Seinfeld Market: Nothing Bad Happening

"The Pitch” is the 43rd episode of the TV sitcom Seinfeld. It is the third episode of the fourth season. It aired on September 16, 1992. In it, NBC executives ask Jerry Seinfeld to pitch them an idea for a TV series. His friend George Costanza decides he can be a sitcom writer and comes up with the idea of “a show about nothing.”

The bull market in stocks since March 2009 has had a fairly simple script too. As a result of the Trauma of 2008, investors have been prone to recurring panic attacks. They feared that something bad was about to happen again, so they sold stocks. When their fears weren’t realized, the selloffs were followed by relief rallies to new cyclical highs and to new record highs since March 28, 2013. Their jitters are understandable given that the S&P 500 plunged 56.8% from October 9, 2007 through March 9, 2009.

From 2009 through 2016, there were four major corrections and several significant scares. I kept track of them and the main events that seemed to cause them. By my count, there were 57 panic attacks from 2009 through 2016, with 2012 being especially anxiety-prone with 12 attacks. (See our S&P 500 Panic Attacks Since 2009.)

From 2010 through 2012, there were recurring fears that the Eurozone might disintegrate. There were Greek debt crises and concerns about bad loans in the Italian banking sector. Investors were greatly relieved when ECB President Mario Draghi pledged during the summer of 2012 to do whatever it takes to defend the Eurozone. China also popped up from time to time as concerns mounted about real estate bubbles, slowing growth, and capital outflows over there. At the end of 2012, fear of a “fiscal cliff” in the US evaporated when a budget deal was struck at the start of 2013 between Democrats and Republicans. I expected it, though I certainly had no idea that it would be worked out between Vice President Joe Biden and Senate Minority Leader Mitch McConnell. In a November 9, 2013 Barron’s interview titled “Lifting the Odds for a Market Melt-Up,” I observed:

I have met a lot of institutional investors I call "fully invested bears" who all agree this is going to end badly. Now, they are a bit more relaxed, thinking it won’t end badly anytime soon. Investors have anxiety fatigue. I think it’s because we didn’t go over the fiscal cliff. We haven’t had a significant correction since June of last year. We had the fiscal cliff; they raised taxes; then there was the sequester, and then the latest fiscal impasse. And yet the market is at a record high. Investors have learned that any time you get a sell-off, you want to be a buyer. The trick to this bull market has been to avoid getting thrown off.

There was another nasty selloff at the start of 2016 as two Fed officials warned that the FOMC was likely to follow 2015’s one rate hike at the end of that year with four hikes in 2016. I had predicted “one-and-done” for 2015 and again for 2016. Contributing to the selloff in early 2016 was the plunge in the price of oil, which had started on June 20, 2014. That triggered a significant widening in the yield spread between high-yield corporate bonds and the US Treasury 10-year bond yield from 2014’s low of 253 basis points on June 23 to a high of 844 basis points on February 11, 2016. The widening was led by soaring yields of junk bonds issued by oil companies. There were widespread fears that all this could lead to a recession. In addition, the Chinese currency was depreciating amid signs of accelerating capital outflows from China.

I remained bullish. In a February 6, 2016 Barron’s interview titled “Yardeni: No U.S. Recession in Sight,” I reiterated my opinions that the Fed was unlikely to hike the federal funds rate more than once and that the secular bull market remained intact. I argued on Monday, January 25 that “it may be too late to panic” and that the previous “Wednesday’s action might have made capitulation lows in both the stock and oil markets.” Sure enough, the price of a barrel of Brent crude oil did bottom on Wednesday, January 20. The S&P 500 bottomed on February 11, the same day that the high-yield spread peaked. The S&P 500 Energy sector dropped 47.3% from its high on June 23, 2014 to bottom on January 20, 2016. During the summer of 2016, I perceived the end of the energy-led earnings recession and projected that the bull would resume his charge.

Following the surprising Brexit vote that summer, the stock market declined for just two days despite lots of gloomy predictions. Just prior to the presidential election, I argued that the rebound in earnings, following the recession in the energy industry, would likely push stock prices higher no matter who won. After Donald Trump did so, I raised my outlook for the S&P 500, expecting that a combination of deregulation and tax cuts would boost earnings. The latest bull market was still going strong in early 2017.

I was interviewed again in the February 4, 2017 issue of Barron’s saying:

It would be a mistake to bet against what President Trump might accomplish on the policy side. I’m giving him the benefit of the doubt, hoping good policies get implemented and bad ones forgotten. We could get substantial tax cuts. All his proposals don’t need to be implemented for the Trump rally to be validated. If you get $1 trillion to $2 trillion coming back from overseas because of a lower tax on repatriated corporate earnings, that would be very powerful in terms of keeping the market up.

So far, investors are relieved that the bad outcomes predicted by the naysayers about Trump in the White House haven’t happened. The anticipated bullish outcomes are also still mostly on-the-come. Nothing really terrible or wonderful is happening other than that earnings are rising in record-high territory again.

By the way, in case you missed it, you might be relieved to know that Greece and its international creditors on Tuesday reached a preliminary deal allowing the country to receive yet another round of bailout payments in exchange for promises to raise taxes and to further cut pensions and social spending. Chinese stocks seem to be stabilizing this week, having dropped sharply during the second half of April after officials slammed what they called short-term speculators. This past Sunday evening, congressional leaders reached an agreement on a spending deal that would fund the government through the end of September and avoid a looming shutdown. This weekend, the French are likely to elect a President who is all for the EU and euro. These developments should all be a relief, though no one really worried much about any of them this time. Nothing bad is happening, which is good news for stocks.

A Happier Global Economy

Since late last year, I’ve liked what I’ve been seeing abroad, especially in emerging economies. The latest batch of data out of China was certainly surprisingly strong, though that isn’t surprising given that the country’s central planners still command the economy over there as they see fit. The EU’s economy also has impressed me. Like everyone else, I’ve been concerned about the region’s political drift toward anti-EU populism that could lead to the destabilizing disintegration of the EU and/or the Eurozone. However, that risk seems to have dissipated significantly given the recent successes of the establishment parties that remain in power in Spain and the Netherlands. Italy continues to be ungovernable—so what else is new?—but still committed to the EU.

What about France? Following last weekend’s first-round presidential election, I expect that pro-EU centrist Emmanuel Macron, who was a member of the Socialist Party from 2006-2009, will beat National Front leader Marine Le Pen during the second-round contest scheduled for May 7. As they say in French, “Plus les choses changent, plus elles restent les mêmes.”

Let’s take a tour of the latest developments around the world, shall we?

(1) Commodity prices. The CRB raw industrials spot price index dropped last week to the lowest level since January 9. However, it’s down only 2.4% from its recent high on March 17. It is still up 26.2% from its most recent low near the end of 2015. In the big picture, this index remains on a solid uptrend. However, it is a bit odd to see this recent weakness coinciding with all the better-than-expected data coming out of China last week.

(2) PMIs & production. There shouldn’t be much more downside in commodity prices given the strength in April’s flash M-PMIs for Germany and France. The composite PMI (C-PMI) for Germany edged down to 56.3 from 57.1 last month. That’s still a relatively high level, with Germany’s M-PMI remaining very elevated at 58.2 versus 58.3 during March. France’s C-PMI jumped to 57.4 from 56.8, with lots of strength in the M-PMI (55.1) and NM-PMI (57.7). Japan’s M-PMI also remained solid at 52.8 this month.

On the other hand, the flash M-PMI for the US continued to edge down from a recent high of 55.0 during January to 52.8 this month. The NM-PMI has also come down from a recent high of 55.6 during January to 52.5 this month. Nevertheless, these are all solid readings for the US. The average of the business conditions indexes from the NY and Philly Fed district surveys declined to 13.6 this month from a recent high of 31.0 during February, as Debbie discusses below. Looks like some of the “animal spirits” unleashed by Trump’s election may be going back into their cages!

On yet another hand, industrial production indexes remain on uptrends in the US, Canada, the Eurozone, and Japan. Even Brazil’s output seems to have bottomed, while Mexico’s remains stalled at a record high despite Trumps tough talk on US trade with our southern neighbor. Most impressive is that industrial production among the 34 members of the OECD rose 1.2% y/y during January after having stalled during 2015 and the first half of 2016. It is now almost at the previous record high during January 2008.

(3) Retail and auto sales. In the Eurozone, the volume of retail sales (excluding motor vehicles) rose 0.7% m/m and 1.8% y/y during February to a new record high. Both French and German shoppers are doing lots of shopping, with their volume indexes up 2.8% and 1.6% y/y, respectively, at record highs. The Italians and Spaniards are lagging far behind. New passenger car registrations in the EU jumped 1.2% m/m and 6.0% y/y during March, using the 12-month sum.

(4) Inflation. Both actual and expected inflation rates have edged down recently, suggesting that the global economy isn’t overheating. Expected inflation implied by the yield spread between the US Treasury 10-year bond and TIPS fell from a recent high of 2.08% on January 27 to 1.84% at the end of last week.

The headline CPI inflation rates, on a y/y basis, moved down in March in the US (from 2.7% to 2.4%) and the Eurozone (from 2.0% to 1.5%), and was little changed in China (from 0.8% to 0.9%). The core CPI inflation rates also have ticked down in the US (from 2.2% to 2.0%) and the Eurozone (from 0.9% to 0.7%), and edged up in China (from 1.8% to 2.0%).

(5) Forward revenues and earnings growth. Interestingly, there has been a significant increase since early last year in analysts’ consensus expectations for short-term revenues growth over the year ahead, from 2.3% to 6.3% in mid-April. Even more impressive is the rebound in year-ahead short-term earnings growth from the most recent low of 6.2% early last year to 13.7% now. Long-term earnings growth, over the next five years at an annual rate, is up to 12.5%, the highest since September 2011.

(6) Global trade. Global trade indicators are looking more buoyant. The Baltic Dry Index is up 86% y/y through mid-April. Over the past 12 months through March, US West Coast ports’ outbound container traffic is up 6.0% y/y to the highest level of activity since January 2015. Actual exports data coming out of Asia are especially strong. March data are available in dollars for India (up 28.3% y/y), Indonesia (23.2), China (17.4), Singapore (15.8), Taiwan (14.0) South Korea (13.5), and Japan (10.3). Altogether, they are up 16.4% y/y, and 15.4% excluding China.

No wonder that the Emerging Markets Asia MSCI stock price index (in local currency) is up 29.0% from its low early last year. The index’s forward earnings (in local currency) is up 8.6% over this period. Analysts’ consensus expected short-term earnings growth over the year ahead for this index was back up to 16.0% in early April compared to the most recent low of 4.5% early last year. The index remains relatively cheap with a forward P/E of 12.2.

(7) IMF forecast. The IMF’s economists are raising their expectations for global economic growth. Since nearly the start of the latest global economic expansion, they were too optimistic and have had to lower their forecasts. Last week, they nudged up the IMF’s forecast for world growth this year a tenth of a percentage point to 3.5%, which will be the fastest rate in five years if they are right. Next year’s growth rate is expected to be 3.6%, according to the IMF’s latest World Economic Outlook. Global growth was 3.1% last year.

The so-called advanced economies, which grew 1.7% last year, are expected to expand by 2.0% during both 2017 and 2018. The emerging and developing economies, which grew 4.1% last year, are predicted to grow by 4.5% this year and 4.8% next year. The top concern among the IMF’s economists is trade protectionism, specifically an “inward shift in policies, including toward protectionism, with lower global growth caused by reduced trade and cross-border investment flows.”

Driving in the Slow Lane

Following the latest reports on housing starts (down 6.8% m/m during March) and manufacturing output (down 0.4% last month), the Atlanta Fed’s GDPNow model showed an increase of just 0.5% (saar) in Q1’s real GDP. As I noted recently, the auto industry is a major soft patch in the economy. Sure enough, auto output fell 3.6% during March. Auto assemblies are down 7.3% over the past five months to 11.1 million units (saar) from last year’s peak of 12.0mu. The weather can be blamed for the drop in housing starts, but not for the weakness in auto sales and production.

There are other soft patches in the economy. For example, the ATA Truck Tonnage Index dipped 1.0% m/m in March, and is up by only 0.7% y/y. In other words, it has stalled at a record high over the past year. Sales of medium-weight and heavy trucks dropped 8.0% m/m in March and 19.0% y/y.

So it comes as no surprise that the Citigroup Economic Surprise Index (CESI) has plunged from a recent high of 57.9 on March 15 to 6.6 on Tuesday. These developments are likely to put pressure on the Fed to hold off on another rate hike for now, and on the Trump administration to move forward with its fiscal stimulus agenda. Treasury Security Steve Mnuchin said on Monday that tax reform might not happen until after the summer. I think the weakness in the economy will prompt a faster response by Washington.

By the way, there is a reasonably good fit between the CESI and the 13-week change in the US Treasury 10-year bond yield. The actual yield has dropped from a recent peak of 2.62% on March 13 to 2.17% yesterday. It seems to be heading toward the bottom end of my predicted trading range of 2.00%-2.50% for the first half of this year.

Back to Slower, Longer Economic Growth?

In my meetings with some of our accounts recently, many were skeptical that the strength in the soft data in the US will trickle down to the hard data until the Trump administration actually succeeds in cutting taxes and in boosting infrastructure spending. The soft data consist mostly of surveys of consumers, CEOs, purchasing managers, small business owners, industry analysts, and investors. They all turned remarkably upbeat after Election Day, as I have been monitoring in our new Animal Spirits chart publication.

On the other hand, a few hard-data indicators are downright downbeat. Auto sales totaled 16.6 million units (saar) during March, down from a recent high of 18.4 million units at the end of last year. Payrolls in general merchandise stores have dropped 89,300 over the past five months through March as a result of widespread store closings due to competition from Amazon. Then again, employment in construction, manufacturing, and natural resources rose 175,000 during the first three months of this year. The sum of commercial and industrial bank loans and nonfinancial commercial paper has been flat since the start of the year.

A bigger question is whether there has been a structural decline in the potential growth of the economy that may defy both the animal spirits that seem to have been unleashed by Trump’s election as well as his “Make America Great Again” (MAGA) fiscal policies, assuming they get fully implemented. If so, then the long-term trend of growth for both the real economy and corporate earnings may be lower than in the past. The good news in this scenario is that it might mean that a boom is less likely, which obviously would reduce the risk of a bust.

While much has changed since Election Day, some things have not. Demography hasn’t changed. Neither has technology. Globalization might change, but for now the world remains very competitive as a result of relatively free (though not necessarily fair) trade. Productivity growth remains abysmal, and might improve as a result of MAGA policies, or might not. Consider the following:

(1) Potential output. The Congressional Budget Office (CBO) calculates a quarterly series for potential real GDP growth that starts in 1952 and is available through 2027. The outlook for this year and beyond is based on demographic projections used to estimate labor force growth and assumptions about productivity. From 1952 through 2001, potential real GDP grew in a range mostly between 2.5% and 4.0%, averaging 3.5%. Since then, growth has consistently been below 3.0%, and actually below 2.0% since Q1-2007.

(2) Real GDP. I constructed a series for the underlying growth in real GDP simply as the 40-quarter percent change in real GDP annualized. It tells more or less the same story as the CBO’s estimate for potential output. From 1960 through 1975, growth averaged 4.7%. From 1975 through 2007, it averaged 3.7%. It plunged during the Great Recession, and has remained consistently below 2.0% since Q3-2009.

(3) Labor force. Trump may or may not succeed with his MAGA plans. However, he certainly can’t Make America Young Again (MAYA). He can’t bring back the Baby Boom. There has been a dramatic slowing in the growth of the working-age population and the labor force, particularly of the 16- to 64-year-olds. The actual growth rates of this age segment of the working-age population and the labor force are down to only 0.5% and 0.3% over the past 10 years at annual rates.

(4) Productivity. The big unknown is whether Trump’s MAGA policies can revive productivity growth. That’s the only way that real GDP growth might finally exceed 2.0%. Getting it up to Trump’s 4.0% goal seems very unlikely. Nonfarm productivity growth has been below 1.0% since Q4-2014, based on the five-year percent change at an annual rate. Surprisingly, manufacturing has contributed greatly to this weakness, also rising less than 1.0% since Q4-2015.

Bull by the Tail

Stock market valuation measures are elevated across the board, for sure. The forward P/E of the S&P 500 is currently 17.7. It is highly correlated with the forward price-to-sales ratio (P/S) of the same stock market index. This valuation metric closely tracks the Buffett Ratio, which is equal to the market capitalization of the entire US equity market (excluding foreign issues) divided by nominal GNP. During Q4-2016, the Buffett Ratio was 1.67, not far below the record high of 1.80 during Q3-2000. The forward P/S rose from 1.58 in early 2016 to a record high of 1.93 in March.

These all are nose-bleed levels. However, they may be justified if Trump proceeds with deregulation and succeeds in implementing tax cuts. His policies may or may not do much to boost GDP growth and S&P 500 sales (a.k.a. revenues). Nevertheless, they could certainly boost earnings.

The risk is that Trump’s victory activated a melt-up mechanism that has nothing to do with sensible assessments of the fundamentals or valuation. Instead, structural market flows may be driving the market’s animal spirits. Consider the following:

(1) Lots of corporate cash is still buying equites. At the end of last week, we updated our chart publications with Q4-2016 data for S&P 500 buybacks. They remained very high at a $541 billion annualized rate. For all of last year, buybacks totaled $536 billion, a slight decline from the previous year’s cyclical high of $572 billion. S&P 500 dividends rose to a record high of $396 billion last year. Since the start of the bull market during Q1-2009 through the end of last year, buybacks totaled $3.4 trillion, while dividends added up to $2.4 trillion. Combined, they pumped $5.7 trillion into the bull market, driving stock prices higher without much, if any, help from households, mutual funds, institutional investors, or foreign investors.

(2) Passive is the new active. On the other hand, equity ETFs have been increasingly consistent net buyers of equities during the current bull market. Their net inflows totaled a record $281 billion over the past 12 months through February. Since the start of the bull market during March 2009, their cumulative net inflows equaled $1,167 billion, well exceeding the $179 billion trickle into equity mutual funds.

So there you have it: The bull may be chasing its own tail. I know that image doesn’t quite jibe with the bull charging ahead, but work with me here. The bull has been on steroids from share buybacks by corporate managers, who have been motivated by somewhat different and more bullish valuation parameters than those that motivate institutional investors, as we have discussed many times before. Most individual investors seemingly swore that they would never return to the stock market after it crashed in 2008 and early 2009. But time heals all wounds, and suddenly some of them may have turned belatedly bullish on stocks after Election Day. Add a buying panic of equity ETFs by individual investors to corporations’ consistent buying of their own shares, and the result may very well be a melt-up.