Soarin’ Fundamentals for Stocks

I spent the long President’s Day weekend with my family in Disney World. It was the first time that my four-year-old granddaughter Cecelia (a.k.a. “CeCe”) attended the theme park. The park’s staffers are trained to say “Have a magical day” whenever they greet visitors. Cece had a magical weekend, and so did the rest of my family. The weather was great, and my wife wisely obtained FastPass+ reservations for most of the rides. We particularly enjoyed a trip around the world on Disney’s flight simulator, Soarin’.

Back on Earth, stock investors have enjoyed a magical bull market since March 2009. It was particularly magical during 2017, when the S&P 500 rose 19.4%. Such a double-digit return is quite extraordinary for an aging bull market going on nine years old in 2018. The magic seemed to stop abruptly when the S&P 500 plunged 10.2% over 13 days from late January through early February. I believe that the latest selloff marked the fourth correction in this bull market, not the beginning of a bear market. The economic fundamentals remain bullish:

(1) 2018 earnings estimates. S&P 500 earnings estimates for 2018 have been soaring during the current earnings season. Industry analysts have been getting guidance by corporate managements on the very positive impact of the Tax Cut and Jobs Act (TCJA), enacted at the end of last year, on their earnings. I have been keeping track of these estimates on a weekly basis. Over the past nine weeks since TCJA was enacted, the 2018 consensus earnings estimate for the S&P 500 has increased by $11.21 per share from $146.26 to $157.47. That’s a 7.7% increase.

(2) Boom-Bust Barometer. My Boom-Bust Barometer (BBB) is simply the CRB raw industrials spot price index divided by initial unemployment claims. It is a great coincident indicator of the US business cycle. It soared into new record-high territory in recent weeks. It did so as the CRB index rose to a new cyclical high following its freefall from the second half of 2014 through the end of 2015. At the same time, weekly initial unemployment claims have dropped to their lowest levels since March 1973.

(3) Weekly Leading Index. I have devised a Weekly Leading Index (YRI-WLI) that is an average of our BBB and Bloomberg’s weekly Consumer Confidence Index (WCCI). It is highly correlated with the index compiled by the Economic Cycle Research Institute. My WLI is based on an open-source formulation, while theirs is based on a secret sauce. Both have been rising in record-high territory in recent weeks.

The YRI-WLI is soaring because the BBB is doing so, and so is the WCCI. Consumers have lots of reasons to be overjoyed with the unemployment rate at a cyclical low and many of them bringing home paychecks boosted by tax cuts. The WCCI is the highest since February 2001.

(4) Forward earnings. Interestingly, the S&P 500 forward earnings is highly correlated with both the Boom-Bust Barometer and the YRI-WLI. The earnings measure is a time-weighted average of analysts’ consensus expectations for S&P 500 earnings during the current year and the coming year. It’s been soaring ever since the end of last year when the TCJA slashed the statutory corporate tax rate. The forward earnings of the S&P 500/400/600 have increased by 9.5%, 8.3%, and 10.4% since the passage of TCJA.

(5) Stock prices. Given all of the above, it’s no wonder that the S&P 500 stock price index is highly correlated with the YRI-WLI. The latter, which is up 9.4% y/y, remains bullish for the former.

Liquidity Legends

The latest and previous stock market corrections could be described as “tightening tantrums.” Investors fretted that the Fed would be raising interest rates faster than had been widely perceived. That was not the case in 2016, when the federal funds rate was raised but only once at the end of the year. There were three widely expected rate hikes in 2017. At the start of this year, investors were anticipating three more rate hikes prior to the release of the wage numbers on February 2.

For stock investors, concerns about the rate hikes during 2017 were more than offset by strong earnings growth attributable to improving global economic growth. The recent correction occurred despite the huge boost to earnings provided by the Tax Cut and Jobs Act (TCJA) at the end of last year. The knee-jerk conclusion of knee-jerk market pundits was that the stock market is adjusting to a period of reduced “liquidity.” This is a concept that I have yet to find a way to suitably quantify. Among the community of instant market pundits, it seems that liquidity is ample when stock prices are rising and scarce when stock prices are falling. Consider the following:

(1) Central bank balance sheets. The more thoughtful liquidity pundits have focused on the balance sheets of the Fed, ECB, and BOJ. They warned that stock prices would plunge once the Fed terminated QE, which happened at the end of October 2014. The S&P 500 is up 35.4% since then!

The Fed started to taper its balance sheet at the start of October last year by letting securities mature without replacing them. The S&P 500 is up 6.1% since then, but the liquidity pundits can argue that the recent correction shows that the stock market is starting to worry about a dearth of Fed-given liquidity. Meanwhile, during January, the sum of the assets held by the Fed, ECB, and BOJ rose to a new record high of $14.6 trillion, led by the ECB.

(2) Chinese bank loans. Often overlooked by the liquidity pundits are developments in China. I monitor the balance sheet of the PBOC. I give even more weight to Chinese commercial bank loans as a measure of liquidity in China. I am amazed, though not surprised, that these loans soared $418 billion during January m/m and a record $2.1 trillion y/y.

(3) Repatriated earnings and buybacks. We find it hard to believe that the stock market suddenly has a liquidity problem given that a couple of trillion dollars in corporate earnings retained abroad are about to be repatriated thanks to the TCJA. The cumulative total of such earnings of nonfinancial corporations since Q1-1986 through Q3-2017 is $3.5 trillion. A significant portion of these funds is expected to come back and be used for share buybacks and dividend payments, which have been the two major sources of funds driving the current bull market.

(4) Earnings. Last but not least is all the liquidity provided by the tax cuts at the end of last year. Over the past nine weeks through last week, industry analysts have raised their 2018 estimate for S&P 500 earnings per share by $11.21 from $146.26 to $157.47. That’s a 7.7% increase.

Outlook for Stocks Remains Fundamentally Strong

Whatever might be the short-term follow-up (or -down) on Friday’s and Monday’s drop, I remain bullish because the outlook for earnings remains very upbeat. Industry analysts have raised their consensus S&P 500 earnings estimate for 2018 by $9.00 per share over the past seven weeks to $155.26 during the week of February 2. That’s mostly on guidance provided by managements during January’s Q4-2017 earnings season about the very positive impact of the corporate tax cut enacted late last year. The actual Q1 earnings season is still ahead, starting in April. By then, corporations are likely also to report that the weak dollar (down 7.7% y/y) has boosted their earnings.

Nevertheless, the latest panic attack isn’t about corporate earnings. Rather, the fear is that wage inflation is making a comeback and that the Fed will respond with more aggressive monetary tightening. Initially, higher inflation and interest rates could depress valuation multiples, as happened on Friday and Monday. Eventually, tighter monetary policy could cause a recession directly by tightening credit conditions or indirectly by triggering a financial crisis.

Wage inflation may finally be picking up, but not by much. Shortly after she was appointed Fed chair four years ago, Janet Yellen said she expected that the Fed’s easy monetary policies would boost wage inflation from around 2.5% to 3.0%-4.0%. It just may reach that zone now that she has left the Fed. However, the markets may have overreacted to data on wages released Friday morning in the Employment Report.

Average hourly earnings (AHE) for all workers rose 2.9% y/y through January, the highest since June 2009. However, the AHE for production and nonsupervisory (P&NS) workers rose by 2.4%, which is roughly where it has been for the past few years. P&NS workers account for 82% of all private-sector payroll employment.

Fueling the Bull Market

As the stock market continues to soar, it is attracting more money into stocks. That’s what usually happens during meltups. I think the market may be in the early stages of a meltup. I will call it a “meltup” if my 2018 year-end target of 3100 for the S&P 500 is reached within the next 3-6 months rather than the next 12-18 months. To some observers, reaching 3100 by the end of next year may appear to be a meltup since it would mean that the S&P 500 would have risen 51.7% over the three years 2016-2018.

Maybe so, but let’s see whether earnings continue to rise rapidly, providing fundamental support for the stock gains so far and in the year ahead. A cut in the corporate tax rate, effective next year, along with continued deregulation should bolster profits. So should a continuation of the global synchronized boom.

Meanwhile, the flow-of-funds case for a meltup is mounting as more hot money pours into equity ETFs. Over the past 12 months through October, equity ETFs attracted a record $375.6 billion of net new money. Admittedly, some of that money might have come out of equity mutual funds, which had net outflows of $51.7 billion over this same period. Collectively, equity mutual funds and ETFs had net inflows of $323.9 billion, the best such pace since September 2014.

So far, the exuberance for stocks reflected in equity fund inflows is supported by the exuberance of industry analysts about the outlook for S&P 500 revenues and earnings. The weekly “squiggles” data for revenues and earnings show that industry analysts are turning increasingly bullish on the outlook for S&P 500 earnings. They are projecting earnings gains of 10.9% this year, 11.4% next year, and 10.1% in 2019. Presumably, these numbers don’t fully reflect the likely big positive impact of a cut in the corporate tax rate next year.

If that happens before the end of this year, analysts may wait until Q4 earnings calls during January to get some guidance from company managements on how tax reform will impact their earnings estimates on balance. These calls are likely to be relatively bullish, driving stock prices higher early next year. Forward earnings is up to a record $145.06 per share, 13.2% above the four-quarter-trailing sum through Q3.

Proprietors’ Income Matters

Almost always ignored in discussions of corporate profits is proprietors’ income, which is included in personal income on a pretax basis. It is up 2.7% y/y and in record-high territory. A comparison with pretax corporate profits shows that proprietors’ income recently has approximated 60% of corporate profits. Here are some definitions from the National Income and Product Accounts:

(1) “Nonfarm proprietors’ income measures the income, before deducting income taxes, of sole proprietorships, partnerships, and other private nonfarm businesses that are organized for profit but that are not classified as corporations. Sole proprietorships are businesses owned by a single individual. Partnerships include most associations of two or more of: individuals, corporations, noncorporate organizations that are organized for profit, or of other private businesses. Other private businesses are made up of tax-exempt cooperatives, including credit unions, mutual insurance companies, and rural utilities providing utility services and farm marketing and purchasing services.”

(2) “Unincorporated businesses … are able to move assets freely between business and personal accounts with little, if any, reporting requirements, and tax liabilities are not separated between unincorporated businesses and their owners. In fact, the income of unincorporated businesses is generally reported on individual income tax returns; while compensation paid to employees is separately reported, the income of the business is not distinguished from the labor of the business owner and therefore reflects the incomes that accrue as a result of the owner’s own labor and entrepreneurship. Similarly, dividend and interest incomes are separately reported but do not distinguish between business and personal receipts.”

(3) “Reflecting the concepts of national economic accounting, nonfarm proprietors’ income in the NIPAs is defined as that arising from current production.”

Obviously, the wellbeing of small unincorporated businesses is an important contributor to the wellbeing of the overall economy. Corporations, partnerships, and sole proprietorships all are likely to increase their payrolls and expand their capacity when their profits are rising. They are likely to retrench when their profits are falling.

We soon should find out whether the Republicans’ tax reform plans include substantial benefits, not only for corporations but for other businesses as well.