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.”

Thursday, May 24, 2018

Earnings Signal Remains Bullish for Stocks

What is the right multiple to pay for S&P 500 earnings? Historically since 1935, the average P/E, using four-quarter-trailing reported earnings, was 17.1. It was 23.7 during Q1-2018. That’s a high reading. However, since 1990—a period of relatively low inflation and interest rates—the average P/E was 25.5.

I am not a fan of P/Es based on trailing earnings, as I explain in my new book, Predicting the Markets. I prefer to focus on the forward P/E of the S&P 500, which is based on the time-weighted average of analysts’ consensus expectations for operating earnings during the current year and coming year. It has averaged 13.9 since the start of the monthly data series during September 1978. It recently rose to a 16-year high of 18.5 during January and fell to 16.5 during May.

The forward P/E based on estimated earnings has been lower than the multiple based on four-quarter-trailing earnings because analysts are looking forward, not backward. There’s one major flaw with the forward valuation approach: Analysts’ earnings estimates tend to be unrealistically inflated in advance of recessions because analysts collectively never see recessions coming until it is too late. Once they do, they slash their earnings estimates at the same time as reported earnings take a dive, and share prices take an unanticipated hit. Conversely, the flaw with P/Es based on trailing earnings, which produce the higher multiples of the two approaches, is that they tend to turn bearish much too early in a bull market. The higher the multiple, the more likely it is to be deemed unduly heady as a bull market continues.

Since I don’t see a recession in the foreseeable future, I continue to focus on the forward P/E, which isn’t alarmingly high, in my opinion. The further out that a recession is perceived as likely to happen, the more sustainable are above-average P/Es. That’s because long expansions give investors the time to see earnings grow, as predicted by industry analysts.

I currently don’t expect a recession over the rest of this year or in 2019. What about 2020? Ask me again in 2019. As long as inflation remains subdued, as I expect, odds are that the expansion will go on and on—until further notice.

My Blue Angels analysis compares the S&P 500 stock price index to its implied value using weekly forward earnings multiplied by forward P/Es of 10.0 to 19.0 in increments of 1.0. Just for fun, let’s compare the index to its implied value using a multiple of 15.0, which seems to be widely viewed as a fair-value multiple for the S&P 500 both by forward-looking and backward-looking investment strategists. The monthly version of this analysis starts in September 1978, while the weekly version is available going back to March 1994.

As long as the economy is growing, I like to think of the implied S&P 500, derived by multiplying forward earnings by 15.0, as the underlying signal that determines the direction of the stock market. The actual S&P 500 is driven by the signal and buffeted around that signal by “noise.”

Currently, the signal is very strong thanks to Trump’s tax cuts. Also contributing to the strong signal is solid global economic growth, which has been bullish for the earnings of commodity companies, especially in the energy sector. The noise recently has been mostly about Trump’s protectionist threats, which already seem to be dissipating. There is also some noise about a pickup in inflation, which remains subdued. Fed officials have provided a relatively steady signal about their intention to normalize monetary policy in a gradual fashion, as confirmed by the latest minutes of the FOMC. (Chapter 13 in my book is all about predicting corporate earnings. Chapter 14 is all about predicting valuation.)

Saturday, May 19, 2018

What Are They Smoking?

I would like to try some of whatever industry analysts are smoking. You can compare my earnings forecasts to their consensus estimates on a weekly basis in YRI S&P 500 Earnings Forecast on our website. I say “tomato.” They say “tomahto.”

My earnings-per-share estimate for 2018 is $155.00 (up 17.4% y/y). The analysts continue to up the ante and are currently at $160.40 (up 21.5%). My estimate for 2019 is $166.00 (up 7.1%). Theirs is $175.72 (up 9.6%). Perhaps the analysts are just high on life.

They could be right about 2018, especially since they just boosted their Q1-2018 sights based on results reported so far during the earnings season. At the same time, they have been conservative on the remaining quarters of this year. Their growth estimate for next year seems too high to me since I expect 2019 earnings growth to settle back down to the historical trend of 7%.

You can drive a truck between my earnings estimates and theirs. However, both suggest that the stock market is likely to be at new record highs by the end of this year. As the year progresses, the earnings estimate for this year will be less relevant, while the estimate for 2019 will be more so. By the end of the year, the market will be discounting analysts’ consensus earnings estimate for 2019, not my estimate.

However, analysts tend to be too optimistic and often lower their estimates as earnings seasons approach. So let’s split the difference between my estimate and their current estimate for 2019. That would put consensus earnings for 2019 at roughly $170 per share by the end of this year. Now let’s apply forward P/Es of 14, 16, 18, and 20 to estimate where the S&P 500 might be at year-end:

2380 (down 12.3% from Friday’s close)
2720 (down 0.3%)
3060 (up 12.8%)
3400 (up 25.3%)

I pick the third scenario as most likely. My year-end target for the S&P 500 remains 3100. In my scenario, inflation remains subdued around 2.0% for the foreseeable future. Real GDP grows between 2.5%-3.0% this year. The Fed raises the federal funds rate to 2.25%-2.50% by the end of the year. The 10-year Treasury bond yield trades between 3.00% and 3.50% over the rest of the year. Investors conclude that interest rates aren’t likely to move much higher in 2019 and increasingly believe that the economic expansion might last beyond July 2019, when it will be the longest one on record. Also fears of a trade war are likely to subside as the year progresses. (For more on “Predicting Corporate Earnings,” see Chapter 13 of my new book, Predicting the Markets: A Professional Autobiography.)

Monday, May 14, 2018

S&P 500 Real Earnings Yield Says Market Isn’t Too Pricey

The May 7 issue of Barron’s included an interview with my good friend John Apruzzese, the chief investment officer of Evercore Wealth Management. In my new book, Predicting the Markets, Chapter 14 is titled “Predicting Valuation.” I explore various models for assessing whether the stock market is undervalued, fairly valued, or overvalued. I discuss a model that John and I both favor as follows:

“The earnings yield of the S&P 500, which is simply the reciprocal of the P/E based on reported earnings, is highly correlated with the CPI inflation rate on a year-over-year basis. The real earnings yield (REY) of the S&P 500 is the difference between the nominal yield and the inflation rate. The result is a mean-reversion valuation model that logically includes inflation. The average of the real yield since 1952 is 3.3%. The model tends to anticipate bear markets when the yield falls close to zero. John Apruzzese ... examined this model in a November 2017 paper titled A Reality Check for Stock Valuations. Based on the REY model, he found that ‘stocks appear more reasonably priced than the conventional P/E ratio suggests during periods of low inflation and rising markets, and more expensive during periods of high inflation and falling markets when they otherwise might seem cheap.’”

As I observe in my book, there are lots of valuation models. None are infallible. None are right all the time. I like the REY model because it does reflect the impact of inflation on valuation. As John observes, “Inflation is absolutely crucial for long-term investors. It’s the most important macro factor. Oddly, the market is stuck on the P/E ratio.” I agree and devote Chapter 4 of my book to “Predicting Inflation.”

The average value of the REY since 1952 has been 3.3%. Presumably, the market is fairly valued around this level, undervalued above it, and overvalued below it. The REY was 2.6% during the first quarter of this year. Since the late 1960s, it worked relatively well as a bear market leading indicator when it fell closer to zero. It also turned out to be a relatively good bull market indicator when it rose back above zero and exceeded its historical average.

In his paper, John concludes, “As of September 30, REY is 3.0%, near its 60-year average, based on a nominal earnings yield of 4.7% and a 1.7% core inflation rate. That indicates that the stock market is fairly valued. By no means does it look like one of the most overvalued markets in history, as measures such as the trailing P/E ratio and the Shiller P/E ratio suggest.” I agree.

Wednesday, May 9, 2018

High Noise-to-Signal Ratio In Stock Market

The 10-year US Treasury bond yield edged up above 3.00% yesterday. This widely feared level didn’t faze the S&P 500, which rose 1.0% on Wednesday to 2697.79. Rising oil prices, in response to Trump’s no-deal with Iran, helped to lift the S&P 500 Energy sector. But the Tech and Financial sectors also had a good day yesterday.

While the 10-year yield suggests that credit conditions are tightening, the yield spread between US high-yield corporate bonds and the 10-year Treasury bond continues to fluctuate in a tight range at a level that matches previous cyclical lows. All of the volatility in the S&P 500, and the downside pressure on this index, so far this year have been attributable to the forward P/E of the index, which has dropped from a high of 18.6 on January 23 to a low of 15.9 on May 3.

The forward P/E has been very noisy so far this year on fears of higher inflation, tighter Fed policy, and trade protectionism. It has masked the underlying bullish trend of the S&P 500 forward earnings. Thanks to Trump’s tax cuts at the end of last year, this weekly measure of industry analysts’ consensus estimates for earnings over the coming 52 weeks has been soaring since the start of the year.

My Boom-Bust Barometer (BBB), which is the ratio of the CRB raw industrials spot price index to initial unemployment claims, continues to be highly correlated with S&P 500 forward earnings. The BBB rose to a record high at the end of April. The BBB is also highly correlated with the S&P 500 stock price index, but less so than with forward earnings. That’s because there is more noise than signal in the S&P 500 than in forward earnings as a result of the short-term volatility of the P/E.

I have managed to tune out most of the short-term noise and focus on the underlying signal coming from earnings since the beginning of the current bull market. I hope I will continue to do so. In my opinion, the signal remains clearly bullish for now despite the noise.

Thursday, May 3, 2018

The Dividend Yield Scare

Contributing to the stock market’s agita so far this year has been the prospect that the 10-year US Treasury bond yield may be on the verge of rising above 3.00%, a level that for some reason is perceived as particularly dangerous for stocks. I suppose that’s mostly because a few widely respected market gurus have been warning that the risks of a bear market in stocks increase above this totally subjective threshold level. Perversely, at the same time, there has been some consternation over the fact that the yield curve has been flattening. That implies that the bond yield hasn’t increased fast enough relative to the federal funds rate and relative to the two-year Treasury note yield! So what are we supposed to be rooting for?

Complicating matters some more are that as the Fed has hiked the federal funds rate, short-term Treasury bill and note yields have risen to match or even exceed the S&P 500’s dividend yield. A few market commentators deem this development as bear-market provoking. So we have nothing to fear but that interest rates will continue to rise above the dividend yield and that short-term rates will rise faster than long-term rates. Consider the following:

(1) S&P 500 yields. I like to look at the S&P 500 dividend yield along with the S&P 500 earnings yield. The latter is derived from the former. On average over time, half of earnings tends to be paid out as dividends. During Q1-2018, the dividend yield was 1.89%, while the earnings yield during Q4-2017 was 4.78% (for the latter, Q1 data aren’t yet available).

(2) Treasury bill rates. The one-year US Treasury note yield rose to 2.06% during March and above the S&P 500 dividend yield for the first time since June 2008. I am hard pressed to see a predictable pattern showing that the spread between the one-year and the dividend yield can be useful in calling bear markets. They tend to occur when interest rates rise high enough to cause a recession. Simply crossing above the dividend yield isn’t a sure-fire signal of an impending recession and bear market.

(3) Treasury bond yields. Comparing the 10-year Treasury bond yield to the dividend yield makes even less sense as a bear market indicator. This Treasury yield is usually compared to the earnings yield, since the total return of stocks tends to be driven by overall earnings. Whether it makes sense for investors to compare just the dividend yield to the bond yield is a debatable issue.

Wednesday, April 25, 2018

Stall Speed, Flattening Yield Curve, and the Longest Expansion

Data for Q1-2018 real GDP will be released on Friday, April 27. The Atlanta Fed’s GDPNow model predicts 2.0% q/q (saar) based on data available through April 17. That would put the y/y rate at 2.8%. I prefer the y/y metric because it solves the annoying “residual” seasonality problem that has plagued the Q1 figure, which has tended to be weaker than the other quarters’ figures since 2010. On a y/y basis, real GDP growth has consistently meandered around 2.0% since 2010, with a low of 1.0% and a high of 3.2%.

Also meandering around 2.0% has been the y/y growth rate of the Index of Coincident Economic Indicators (CEI). It’s not a coincidence that this growth rate closely tracks the comparable growth rate in real GDP. The CEI was up 2.2% y/y through March. During 2010, pessimistically inclined economists observed that 2.0% growth had been the economy’s stall speed during all expansions since WWII. In other words, 2.0% growth meant a recession was likely to occur soon. It’s eight years later now, and real GDP still is growing around its purported stall speed without stalling.

This demonstrates that while history often repeats itself, there are exceptions. So if the stall speed concept isn’t working, then perhaps the following widely believed notion might also be wrong this time: A flattening yield curve signals an inversion in the shape of the yield curve, which signals recession. In the past, that’s held true, but I don’t see a recession anytime soon. Consider the following:

(1) Leading indicators. The Index of Leading Economic Indicators (LEI) first rose above its previous cyclical high during March 2017 and hasn’t looked back since then. That’s relatively recent, and suggests that the LEI has time to climb higher in record-high territory, as it has in the past. Keep in mind that the yield curve spread is actually just one of the 10 components of the LEI!

(2) Coincident indicators. Back in 2014, I predicted that the next recession wouldn’t happen sooner than 2019. I based that on my observation that the average length of economic expansions after they recovered above the previous cyclical high was 65 months over the previous five cycles. The CEI started making record highs again during February 2014. Using the average of the past five cycles as a benchmark would place the next business cycle peak during March 2019.

(3) Boom-Bust Model. In Chapter 5 of my new book, Predicting the Markets: A Professional Autobiography, I discuss my Boom-Bust Model of the business cycle. The bottom line is obvious: Booms set the stage for busts, so if there is no boom, then there will be no bust. During booms, financial excesses mount. Too much debt finances too much business activity. The resulting inflationary and speculative excesses cause interest rates to rise to levels that burst the debt-fueled bubble. A financial crisis occurs, triggering a credit crunch, which causes a recession. Most recessions coincide with a financial crisis.

(4) Long expansions. The CEI data start in 1959. There have been eight economic expansions since then. The current economic expansion has lasted 105 months through March. That makes it the third longest of the eight expansions. It will be the second longest during May, and the longest of them all in July 2019. I think it has a shot at making the record books. The LEI remains bullish on the outlook for real GDP even though one of its 10 components (the yield curve) has raised widespread concern. I remain bullish on the outlook for this expansion and for stocks. (For a handy table of US Business Cycle Expansions and Contractions: 1854-Present see Appendix 5.1 in my new book.)

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, 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?