Perspectives

Party Like Its 1929

Since the election, the US risk assets (stocks and high-yield bonds) have experienced a significant speculative rally based on positive sentiment across the board.  Stocks were also supported by a spike in corporate buybacks in December.  While positive sentiment alone can boost economic growth in the short term, it does not guarantee the sustained economic growth required to validate the current market valuations.

Market valuations provide little help in timing the market in the short term, but do highly correlate to predicting long term returns.  The market today is priced for dismal returns over the next decade regardless of economic growth…

…unless the US government allows the Federal Reserve to start buying into the stock market with money created out-of-thin-air as Japan already does.  A former Treasury Secretary has suggested this in the US – of course one has to ask why exactly would this be necessary?

The “why” can be partly derived from Dr. Hussman’s chart that provides us the historic picture of the median SP500 price compared to corporate revenues. It is one of many measures showing the stock market is very expensive these days.  Revenue is difficult to financially engineer like earnings and provides a more stable long-term measuring stick. The “median” shows this is a broad-based bubble.

While there are some good reasons why the ratio should be slightly higher today than 30 years ago, I do not see much room for a new bull market under normal circumstances.

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The average for the ratio since around 1950 is close to 1.  The last two bear markets at least touched 1.1 which today would require a 55% drop in the median price of the SP500 if all else remains unchanged.  A 30% drop in the SP500 index would merely return us to the price-to-revenue level seen at the top of the 2000 and 2007 bull markets.

Revenues can and should rise, but I think 120% growth in revenue is unlikely in the near term to bring the ratio down to 1.1. So only if the Fed is targeting stock market bubble would they want to engage in stock purchases to prevent losses.

How did we get to this level?

One dead horse I will continue to beat is the effect of extreme monetary policy on the economy (marginal) and on financial asset prices (significant).  In short we are in a global credit boom that has inflated financial assets.  A recent Bank of International Settlements (BIS) study re-confirmed the obvious [my adds].

“While conventional monetary policy easing boosts economic activity pre-crisis, unconventional monetary policy post-crisis is found to have no statistically significant real impact [on the economy], despite having a sizeable negative effect on the term premium [high financial prices for the risk assumed],” wrote BIS researchers Sushanta Mallick, M. S. Mohanty and Fabrizio Zampolli.

In other words, recent unconventional monetary policy was perfect for propping up financial asset prices without encouraging economic growth that might lead to rapid job creation, higher wage push inflation and thus lower corporate profits.  Now the central banks are stuck in a tug-a-war with the financial markets that is costing them more each pull.  Discussing stock purchases reveals how concerned some are becoming.

If you take away the 2 trillion dollars created-out-of-thin-air that the other developed-nation’s central banks dumped into the financial markets in 2016 then we would have completed that 30% + pull back in 2016.  Take away the estimated 2 trillion dollars China dumped into their credit markets in 2016, then we would be on our way to the 55% pull-back.  While there is talk of slowing down the global QE experiment, developed nation central banks are on track for slightly less than 2 trillion in monetary “stimulus” in 2017.

A Permanently High Plateau

What could derail the monetary-blown global bubble?  First is fiscal stimulus replacing monetary stimulus.  I think fiscal stimulus is the direction we are going, but its effects on the markets will have an opposite effect.  The bad-economic-news-is-good-news, will be replaced by good-economic-news-is-bad-news if that news includes higher inflation and interest rates.  Maintaining both stimulus could lead us back to that “permanently high plateau” of 1929 by keeping interest rates below inflation levels.

Then there is a possible sea change forced on the “independent” central bankers. Senator Henry, the Vice Chairman for the Financials Services Committee, just sent the first shot across the bow of the Federal Reserve – actually it was a direct hit.   He wrote a letter to the Federal Reserve stating:

…it appears that the Federal Reserve continues negotiating international regulatory standards for financial institutions among global bureaucrats in foreign lands without transparency, accountability, or the authority to do so.

This is unacceptable.

…will likely require a comprehensive review of past agreements that unfairly penalized the American financial system in areas as varied as bank capital, insurance, derivatives, systemic risk, and asset management.

I am sure that with the help of “independent” former Goldman Sachers, regulatory standards can be written to be much more profitable for Wall Street in the future with continued US taxpayer bailouts if when needed or maybe even before needed.

Another obstacle to reaching the 1929 “permanent plateau” levels in the stock market was just rolled back (Dodd-Frank) by the President with his Goldman Sachs advisers standing by his side. You know… the ones Hillary gave speeches to and Trump accused her of being too close to.

Already gone is the “fiduciary rule” that was aimed at blocking financial advisers from steering clients toward investments with higher commissions and fees that can eat away at retirement savings.

The former Goldman president, Gary Cohn, now the White House National Economic Council Director, spun it a little differently in an interview with The Wall Street Journal where he said “the banks are going to be able to price product more efficiently and more effectively to consumers.”

Yes not being able to steer clients to the same exact fund at 2.5% annual fees instead of .5% annual fees was a painful and costly regulation to have to enforce.  And more importantly not being able to offload risky assets to clients (pension funds and retirees) and then bet against them really eats into Wall Street profits.

In fairness, the President can still deliver another Glas-Steagel as he campaigned for on the campaign trial. So far he is executing exactly what he said he was going to and so we should hope this is one area he will follow through on before it is too late.

But Wall Street fought re-instating the simple Glas-Steagel after the financial crisis and forced a more complicated Dodd-Frank regulation.  Then they complained about how complicated and expensive it was to implement.  So I am a little wary of any reform getting accomplished when the largest donors to both political parties – the financial sector – is helping to review and write the new regulation.

When the Road Meets High Expectations

The current talk of the markets is guessing the effects Trump’s expected policies. My view is if Trump does manage to engineer faster economic growth, it will negatively impact the financial markets due the side effects of higher inflation and interest rates in time.  Short term, the market appears to be pricing in lower corporate taxes, the expensing of capital investments, more buybacks, and deregulation. Let’s look at a couple of the expected positives.

While Trump talks about lowering the corporate tax rate from 35% to 15%, the effective tax rate today (after deductions) is already 24% of gross profits (Yardeni).  Trump’s plan will eliminate some of those deductions so the effective drop in corporate taxes will not be as significant as expected.  The effective corporate tax rate prior to the 2000 market top was double the current effective rate and does explain some of the increase in the price-to-revenue ratio.

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Currently, corporate taxes equal only 4% of corporate revenues (Hussman).   So yes, profit margins after taxes can be driven a bit higher, but not much.  Unfortunately, there is little historical evidence the marginal increase in cash flow from a cut in taxes will find its way into corporate investment in future production or new jobs.  Expectations of demand drive corporate investment not higher cash flows.

And the rallying markets know the last time the US had a “tax holiday” on returning US overseas corporate profits most of the funds flowed into stock buybacks and not into the economy.  So let’s hope the President listens to BlackRock’s CEO and adjusts tax policy to slow the pace of buybacks and encourage the increase real investments such as related to his infrastructure spending.

Reflate or Deflate

Many investors focus on Trump’s reflation policies to include his purposed 1 trillion dollars in infrastructure spending over the next four years.  But they ignore his purposed 10 trillion dollars in federal spending cuts.  We know, of course, the dollar amounts are his starting points for negotiations designed to shock and awe.

But we need to remind ourselves that spending cuts in excess of infrastructure spending equals fiscal braking, not reflation. If his federal spending cuts merely offset his spending, then there is no fiscal stimulus. The rally since the election has only priced in the positive sides of purposed Trump policies.  Not the negatives to include fiscal braking, trade wars, real conflicts with China, higher inflation, etc.

Suspended Bubble

The Trump rally started from an historically high level of market valuations as President Trump eloquently stated in December “We are in a big, fat, ugly bubble”.  The question is will the “everything” bubble continue to inflate, slowly deflate or pull a Hindenburg. Today it appears we are in a rising bubble in search of a pin.