Weekly Update: If we all know it, isn't it already priced in?

04-20-2018

The market is a forecasting mechanism and nothing matters more for the health of the rally than the ability of companies to churn out profits. Despite high-profile stumbles, the news to date this reporting season has moved the market—at this writing, the major indexes are on track to record their second straight weekly gain. Much of the rise in the equity market since late 2016 occurred during earnings seasons, with earnings “beats’’ the catalysts. Generally speaking, a high-and-rising beat rate for earnings is bullish. But if the beat rate is high and rising for long enough, the risk rises that investors start to become complacent, fully expecting the earnings to beat expectations and giving new meaning to “earnings surprises.” No longer surprised by better-than-expected reports, investors would be far more surprised by lower-than-expected results, selling on the disappointments. The most extreme example is the secular peak in Q1 2000, when 77% of the reports beat expectations for the ACWI and the S&P 500. The percentage dropped sharply over the next two quarters, with equities gaining the downside momentum that would become commonplace as the secular bear progressed.

Measured from 2000, S&P earnings would be $81.30, far below the current trailing level of $124.10, if companies had not reduced their share counts through repurchases. Evercore ISI estimates that without buybacks, the trailing P/E would be above 30. That implies this equity rally has been significantly supported by buybacks, and further increases in cash return can help carry markets higher over the coming quarters. This seems likely, as surveys suggest buybacks are the No. 1 way companies are using cash generated by the tax cuts (more below). Since the correction bottomed, the forward P/E has ample room to expand before it bumps into the ceiling of 17.4 prior to the presidential election. That’s good news. Thursday’s pullback suggests that equities will grind upward, but will take until at least the summer before refreshing their peaks from January. The session range traced by the S&P benchmark measured a mere 78 basis points of its price level. The blue chip index has garnered 291% of its aggregate returns since October 2001 when this statistic has fallen at or below 1.25%. Investors have far more temerity to augment their exposure when the risk of suffering from a quick and painful loss has subsided.

Even though we are late cycle on a number of indicators, the tailwind from the fiscal expansion—the tax cuts and budget increases enacted this year—is likely so significant that the economy will continue to grow well with above its potential over the coming quarters. The superficial judgment is that since many markets (S&P, small-cap stocks, financials) have given back most of their gains since late November 2017 when tax reform gathered congressional momentum, the negatives from Trumponomics must be overwhelming the positives. That assessment misses a succession of other mini-shocks that have materialized over the past three months, from early February’s upside inflation scare to downside surprises on global growth in March and early April. According to Bank of America’s proprietary Global Fund Managers Survey, expectations for faster global growth tumbled in April with only 5% of net respondents expecting stronger growth, the lowest since the Brexit vote in June 2016. The concern is that early survey evidence suggests consumers may have embraced a somewhat frugal attitude when it comes to responding to the tax cuts, elevating the downside risks to Q2 growth and consumption. But back here in the U.S., most macroeconomic indicators that could be damaged by “America First” policies have remained quite stable, JP Morgan observes. For example, consensus 2018 U.S. growth forecasts jumped from 2.4% before tax reform’s passage to 2.8% after, where they have remained since. Q1 earnings are strong—everyone knew they would be. So the market is again eyeing 3% on the 10-year Treasury and a continuing flattening yield curve. Sloppy! Whatever. At the end of it all, it’s only about earnings and P/E. Check and check.

Positives

Retail sales rebound They rose 0.6% in March, double expectations and the first increase in four months. Car sales drove the activity, up 2%, the most in six months. The bounce-back indicates weakness at the start of the year was temporary, likely due to severe winter weather in large parts of the country and delayed tax refunds as a result of a change in IRS procedures to reduce fraud. While sales for the quarter were still up at a fraction of the previous quarter’s 10.4% annualized pace, the March report suggests consumer spending remains on a solid footing.

Where are we in the economic cycle? Conference Board leading indicators rose a 19th straight month in March, albeit at a slower rate on slower employment growth and the pullback in stock prices. The 6-month average increased to nearly an 8-year high, while the year-over-year increase of 6.2% was nearly three times normal. Both imply growth should pick up over the next six months. OECD leading indicators remained unchanged, signaling global growth may be peaking as the share of countries above their long-term average slipped to a 13-month low.

Small business optimism, revisited While last week’s NFIB report suggested enthusiasm waned a bit, a deeper dive indicates small business owners are more optimistic than at any time in the last nine years—the monthly gauge has been higher only 20 times in the last 432 surveys (36 years!). The source of this optimism can be seen in the survey details: taxes received the fewest votes since 1982 as the No.1 business problem; the net percent of owners reporting higher selling prices reached its highest reading since 2008; and reports of improved earnings trends were the second best since 1987.

Negatives

If we’re ever going to get inflation, this would be the year The Philly Fed PMI’s prices-paid measure jumped to a 7-year high, its prices-received component hit a cycle high and New York’s Empire prices-received gauge reached a 6-year high. While the Fed Beige Book offered no suggestion of broadly accelerating wage growth, it also noted input costs for steel and building materials accelerated, with businesses anticipating further increases. Meanwhile, consumers have watched retail gasoline prices rise sharply in recent weeks to about 30 cents above year-ago levels—a trend that if it continues could offset the benefits of tax cuts for lower-income households.

Single-family construction MIA While March housing starts outperformed expectations, rising to their highest level since August 2007, the improvement was solely in volatile multifamily units. Single-family starts and permits were down 3.7% and 5.5%, respectively, the latter the biggest drop since February 2011. And the drop-off was across regions, negating the “bad weather’’ argument. NAHB sentiment also ticked down a fourth straight month as builders continue to face constraints such as a lack of buildable lots. With mortgage rates at a 4-year high and prices at pre-crisis highs, the National Association of Realtors says housing affordability remains challenged.

Manufacturing slowing down? Even though the Philly Fed’s manufacturing index edged higher in April, new orders and shipments softened significantly, a sign activity may moderate in the months ahead. New York’s companion Empire survey decelerated for the fifth time in six months to a 9-month low, although the drop-off was driven by a deteriorating 6-month outlook on tariff and trade concerns. And ex-energy, March industrial production was flat, with the manufacturing component eking out a 0.1% monthly gain, aided by autos and business equipment. Overall Q1 production rose at a healthy 4.5% annualized rate, down from Q4 2017’s torrid 7.8% pace.

What else

About that tax-cut wage windfall According to Paul Tudor Jones’ Just Capital survey of Russell 1000 firms, only 6% of tax cut savings will go to employees, mostly as one-time bonuses. About 20% will go to job creation. And about 57% will be returned to shareholders, primarily through buybacks. Perhaps this is why the latest Wall Street Journal/NBC poll shows the tax bill remains unpopular, with just 27% of respondents saying it was a good idea while 36% thought it was a bad idea.

The bond bears are aware of this The 10-year budget and economic outlook from the Congressional Budget Office (CBO) suggests the U.S. is set to run federal budget deficits averaging $1.2 trillion per year over the next 10 years through 2028. The CBO doesn’t buy the notion that the Trump administration’s tax cuts will boost growth sufficiently to pay for themselves as it envisions federal debt will increase faster than GDP.

Growth is increasingly difficult to measure in a digital economy Depending on the methods used, Barclays notes annual GDP growth rates could be up to three-quarters of a point higher if adjusting for the digital economy’s affects, from sharing and disintermediation to quality improvements and intangible capital. Furthermore, it says inflation is likely lower than official estimates for similar reasons, with official inflation rates at times over-recording inflation by as much as a full percentage point.

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