Weekly Update: Greed

10-06-2017

I started the week speaking at a former monastery to a large group of trust clients. Memorable questions evidenced the underlying melt-up watch which has been clearer in each of the last several weeks. “What do I tell my client who owns conservative dividend-paying stocks and is comparing their performance to the S&P?” And, “What about bitcoin?” Hmm. Given overbought conditions, consolidation is possible but pullbacks are likely to be shallow. Momentum is impressive, with Russell 3000 1-month highs surging to over 45%, led by mid- and small-caps. Historically, the fourth quarter has looked favorably on momentum stocks. Many value names are catching a bid on rising optimism for tax reform (more below), feeding a recent reversal in 2017’s outperformance of growth vs. value stocks—the Russell 1000 Value Index has outperformed Russell 1000 Growth by 250 basis points since Sept. 7. Rising oil prices also have been a catalyst, raising long-dormant inflation expectations and boosting energy stocks, which account for 11% of the Russell 1000 Value index and outperformed the S&P 500 by 8% the past four weeks. With Baa corporate spreads at fresh lows, the credit backdrop is favorable for small-caps relative to large-caps, as illustrated in the Russell 2000’s breadth, where gainers are outpacing losers 5-to-1. Seasonality remains firm, and neither cash ratios nor equity ownership levels suggest a significant peak yet. Both the AAII Bull/Bear and ISE sentiment surveys are still neutral at current levels, while the average monthly NYSE closing TICK—stocks in uptrends vs. downtrends—has been neutral an unfathomable 135 of the past 137 days, a sign institutions have yet to boost exposure to maximum targets. So there’s dry powder out there. October has a mixed history. Thirty years ago, it saw the worst sell-off ever. Twenty years ago was bad, too. Ten years ago preceded the financial crisis’ waterfall decline. But Renaissance Macro observes in the 18 instances since 1962 when the market’s been as strong as has been in this year’s first nine months, October has tended to be weaker, followed by abnormally strong Novembers and Decembers.

As the S&P keeps hitting new highs, its forward P/E keeps climbing. At around 18, it’s just shy of the late-winter peak that was its highest level since the dot-com bubble burst. The blue chip index has risen 11 months in a row, the longest stretch since 1959, and hasn’t seen a 5% correction since June 2016, its longest streak in 21 years. If it can hold on until Nov. 9, it will be the longest on record. What might rock the boat? The Fed? It has begun to pare its balance sheet, but at such a torturously slow pace that the ramifications—if any—may not become apparent for months. Earnings? Perhaps, but while there are concerns about 2018, Q3 is expected to be good. Perhaps tax reform? Republican officials acknowledge that their tax plan may actually raise taxes for some in the middle class, an admission that could imperil the entire initiative. And squabbling over whether to scrap state/local tax deductibility (SALT) is nearly as intense as it was with the border-adjustment tax. This is a huge issue for high-tax, politically blue states. Californians are well aware of this. But without some $1.3 trillion in SALT revenue over 10 years, it becomes very difficult to materially lower rates. Sen. Orrin Hatch, chairman of the Senate Finance Committee and a key person in the debate, said it would be a “miracle” to get the corporate rate as low as 25%. That would put it just a few ticks below the already effective rate of 27% for the median S&P company and well above the OECD average statutory corporate tax rate of 20%. President Trump, having moved up from his preferred 15% rate, calls 20% a “perfect number.’’ It’s estimated that a 20% rate could lift after-tax S&P earnings by 7%, and maybe double that for small-cap stocks. This is a key reason the market got excited. But to pay for this, SALT money is needed, and who throws SALT in a punch bowl?

What should investors do now? Even Robert Shiller suggests it’s difficult to fight the tape. His highly publicized valuation indica­tor—a P/E based on average inflation-adjusted earnings over the prior 10 years and known as CAPE (for Cyclically Adjusted P/E)—is about as overvalued as it was at the 1929 peak. Yet he isn’t ruling out a market that continues to churn out fresh records for months, if not years. “I wouldn’t call it healthy, I’d call it obese,'' he says. "But you know, some obese people live to be 100-years-old, so you never know.” (?? How many obese 100-year-olds do you know?) But as long as inflation and interest rates remain so low, no less than Warren Buffett this week said he considers stocks to be undervalued. And Ned Davis says since 1952, periods of very low unit labor costs such as we are having now are consistent with double-digit gains in stocks. I finished the week in Sacramento, speaking before a large group of elderly investors in a retirement community. Show of hands, “Who is bullish today?” Many hands went up. “Bearish?” Crickets. What happens when greed proliferates? Melt-up. That’s a shame—I much prefer the Wall of Worry. Hmm.

Positives

Manufacturing gung ho … Both ISM and Markit manufacturing indexes rose, the former for the fourth time in five months to its highest level since May 2004. Factory activity accelerated and was reflected in August’s rebound in factory orders, which exhibited strong gains in core capital goods orders and shipments as companies continued to ramp up capital expenditures. The global PMI also was strong, matching its fastest growth since May 2011 at levels last seen prior to the global financial crisis.

… services, too The ISM nonmanufacturing unexpectedly jumped in September to nearly 60, its highest level in a dozen years and a reading consistent with above-trend economic expansion. It was the biggest increase in a year and the fourth biggest gain on record. Consensus had been expecting a decline. Markit’s reading wasn’t as strong; it actually ticked down for the first time in six months. But it remained in the mid-50s, a level indicative of robust growth, with new orders near a 2-year high.

Harvey and Irma lift car sales September light vehicle sales surged 15.3% to an 18.5 million annualized rate, their biggest gain in eight years and the highest sales rate in a dozen years. The increase was partly due to the replacement of vehicles damaged or lost to the hurricanes, which was expected. But WardsAuto says record-high industry incentives and a year-over-year (y/y) decline in transaction prices also were factors as dealers tried to work off inventories ahead of new 2018 models hitting the market. It’s estimated dealers were able to pare inventories from 20% to 10% above demand, suggesting October could see a further lift from deal-driven sales.

Negatives

Hurricanes hit jobs September nonfarm payrolls fell 33K, the first decline since 2010, as Hurricanes Harvey and Irma played havoc with the government’s survey—an outcome that was expected. The surprise was on the wage front. Average hourly earnings spiked 0.5%, raising the y/y change to 2.9%. This and a drop in the jobless rate to 4.2%, its lowest since February 2001, suggest the labor market is tightening further, making a December rate hike almost a certainty. Elsewhere, ADP private payrolls had their smallest gain in nearly a year, as the back-to-back storms weighed the heaviest on small businesses, where payrolls shrank for the first time since December 2013.

Inflation watch Despite the core PCE’s annual 1.3% rate, bond investors are pricing in a move higher over the intermediate term as both the TIPS market and the inflation swaps market show inflation expectations rising above 2%. This comes as global price pressures strengthened markedly in the latest PMI survey, as increases across a broad range of commodities caused input prices to accelerate. Supply-chain pressures also pushed the output price component to its highest point since May 2011. Some of the issues reflected the disruptions caused by the hurricanes, but as September’s jump in hourly earnings suggests, the Fed’s narrative that temporary forces are holding inflation down may be coming to pass. The market isn’t priced for a notable pickup in inflation.

Where are we in the economy cycle? The Philly Fed State Coincident Indexes increased in 27 states, decreased in 18 and were stable in five in August as economic growth weakened across a larger number of states. The companion U.S. Coincident Index, based on the state indexes, decelerated but still indicated steady improvement. A Ned Davis proprietary recession probability model based on the state coincident indexes nearly doubled in August to a 5-year high but still remained consistent with a small risk of recession at this time.

What else

Political watch The House budget passed this week has a very strict reconciliation instruction which if enacted would make it tough to pass tax reform. Specifically, the instruction requires “revenue neutrality,” which means for every dollar cut in taxes, an equivalent amount needs to be removed in deductions and credits. Typically, this is what tax reform is: as tax rates get lowered, deductions are removed to pay for the lower rates so that there’s little impact on the deficit. The U.S. has successfully done this only once in 100 years, and only after Ronald Reagan won 49 states in his re-election. Today’s political environment is much worse.

Political watch The margin of error in the Senate is sure to be really small as John McCain, as was the case in the Bush years, seems unwilling to be part of any tax bill. That means you can lose only one more Republican senator, assuming Democrats are not on board. Republicans need to be careful not to bite off their nose to spite their face. Most members were not around during the Bush years when governing actually was done.

Political watch Even if the Senate passes its version of a fiscal 2018 budget during the week of Oct. 16 (it’s out next week for the Columbus Day recess), it will have to hammer out an agreement with the House and pass them all over again. A "bull case" time frame would see the budgets done by Halloween with the House tax bill seeing light of day in early November and the full House voting by Thanksgiving. But Cowen & Co. expects any timetable to continue the dominant legislative trend of 2017: over promising and under delivering. The primary obstacle is math. Tennessee Sen. Bob Corker, who has said he won’t seek re-election, has made clear he’s not much in favor of anything that will raise the deficit, which means the SALT fight could get nasty. Sen. McCain is for all intents and purposes a Democrat. And the prospect of Democrats reaching across the aisle? Fuhgeddaboudit.

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