Buyback Bonanza

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

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

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

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

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

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

Trade War Noise vs Earnings Signal

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

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

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

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

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

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

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%.

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.

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.”