What can end the long cycle?

09-12-2018

After a week off to clear my head, I’ve spent the last few days with our investment teams reviewing our portfolios as well as the piles of Wall Street research reports—macro and micro—stacked neatly in my computer’s “In” bin by my trusty assistant Mary. The good news is we remain lodged above the all-important 2,850 support level on the S&P 500—up 7.5% year-to-date and 16% over the last 12 months. You can thank another stellar earnings season, continued unexpectedly strong economic news, multiyear and multi-decade highs in consumer and business confidence, and a P/E market valuation on current year earnings that’s down from 18.0 a year ago to 17.7 today, almost unheard of at this stage.

On the other hand, we’ve seen in recent weeks bond yields retrace toward 3%; mixed trade-war news out of Mexico (good) and China (bad); ongoing concerns about Turkey and more broadly emerging markets; more leaks from “senior administration officials” about the “chaos” in the Trump administration; and a modest worsening of the odds that the current market and economy friendly Republican Congress could end up divided or even all Democratic on Nov. 6. With another 8% to go on our long-anticipated advance to 3,100 by year-end, that’s a lot of baggage.

So as I ask myself, “What will it take to break through to 3,100 and beyond,” I believe it boils down to one issue: “The Cycle.” The bears worry that “this is as good as it gets,” “we are long in the tooth” and sooner rather than later, “The Cycle” will end. Indeed, with this week’s 10-year anniversary of the “Fall of the House of Lehman,” the bears sound ever more prescient to some. We’ve written extensively on why we think this view is wrong-headed, and this memo is meant not so much to reiterate these points (for that, see “Secular Bull Update: Patience is a virtue” and “Market Memo: Bearish market myths make for a buying opportunity”) but rather to review the latest list of worries, why they are misplaced and why the market should grind higher toward our target.

Worry 1: The trade war will escalate and kill off the expansion This worry peaked mid-summer but lingers. The concern is the president’s attempt to negotiate better trade deals will end poorly, with reciprocal tariffs and other barriers rising, undermining confidence and economic growth in the U.S. So far, the bears have been disappointed, largely because their math has been poor and they have underestimated the confidence that small business has in the Trump economy. The poor math is simply that the first-order stimulative impact of the president’s tax cuts and incremental government spending—almost $2 trillion spaced fairly evenly through 2020—swamps the amount of tariffs announced and threatened to date on Chinese, Mexican, Canadian and European goods combined ($120 to $190 billion) by over $1.8 trillion. Even for the $20 trillion U.S. economy, $1.8 trillion matters. On the confidence front, despite all the negative news flow about tariffs, small businesses’ optimism just hit an all-time high, suggesting they’ve either done this math already and/or expect the trade dustup to pass eventually without hurting their longer-term investment. We think this is right. The odds seem high a new Nafta deal is near and an announcement of such in coming weeks could mark the high-water mark of trade fears. Europe is more complicated and will take longer but will surely follow along, as negotiators for both sides suggested this week. Chinese negotiations will clearly drag on the longest but based on market and economic performance so far this year, the Chinese are losing, not winning. At some point, a “deal” ending the conflict seems likely. And as this reality sets in, the markets should have reason to cheer.

Worry 2: Late-cycle wage pressures will push the Fed into a policy error With unemployment at an 18-year low, it’s reasonable to expect wage inflation to pick up, as it did in last week’s jobs report, with annualized average hourly earnings rising 2.9%, their fastest pace in more than nine years. We think this is good, not bad, for the bull case and won’t prod the Fed into excessive tightening. First, 2.9% wage inflation, while higher than we’ve experienced in this expansion, remains low relative to previous levels associated with accelerated Fed tightening (i.e., in the 4% range). Second, wage inflation does not necessarily correlate with broader price inflation (measured by the core PCE deflator) since corporations have two tools to offset wage growth without raising prices: productivity gains through increased capital investment (now accelerating because of tax reform) and profit growth (currently well into the double digits). Also, with so many new technology disruptors attacking established companies with price deflation (think Amazon, Uber and Facebook) and providing old economy companies with new tools to improve worker efficiency (think Salesforce.com and Google), companies have unusually high incentives and means to avoid big price hikes. Many Fed governors have made this point recently as they, again and again, emphasize “data dependence.” Our view is wage pressures will only gradually feed into core PCE readings, and that the current dovish Fed path will remain intact. As evidence of this continues to dribble in through the fall, another bear worry should get less severe.

Worry 3: A trade war and/or wage pressures and/or “something else” will kill off profit growth Frankly, some version of this worry has been in place for nearly all of the 10-year expansion that has seen S&P earnings rise from $55 in 2009 to $161 today. While some broad measure of cynicism around profits is healthy, our bottom-up work suggests the profit expansion remains very much in place. Top-line growth is improving, not decelerating. Cash-flow growth is strong, in many cases stronger than earnings growth, making earnings quality better than it’s been in some time. Both ours and the market’s bottom-up estimates for this year and next continue to rise—a very unusual, positive development. We anticipate Q3 earnings and Q4 guidance will be very strong for most companies when they start reporting in a few weeks, providing another catalyst for stocks as we approach year-end.

Worry 4: The “Sugar High” is set to wear off and G-forces from the ensuing deceleration will weaken growth and earnings This worry, also commonly referenced as the coming “Fiscal Cliff,” also is overdone in our view. If you examine the details of the tax reform package and incremental spending bills, as Dan Clifton of Strategas Research Partners has done, you’ll see the first-order fiscal stimulus currently in place is pretty evenly spread across the next three years, even if you assume the 2018-19 stimulus unleashed by the omnibus spending bill is not rolled over as expected in 2020. Beyond this, readers of this space know our view that the bill’s most powerful stimulus is not the demand-side piece everyone focuses on but the supply-side tax-reform element that raised permanently after-tax returns on investment. This already has stimulated increased corporate investment in 2018, but given planning cycles for big corporate projects and our own discussions with corporate CFOs, there will be even more next year, not less. And none of this accounts for the multiplier effects, which take time to work though, from not only the tax cuts but also from improvements in jobs, incomes and confidence. Our macro committee GDP forecasts for next year are in fact much closer to our numbers for this year, in the 2.8-3% range, than in the desultory 1.5-2% levels the bears see once the sugar melts. So as we move through the fall months, continued strong economic numbers should give the markets more confidence to advance as they see the bears, once again, are wallowing a little too deep in the muck.

Worry 5: Some international Black Swan (Italy? Turkey? Brexit?) will swoop in and undo us One or more of these black swans could land, for sure, but we think the odds heavily favor that they will be closer to white by the time they arrive. In Italy, the new finance minister seems to have a grip on bond math and understands the budget hit that would come from rising Italian bond yields if it plays the “Italexit card” would dwarf whatever fiscal stimulus his country may pursue. Turkey is more of a wild card, but the recent attack on its currency seems to have sobered President Erdogan enough to avoid a meltdown. And Britain’s Theresa May seems to be grinding slowly toward a market friendly soft Brexit. So far from being a downer, the ultimate outcome on any of these could prove another positive.

Worry 6: The midterm elections will go poorly for Republicans, leading to policy uncertainty At the moment, the only good news I can report is the market seems to be already pricing in a Blue Wave that flips the House and possibly the Senate. So from that perspective, we’d argue there’s nothing but upside. If you review the House races district by district instead of the so-called generic ballot (which is national and prone to the same prediction errors that led consensus the wrong way in 2018), a flip of the Senate seems highly unlikely and a flip of the House too close to call—hardly a wave, in any case. If we wake on Nov. 6 with R’s holding both houses of Congress, expect an echo of the 9% market run we saw in the S&P and even larger 20% jump in the broader Russell 2000 in the six weeks after their Nov. 4 trough just days before Trump’s election. But even if the House does fall narrowly, this would probably be better than the market thought and would presage virtually no change in policy (given the president’s veto power as well as the nearly balanced Senate makeup) for at least two more years. Either way, we’d expect the market to move higher once the elections are over.

There are always worries

I’m sure there are other worries out there and if you have one, send it to me. My experience over a long period of ups and downs is that in the end, fundamentals drive markets and worries that we can all list are almost always already priced in. With the economy strong, forward indicators such as confidence even stronger, earnings growth in double digits and valuations fair to low, this market has plenty of room to grind higher. We expect it will.

Indeed, as we first outlined in our market memos in 2011 and reiterated regularly since, we believe we currently are in what we would call “The Long Cycle,’’ a bull market advance similar to the long 20-year, 10 times bull markets that followed the Great Depression and later, the 1970s’ stagflation disaster. Although this economy is sure to have modest inventory-adjustment style recessions along the way, and even a few 20% market declines, we anticipate that patient investors will be rewarded with returns not seen since the great 1974-to-1999 bull run. And in the short- term, we can look to 3,100 by late December.