Weekly Update: Boy, this melt-up could use a nice political headline

12-01-2017

I began the week at our annual trust officers event in Harrisburg, where we had the largest attendance yet. After my remarks, a veteran told me that he will retire at year’s end with a nest egg that holds no bonds! Next stop, Phoenix, another annual event where the discussion centered around ETF proliferation and how it complements, not replaces, active management. But much of the banter was about bitcoin, which was surging another $1,000 that day. An informal show of hands found only two advisors own any. Said my tablemate, “It can’t be a bubble until everyone is in it.” Perhaps, but a new cryptocurrency ETF is being fashioned, which I believe will entice many retail investors, giving us our bubble and setting it up for a pop—which I aver could possibly affect the broader market (more below). At my late-week panel with top women advisors across the nation, one wanted ammunition to tell her clients that the S&P 500 is unusually dominated by a few stocks. “Not true,’’ I replied. For while this may not be the broadest market we’ve ever seen, it’s not even close to being the narrowest. Year-to-date, the S&P is up roughly 15% and more than 70% of stocks are positive. In 1999, the S&P was up nearly 20% but only 49% of issues were positive for the year. Strategas Research notes the spread between the cap-weighted and equally weighted S&P is barely 250 basis points vs. nearly 1,000 basis points in 1999, another sign of broad participation. This week, the NYSE breadth line confirmed the market’s advance with a new high of its own, and breadth within the S&P, Industrials and Transports sectors, and the Russell 2000 hit all-time highs. This comes as the market is entering its seasonally strongest month. Over the last 30 years, the Nasdaq, S&P and Russell 2000 have averaged respective gains of 2.2%, 1.7% and 3.0% during December.

The market is not cheap and we all know that. But Cornerstone Macro sees little evidence valuation plays any role in determining near-term market returns. It’s a poor timing tool because the index composition changes so widely across time. In other words, is it really fair to compare today’s market P/E to that of 2007, 2000 or 1985? Each market had very different makeups in very different economic environments. For example, no longer is GE, the oldest Dow component, a good barometer of the equity market. This cycle is different from others in that the exceptional fundamentals of the margin leadership (and market leadership) group is having profound effects. Companies in the top quintile of margins have a 15% margin advantage over the rest of the market—Empirical Research says there’s never been such a wide gap. Heavily represented by the tech and health-care sectors, this group’s average revenue growth is more than double that of overall market. This is what a secular bull looks like.

Everyone’s talking about the market’s historically low volatility. There has been the occasional spike, just as we saw today when news broke that former National Security Adviser Mike Flynn said he’s cooperating with the special counsel probe into potential links between the Trump campaign and the Kremlin during the 2016 election. But those run-ups have tended to reverse just as quickly. Many fear that when this era of low volatility breaks, it could be very disruptive—the volatility futures curve has been steep for a long time, meaning that investors have been expecting a regression to the mean. But history shows that a low-vol market is likely to remain that way; further, big spikes occur too infrequently to make them good bets. Like valuations, the level of volatility doesn’t predict the returns of the equity market. My last stop was at the Barron’s Top Women Advisors Summit in posh West Palm Beach, Fla., where the topic was “Challenging the Index,” to include a discussion of active vs. passive investing. S&P reports that there are now over 1 million indexes in the world, thanks to no barriers to entry and perceived demand. There are 43,000 stocks in the world, of which only 3,000 are liquid. It makes a mockery of benchmarks and invites us to challenge many more than one index. I made my case for the asset classes in which active tends to excel—bonds, equity income stocks, foreign and small caps. I described the market environments in which active tends to excel—sideways, down and trending markets (in which a certain investment type, say tech stocks, outperforms for an extended period of time). I slipped in the pitfalls of passive management, including lack of price discovery and the herding effect, which can be trouble in tough market environments and in the event of flash crashes. A coup to be invited to speak before this august group, for which I prepared extensively … to include a brand new pair of Jimmy Choo’s. Think I can run them through my expense report??

Positives

More signs of manufacturing strength ISM and Markit gauges slowed a tad but were still very strong in November and near their highs for the year, as new orders and backlogs continued to expand. Among regional indicators, the Chicago PMI posted a robust 60+ reading for a third straight month, its best streak in 3½ years; the Richmond Fed index shot up the most in 20 months to a record high; and expected future activity in Texas hit a 10-month high.

Is that Santa I see? Heading into the busiest part of the holiday sales season, consumer confidence was as high as it’s been in 17 years, the Conference Board said, with both the present situation and future expectations components contributing to November’s surprise gain. The current level is consistent with increases in near-term sales; Bank of America estimates sales during the Black Friday period rose 2.1% year-over-year, while early indications are vehicle sales moderated after the prior month's hurricane-driven replacement surge.

A bounce in housing After summertime sluggishness, new home sales surprised for a second straight month in October, reaching their highest level since 2007. A surge in pending home sales added to evidence of renewed momentum, even as shortages and various price gauges—CoreLogic, Case-Shiller and FHFA—showed prices continuing to rise, cutting into affordability.

Negatives

Trade, inventories a drag October’s trade deficit widened to a 2½-year high, a sign net exports could trim Q4 GDP by more than the currently projected two-tenths of point. Preliminary data also show inventories shrank in October, another negative for Q4 after Q3’s strong build. As for Q3 GDP, it was revised up from 3.1% to 3.3%—a 3-year high—on stronger capex & inventory accumulation, and upwardly revised residential investment and state/local government spending.

What if the bitcoin bubble bursts? A big concern with the cryptocurrency’s parabolic move is what effect this will have on other markets. If pain is felt in bitcoin, Rhino Trading Partners says it’s sure to affect tech and arguably stocks in general. When that bubble bursts, what matters is: Who owns what? How much pain are they in? What are they going to do about it? That’s the correlation that matters.

A read on the tax bill as it currently stands Ned Davis Research estimates a boost of 0.1% to 0.9% of GDP in 2018 and 2019 from the tax bill, based on fiscal multipliers from the Congressional Budget Office. Given that the economy is in its eighth year of expansion, and the output and unemployment gaps have been practically eliminated, this could feed into higher inflation, prompting the Fed to accelerate its interest-rate increases and negating some of the stimulus impact. Also, individual income-tax cuts are heavily geared toward high-income earners, likely limiting its potential impact while exacerbating income inequality. The Tax Policy Center estimates about 80% of the individual tax cuts will accumulate to the top two income quintiles.

What else

Political watch Up until Friday morning’s Flynn news, this should have been the best week of Trump’s presidency, with the tax bill at first and goal and a full head of momentum. Whether one believes the bill is good or bad policy, this is the biggest rewrite of the U.S. tax code in 31 years. Instead of message discipline and taking a simple victory lap, Trump spent most of the week antagonizing the following: Congressional Democrats, Native Americans, North Korea/Little Rocket Man/Sick Puppy, FAKE NEWS, Hillary Clinton, Islam, Media Executives, the NFL, Alabama Senate race and British Prime Minister Theresa May. Cowen & Co. says this lack of focus on selling the tax bill to the American public is just one reason why the bill continues to take on water with polling and public perception.

Student debt is not a macro issue The latest data show that of 44 million student loans outstanding, only about 7 million borrowers—about 2% of the overall U.S. population—have a balance bigger than $50K. This 16% cohort accounts for 56% of all outstanding student loans.

Four is the magic number Using data from 1900 to date, Dudack Research found that inflation over 4% equates with an average trailing 12-month P/E multiple of 11.6. However, inflation of less than 4% results in multiples averaging 16. The best overall environment for equities is found when inflation is greater than zero but less than 4%.

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