Margin Debt (excerpt)

In the February 5 Morning Briefing, I outlined the Irrational Exuberance scenario as follows: “In a melt-up scenario, the market [S&P 500] would do just that, jumping to my yearend target [1665] or higher before the middle of the year. … The Fed’s critics, including dissenters on the FOMC, will warn that ultra-easy monetary policy is once again pumping air into a stock market bubble. So a melt-up could be followed by a meltdown, or at least a very nasty 15%-20% correction later this year if the Fed is forced to stop its quantitative easing by soaring stock prices…”

Alternatively, Fed Chairman Ben Bernanke and his dovish allies on the FOMC might respond to their critics by raising stock market margin requirements. During March, margin debt soared to $380 billion, up 28% y/y, matching the previous record high during July 2007. The margin requirement has been flat at 50% since January 1974.

Soaring margin debt certainly supports the charge that the Fed is once again inflating asset bubbles. However, valuation multiples aren’t flashing irrational exuberance yet, but that could change quickly in a debt-financed melt-up of stock prices.

Today's Morning Briefing: Exuberance. (1) Within shouting distance of 1665. (2) A short history of the bull’s P/E. (3) Taking Greece out of the P/E. (4) Probability-weighted math yields 1695 target for S&P 500. (5) Weighing the odds of a melt-up followed by a meltdown. (6) If stock prices soar, Fed will have to do something. (7) Phase out QE or raise margin requirements? (8) Throwing a wet towel on the bull. (9) Will someone please hit the pause button? (10) Good news out of Germany and China bolster outlook for slow, but steady global growth. (11) Copper starting to shine again? (More for subscribers.)

Dow Theory (excerpt)

Dow Theoreticians insist that the stock market averages for the industrial and transportation companies should confirm one another. In a bull market, the Dow Jones Industrials Average (DJIA) and the Dow Jones Transportation Average (DJTA) should both be ascending. In a bear market, they should both be descending. The practitioners of this theory get very jittery if the two indexes diverge or if one of them lags significantly behind the other. So for example, if the DJIA is making new highs and the DJTA is not, or is going the other way, that makes them bearish on the overall market. That’s what happened in early April.

But now, all is well with the world again. The bulls are in charge again now that the DJIA and the DJTA are both happily charging together to new record highs. The S&P 500 Industrials Composite--which is the S&P 500 excluding Financials, Transports, and Utilities--and the S&P 500 Transportation Composite are also prancing along together to new record highs.

Today's Morning Briefing: All Abroad! (1) Dow Theory is bullish for now. (2) From divergence to convergence. (3) Central banks delivering liquidity, while truckers and trainmen deliver the goods. (4) Transport’s forward earnings moving forward. (5) Car loads loaded with oil, autos, and lumber. (6) Intermodal loadings trending higher along with business inventories. (7) Trucks hauling record freight. (8) Rally in transportation stocks fueled more by domestic than global economy. (9) Focus on market-weight-rated S&P 500 Transportation. (More for subscribers.)

Compensation & Entitlements (excerpt)

It is true that compensation of all employees has been trending down from a record high of 69% during Q2-1980 to 62% at the end of last year. Even worse is that wages and salaries in national income have dropped below 50% last year for the first time on record. Yet pre-tax personal income and disposable personal income were at 97% and 87% of national income at the end of last year. How can this be?

The answer is deficit-financed government spending on entitlements. National income shares are based on incomes before taxes and before the government redistributes income through entitlements, which have soared from around 5% of national income in the early 1960s to around 17% currently.

Of course, not all the money borrowed by the government comes from current national income produced and earned in the US. Some is borrowed from abroad. Some is monetized by the Fed through QE. It is a mounting burden on future generations.

The bears are right that this can’t be sustainable. One day they will be proven right about that.

Today's Morning Briefing: Crying Foul. (1) The bears were wrong about revenues. (2) Revenues, business sales, and GDP at record highs. (3) Latest earnings season had disappointing revenues. (4) Not so bad excluding falling Energy revenues. (5) Bears preach that Capitalists’ gain is Labor’s pain. (6) The market doesn’t take sides in class wars. (7) The government redistributes income, borrows from strangers, and prints money. (8) That’s all bullish until it isn’t. (9) Let It Be. (More for subscribers.)

Valuation (excerpt)

The forward P/E of the S&P 500 rose to 14.0 on Friday, the highest since April 2010. Over the past seven weeks, the forward earnings of the S&P 500 has leveled out around a record high of $115 per share. Now that the index is already within sight of my yearend Rational Exuberance target of 1665, what is the upside in an Irrational Exuberance melt-up scenario? Let’s review the potential upside suggested by some valuation models:

(1) Fed’s Stock Valuation Model. In 1997, I noticed that the second section of the Fed’s Monetary Policy Report to Congress included a chart and a brief discussion of the close fit between the 10-year Treasury bond yield and the inverse of the S&P 500’s forward P/E. I dubbed it the "Fed’s Stock Valuation Model" (FSVM). The model became instantly popular and controversial, as discussed in a Wikipedia article about it.

Ironically, after I “discovered” the FSVM, the Fed never mentioned it again, and it hasn’t even worked for the past two decades. It was bullish on stocks during the bull markets of the previous and current decades. But they were driven mostly by rising earnings, while the secular trend in the valuation multiple was downwards. The FSVM currently suggests that stocks are 75% undervalued relative to bonds. Alternatively, bonds are grossly overvalued relative to stocks.

(2) Rules of 20. A simple alternative to the FSVM is the Rule of 20, which compares the forward P/E of the S&P 500 to the difference between 20 and the CPI inflation rate on a y/y basis. Currently, it shows that the P/E should be 18.5, well above the market’s current P/E of 14. That would put the S&P 500 at 2133, or 32% above Friday’s close.

A hybrid valuation multiple that combines the Rule of 20, the FSVM, and our Blue Angels multiplies the latest forward earnings of the S&P 500 by the P/E derived by subtracting the 10-year Treasury bond yield from 20. The result shows that the S&P 500 should be around 2100.

Today's Morning Briefing: Rules of 20. (1) The valuation question in London. (2) From downside to upside. (3) Ahead of schedule on yearend target. (4) Qualitative and quantitative dimensions of a melt-up scenario. (5) One more time: Don’t fight the central banks. (6) Phasing out phasing out QE. (7) Draghi “ready to act if needed.” (8) Japan may be a leading indicator. (9) Playing both defense and offense. (10) Valuation models for a melt-up scenario. (11) Payrolls rose, but paychecks fell in April. (12) Focus on market-weight-rated auto-related stocks. (More for subscribers.)

Unemployment In Europe (excerpt)

On Thursday, the ECB is expected to lower its official rate from 0.75% to 0.50%. This expectation was in the financial markets even before Eurostat yesterday reported that the euro zone’s CPI rose only 1.2% y/y in April, easing from March’s 1.7% reading. That’s well below the ECB’s target of 2%.

Yesterday, Eurostat also reported that euro zone unemployment rose to 12.1% during March, an all-time high. Youth unemployment for workers under 25 years old rose to 24%. Unemployment is especially high in Italy (11.5%) and Spain (26.7%). In Italy, youth joblessness is significantly higher at 38.4%, and shockingly high at 55.9% in Spain.

Today's Morning Briefing: Jam-Packed. (1) Two policy meetings and lots of economic data. (2) Carbon copy FOMC statement? (3) Inflation may be too low for Fed and ECB. (4) Unemployment rate is certainly too high in euro zone. (5) Will ECB copy BoE’s Funding for Lending Scheme? (6) A deluge of PMIs confirming recession in Europe, slowdown in China and US, and better growth in Japan. (7) Fed district surveys for April are uninspiring. (8) Will frigid March heat up April’s payrolls? (9) Consumer confidence blossoming in the spring. (10) Fundamental Stock Market Indicator is looking up again. (11) Focus on overweight-rated Financials. (More for subscribers.)