I spent the week in San Francisco, a deep blue city in a very blue state, with gorgeous views, temperate weather and glaring extremes. The ultra-rich live in lavish downtown high-rises, while panhandlers walk the sidewalks below. This week’s big issue was a vote on whether SF will become the first city to ban the sale of fur clothing. There is a constant stream of tourists and convention-goers, driving up hotel prices and clogging restaurants. I stayed in a lovely hotel by the convention center, which was hosting the Fancy Food Convention. A raucous bunch—I couldn’t hear myself think as I dined. I saw lots of young, trim, beautiful advisors, and everyone ordered a salad for lunch. We had meetings with numerous highly successful advisors, many with clients of significant tech wealth who prefer to hold lots of cash in the current market environment. Several discussions centered on the outlook for the market and when value will begin to work versus growth. Momentum leaders have opened a 4% lead on value stocks year-to-date, after crushing them in 2017. Massive growth outperformance is a classic late-cycle sign, but there are reasons to believe the market, while frothy, is not exhausted. This week’s leading indicators continued the 5%+ growth trend. Earnings—and guidance—are accelerating. And a strong January historically has foretold a strong year. In fact, momentum surges typically precede above-average returns six to 12 months out.
To be sure, some investors fear the market is forming a bubble. The most important characteristic of a bubble is the belief that some macro factor (usually a technological advancement) makes the financial environment “different this time,” causing equities to disconnect from valuation, move substantially higher and become what late economist Charles Kindleberger called “overowned.” None of these characteristics exist today. The S&P 500’s price performance since early 2015 has been in line with earnings growth expectations—distinctly different from the bubble environment seen in 1997-2000, when stock prices moved well above earnings expectations on narrow tech and telecom leadership. The current rotation of leadership is healthy, preventing too many groups/names from being overbought at once. The NYSE advance/decline line continues to confirm new S&P highs with record highs of its own. Technically, the 14-month Relative Strength Index is at a 22-year high, a rare bullish signal reached only 1% of the time since 1930. Fundamentals also look favorable. Headline GDP fell short of 3% but the underlying factors were much stronger in today’s initial take on Q4 (more below). (This was before the huge tax-cut stimulus.) Inflation and interest rates remain unusually low. Historically, core inflation has had to move toward 3% before its relationship with the S&P forward P/E turns negative. It’s struggling to reach 2%.
Still, advisors in San Francisco as elsewhere in my travels shared that they're on the edge of their seats, wondering when the current pace of market ascent will stop—and perhaps reverse. They’re worried if they’ll be able to protect clients’ gains (there was surprising interest in a conservative income-oriented strategy). Meanwhile, in my own research, I found two Wall Street prognosticators calling a peak to the advance and many others attempting to ascertain whether we are in a melt-up. Melt-ups are rare, defined by markets that have risen more than 50% within 18-months and are at new highs. Today we’re up 31%, meaning the S&P would need to reach 3,420 in six months or 3,715 in 12 months to qualify as a melt-up! I believe market timing is impossible, and that attempting to pinpoint a peak is a dangerous game. Seasonally, February has a reputation for being a softer month, so a pause or pullback is possible. But the broader macro environment—tax cuts, deregulation, higher consumer and business confidence, the dollar’s decline (supported this week in Davos by Treasury Secretary Mnuchin) and stronger foreign economies (more below)—remains bullish. While it’s early in the earnings season, positive surprises are their highest and negative surprises their lowest since 2010. Consensus estimates have surged as tax reform gets incorporated into forecasts, but price momentum has outpaced revisions, pushing the S&P forward P/E to a 15-year high. Yet equities still appear historically cheap relative to bonds. Late-stage bull markets are typically driven by sentiment, and today most indicators are suggesting increasing optimism, not euphoria. Seems everyone is on euphoria watch. A bubble needs euphoria and we don’t have it … yet.
Headline miss belies robust GDP report Q4’s initially estimated 2.6% growth rate fell short of estimates—many expected a print of 3% or higher. But the underlying story was very strong. Consumer spending rose 3.8%, led by a 14% jump in durable sales. Residential investment was up nearly 12%. And nonresidential fixed investment, aka business spending, jumped nearly 7%, the fourth straight solid quarterly increase in capital expenditures before the prod of tax reform that kicks in this year. This suggests ample momentum heading into 2018. Inventories and, as has been the case for some time, trade, (see below) were drags.
Global growth improving, too The IMF this week raised its global growth forecast two ticks to 3.9% for this year and next, and Goldman Sachs’ proprietary euro-area activity indicator shows growth picked up to 3.9% in December from 2.7% in January 2017, the fastest pace since early 2011. The eurozone composite PMI continues to surge and currently is above a strong U.S. print.
Flash PMIs solid Markit’s initial gauge of January manufacturing rose to near a 3-year high as factory activity strengthened, output grew at its fastest pace in a year, new orders picked up and export sales were their strongest since August 2016. The services gauge moderated—it slipped to a 9-month low even as new orders accelerated on “improved client demand and greater willingness to spend among consumers." Regional Kansas City and Richmond Fed PMIs saw manufacturing activity accelerate in the former and ease slightly in the latter. Also, December durable goods orders jumped, although ex-transportation, the improvement was modest.
Home sales end big up year on a down note New and existing home sales slid sharply in December, but the headline needs to be put in context. Driven largely by inadequate supply and rising prices, the declines followed November surges, which masked what still were healthy sales rates in the final month of the year. For example, December’s new homes sales rate of 625K was still the fourth best of this 10-year cycle, but it came after November’s revised 689K rate, which is the cycle high so far. For the year, both new and existing sales were their highest since 2006.
Trade a fly in GDP ointment The trade deficit continues to grow, cutting into headline GDP. But as with GDP, the underlying story is much better as exports continue to show wide strength, led by capital goods, up 2.7% in December and 5.6% in November. Consumer goods exports are robust, too, rising 2.7% and 4.1%, respectively, the past two months. The only problem: consumer goods imports are rising much faster to feed America’s growing appetite. The result, Q4’s 7% gain in exports was overwhelmed by a 14% surge in imports, paring GDP growth.
What could go wrong? Market implied inflation expectations are climbing on rising oil prices, a weakening dollar and faster growth. This week, the 10-year Treasury yield hit levels last seen in 2014, while the dollar fell to a 3-year low. Institutions could be quick to dump risk on any sign of trouble, be it rising inflation or more trade actions. FBN Securities says most managers will happily get out of the way of any perceived sustainable pullback; unfortunately, the exit door is always narrower than the entrance.
California steamin’ D.C. policy is hitting California hard, led by tax reform. SF has the second-priciest real estate in the country, behind only nearby San Jose, home to many Facebook and Apple employees. So the tax law’s caps on SALT and mortgage interest deductions mean many here will see their taxes spike. Also, crackdowns on immigration are crimping Silicon Valley and large agricultural regions, which respectively rely heavily on highly skilled and farm-working immigrants; President Trump’s decision this week to slap a 30% tariff on imported solar panels has the state’s large solar industry reeling—it accounts for more solar jobs and installed megawatts of capacity than any other state; and a weakening of—if not end to—NAFTA represents a major threat for a state with the largest Latin America population and the second-largest export exposure to Mexico, behind only Texas.
What will you do with your tax cut? The impact should begin showing up in mid-February’s paychecks and UBS calculates most households will see an increase in disposable income of 2-4%. Cornerstone Macro’s proprietary consumer survey indicates those households plan to save more than 60% of the tax cut.
Shout-out to my girls, Caroline and Anne! A study of personal relationships by UC Berkeley and Israel's Bar-Ilan University said close female relatives—mothers, sisters and wives—were flagged most often as people the 1,000 survey respondents sometimes found “demanding or difficult.’’
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