The ECB’s Conundrum (excerpt)

ECB President Mario Draghi’s pledge to do whatever it takes to defend the euro has worked like a charm to calm the Eurozone’s financial markets. Indeed, since he said so back in July 2012, the area’s bond yields have plunged and stock prices have soared, especially among the peripheral countries. However, now ECB officials are concerned that the euro is too strong and contributing to deflationary pressures. So they seem to be doing their best to talk the euro down by hinting that they are considering various measures to ease credit conditions further.

The problem is that while ECB officials are trying to find the accelerator, they are still pumping the brakes. They are doing so by requiring Eurozone banks to pass stress tests. So the banks are shoring up their capital and improving the quality of their loan portfolios. It’s not obvious that imposing negative interest rates on their reserve deposits at the ECB or implementing QE would cause the banks to lend more.

ECB officials seem to understand that, which is why Draghi has been dragging his feet about actually doing whatever it takes. Draghi seems to be especially loath to drug up the Eurozone with liquidity by implementing QE. He must be unimpressed by the effectiveness of the QE programs in both the US and Japan. While he is struggling to determine what to do next, the Eurozone’s latest money and credit data show ongoing weakness:

(1) Money growth slowing. The Eurozone’s monetary aggregates are growing at a slower pace. Indeed, M2 was up only 2.2% y/y during March, the lowest growth since December 2011. A year ago, the comparable growth rate was 4.2%. This deceleration coincides with a decline in the Eurozone's core CPI inflation rate from 1.5% to 0.7% over the same period.

(2) Bank loans falling. There was more bad news in March’s lending by Eurozone MFIs. The three-month change in loans outstanding was negative for the 20th consecutive month. The good news is that the decline was only €37.6 billion, the least negative reading since July 2012, when the yearly rate was slightly positive.

Today's Morning Briefing: On Drugs. (1) Overweighting Health Care. Market-weighting Consumer Discretionary. (2) Some consumer stocks are too expensive now. (3) Auto- and housing-related stocks reflect weakening recoveries. (4) Health Care stocks aren’t cheap either, but sector's M&A is bullish, and so are earnings. (5) The rush to invert. (6) Global tour of Pharma industry. (7) Best to invest in industries with barriers to entry. (8) Why is Draghi dragging his feet? (9) ECB isn’t rushing to drug up Eurozone with QE. (More for subscribers.)

Is the US Fairest of Them All? (excerpt)

Forward earnings are at record highs for all three of the S&P market cap indexes. There are no other developed countries with forward earnings trending higher into record-high territory. Let's have a closer look:

(1) Indeed, the forward earnings of the Developed World ex-US MSCI is still below its 2011 high, though it has been recovering since mid-2013. That’s mostly because the plunge in the yen in response to Abenomics propelled the forward earnings of the Japan MSCI by 37.0% last year.

(2) So far, the recovery in the Eurozone hasn’t shown up in the forward earnings of the EMU MSCI. Despite solid rebounds in the Eurozone’s M-PMI since mid-2012 and a similar upturn in Germany’s Ifo Business Climate Index, the EMU’s forward earnings has been flat for the past year after falling from mid-2011 through early 2013.

(3) Even more puzzling is the UK, which has had stronger economic growth than the Eurozone over the past couple of years. Yet forward earnings, which have been declining since the second half of 2011, are still falling.

(4) As for emerging markets, they are neither emerging or submerging, according to the forward earnings of the EM MSCI. It’s been basically flat since 2011.

The bottom line is that the US is the fairest of them all based on my analysis of forward earnings around the world. The only problem is that the US isn’t the cheapest of them all. There is a bit of a valuation problem in the US stock market because many stocks are either fairly valued or overvalued. The current internal correction should correct this problem. While it is happening, the S&P 500 could churn sideways for a while before grinding higher to end 2014 at 2014.

Today's Morning Briefing: Earnings World. (1) Fully Invested Bears. (2) Barron’s has a tired bull on the cover. (3) Big Money poll finds more bulls than bears, but less bullishness. (4) Everyone hates bonds. We don’t, but we don’t love them either. (5) Contrarian indicators. (6) Is the market’s leadership change a sign of a top? (7) A brief review of the internal correction. (8) A brief review of forward earnings around the world shows USA is fairest of them all, but not cheapest. (More for subscribers.)

Fed Model, Buybacks, and M&A (excerpt)

Previously, I’ve argued that as long as the forward earnings yield of the S&P 500 exceeds the corporate bond yield, buybacks are likely to continue. This is a variation of what I called the “Fed Stock Valuation Model (FSVM),” which I discovered buried in the Fed’s Monetary Policy Report of July 1997. It showed a close fit between the earnings yield and the 10-year Treasury bond yield from 1982 through 1997. That’s just about when the model stopped working as a useful investment tool. It did show that the S&P 500 was overvalued during the late 1990s. But it has been significantly undervalued ever since then according to the model, which never gave a sell signal in 2007 or 2008. (See the Wikipedia article on the Fed Model.)

The model has been more useful for explaining corporate financial behavior. The corporate finance yield spread between the S&P 500 forward earnings yield and Moody’s seasoned Aaa corporate bond yield has been positive since 2004 and is currently 237bps. When it is positive, company managements can get a better return on their cash by repurchasing their shares than by investing it in fixed-income securities.

Alternatively, their companies can benefit by borrowing the money to buy back some of the company shares. Last year, nonfinancial corporations’ net new issuance of bonds totaled a record $640 billion. Some of those proceeds funded buybacks. (Although the Aaa yield applies to only a handful of corporations, it is pre-tax. So it should still be a good proxy for corporate borrowing rates after taxes, in my opinion.)

The corporate finance version of the FSVM suggests that companies can also benefit by using their cash or borrowed money to fund M&A when the forward earnings yield of the combination exceeds the corporate bond yield.

Today's Morning Briefing: M&A Mania? (1) Here we go again. (2) Fed Model not a good market timing tool, but it does explain corporate buybacks. (3) Forward earnings yield vs. corporate bond yield. (4) Companies using inflated stock prices as M&A currency. (5) Software and R&D accounting for more of capital spending. (6) Macroeconomic vs. microeconomic models of inflation. (7) Competitive model explains a lot. (8) Yellen’s tools aren’t working. (9) Stocks should grind higher this year. (10) So far, 2014 is reminiscent of 2013, when defensive stocks outperformed until the end of April. (More for subscribers.)

China’s Excess Capacity Weighing On Growth (excerpt)

China’s flash M-PMI edged up to 48.3 this month from 48.0 last month. It’s been below 50 for the past three months, suggesting that manufacturing is slowing. That’s not a surprise given recent weak exports data. In addition, the PPI inflation rate on a y/y basis has been negative for the past 26 months through March, indicating excess capacity is also weighing on manufacturing. The property construction market is also showing some signs of deflation recently.

So far, the government’s response hasn’t been sufficient to boost growth. That may be because the government is trying to reduce some of the excesses that led to the building of too many factories and too many ghost cities.

By the way, China’s crude oil demand has been flat at a record high over the past nine months through March. That doesn’t bode well for the country’s economic growth either. It actually suggests that growth may be slowing even faster than suggested by GDP and production indicators.

Today's Morning Briefing: Mixed Global Signals. (1) Top down and bottom up lead to same conclusion. (2) Industrial commodity prices firming. (3) Growth in global crude oil demand slowing, especially among EMs. (4) Europe’s soft data stronger than hard data. (5) Auto recovery just starting in Europe. (6) China paying the price for too much capacity. (7) Another setback for Abenomics in exports. (8) Housing and auto recoveries stalling, according to railcar loadings. (9) Focus on underweight-rated S&P 500 Energy. (More for subscribers.)

Is Slow Growth Bullish? (excerpt)

I’ve previously made the case for a secular bull market in stocks on the premise that subpar economic growth in the US and around the world reduces the likelihood of a recession. That’s because slow growth is bound to keep a lid on inflation, which means that the major central banks are more likely to maintain their easy monetary policies. In the past, maturing economic expansions often ended when inflationary booms caused monetary policy to tighten. The boom was then followed by a bust.

That’s not happening this time. The 4/20 WSJ included an interesting article titled, “Sluggish Economic Recovery Proves Resilient.” It reviews the various possible explanations for why the current recovery “is proving to be one of the most lackluster in modern times.” Nevertheless, “[i]t also is shaping up as one of the most enduring.”

The Business Cycle Dating Committee of the National Bureau of Economic Research determines the length of economic expansions and contractions (table). The current economic expansion just matched the 58.4 months average length of the previous 11 expansions since World War II. So far, real GDP is up 11.0% since Q2-2009, the trough of the last recession. That’s the weakest recovery of the previous six. That’s mostly attributable to the subpar recovery in real personal consumption expenditures.

So why is the recovery so slow? The article notes that Republicans blame Democrats for burdening the economy with taxes, debt, and regulations. Democrats blame Republicans for not agreeing to more fiscal spending and for playing a game of chicken with the debt ceiling. Economists are also a disagreeable lot, with some saying that the financial crisis of 2008 is still weighing on the economy. Others see “secular stagnation.” Not mentioned in the article was income inequality, which has recently become one of the main explanations of progressive economists.

I tend to side with the conservatives. I’ve frequently marveled at the resilience of the US economy notwithstanding the meddling of the federal government. I also believe that powerful deflationary forces have been unleashed by the proliferation of globalization and technological innovations. They are keeping a lid on inflation, which lowers the likelihood of a recession caused by tight money conditions.

Meanwhile, there’s certainly no hint of a recession in the Index of Leading Economic Indicators, which rose in March to a new cyclical high, and the highest reading since December 2007. The Index of Coincident Economic Indicators has been in record-high territory since last summer, and rose to yet another new high last month.

Our Fundamental Stock Market Indicator (FSMI), which tends to track the ECRI index, jumped 7.7% over the past eight weeks to a new cyclical high that nearly matches the previous peak during 2007. That’s a good omen for the stock market, since our FSMI is even more highly correlated with the S&P 500.

Today's Morning Briefing: Moving Forward, Slowly. (1) Q1 earnings growth turns slightly negative. (2) The upbeat Tale of Three Cities. (3) Forward earnings still moving forward. (4) Might slow growth be bullish for valuations? (5) No boom, no bust. (6) Dating Committee data show expansion set to exceed average length. (7) No recession in leading indicators, including ECRI weekly. (8) Our Fundamental Stock Market Indicator is bullish. (More for subscribers.)