Weekly Update: God bless
I stayed close to home this week as many religious holidays and spring vacations made it difficult to arrange meetings with advisers. It was a good week. After selling off 4% since early April—6% on the Nasdaq—the market rebounded the past three days, abetted by signs the economy is improving with the weather (more below) and by a Fed in no rush to take away the punch bowl (more below). One concern throughout this bull has been poor market liquidity, i.e., the absence of anyone on the other side of the trade. ISI says the demise of NYSE specialists, sharply reduced block trades and the elimination of proprietary trading desks means historical market stabilizers—traders buying on “minus ticks” and selling on “plus ticks”—are gone. There have been numerous examples of illiquidity the past few years—perhaps 15 times, the Dow opened up 150 points on Fed or ECB news—but these were all on the upside, producing smiles not concern. But illiquidity is a two-way street. It can fuel melt-ups but also waterfall declines. Numerous liquidity events have been initiated from the unwinding of carry trades that suddenly turn negative (note the rise in the yen), margin calls (sparked by the declines in momentum stocks) or a hedge/commodity fund in need of instant cash (from margin calls or redemptions). More often than not, Dudack Research says these events provide buying opportunities for long-term investors.
Financial liquidity, which is separate from market liquidity, has always been one of the key drivers of bull markets. Three cycles since the 1970s in which stocks rose five consecutive years or more were periods of excess financial liquidity. While money supply growth has decelerated from early 2012’s 10.2% peak, it was rising 6.3% as of February—high relative to current inflation. Further, Bhirud Associates notes after-tax corporate profits at the GDP level are at their highest level in modern history. Profit margins relative to GDP also are at historic highs, and there’s little reason to expect profits or margins to shift downward anytime soon, Bhirud says. This is because significant cost reduction is continuing on all fronts, i.e., labor, IT spending and administrative; effective tax rates are in a secular decline; and foreign profits are now significant contributors to overall profits.
Many bulls on Wall Street are worried about inflation. There are signs prices have bottomed—Barclays says U.S. growth momentum and CPI data is consistent with its view that core inflation will strengthen this year. March’s headline and core CPI rose 0.2%, double the consensus for each. Commodity prices are spiking after a three-year sideways pattern, March PPI increased 0.5%, and capacity utilization has climbed to 2005-06 levels, indicating there’s not much slack left. The Fed’s own survey shows a solid increase in wage-inflation expectations in recent months across all income groups, suggesting wages could begin a broad-based uptrend in 2015. But offsetting all that are CPI and PPI levels that remain well below Fed targets, a relatively low rate of commodity price pass-throughs to headline inflation, excess global capacity and virtually non-existent wage pressures. Moreover, Fed Chair Yellen this week said she sees the risk around inflation as skewed to running persistently below its long-run 2% target as opposed to running persistently above it—a not-so-subtle signal the Fed’s in no hurry to accelerate tapering or initiate a rate-hike cycle. Inflation worries just seem too early. Ned Davis Research notes we have gone 600 days without a 10% correction, beyond normal even for a secular bull, and have gone longer than normal without a 20% decline. There is a tendency of sell in May, especially in the second year of the four-year cycle, with the median drawdown from the high of about 12%, going back to 1974. But in 1994’s raging bull, the drawdown was just 9%. You know, I tend to say “God bless’’ when I part company with someone—my way of saying goodbye. Some people take this to mean that I’m particularly religious. I don’t know about that, but I’m looking at a warm, sunny three-day weekend, surrounded by my family. And I’m counting my blessings. God bless you, too.
Shoppers warm up to spring March retail sales jumped 1.1%, well above consensus and the most since September 2012, while on revision, February’s increase more than doubled to 0.7%. Leading the gains over the past two months was the release of pent-up demand accumulated during the unusually cold winter months. Excluding vehicle and gas station sales, retail sales rose the most in over two years on broad-based improvement. Notably, general merchandise surged 1.9%, the most since October 2005. Still, year-over-year, sales were rising near the slowest pace since December 2009, and well below the 5.2% per annum gain during this recovery.
Production picking up Industrial production rose a slightly better-than-expected 0.7% in March, with strong gains in utilities and mining. At +0.5%, manufacturing output was a tick below forecasts but February’s revised growth nearly tripled to 1.5%, reversing January’s weather-related slump. As a whole, manufacturing output rose 1.7% in the first quarter, well below 2013’s Q4 but with momentum heading into spring. This was reinforced by today’s Philly Fed report on April activity, which rose much more than expected to its highest level in seven months, with across-the-board strength in shipments, new orders and employment. While New York’s Empire gauge disappointed, it remained in expansion territory with six-month manufacturing expectations rising.
All roads lead to jobs The four-week average of initial claims fell again to its lowest level since August 2007. The continued decline in claims suggests the rate of job losses have slowed further this month and that employment growth likely picked up. While the claims data also suggest the labor market may be making progress toward the Fed’s labor market objective more quickly than many policymakers expect, Yellen this week seemed to shift the Fed’s narrative from talking about an unemployment threshold to talking about full employment—another sign that a rate-hike cycle will likely come later than sooner.
Housing ho-hum March starts rose less than expected and, on a 12-month average basis, have held near the 920K level for five months, indicating the prior upward trend has reached a plateau. Permits unexpectedly fell but, year-over-year, were up 11.2% while starts were down 5.9%, both significantly below their peak rates earlier in the recovery. The builder’s monthly sentiment gauge edged up to 47, below the expected 50, and remained in the holding pattern that has marked the year so far. Still, upwardly revised activity in prior months suggests housing’s sluggishness reflects temporary weather impacts, not fundamental weakening.
China watch It reported Q1 annualized GDP grew a better-than-expected 7.4%, with official government sources saying reform efforts to cut overcapacity was a drag but that consumption growth was a strong contributor. Many analysts are skeptical that this number is real and think China is set to introduce stimulus. China’s economy has become an increasingly important risk factor for the broader financial markets on concerns its economy might suffer a hard landing than expected and that Chinese weakness could reverberate around the world.
Many taxpayers were shocked at their bill this week This is because in 2013, many taxpayers faced 1) an additional Medicare tax of 0.9% on wages and 3.8% on investment income; 2) resumption of the exemption phase-outs and deduction limitations after a three-year hiatus; and 3) an increase in the tax on qualified dividends and capital gains to 20% from 15%. Deutsche estimates these changes raised the tax bills of 3 million households by $50 billion, with $35 billion likely paid in April. This compares to an estimated $11 billion inflow into U.S. equity funds and ETFs in Q1. Further, the Congressional Budget Office estimates federal taxes should climb to 17.5% of GDP this year, slightly above its average since 1970, and reach 18.2% in 2015.
Fiscal finances improving The federal budget deficit is falling much faster than expected—it’s now below 3% of GDP—and state and local government budgets are improving at a rapid rate due to the same trends. State governments received more than $846 billion in tax revenue in the latest fiscal year, a record high, with the Census Bureau reporting a 10% increase in individual income taxes to a record high $309 billion and a nearly 8% increase in corporate income tax receipts to $45 billion. ISI says its tax-revenue indicators suggest we’re on the verge of a blowout April tax-collection season. This is important because spending has been restrained and estimates of tax revenues have been conservative, harming most governors up for reelection in November. Having failed to enact many new spending programs and/or tax cuts since their election four years ago, their approval ratings are low.
We much prefer dividends Bank of America said its proprietary share repurchase strategy lagged the market by about 2% in Q1 and finished among the worst five screens—a dramatic reversal from the last two years' outperformance. Performance hit an inflection point in November 2013, and the downtrend could continue as buybacks are rewarded less uniformly. Of cash-return strategies it follows, high-dividend yield enjoyed a resurgence in tandem with a 30 basis-point drop in the 10-year Treasury yield. A separate study by Bhirud said S&P 500 dividends paid for the four quarters ending Q1 2014 were $36.23, up 12.8% year-over-year and 25.6% over the Q3 ’08 level. But the dividend payout ratio was still at the low end of its range for the last 88 years on an annual chart and for the last 63 years based on a quarterly chart.
Better a correction than a melt-up Yardeni Research believes the recent meltdown in “momentum” stocks, i.e., the ones that had been soaring over the past couple of years to excessively high valuations, reduces the risks of a broader melt-up followed by a more severe meltdown. If so, then it’s actually a positive development for the longevity of the secular bull market.