Wednesday, November 27, 2019

Thanksgiving: The Bull Is No Turkey

Thanksgiving is my favorite holiday. It’s great getting together with family and friends. We always take turns—going around the dinner table—sharing what we are most thankful for. The comments tend to focus on health and supportive family members.

According to the weather forecasters, most of us won’t be thankful for the weather on Thursday when we gather for Thanksgiving. It’s going to be stormy around the country. Depending on the winds, the organizers of the Macy’s Thanksgiving Day Parade might have to ground their balloons.

For those of us in the stock market, the questions are whether there will be a Santa Claus rally this year, and whether it will inflate stock prices with too much hot air. I am predicting that the S&P 500 will reach 3500 by the end of next year. That’s an increase of 12.5% over Friday’s close, which itself represents a year-to-date gain of 24.1%.

My main worry currently is that the S&P 500 will get to 3500 well ahead of schedule in a meltup scenario. My 3100 target for this year was surpassed on 11/15. However, that was actually well behind schedule, since 3100 had been my target for the end of last year. Everything was working out fine for my forecast through 9/20/18, when the S&P 500 peaked at 2930.75. But then recession fears emerged as investors fretted that the Fed was set on an overly restrictive monetary policy course and that the trade war with China was escalating. The S&P 500 proceeded to plunge by 19.8% through the day before Christmas (Fig. 1).

The day after Christmas, investors came to their senses, betting that Fed officials would do the same and that the US and China would eventually work out a trade deal. As a result, there has been a meltup of sorts in the S&P 500 and its 11 sectors since the day before last Christmas through Friday’s close, as follows: Information Technology (50.0%), Industrials (35.3), Communication Services (35.2), Financials (33.7), S&P 500 (32.3), Consumer Discretionary (30.5), Real Estate (26.9), Consumer Staples (25.4), Materials (25.4), Utilities (21.7), Health Care (21.6), and Energy (10.0) (Fig. 2).

However, it doesn’t look like a meltup when we compare the market’s performance since last year’s 9/20 peak: Utilities (18.8%), Information Technology (15.3), Real Estate (14.4), Communication Services (12.5), Consumer Staples (11.0), S&P 500 (6.1), Health Care (4.2), Financials (3.4), Industrials (2.7), Consumer Discretionary (1.0), Materials (-2.4), and Energy (-20.7) (Fig. 3).

When we look at fluctuations in the S&P 500’s valuation multiple, however, the picture does look like a meltdown during 2018 followed by a meltup this year (Fig. 4). The forward P/E of the S&P 500 peaked at 18.6 on 1/23/18, the highest reading during the current bull market. It crashed 28% to 13.5 on 12/24/18. It soared back up to 17.5 last week.

Let’s consider some of the possible events during the holiday season that might fuel the meltup or trigger panic attack #66. (See our table of the 65 panic attacks since the start of the current bull market.) Let’s start with the meltup scenario:

(1) Growth. On the meltup side, investors are starting to anticipate better global economic growth next year, while inflation is expected to remain subdued. This year’s earnings growth slowdown to near zero was mostly attributable to tough y/y comparisons because last year’s growth rate was boosted by Trump’s tax cut and higher Energy earnings. Earnings comps should be easier next year, with industry analysts currently projecting gains for S&P 500 operating earnings of 9.1% in 2020 and 10.8% in 2021 (Fig. 5). I think the analysts are too optimistic, as they often have been in the past. Earnings should grow in line with revenues growth, which is currently expected to be 5.2% in 2020 and 4.7% in 2021 (Fig. 6). Analysts tend to be more realistic about revenues growth than earnings growth.

(2) Monetary policy. The major central banks are likely to persist with their ultra-easy monetary policies. The Fed probably will keep the federal funds rate unchanged through next year’s election. However, the Fed started buying $60 billion per month in Treasury bills during mid-October and will continue doing so through mid-2020 (Fig. 7). On the other hand, the Fed’s holdings of mortgage-backed securities continue to decline (Fig. 8).

Now let’s consider some of the possible triggers of yet another panic attack and why the next one should be followed by yet another relief rally rather than a bear market:

(3) Trade war. Both China and the US have a clear interest in getting a phase-one trade deal completed relatively soon to calm financial markets and reduce the drag on their economies from the uncertainty attributable to the trade war. However, it won’t be a done deal until the deal is done.

Trump wants to secure a big phase-one announcement. He is expecting that the Chinese will commit to purchases of US agricultural goods that he can tout as an important win during his re-election campaign. The signing of a phase-one deal could slide into next year as the two countries tussle over Beijing’s demand for more extensive tariff rollbacks.

In any event, Beijing trade officials aren’t likely to sit down to discuss a phase-two deal before the US election, in part because they want to wait to see if Trump wins a second term.

If there is no deal, stock prices could crater. However, Trump views the DJIA as his most important poll. So he would likely respond to a market selloff with some encouraging words. More importantly, Fed officials would most likely signal a willingness to ease some more if trade headwinds threaten to depress the US economy.

(4) Hong Kong. An 11/25 NBC News article reported: “Pro-democracy forces swept Hong Kong district council elections over the weekend, boosting pressure on the city’s Beijing-backed government to listen to protesters’ demands for greater freedoms.

“China responded sternly to the landslide in the vote widely seen as a referendum on public support for the anti-government movement. Foreign Minister Wang Yi said that no matter how the situation in Hong Kong changes, the semiautonomous region is part of China.”

Beijing has avoided directly intervening so far, preferring to let Hong Kong’s embattled leader Carrie Lam handle the situation. In this age of smartphones, Beijing has been deterred from cracking heads and having the carnage live-streamed around the world.

(5) Middle East. Yesterday, Brig.-Gen. Zvika Haimovich, former commander of the Israel Defense Forces’ Aerial Defense Division, warned that Iran is planning a “multi-directional” attack against the state of Israel together with its proxies, and that the Jewish state needed to prepare for it now.

Iran has been gripped by an economic crisis since the US restored painful sanctions on 5/8/18 after withdrawing from the 2015 nuclear deal. Last week, there were widespread riots in Iran following a fuel price hike by the government. During the violence, dozens of banks, gas pumps, and police stations were torched across the Islamic republic.

Iranian officials accused the US, Britain, Israel, and Saudi Arabia of stoking the unrest. Yesterday, the head of Iran’s Islamic Revolutionary Guard Force threatened to destroy Israel, the US, and other countries as he addressed a pro-government demonstration.

There's plenty to worry about. But let's enjoy Thanksgiving and look forward to a Santa Claus rally, maybe.

Tuesday, November 19, 2019

Are Stocks Overvalued?

In my book Predicting the Markets (2018), I reviewed various valuation models that stock investors follow. My main takeaway was that, “Judging valuation in the stock market is akin to judging a beauty contest. … Not only is beauty subjective, Hollywood tells us—it can be dangerous. At the end of the original version of the movie King Kong (1933), the big ape’s death is blamed by his handler on Ann Darrow, Kong’s blonde love interest, played by Fay Wray: ‘It was beauty that killed the beast.’ Valuation is in the eye of the beholder too. And buying stocks when they are most loved and very highly valued can also be deadly.”

In today’s politically correct times, it’s probably best to compare valuation to a talent contest rather than a beauty contest. Like any objective judge at a talent show, I want to see the contestants compete before I pick the winner. In recent years, I’ve given more of my votes to the contestants that incorporate inflation and interest rates into their acts. That’s led me to a more sanguine opinion about stock valuation than suggested by the more traditional reversion-to-the-mean P/E models, especially the ones based on trailing earnings.

Here’s an update of four of the valuation models that I reviewed in my book:

(1) Buffett ratio. Warren Buffett has said he favors the ratio of the value of all stocks traded in the US to nominal GNP, which is nominal GDP plus net income receipts from the rest of the world (Fig. 1). The data for the numerator are included in the Fed’s quarterly Financial Accounts of the United States and lag the GNP report, which is available on a preliminary basis a few weeks after the end of a quarter. Needless to say, they aren’t exactly timely data. However, the forward price-to-sales ratio of the S&P 500, which is available weekly, has been tracking Buffett’s ratio very closely. The quarterly series is back at the 1.90 peak just before the bear market of 2000-2002. The weekly series was 2.07 at the end of October. Buffett has remained bullish, observing that historically low inflation and interest rates justify these high ratios.

(2) Rule of 20. The “Rule of 20” was devised by Jim Moltz, my mentor at CJ Lawrence. It simply compares the S&P 500 forward P/E to the difference between 20 and the inflation rate, using the y/y percent change in the CPI. When the sum of the forward P/E and the inflation rate is above (below) 20, stocks are deemed to be overvalued (undervalued) (Fig. 2). It was slightly below 20.0 during October. This rule of thumb has had a few hits and misses, as have more sophisticated models.

(3) Real earnings yield. 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 y/y basis. The real earnings yield (REY) of the S&P 500 is the difference between the nominal yield and the inflation rate (Fig. 3). The result is a mean-reversion valuation model that logically includes inflation.

The average of the real yield since 1952 through Q3-2019 is 3.19%. The model tends to anticipate bear markets when the yield falls close to zero. Our friend John Apruzzese, the Chief Investment Officer of Evercore Wealth Management, 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.”

According to the model, stocks remained reasonably priced during Q3, with the REY at 2.92%.

(4) Misery-adjusted P/E (MAPE). The Misery Index is the sum of the unemployment rate and the yearly percent change in the CPI inflation rate (Fig. 4 and Fig. 5). The Misery Index tends to fall during bull markets and to bottom before bear markets. It was down to 5.4% during October, almost matching the most recent low of 5.0% during September 2015, which was the lowest reading since April 1956. What you’re about to hear may be hard to believe, I know, amid all the naysaying by all the naysayers, but the truth is: Most Americans have never been less miserable, at least in terms of how they’re affected by the performance of the macro-economy.

I’ve found that there is a reasonably good inverse correlation between the forward P/E of the S&P 500 and the Misery Index (Fig. 6). That makes sense to me. When we are miserable, we aren’t in the mood to drive up the valuation multiple. When we are happy, we tend to become exuberant, driving up the P/E. However, a high P/E, by historical standards, may not necessarily reflect irrational exuberance if interest rates are historically low because inflation is subdued. In other words, the current readings of the Misery Index are historically low and may justify P/Es that exceed the historical average.

My homebrewed MAPE is the sum of the S&P 500 forward P/E and the Misery Index (Fig. 7). It averaged 23.8 from September 1978 through October 2019. Readings above (below) the average suggest stocks are overvalued (undervalued). It was 22.6 during October, i.e., below average. MAPE correctly warned that stocks were overvalued prior to the bear markets of the early 1980s and 2000s. It did not anticipate the last bear market, but that’s because the problem back then was the overvaluation of real estate, not stocks.

Thursday, November 14, 2019

Zombies in the Fed's Soup

I’m finishing up writing my next book, Fed Watching for Fun and Profit: A Primer for Investors. I’ve had a lot of fun writing it, and it has given me a broader perspective on the making of monetary policy by the Fed in particular and central bankers in general.

In my opinion, they all suffer from group-think.

They all use the same or similar models of the economy. Some are empirical models, but most are theoretical. The empirical ones create the illusion of a precise scientific analysis of how the economy works. The theoretical ones tend to be, well, too theoretical. Both can be quite misleading, especially if they are based on faulty assumptions and logic. Put simply, most of the models reflect thinking that bears little resemblance to reality and lacks plain old common sense.

When reality conflicts with what their models suggest to be the case, the central bankers—rather than questioning their models and learning from their mistakes—resolve the cognitive dissonance by doubling down on their commitment to their models. In other words, they do more of the same, expecting that the result will eventually coincide with their models’ predictions.

A case in point is their determination to provide ultra-easy monetary policies to boost inflation to their target of 2.0%. The major central bankers have been trying to do so for over 10 years without success. They seem totally befuddled. Fed officials have recently been talking about their “symmetrical target” of 2.0%, implying that they are willing to let the economy run hot, with inflation exceeding 2.0% for a while, since it has been running below that pace for so long. That’s an interesting idea, but they can’t even get inflation up to 2.0%—why embarrass themselves further by shooting for an even higher target?

The Fed pivoted at the start of this year from signalling three hikes in the federal funds rate during 2019 to actually lowering it three times this year. Outgoing European Central Bank (ECB) President Mario Draghi loaded up his bank’s bazookas yet again as he was walking out the door at the end of October. On 9/12, the ECB’s Governing Council voted to lower the bank’s deposit facility rate from -0.40% to -0.50% and to restart the asset purchase program at the pace of €20 billion per month with no set end date. The Bank of Japan never let up on its ultra-easy policies, but it did stop projecting when inflation might get up to 2.0%. The inflation rates in the US, Eurozone, and Japan are currently 1.7% (core US PCED), 0.7% (Eurozone CPI), and 0.3% (core Japan CPI) (Fig. 1, Fig. 2, and Fig. 3).

The major central banks all are run by PhD macroeconomists as well as people like Jerome Powell at the Fed and Christine Lagarde at the ECB who have been surrounded by macroeconomists their entire careers. Most of the macroeconomists working at the central banks were trained as demand-side Keynesians. They believe that easy money should stimulate demand, which should revive inflation. That’s their core belief, in fact.

More specifically, easy money should boost consumer spending on durable goods and housing. It should stimulate capital spending by businesses. When the economy runs out of slack, that’s when it will run hot enough to heat up inflation. The central bankers admit that there has been more slack than they expected, but once the economy runs out of workers, wage inflation will rise, pushing price inflation higher, especially once capacity utilization gets to be tight enough. The Phillips Curve and output-gap models are variations of this demand-side view of the world.

There are two major flaws in this model: It fails to recognize that there are limits to how much debt demand-side borrowers can carry to keep buying stuff. And it completely ignores the impact of easy money on supply-side borrowers. Consider the following:

(1) Too much debt on the demand side. In the past, when demand-side borrowers had plenty of capacity to take on more debt, easy money effectively stimulated demand. It seems to have lost its effectiveness because monetary policy has been easy for so long, resulting in high debt-to-income ratios. Even historically low interest rates, which reduce the cost of servicing debt, don’t seem to be stimulating demand, which might explain why interest rates are historically low, of course.

(2) Too many zombies on the supply side. Meanwhile, supply-side borrowers, who produce the goods and services purchased by demand-side borrowers, can take advantage of easy money to refinance their debts at lower rates. Producers may also borrow more to keep their businesses going. The ones who are most likely to do so are the ones who would be out of business if they couldn’t borrow money. In other words, they are zombie businesses, i.e., the living-dead companies that won’t die because they are resuscitated by the cash infusions provided by their lenders. As long as they stay alive, they create deflationary pressures by producing more goods and services than the market needs.

And why are lenders willing to lend to the zombies? Instead of stimulating demand, historically low interest rates incite a reach-for-yield frenzy among creditors. They are willing to accept more credit risk for the higher returns offered by the zombies. Besides, if enough zombies fail, then surely the central banks will come up with some sort of rescue plan.

(3) Debt binges, now and then. It’s interesting to compare the borrowing binge in home mortgages that led to the Great Financial Crisis and the current borrowing binge in nonfinancial corporate (NFC) debt, including bonds and loans. At the start of 1990, the amount outstanding of both equaled around $2.4 trillion each (Fig. 4). Home mortgages then soared by 378%, or $9.0 trillion, to a record $11.3 trillion during H1-2008. Over the same period, NFC debt rose 162%, or $4.0 trillion to $6.4 trillion.

After peaking, home mortgages outstanding fell $1.4 trillion through Q1-2015, and then increased by $1.1 trillion to $11.0 trillion by Q2-2019. That was still slightly below the record high. Over the same period, NFC debt rose 55%, or $3.5 trillion, to a record $10.0 trillion.

During Q2-2019, NFC corporate bonds outstanding rose to a record $5.7 trillion (Fig. 5). NFC loans held by banks rose to a record $1.1 trillion, while “other loans” (which are mostly leveraged loans) rose to a record $1.8 trillion (Fig. 6).

The NFC data are less alarming when scaled by nominal GDP (Fig. 7 and Fig. 8). Home mortgages outstanding peaked at a record 77% of GDP during Q1-2009. NFC debt rose to a record high of 47% of GDP during Q2-2019.

(4) Central banks fueling deflation by feeding zombies. My interpretation of the data is that excessively easing credit conditions fueled the mortgage borrowing binge and housing boom that ended with the Great Financial Crisis. The strong debt-financed demand for homes stimulated economic activity and caused home prices to soar.

Since the Great Financial Crisis, the borrowing binge in NFC debt hasn’t contributed much to economic growth, and consumer price inflation has remained subdued. Apparently, a significant percentage of NFC debt is attributable to zombie companies using most of the proceeds from their borrowing to stay in business. The Fed’s May 2019 Financial Stability Report nailed it, as follows:

“[T]he distribution of ratings among nonfinancial investment-grade corporate bonds has deteriorated. The share of bonds rated at the lowest investment-grade level (for example, an S&P rating of triple-B) has reached near-record levels. As of the first quarter of 2019, a little more than 50 percent of investment-grade bonds outstanding were rated triple-B, amounting to about $1.9 trillion.”

The report also warned about leveraged loans as follows:

“The risks associated with leveraged loans have also intensified, as a greater proportion are to borrowers with lower credit ratings and already high levels of debt. In addition, loan agreements contain fewer financial maintenance covenants, which effectively reduce the incentive to monitor obligors and the ability to influence their behavior. The Moody’s Loan Covenant Quality Indicator suggests that the overall strictness of loan covenants is near its weakest level since the index began in 2012, and the fraction of so-called cov-lite leveraged loans (leveraged loans with no financial maintenance covenants) has risen substantially since the crisis.”

During his 10/30 press conference, Fed Chair Jerome Powell was asked about financial stability. He responded: “Obviously, plenty of households are not in great shape financially, but in the aggregate, the household sector’s in a very good place. That leaves businesses which is where the issue has been. Leverage among corporations and other forms of business, private businesses, is historically high. We’ve been monitoring it carefully and taking appropriate steps.”

He didn’t specify those steps. However, the Fed’s three interest-rate cuts are likely to feed the zombies’ appetite for more debt. In other words, the easy money provided by the Fed and the other central banks may be contributing to deflationary pressures attributable to supply-side borrowers. This would certainly explain why easy money has failed to boost inflation as expected by the proponents of demand-side models.

(5) Is a zombie apocalypse inevitable? If you want to read a very frightening script of how this horror movie plays out, see the October 2019 Global Financial Stability Report prepared by the International Monetary Fund. Here is the punchline: “In a material economic slowdown scenario, half as severe as the global financial crisis, corporate debt-at-risk (debt owed by firms that cannot cover their interest expenses with their earnings) could rise to $19 trillion—or nearly 40 percent of total corporate debt in major economies, and above post-crisis levels.”

There’s certainly lots to digest and think about in this unsettling report as the S&P 500 climbs to another record high. Apparently, investors expect that before doomsday arrives, even the Fed will lower interest rates close to zero again, allowing all the zombie borrowers to refinance their debts, thus postponing the zombie apocalypse.

Powell testified before the House Budget Committee on Thursday, 11/4. He said that he isn't worried about bubbles: “If you look at today’s economy, there’s nothing that’s really booming now that would want to bust.” He reassuringly added, “I think possibly the day of reckoning could be quite far off.”

I remain bullish on the economy and the stock market for now. But my contrary instincts are on full alert thanks to Powell. Stay tuned.