ed Yardeni’s New Book

Here, in summary, are a few of the lessons I have learned over the years from doing what I do:

(1) Be an investor, not a preacher. Investing isn’t a moral pursuit. It’s not about right or wrong, good or evil. It’s about bullish or bearish. In other words, don’t let your political views bias your investment decisions. Buy low, sell high, but invest for the long run, if you are young enough.

(2) Be an empiricist, not a dogmatist. Get to know the data before you come up with your theory. This helps to avoid the curse of faith-based, rather than fact-based, analysis. Recognize that there are lots of intellectual hucksters promoting their theories without ever letting the facts get in the way. When the facts suggest a scenario that you didn’t expect, be open-minded enough to recognize its import. Don’t let cognitive bias blind you to what’s really going on. Be willing to change what you believe if the facts warrant it. Staying wedded to constructs or ideas that have outlived their usefulness is a sure way to lose money.

(3) Be a policy wonk, not a critic. Don’t second-guess policymakers and expect them to change course just because you are convinced they are on the wrong one. However, as I learned along the way, pay close attention to new legislation that changes taxes or regulations. I wish I had paid more attention to the unintended consequences of some of the major laws that deregulated the financial industry.

(4) Be a lender, not a borrower. While we all know that Polonius said, “Neither a borrower nor a lender be,” there’s no evidence that Einstein said, “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.” But it sounds like something he might have said. You can make a bundle of dough by borrowing money and buying stocks on margin. But you can also lose lots of money that way. If day trading isn’t your day job, succeed at what you do best and let dividend-yielding companies work their magic of compounding your return.

(5) Be revolutionary, not evolutionary. I’m not advocating that you conspire to overthrow the government. However, change happens, and sometimes it happens much faster than was widely anticipated or even perceived as it was happening. The end of the Cold War and China entering the World Trade Organization were revolutionary changes with major consequences for the global economy and financial markets. While such dramatic events might be infrequent, the revolutionary impact of technological innovation on our lives seems to be moving at a faster and faster pace.

(6) Be an optimist, not a pessimist. History shows that optimistic investment strategies tend to work better over time than pessimistic ones. Doomsdays occur from time to time, but they don’t last as long as the good times. If you are going to be bearish, try to be so when everyone is too bullish. Then when everything falls apart, you can say, “I told you so.” However, don’t forget to turn optimistic once everyone else is pessimistic. Remember: don’t worry, be happy, but stay informed!

For more, please see the book’s website and Amazon page.

Wednesday, April 4, 2018

Global Growth Fundamentals Remain Strong

Economies around the world continue to experience synchronized growth, as they have since the second half of 2016. However, there is some chatter going around about a slowdown in the global economy. I am not seeing it in the stats I follow. Consider the following:

(1) Global trade at record levels. I don’t expect a trade war. Global trade remains at a record high. I believe that countries have become too interdependent to resort to widespread prohibitive protective barriers. The volume of world exports rose 4.5% y/y to a record high during December 2017. The sum of inflation-adjusted US imports and exports closely tracks the global measure of world exports. It was up 3.0% y/y during January, edging down from December’s recent high. The growth rates of both measures have been running around 4.0% since late 2016, a significant improvement from the near-zero growth rates during late 2015 and early 2016.

Given the importance of China in world trade, I also note that the sum of Chinese imports and exports, in nominal terms, rose 19.3% y/y to a record high of 30.0 trillion yuan during February.

(2) Global M-PMI remains high. Some of the recent concerns about global growth focused on the decline in March’s global M-PMI to 53.4 from a recent high of 54.5 at the end of last year. The weakness was led by a drop in the M-PMI for advanced economies from 56.3 during January to 54.9 in March. However, the March readings for both the global and advanced M-PMIs remain solidly above 50.0.

The March levels for the US (59.3), Eurozone (56.6), the UK (55.1), and Japan (53.1) all were down from recent cyclical highs but solid nonetheless. The March M-PMIs for the major emerging economies were more muted for Russia (50.6), India (51.0), China (51.5), and Brazil (53.4). But again, they all exceeded 50.0. Keep in mind that PMIs are diffusion indexes. That means that if the current month was just as good as the previous month, the diffusion index will be around 50.0.

By the way, I've found that the sum of the US M-PMI sub-indexes for new export orders and imports is highly correlated with the growth rate of the volume of world exports on a y/y basis. The former rose to a record high of 123.3 during February and edged down to 118.4 in March. The US is experiencing a trade boom, with both real merchandise exports and imports in record-high territory. The problem is that the latter exceeds the former by $837 billion (saar).

(3) MSCI forward revenues moving higher. I’ve also found that we can track the global economy on a weekly basis using analysts’ consensus expectations for revenues over the next 52 weeks for the major MSCI stock price indexes. To derive these “forward revenues” series, I use a time-weighted average of analysts’ consensus expectations for the current year and the coming year. The current year has more weight than the coming year at the present time. By the middle of the year, they will be equally weighted. By year-end, forward revenues will be the same as the consensus expectations for 2019.

The broadest measure of forward revenues per share is the one for the All Country World MSCI (in local currencies). It dropped sharply from its record high during the summer of 2014 and bottomed in early 2016. That drop reflected the depressing impact of the plunge in oil prices on the world energy industry. Since then, oil prices have recovered but remain well below the levels of early 2014. The revenues measure also has recovered and has been rising in record-high territory this year. Industry analysts have been raising their global revenues estimates for both 2018 and 2019.

(4) NRRIs are in positive territory. I also track Net Revenues Revisions Indexes (NRRIs) for the major MSCI stock price indexes. Keep in mind that analysts have a tendency to be too optimistic, so it isn’t unusual to see NRRIs in negative territory even as the global economy is growing and stock prices are moving higher. The NRRI for the All Country World MSCI has been positive since February 2017, and increasingly so since late 2017. This measure of net revenues revisions was in negative territory every single month from July 2012 through January 2017!

Wednesday, March 28, 2018

Bullish Earnings Ahead

Spring started on March 20. Spring is Goldilocks’ favorite season because it is neither too cold nor too hot. Chauncey Gardiner, antihero of Jerzy Kosinski’s satirical novel Being There, also likes spring because that’s when his flowers and plants start to blossom and grow. In the movie version (“Being There,” 1979), Chauncey, played by Peter Sellers, is mistaken for an insightful economist with a penchant for gardening metaphors instead of the literally speaking gardener that he is. When asked by the President of the United States whether the government can stimulate economic growth with temporary incentives, Chauncey replies: “As long as the roots are not severed, all is well. And all will be well in the garden.” He explains that “growth has its seasons.” And “Yes, there will be growth in the spring!”

The President responds: “Hm. Well, Mr. Gardiner, I must admit that is one of the most refreshing and optimistic statements I’ve heard in a very, very long time. I admire your good, solid sense. That’s precisely what we lack on Capitol Hill.”

I presume that President Donald Trump is getting more informed economic advice than provided by Chauncey. He should be doing so now that my friend Larry Kudlow is in charge of the National Economic Council. Larry interviewed me about my book on Saturday, March 18:

“Welcome back folks, I’m Larry Kudlow, pleasure to be back with you. Old friend of mine, one of Wall Street’s absolute top number-one economic and investment strategy forecasters—he’s got a new book out—I’m talking about Dr. Ed Yardeni, president now of Yardeni Research (that’s yardeni.com), previously economist with Federal Reserve Bank of NY and the US Treasury. I want to say that Ed Yardeni and I were—I don’t know what we were—friendly rivals, but mostly friends. Down through the years—the 1980s, 1990s—there were three names at the top of the list of Institutional Investor’s All Star Team, going back. One was Ed Hyman, the other was Ed Yardeni, and the other one was a wacko named “Larry Kudlow,” so you are going to get some great stuff here. Ed has a new book, called Predicting the Markets: A Professional Autobiography.”

I mentioned that I remain bullish on the stock market because the outlook is bullish for earnings. Previously, in the 3/14 Morning Briefing, I wrote:

“The Q4-2017 earnings season is over. Industry analysts received quite a bit of guidance on the positive impact of the corporate tax rate cut at the end of last year on earnings this year. There will be more to come during the Q1-2018 earnings season in April, which will provide more specific numbers showing how much the Tax Cut and Jobs Act (TCJA) boosted earnings during that quarter, and is likely to boost earnings over the rest of the year.

“In other words, I suspect that neither the analysts nor investors have fully discounted the big windfall the TCJA will provide to corporate bottom lines. That’s because corporate managements probably weren’t sure themselves about the full impact of the TCJA during their conference calls in January, which obviously focused on last year’s final results. So while many of them were giddy about the coming earnings boost in their calls with analysts and investors, they might actually have toned down their giddiness!” Let’s review the latest relevant data:

(1) Revenues for S&P 500/400/600. Industry analysts are expecting S&P 500 revenues to grow 6.8% this year and 4.6% next year. They are expecting S&P 400 revenues to grow 6.1% this year and 4.1% next year. For the S&P 600, they are predicting 6.5% in 2018 and 4.5% in 2019.

Forward revenues, the time-weighted average of consensus estimates for this year and next year, continue to move up in record-high territory for the S&P 500/400/600. On a y/y basis, forward revenues for the S&P 500/400/600 are up 8.0%, 11.9%, and 14.5% through the week of March 15.

(2) Revenues for S&P 500 sectors. Since the start of the data in 2006, forward revenues are at record highs for the following S&P 500 sectors: Consumer Discretionary (up 7.0% y/y), Consumer Staples (9.9%), Financials (8.8%), Health Care (7.4%), Industrials (8.5%), Information Technology (15.5%), Materials (11.3%), and Real Estate (2.7%).

(3) Net Revenues Revisions Indexes. March data are now available for our Net Revenues Revisions Indexes (NRRIs) for the S&P 500 and its 11 sectors over the past three months. NRRIs are positive for all sectors with the exception of Real Estate and Utilities. Here is the performance derby for the NRRIs: Industrials (22.5%), Materials (20.5), Financials (16.4), Health Care (16.2), Information Technology (16.1), Energy (16.1), S&P 500 (14.7), Consumer Discretionary (14.1), Consumer Staples (12.9), Telecommunication Services (3.6), Real Estate (-2.7), and Utilities (-13.1). At 14.4 during March, the S&P 500’s NRRI is at a record high, slightly exceeding the previous record high during May 2004.

(4) S&P 500 earnings. We will soon find out whether Q1-2018 earnings turned out to be even better than industry analysts expected after receiving guidance last quarterly earnings season on the positive impact of the TCJA on earnings this year. They certainly raised their 2018 earnings-per-share estimates sharply during the 14 weeks after the TCJA was enacted on December 22 through the week of March 22 for the S&P 500/400/600 by $11.58 (7.9%), $7.41 (7.2%), and $5.43 (11.6%). They now expect 2018 earnings for these three composites to grow 19.6%, 19.6%, and 23.6%.

(5) S&P 500 buybacks. S&P 500 buybacks data are now available through Q4-2017. I like to combine buybacks with dividends paid by the S&P 500 as a measure of corporate cash flow that is getting ploughed back into the stock market. I realize that not all dividends are reinvested in the stock market, but lots are reinvested, particularly by institutional investors.

The sum of buybacks and dividends last year was $938 billion. The four-quarter moving sum of this series has been hovering around $900 billion since 2014. Buybacks totaled $548 billion last year, continuing to hover around $500 billion since 2014. Dividends rose to another record high of $436 billion.

I expect that buybacks and dividends will continue to be bullish for the stock market. Both could get a lift from significant repatriated earnings from abroad resulting from the TCJA.

Wednesday, March 21, 2018

Animal Spirits Remain Spirited

It has been almost a year and a half since the election victory of President Donald Trump on November 8, 2016. The surprising upset seemed to awaken the economy’s animal spirits. They remain aroused. The soft data, based mostly on surveys, remain strong. On the other hand, the hard data, based on business cycle indicators, remain mixed.

However, the hard data that matter most to the stock market, i.e., earnings, remain bullish. The hard data that are the most important to the Fed and the bond market are dotted with soft patches, which augur for a continuation of the Fed’s gradual normalization of interest rates. Without any further ado, let’s have a closer at the hard soft data:

(1) CEOs’ optimism is flying. I described the mood of corporate managements during the Q4-2017 earnings season as “giddy.” I listened to several earnings conference calls during January and read the transcripts for all 30 DJIA companies’ calls. Managements were elated by the cut in the corporate tax rate at the end of last year. Their elation was confirmed by the Q1-2018 CEO Outlook Index compiled by Business Roundtable. It jumped to 118.6, the highest on the record for this series, which started during Q1-2003. It is very highly correlated with the yearly percent change in capital spending in both nominal and real terms.

(2) Small business owners are euphoric. The NFIB Small Business Optimism Index was 107.6 during February (the second-highest reading in the 45-year history of the survey), up from 94.9 during October 2016. The net percentage of respondents agreeing that now is a good time to expand jumped from 9.0% during October 2016 to 32.0% during February, the highest in the history of the series, which starts in 1974.

(3) Purchasing managers reporting robust growth. The M-PMI rose to 60.8 during February, up from 51.8 during October 2016 and the highest since May 2004. This index happens to be highly correlated with the y/y growth rate in S&P 500 revenues per share, which jumped to 9.4% during Q4-2017, the highest since Q3-2011.

(4) Consumer sentiment is upbeat. The Consumer Sentiment Index rose during the first half of March to 102.0, the highest reading since January 2004. It was 87.2 during October 2016, just before the election. It was led by a jump in its current conditions component to a record high of 122.8. It was 103.2 just before the election.

The Weekly Consumer Comfort Index (WCCI) has been hovering around 56.5 over the past five weeks. It’s up from 44.6 at the end of October 2016. It’s the highest since February 2001.

(5) Boom-Bust Barometer is hot. Often in the past, I’ve stir-fried the WCCI with my Boom-Bust Barometer (BBB) to derive my Weekly Leading Index (WLI). I derive my BBB as the ratio of the CRB raw industrials spot price index and initial unemployment claims. It rose to a record high in late February. So did my WLI, which has been very highly correlated with the S&P 500 since 2000.

Thursday, March 8, 2018

The Fed: Rooting for Higher Inflation

While the financial markets have started to worry about a reflation scenario, Fed officials continue to hope that inflation will rise in 2018 to hit their target of 2.0% for the core PCED rate. It was 1.5% last year on a December-to-December basis.

The minutes of the January 30-31 meeting of the FOMC were released on February 21. The word “inflation” was mentioned 129 times. The word “unemployment” was mentioned just 13 times. However, that doesn’t mean that Fed officials are worrying about higher inflation. Rather, they seemed to spend most of their time on the subject trying to convince one another that it should rise back up to 2.0% this year now that the economy is at full employment.

In my new book, Predicting the Markets: A Professional Autobiography, I note that the FOMC has a tradition of starting the year with a “Statement on Long-Run Goals and Monetary Policy Strategy.” They’ve been doing that since January 25, 2012. They’ve invariably expressed the following view that was repeated in the latest minutes:

“The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.”

In fact, inflation, based on the core PCED, has been below 2.0% most of the time since 2008, even as monetary policy turned ultra-easy. The FOMC’s confidence in the notion that inflation is mostly a monetary phenomenon in the long run begs the question: “Are we there yet?” Nope! If not, then why not? The answer could be that inflation isn’t just a monetary phenomenon. There are powerful structural forces keeping it down, including competition unleashed by globalization, deflationary technological innovations, and aging demographics, as I thoroughly discuss in my book.

The latest FOMC minutes note that the Fed’s staff presented “three briefings on inflation analysis and forecasting.” Here are a few excerpts from the minutes rendition and my reaction:

(1) Inflation models are error prone. “The presentations reviewed a number of commonly used structural and reduced-form models. These included structural models in which the rate of inflation is linked importantly to measures of resource slack and a measure of expected inflation relevant for wage and price setting—so-called Phillips curve specifications—as well as statistical models in which inflation is primarily determined by a time-varying inflation trend or longer-run inflation expectations.”

And how well have those models been working? “Overall, for the set of models presented, the prediction errors in recent years were larger than those observed during the 2001–07 period but were consistent with historical norms and, in most models, did not appear to be biased.” I think that means: The models have worked terribly since 2007, but that’s normal.

(2) Resource utilization is hard to measure. Monetary policy presumably “influences” inflation by affecting resource utilization. “The briefings highlighted a number of other challenges associated with estimating the strength and timing of the linkage between resource utilization and inflation, including the reliability of and changes over time in estimates of the natural rate of unemployment and potential output and the ability to adequately account for supply shocks.” In other words, the macro inflation models depend on variables that really can’t be observed and measured.

(3) Inflationary expectations are also hard to measure. The Fed also presumably can influence long-term inflationary expectations, which should drive actual inflation. “Moreover, although survey-based measures of longer-run inflation expectations tended to move in parallel with estimated inflation trends, the empirical research provided no clear guidance on how to construct a measure of inflation expectations that would be the most useful for inflation forecasting.”

(4) Insanity is using the same flawed models knowing they are flawed. No comment is necessary on the following: “Following the staff presentations, participants discussed how the inflation frameworks reviewed in the briefings informed their views on inflation and monetary policy. Almost all participants who commented agreed that a Phillips curve–type of inflation framework remained useful as one of their tools for understanding inflation dynamics and informing their decisions on monetary policy.”

And what about long-term inflationary expectations? The minutes noted: “They [FOMC participants] commented that various proxies for inflation expectations—readings from household and business surveys or from economic forecasters, estimates derived from market prices, or estimated trends—were imperfect measures of actual inflation expectations, which are unobservable. That said, participants emphasized the critical need for the FOMC to maintain a credible longer-run inflation objective and to clearly communicate the Committee’s commitment to achieving that objective.”

Groupthink continues to flourish at the Fed. While the Fed staff are conceding that their macro inflation models aren’t working, Fed officials continue relying on them.

(5) Tapering the balance sheet. Meanwhile, the Fed started to taper its balance sheet last October at an announced pace that will reduce its holdings of US Treasury securities and mortgage-backed securities (MBS) by $300 billion over the current fiscal year (through September 2018) and then by $600 billion during the following fiscal years. At this pace, the Fed’s balance sheet will be back down to where it was in August 2008 by June 2024. Over the 2018 and 2019 fiscal years, the Fed is scheduled to reduce its holdings of Treasuries by $540 billion and MBS by $360 billion.

So while the Fed is tapping on the monetary brakes, fiscal policy is stepping on the gas with tax cuts and more spending. Fasten your seat belts.

Sunday, March 4, 2018

Smoot-Hawley Triggered the Great Depression

The following is an excerpt from my new book, Predicting the Markets. It seems especially relevant after President Donald Trump raised tariffs on imports of solar panels and washing machines during January, and is planning on raising tariffs on aluminum and steel imports this week:
[T]he 1920s was a period of globalization, with peace, progress, and prosperity. Yet by the early 1930s, the world fell into a depression that was followed by World War II near the end of the decade.

My research led me to conclude that the Great Depression was caused by the Smoot–Hawley Tariff Act of June 1930. During the election of 1928, Republican candidate Herbert Hoover promised US farmers protection from foreign competition to boost depressed farm prices. However, he was appalled by the breadth of the tariff bill that special interest groups had pushed through Congress, denouncing the bill as “vicious, extortionate, and obnoxious.” But he signed it into law under intense political pressure from congressional Republicans.

The tariff triggered a deflationary spiral that had a deadly domino effect. Other countries immediately retaliated by imposing tariffs too. The collapse of world trade pushed commodity prices over a cliff. Exporters and farmers defaulted on their loans, triggering a wave of banking crises. The resulting credit crunch caused industrial production and farm output to plunge and unemployment to soar. In my narrative, the depression caused the stock market crash, not the other way around as is the popular belief. Consider the following grim post-tariff statistics:

(1) Trade. Data compiled by the League of Nations show that imports of 75 countries dropped 55% from June 1930 through March 1933. In the United States, industrial production dropped 41% from June 1930 through March 1933. Historian John Steele Gordon observed that US exports in 1929 were $5.24 billion, whereas by 1933, exports were only $1.68 billion; when inflation is taken into account, the latter amount was less than US exports in 1896. As countries successively raised tariffs, world trade fell by two-thirds from 1929 to 1934. Gordon concludes, “Thus, Smoot–Hawley was one of the prime reasons that a stock market crash and an ordinary recession turned into the calamity of the Great Depression.”

(2) Prices. The producer price index (PPI) for industrial commodity prices plummeted 24% from June 1930 until it bottomed during April 1933. The PPI for grain prices plunged 59% until it bottomed during December 1932. The consumer price index (CPI) fell 25% from June 1930 until it bottomed during the spring of 1933.

(3) Loans and deposits. Commercial bank deposits fell 36% from $43 billion during 1929 to $27 billion during 1933. Deposits frozen at suspended commercial banks rose sharply during the three banking panics from 1930 to 1933.

(4) Unemployment. The unemployment rate for nonfarm employees soared from 5.3% during 1929 to peak at a record high of 37.6% during 1933. Over this same period, it jumped from 3.2% to 25.2% for the civilian labor force, including farm workers.

The Dow Jones Industrial Average (DJIA) plunged 47.9% from its record high of 381 on September 3, 1929 to the year’s low of 199 on November 13. From there, it rebounded 48.0% to 294 on April 17, 1930. It was down only 5.1% on a year-over-year basis, suggesting that the Great Crash wasn’t so great! But the worst was ahead, as the stock market started to anticipate the passage of the tariff bill, despite a letter printed in the May 5, 1930 issue of The New York Times signed by 1,028 economists who opposed the bill. The DJIA proceed to fall by 86.0% from the April 17, 1930 high to the low of 41 on July 8, 1932. That was the Great Crash indeed! (See Appendix 2.1, The Protests of Economists Against the Smoot-Hawley Tariff.)

That’s my explanation of what caused the Great Depression. ... Google search the “Great Depression” and you’ll find more than 20 million links. Narrow the search to “causes of the Great Depression” and you’ll find more than three million links. In my home office, I have three shelves of books that offer lots of explanations for this economic disaster. Few of them give a starring role to the tariff. Excessive speculation in stocks that set the stage for the Great Crash often gets blamed for starting the mess.

Saturday, March 3, 2018

Dr. Ed’s New Book

I started my career on Wall Street in 1978. Ever since then, I have been thinking and writing about the economy and financial markets as both an economist and an investment strategist. While I have a solid academic background to be a Wall Street prognosticator, I learned a great deal on the job. In Predicting the Markets: A Professional Autobiography, I share my insights into forecasting the trends and cycles in the domestic and global economies and financial markets—including stocks, bonds, commodities, and currencies. Please visit the book’s home page to learn more about it.

Thursday, March 1, 2018

Dow Vigilantes

The Tax Cut and Jobs Act’s (TCJA) cut in the corporate statutory tax rate at the end of 2017 will send earnings hurtling beyond the Earth’s gravitational pull this year into outer space.

They were heading in that direction last year. It’s conceivable that some of last year’s earnings extravaganza was attributable to the Trump administration’s easing of regulatory costs. More likely is that 2017 earnings were boosted by the synchronized global economic expansion that followed the worldwide energy-led global growth recession from 2014 through 2016. I started to see signs of a global recovery during the summer of 2016, which led me to conclude that stock prices were likely to head higher no matter who won the presidential race on November 8, 2016. Trump won on his campaign promise to “Make America Great Again.” Earnings were on course to be great again in any event, and now they will be even greater thanks to the TCJA.

That simple insight led me to conclude that the meltdown in the stock market in early February was a flash-crash correction that would be short-lived given the meltup in actual and expected earnings. We now have the results for S&P 500 earnings during Q4-2017. They were HUGE. Consider the following:

(1) Revenues. S&P 500 revenues rose to a record high of $329.41 per share at the end of last year. Remarkably, revenues per share rose 9.4% y/y, the fastest since Q3-2011. Needless to say, it’s hard to imagine that this fast pace was boosted by anything that can be traced to the White House, especially since almost half of S&P 500 revenues come from abroad. In the US, nominal GDP was up 4.4% y/y during Q4, lagging the 8.5% growth in S&P 500 aggregate revenues.

On the other hand, the trade-weighted dollar fell 7.0% y/y last year, which must have boosted revenues. As I previously observed, the dollar tends to be weak when the global economy is doing well and commodity prices are rising.

I’m not that surprised by the strength in revenues at the end of last year. That’s because it was clearly signaled by the weekly S&P 500 forward revenues series, which is the time-weighted average of industry analysts’ consensus expectations for revenues during the current year and the coming year. It continues to rise in record-high territory.

(2) Earnings. Also, I’m not surprised that S&P 500 operating earnings per share jumped 15.3% y/y during Q4-2017 according to Thomson Reuters. Nevertheless, I am certainly impressed. S&P also compiles operating earnings for the S&P 500 operating earnings using a more conservative approach for one-time nonoperating gains and losses. This measure rose even more impressively, with a 22.3% y/y gain.

Interestingly, S&P 500 reported earnings dropped sharply during Q4-2017, and was basically flat compared to a year ago. Weighing on earnings during the last quarter of 2017 were charges related to the TCJA, such as a substantial drop in the value of deferred tax assets given that the corporate tax rate was cut from 35% to 21%.

Again, I’m not surprised by the strength in earnings. It was clearly signaled by the weekly S&P 500 forward operating earnings. The four-quarter sum of S&P 500 operating earnings per share (based on the Thomson Reuters data) was $133 last year. The forward earnings series suggested in late February that earnings are headed toward $160 per share this year. That would be a 20% jump.

At the end of February, the analysts’ consensus earnings estimate for 2018 was actually $157.92, a 19.1% y/y gain. I am currently forecasting $155.00, a 16.8% increase. In any event, earnings will be up HUGEly this year.

(3) Profit margin. Now let’s take a moment to remember all those growling bears who have been trampled by the stampeding bulls since 2009. I miss them. I would have more confidence in the longevity of the bull market if they were still growling (as they mostly did from 2009-2013) that the bull market was on a sugar high and that earnings would be disappointing, or that the profit margin would soon revert to its mean.

The flash crash a few weeks ago might have given the bears a reason for living, but it was too short-lived. And here’s another disappointing flash for the bears: The operating profit margin of the S&P 500 rose to a new record high during Q4. It was 11.0% based on Thomson Reuters data and 10.4% based on S&P data. It will be higher during Q1-2018 thanks to the TCJA.

The bears could make a comeback if President Donald Trump turns into an outright protectionist. More likely is that he will back off if the market continues to react badly to his protectionist pronouncements. After all, he clearly prefers the Dow Jones Industrial Average as a measure of his popularity rather than opinion polls. Could today’s sharp stock market selloff on news that Trump intends to slap tariffs on steel and aluminum imports be the incipient formation of the Dow Vigilantes?

Thursday, February 22, 2018

Soarin’ Fundamentals for Stocks

I spent the long President’s Day weekend with my family in Disney World. It was the first time that my four-year-old granddaughter Cecelia (a.k.a. “CeCe”) attended the theme park. The park’s staffers are trained to say “Have a magical day” whenever they greet visitors. Cece had a magical weekend, and so did the rest of my family. The weather was great, and my wife wisely obtained FastPass+ reservations for most of the rides. We particularly enjoyed a trip around the world on Disney’s flight simulator, Soarin’.

Back on Earth, stock investors have enjoyed a magical bull market since March 2009. It was particularly magical during 2017, when the S&P 500 rose 19.4%. Such a double-digit return is quite extraordinary for an aging bull market going on nine years old in 2018. The magic seemed to stop abruptly when the S&P 500 plunged 10.2% over 13 days from late January through early February. I believe that the latest selloff marked the fourth correction in this bull market, not the beginning of a bear market. The economic fundamentals remain bullish:

(1) 2018 earnings estimates. S&P 500 earnings estimates for 2018 have been soaring during the current earnings season. Industry analysts have been getting guidance by corporate managements on the very positive impact of the Tax Cut and Jobs Act (TCJA), enacted at the end of last year, on their earnings. I have been keeping track of these estimates on a weekly basis. Over the past nine weeks since TCJA was enacted, the 2018 consensus earnings estimate for the S&P 500 has increased by $11.21 per share from $146.26 to $157.47. That’s a 7.7% increase.

(2) Boom-Bust Barometer. My Boom-Bust Barometer (BBB) is simply the CRB raw industrials spot price index divided by initial unemployment claims. It is a great coincident indicator of the US business cycle. It soared into new record-high territory in recent weeks. It did so as the CRB index rose to a new cyclical high following its freefall from the second half of 2014 through the end of 2015. At the same time, weekly initial unemployment claims have dropped to their lowest levels since March 1973.

(3) Weekly Leading Index. I have devised a Weekly Leading Index (YRI-WLI) that is an average of our BBB and Bloomberg’s weekly Consumer Confidence Index (WCCI). It is highly correlated with the index compiled by the Economic Cycle Research Institute. My WLI is based on an open-source formulation, while theirs is based on a secret sauce. Both have been rising in record-high territory in recent weeks.

The YRI-WLI is soaring because the BBB is doing so, and so is the WCCI. Consumers have lots of reasons to be overjoyed with the unemployment rate at a cyclical low and many of them bringing home paychecks boosted by tax cuts. The WCCI is the highest since February 2001.

(4) Forward earnings. Interestingly, the S&P 500 forward earnings is highly correlated with both the Boom-Bust Barometer and the YRI-WLI. The earnings measure is a time-weighted average of analysts’ consensus expectations for S&P 500 earnings during the current year and the coming year. It’s been soaring ever since the end of last year when the TCJA slashed the statutory corporate tax rate. The forward earnings of the S&P 500/400/600 have increased by 9.5%, 8.3%, and 10.4% since the passage of TCJA.

(5) Stock prices. Given all of the above, it’s no wonder that the S&P 500 stock price index is highly correlated with the YRI-WLI. The latter, which is up 9.4% y/y, remains bullish for the former.

Monday, February 19, 2018

Liquidity Legends

The latest and previous stock market corrections could be described as “tightening tantrums.” Investors fretted that the Fed would be raising interest rates faster than had been widely perceived. That was not the case in 2016, when the federal funds rate was raised but only once at the end of the year. There were three widely expected rate hikes in 2017. At the start of this year, investors were anticipating three more rate hikes prior to the release of the wage numbers on February 2.

For stock investors, concerns about the rate hikes during 2017 were more than offset by strong earnings growth attributable to improving global economic growth. The recent correction occurred despite the huge boost to earnings provided by the Tax Cut and Jobs Act (TCJA) at the end of last year. The knee-jerk conclusion of knee-jerk market pundits was that the stock market is adjusting to a period of reduced “liquidity.” This is a concept that I have yet to find a way to suitably quantify. Among the community of instant market pundits, it seems that liquidity is ample when stock prices are rising and scarce when stock prices are falling. Consider the following:

(1) Central bank balance sheets. The more thoughtful liquidity pundits have focused on the balance sheets of the Fed, ECB, and BOJ. They warned that stock prices would plunge once the Fed terminated QE, which happened at the end of October 2014. The S&P 500 is up 35.4% since then!

The Fed started to taper its balance sheet at the start of October last year by letting securities mature without replacing them. The S&P 500 is up 6.1% since then, but the liquidity pundits can argue that the recent correction shows that the stock market is starting to worry about a dearth of Fed-given liquidity. Meanwhile, during January, the sum of the assets held by the Fed, ECB, and BOJ rose to a new record high of $14.6 trillion, led by the ECB.

(2) Chinese bank loans. Often overlooked by the liquidity pundits are developments in China. I monitor the balance sheet of the PBOC. I give even more weight to Chinese commercial bank loans as a measure of liquidity in China. I am amazed, though not surprised, that these loans soared $418 billion during January m/m and a record $2.1 trillion y/y.

(3) Repatriated earnings and buybacks. We find it hard to believe that the stock market suddenly has a liquidity problem given that a couple of trillion dollars in corporate earnings retained abroad are about to be repatriated thanks to the TCJA. The cumulative total of such earnings of nonfinancial corporations since Q1-1986 through Q3-2017 is $3.5 trillion. A significant portion of these funds is expected to come back and be used for share buybacks and dividend payments, which have been the two major sources of funds driving the current bull market.

(4) Earnings. Last but not least is all the liquidity provided by the tax cuts at the end of last year. Over the past nine weeks through last week, industry analysts have raised their 2018 estimate for S&P 500 earnings per share by $11.21 from $146.26 to $157.47. That’s a 7.7% increase.

Tuesday, February 6, 2018

Outlook for Stocks Remains Fundamentally Strong

Whatever might be the short-term follow-up (or -down) on Friday’s and Monday’s drop, I remain bullish because the outlook for earnings remains very upbeat. Industry analysts have raised their consensus S&P 500 earnings estimate for 2018 by $9.00 per share over the past seven weeks to $155.26 during the week of February 2. That’s mostly on guidance provided by managements during January’s Q4-2017 earnings season about the very positive impact of the corporate tax cut enacted late last year. The actual Q1 earnings season is still ahead, starting in April. By then, corporations are likely also to report that the weak dollar (down 7.7% y/y) has boosted their earnings.

Nevertheless, the latest panic attack isn’t about corporate earnings. Rather, the fear is that wage inflation is making a comeback and that the Fed will respond with more aggressive monetary tightening. Initially, higher inflation and interest rates could depress valuation multiples, as happened on Friday and Monday. Eventually, tighter monetary policy could cause a recession directly by tightening credit conditions or indirectly by triggering a financial crisis.

Wage inflation may finally be picking up, but not by much. Shortly after she was appointed Fed chair four years ago, Janet Yellen said she expected that the Fed’s easy monetary policies would boost wage inflation from around 2.5% to 3.0%-4.0%. It just may reach that zone now that she has left the Fed. However, the markets may have overreacted to data on wages released Friday morning in the Employment Report.

Average hourly earnings (AHE) for all workers rose 2.9% y/y through January, the highest since June 2009. However, the AHE for production and nonsupervisory (P&NS) workers rose by 2.4%, which is roughly where it has been for the past few years. P&NS workers account for 82% of all private-sector payroll employment.