Morning Briefing Archive (2017)

2-2-2 Scenario

July 31, 2017 (Monday)

See the pdf and the collection of the individual charts linked below.

(1) Time to reminisce about old times. (2) On the mark. (3) Tom Hanks and Da Vinci. (4) 666: Permutations and combinations of a devilish number. (5) More on the 2-2-2 scenario. (6) Productivity and labor force trends argue for low secular growth. (7) Shooting for 2700 on S&P 500 by mid-2018. (8) Speaking of old times: Will it soon be 1987 all over again? (9) Movie Review: “Atomic Blonde” (+).


US Economy: Symbolism. On March 12, 2009, a subcommittee of the House Financial Services Committee held a hearing on the mark-to-market (MTM) accounting rule. Rep. Paul Kanjorski, who headed the subcommittee, warned the chairman of the Financial Accounting Standards Board (FASB) that if his organization didn’t suspend MTM, Congress would. At the hearing, my congressman Gary Ackerman reminded the man from FASB that Congress was considering a bill to broaden oversight of his organization. Ackerman instructed him to fix MTM: “It will be done in three weeks. Can and will.” On April 2, FASB did just that. (For more, see the 3/12/09 FT story titled “Congress warns on mark-to-market rule,” the 4/3/09 WSJ story titled “FASB Eases Mark-to-Market Rules,” and the 6/3/09 WSJ article titled “Congress Helped Banks Defang Key Rule.”)

Since I firmly believed that MTM had been a major contributor to the bear market in stocks—and shared that view with Ackerman at his Queens, NY office on November 25, 2008—I turned bullish four days after the hearing. On March 16, 2009, I wrote:

“We’ve been to Hades and back. The S&P 500 bottomed last week on March 6 at an intraday low of 666. This is a number commonly associated with the Devil. … The latest relief rally was sparked by lots of good news for a refreshing change, which I believe may have some staying power … I’m rooting for more good news, and hoping that 666 was THE low.”

That very same day (March 16), the bullish news included the Fed’s announcement that its QE1 bond-buying program would be expanded to $1.25 trillion in mortgage-related securities and $300 billion in Treasury bonds. On July 27, 2009, I wrote:

“I prefer melt-ups to meltdowns. The S&P 500 has been on a tear ever since it bottomed at the intraday low of 666 on Friday, March 6. We should have known immediately that this devilish number was the bear market low. It took me a few days to conclude that it probably was the low. … I felt like Tom Hanks in the ‘The Da Vinci Code.’” Subsequently, when I told this story to our accounts, I said that I called the bottom in stocks more as a symbolist than as an investment strategist.

Admittedly, I’ve recounted this story a few times since the start of the bull market. That’s what happens as I get older—I start repeating myself more often. Speaking of symbolism, my latest shtick is 2-2-2 for the US economy, with real GDP continuing to rise 2%, CPI inflation remaining around 2%, and the federal funds rate likely to top out at 2% during the current economic cycle. I’m not ready to call the next recession in 2022, but I do think it could be a while before the next downturn.

As for the S&P 500, we’ve already blasted through 1998, which is 666 times 3. The next objective is 2664 (666 times 4), which is my target, as a symbolist, for the middle of next year. Now let’s have a closer look at 222, which is 666 divided by 3:

(1) Real GDP at 2%. As Debbie reviews below, real GDP rose 2.6% (saar) during Q2, up from 1.2% during Q1. On a y/y basis, real GDP growth has been remarkably steady since 2010, fluctuating around 2.0% (Fig. 1). It was 2.1% during Q2, following Q1’s 2.0% (Fig. 2).

The growth of the economy during the latest expansion looks better using the real output of the nonfarm business (NFB) sector, which is essentially the same as real GDP excluding government (Fig. 3). It’s been hovering around 3.0% since the start of the current expansion. However, it may be slowing to 2.0% as nonfarm productivity growth remains weak, while the growth of hours worked is slowing for demographic reasons.

Over the past 10 years (40 quarters through Q1), NFB productivity is up just 1.3% per year, on average (Fig. 4). The civilian working-age age population is up just 1.0% on average over the past 10 years (120 months), while the 16- to 64-year-old segment is up just 0.5% through June (Fig. 5). Over that same period, the civilian labor force is up only 0.5%, while the 16- to 64-year-old segment is barely up, with a gain of 0.2% (Fig. 6). The only segments of the labor force that are growing are the 55 to 64 year olds and the 65+ year olds, with more of them dropping out for retirement (Fig. 7).

The 10-year annualized growth trend of the US was down to 1.5% during Q2 (Fig. 8). The Congressional Budget Office projects that real GDP growth will remain below 2.0% through 2027, based on a lackluster outlook for productivity combined with slow population growth rates (Fig. 9).

(2) CPI at 2%. The core CPI inflation rate, excluding food and energy, has been fluctuating around 2.0% since 1999 (Fig. 10). The Fed tends to focus on the core PCED inflation rate, which has been mostly below 2.0% since 1997, though that’s been the FOMC’s target since January 2012. In June, the headline CPI was up 1.6%, while the core was up 1.7%.

(3) Federal funds rate at 2%. The latest economic projections table of the FOMC participants was released after the 6/14 FOMC meeting. It shows that the median forecast for the federal funds rate is 1.4% by the end of this year. That implies one more 25bps rate hike this year to 1.25%-1.50%. The projection for the end of 2018 is 2.1%, implying an additional two or three rate hikes next year. Key Fed officials have been saying that while they expect the real “neutral” interest rate to rise, it is probably close to zero right now and for the foreseeable future. It’s hard to see what will make it move higher since they attribute the historically low rate to productivity and demographic factors, which don’t change very rapidly. They’ve also signaled that the nominal rate should be 2 percentage points above the real rate. That’s consistent with their forecast of 2.1% for the federal funds rate at the end of next year.

Strategy: Four-Bagger. Stock prices edged down on Friday, with the S&P 500 closing only 0.2% below the record high of 2477.83 set on Wednesday. So where do we go from here? On Thursday and Friday, there was some buzz about a bearish research note sent to clients by JPMorgan’s quantitative and derivative strategist Marko Kolanovic. According to an article posted on CNBC, he is warning about a possibility of a 1987-style meltdown. His main fundamental concern seems to be that “global central banks are likely to commence reducing their balance-sheet accommodation (level for Fed, and inflows for ECB/BOJ) in the near future.” He notes that all three have September meetings scheduled.

Kolanovic cited how the VIX closed below 10 every day for the past two weeks through last Wednesday, which is the “lowest level of volatility” since 1983. He is concerned if the market falls, levered investors will begin “selling into market weakness to cut losses,” just like what happened in 1987.

It’s a reasonable concern. Melissa and I have written that the next major selloff could be exacerbated by all the money that has been pouring into equity ETFs in recent months suddenly pouring out of them when/if something terrible occurs. We are hard-pressed to imagine what that might be. We are not convinced that a synchronized reduction in the balance sheets of the Fed/ECB/BOJ is either imminent or even likely to be the trigger for the next stock market selloff.

So, for now, the path of least resistance is still higher for stocks, especially since forward earnings continue to blaze that trail, as Joe and I have been noting since last summer. So the answer to “where do we go from here?” is probably “higher, for now.” Our yearend target of 2400-2500 has been achieved way ahead of schedule. Now, as strategists, we are aiming for 2700 by the middle of next year, a four-fold increase since March 2009 (Fig. 11). Assuming a forward P/E of 18, we would need to see forward earnings climb to $150 per share by the middle of next year, up about 7.4% from the latest reading in late July. That’s realistic, in our estimation.

Movie. “Atomic Blonde” (+) (link) features Charlize Theron playing a spy working for M16 British intelligence just as the Berlin Wall is coming down. The movie is intentionally campy with lots of pop hits from the late 1980s. Charlize leaves a long trail of dead bad guys as the one-woman death squad mercilessly pursues her mission impossible. This could be the beginning of a new spy thriller series. After all, James Bond must be ready for the nursing home of retired spies by now. The movie starts slow, but the pace of mayhem speeds up along the way.


Shovel-Ready Industrials

July 27, 2017 (Thursday)

See the pdf and the collection of the individual charts linked below.

(1) Tale of two industrial companies. (2) Purchasing managers are purchasing. (3) Good vibes from the commodity pits and the forex markets for Industrials. (4) Low-octane fuel. (5) Cat is a tiger. (6) Boeing is flying high. (7) Not much drive among auto manufacturers.


Industrials I: Digging Most of Them. In recent days, General Electric and Caterpillar reported earnings. Both companies are in the S&P 500 Industrials sector, and both have operations spanning the earth. But their results—and the response of their respective shares—couldn’t have been more different.

General Electric shares slumped 2.9% from Thursday’s close to Friday’s close after investors learned that the company’s fiscal 2017 earnings would come in at the low end of a range given earlier this year. Conversely, Caterpillar shares rallied 5.9% after the company increased both its revenue and its earnings guidance. GE suffered from its exposure to the oil and gas industry and the gas turbine market. Caterpillar benefitted from its exposure to the construction of housing and buildings, mining, and the fracking industry.

GE is such a large company that its underperformance this year—its stock is down 19.5% ytd—is overshadowing the strong performance of other industrial companies. The S&P 500 Industrials stock price index is up 8.7% ytd through Tuesday’s close, which means it’s lagging behind the S&P 500, which is up 10.6% over the same period. Without GE, however, the S&P 500 Industrials stock price index would be up roughly 13.0%, according to Joe’s calculations. It would be outperforming the S&P 500 and would be the third-best-performing sector.

Here’s the performance derby of the S&P 500’s sectors ytd through Tuesday’s close: Tech (22.9%), Health Care (16.6), Consumer Discretionary (12.3), Materials (12.0), S&P 500 (10.6), Industrials (8.7), Financials (8.2), Utilities (8.0), Consumer Staples (7.1), Real Estate (5.3), Energy (-12.7), and Telecom Services (-15.3) (Fig. 1).

An outperforming Industrials sector makes more sense given some of the strong economic data that has rolled in. Consider the following:

(1) Managers purchasing. The US and global M-PMIs have been solid this year. The US M-PMI, at 57.8 in June, has been north of 50.0 since last September. Likewise, the new orders component of M-PMI stands at 63.5, and the employment category clocks in at 57.2 (Fig. 2). The indicator is also throwing off positive readings around the world. In advanced economies the M-PMI was 53.9 last month, and in emerging economies it was 50.8, the latter indicating economies that were growing but just barely (Fig. 3).

(2) Commodity strength. The prices of most industrial commodities are signaling that all’s fine in the world of manufacturing. The CRB raw industrials spot price index is up 2.3% ytd through Tuesday’s close and 27.0% from its 2015 cyclical low (Fig. 4). The price of copper is up 14.3% since May 8 (Fig. 5). Even agricultural commodities look like they’re bottoming after falling sharply since 2013 (Fig. 6).

(3) Oil slick. There are certainly things to worry about, including the recent drop in the price of oil. A barrel of Brent crude oil recently topped out at $57.10 on January 6 and has since fallen to $44.92. However, the decline isn’t anywhere near the magnitude of the drop experienced from 2014 through early 2016, when a barrel of crude fell from $115.06 to $27.88, sending the industrial sector into a mini-recession (Fig. 7).

(4) Dollar tailwind. Looking ahead, Industrials stands to benefit if the recent decline in the dollar holds. The dollar, which rallied since the summer of 2014, continued to do so in the wake of the US presidential election last year and peaked on January 11 at 126.21, falling 7.2% since then to 117.10 (Fig. 8). If the dollar is flat for the remainder of the year, S&P 500 earnings growth will get a 4ppt earnings bump, according to a 7/25 Bloomberg article citing Morgan Stanley estimates.

Industrials II: Winners & Losers. A number of industries within the S&P 500 Industrials sector are generating very different returns this year. Some of the winners ytd through Tuesday’s close include: Construction Machinery & Heavy Trucks (19.7%), Aerospace & Defense (19.5), Industrial Machinery (14.9), and Electrical Components & Equipment (13.5) (Fig. 9). Meanwhile, some industries that have underperformed ytd include: Industrial Conglomerates (-4.1), Trucking (-4.5), Air Freight & Logistics (4.2), and Airlines (6.3) (Fig. 10).

Overall, the Industrials sector is expected to produce 4.1% revenue growth over the next 12 months and earnings growth of 10.1% over the same period. The fastest-growing industries in the sector include: Construction & Farm Machinery, with forward earnings expected to grow 17.2%, Diversified Support Services (16.7%), Agricultural & Farm Machinery (15.8), Construction & Engineering (14.6), and Railroads (14.6).

Some of the slowest earnings growth over the next year is expected to come from Human Resources & Employment Services (5.1%), Trading Companies & Distributors (6.9), Airlines (7.6), Building Products (8.0) Air Freight & Couriers (8.1), and Environmental & Facilities Services (8.1). Industrial Conglomerates clocks in at 9.8% earnings growth over the next 12 months.

Here’s a look at recent news from Industrials companies and what it may imply about the industries in which they reside:

(1) Caterpillar: Caterpillar’s Q2 sales rose 10.0% y/y, and operating profit soared 59.4%. The company credited strong results to construction in China and gas compression in North America. In addition, mining and oil-related activities have “come off recent lows, and we’re seeing improving demand for construction in most regions,” said CEO James Umpleby in the company’s Q2 earnings conference call transcript. Just imagine what the company could earn if an infrastructure spending bill ever passed Congress.

Caterpillar raised its FY revenue outlook to a range of $42 billion to $44 billion, up from its previous outlook of $38 billion to $41 billion. The EPS guidance was increased to $3.50 assuming revenue comes in at the middle of the expected range, up from an earlier estimate of $2.10. On an adjusted basis, EPS of $5.00 is now expected, up from $3.75.

Cat is part of the S&P 500 Construction Machinery & Heavy Trucks index, which is up 19.7% ytd (Fig. 11). Expectations for the industry’s earnings growth over the next 12 months have been improving since late 2015 and now stand at 17.2% (Fig. 12). Its forward P/E reached a high of 24.3 in December 2016, when forward earnings hit a cyclical bottom before falling to the current 19.2, which is still high relative to the past 20 years (Fig. 13).

(2) General Electric: The company that brings good things to life reported Q2 revenue of $29.6 billion, down 12%, and adjusted EPS of 28 cents, down from 51 cents a year earlier. Much of the decline was due to the boost in results received last year from the sale of GE’s appliance business.The results for the quarter beat analysts’ expectations; however, the company issued a disappointing warning that its full-year results would be on the “weak side” of its previously announced range of $1.60 to $1.70 a share, reported a 7/21 WSJ article. In addition, incoming CEO John Flannery won’t unveil his 2018 outlook for GE until mid-November, a lifetime on Wall Street.

GE is a member of the S&P 500 Industrial Conglomerates stock price index, which has fallen 4.1% ytd (Fig. 14). Other members of the industry have turned in much stronger performances: Honeywell International has risen 18.5% ytd, 3M is up 11.5% even after pulling back this week in the wake of its earnings report, and Roper Technologies has rallied 27.5%. The S&P 500 Industrial Conglomerates is expected to generate 2.9% revenue growth over the next 12 months and 9.8% earnings growth (Fig. 15). At 17.9, the Industry’s P/E has come off its high of 20.4 hit during July 2016.

(3) Boeing. The airplane manufacturer beat Q2 earnings expectations and raised its 2017 earnings estimates, which sent its shares flying. In Q2, the company earned an adjusted profit of $2.55 a share, above analysts’ consensus estimate of $2.30 a share and up from last year’s loss of 44 cents a share. The company is now calling for its 2017 earnings to fall between $9.80 and $10.00 a share, up from its previous guidance of $9.20 to $9.40 a share. The shares were up 9.9% Wednesday and have jumped 50.0% ytd.

Boeing is a member of the S&P 500 Aerospace & Defense stock price index, which is up 19.5% ytd through Tuesday’s close (Fig. 16). The industry is expected to grow revenue by 3.4% over the next 12 months and earnings by 9.1% (Fig. 17). Its forward P/E is at a lofty 19.9, but its forward profit margin, at 7.9%, is below its record high of 9.0% in September 2014 (Fig. 18). The ability to improve margins, combined with the continued increase in defense spending domestically and abroad, could keep shares afloat.

(4) Autos. Auto manufacturers are lumped into the Consumer Discretionary sector, but their manufacturing heft makes them important to watch when tracking the Industrials sector. Both GM and Ford reported disappointing Q2 earnings, with strong US truck sales unable to offset the decline in US car sales.

Ford’s Q2 operating income fell 16% to $2.5 billion, and the company lowered its 2017 EPS guidance to a level that implies pre-tax operating earnings will be in a range of $7.8 billion to $8.7 billion. That’s down from the previous outlook for $9 billion of pre-tax operating earnings and below the $10.4 billion earned last year, the 7/26 WSJ reported.

GM’s Q2 earnings dropped 42% to $1.7 billion, hurt by costs associated with exiting markets in Europe, India, and South Africa. Both companies have elevated inventory levels. At GM, nearly 1 million vehicles are on dealer lots, equating to 105 days of supply.

Much of this dour news is baked into the S&P 500 Automobile Manufacturing stock index, which is down 2.3% ytd. Analysts are calling for the industry’s revenue to drop 3.0% and earnings to fall 2.4% over the next 12 months.


Earnings-Led Melt-Up?

July 26, 2017 (Wednesday)

See the pdf and the collection of the individual charts linked below.

(1) Earnings trump worries, including Trump. (2) Nothing to fear but nothing to fear. (3) Stock prices rising along with earnings. (4) Consumer confidence survey confirms that life is good, and the labor market has plenty of job openings. (5) Germany having Oktoberfest in July. (6) Frictional unemployment in the US. (7) Excluding retiring seniors and studying juniors, there isn’t much slack left in US labor market.


Strategy: Climbing a Wall of Earnings. Technicians and contrarians, especially contrarian technicians, are most bullish when everyone seems to be most bearish. They observe that some of the best bull markets have “climbed a wall of worry.” The current bull market has certainly done so. Joe and I have counted 56 panic attacks since the start of this bull market in our S&P 500 Panic Attacks Since 2009.

Most recently, there was a one-day “Trump Impeachment Scare” on May 17 (Fig. 1). We count seven scares last year, including the “Endgame Panic” at the beginning of 2016, “Brexit” during the summer, and “FBI Flags HRC” last fall (Fig. 2). Since the start of the bull market, the panic attacks have been followed by relief rallies to new cyclical highs, then to new record highs since March 28, 2013 (Fig. 3). So here we are at yet another set of new record highs for the S&P 500/400/600 (Fig. 4). However, this year’s ascent has occurred without any meaningful panic attacks. There’s been no wall of worry. There’s been nothing to fear but nothing to fear, as we observed in Monday’s commentary titled “Summertime Lullaby.”

Helping to allay fears have been the steady increases in the forward earnings of the S&P 500/400/600 to new record highs over the past year (Fig. 5). These uptrends have been supported by rising forward revenues for all three S&P composites (Fig. 6). Most encouraging is that stock prices have been rising along with forward earnings, so that the forward P/Es of the S&P 500/400/600 have actually edged down slightly so far this year (Fig. 7).

That’s a very healthy development. Valuation multiples remain highly elevated, of course. But it isn’t a melt-up if stocks are rising along with earnings rather than on higher valuation multiples.

Confidence I: US Consumers Upbeat. Another healthy development is that the current conditions component of our Consumer Optimism Index (COI) rose to a new cyclical high during July (Fig. 8). It is at the highest level since May 2001. Debbie and I calculate the COI as the average of the Consumer Sentiment Index (CSI) and the Consumer Confidence Index (CCI). The current conditions component of the latter tends to fluctuate with more amplitude than the former. It also tends to be a more sensitive indicator of labor market conditions. In the CCI survey, we put a lot of weight on the “jobs plentiful” series. Here is what it shows:

(1) Bountiful. The percentage of respondents agreeing that jobs are plentiful rose to 34.1% during July, the best reading since July 2001 (Fig. 9). The percentage saying jobs are hard to get fell to 18.0%, the lowest since February 2007. This series is highly correlated with the unemployment rate and suggests it could continue to fall (Fig. 10).

(2) Help wanted. The jobs plentiful series is highly correlated with the percent of small business owners with job openings, a series compiled by the National Federation of Independent Business (Fig. 11). The latter, on a three-month-average basis, rose to 32.3% during June, the highest since January 2001.

(3) Wage paradox. There are fewer and fewer labor market indicators suggesting that there is still slack in the labor market. The one that really stands out is wage inflation. It remains remarkably subdued given its past tight correlation with the jobs plentiful series (Fig. 12). During the past three business cycles, wage inflation rose to about 4.0% when the jobs plentiful reading was as high as it is now.

Confidence II: Off the Charts in Germany. Meanwhile, over in Germany, they’ve started Oktoberfest early. July’s IFO Business Confidence Index soared to another fresh record high in July, led by its current conditions component (Fig. 13 and Fig. 14). Could it be that the huge influx of immigrants is boosting economic growth over there? It always has when it happened in other countries in the past.

US Labor Market: Shortage of Slackers. In our spare time, Debbie and I have been slicing and dicing the US labor market data to determine whether the remarkably subdued pace of wage inflation is attributable to the availability of more slack than suggested by the unemployment rate, job openings, and consumer surveys.

As we’ve noted before, there are currently as many job openings as there are unemployed workers. Both are around 6 million. In our opinion, that confirms that the economy is at full employment, with only “frictional” unemployment caused by geographic and skills mismatches. But what about the low labor force participation rate? Could it be that there are still lots of working-age people who are NILFs (not in the labor force) because they had dropped out but are starting to come back? We don’t think so. Many of the NILFs are retired Baby Boomers. In addition, more young adults are going from high school to college rather than straight to work. Consider the following:

(1) Participation rate. If the labor force participation rate of the civilian working-age population were still 65%, as it was when the unemployment rate peaked at 10.0% during October 2009, then the unemployment rate today would be 7.6% (Fig. 15). Instead, the jobless rate is only 4.4% because the participation rate has dropped to 62.8%.

Now, excluding people who are 65 years old or older from the numerator and denominator of the participation rate shows that the participation rate was 73.3% during June (Fig. 16). Removing 16-24 year olds as well results in a 77.2% participation rate.

(2) Employment/population ratio. Doing a similar analysis of the employment/population ratio shows it at 60.1% during June (Fig. 17). Excluding seniors, it was 70.1%; excluding seniors and juniors brings it up to 74.5%. It’s certainly hard to see any slack in the unemployment rate for 25-54 year olds, which fell to only 3.8% during June (Fig. 18).


Go With the Capital Flows

July 25, 2017 (Tuesday)

See the pdf and the collection of the individual charts linked below.

(1) Dollar moved down as global economy was moving on up. (2) Dollar peaked after Trump won and before latest two Fed rate hikes. (3) Draghi and Kuroda are more dovish than Brainard and Yellen. (4) Our international capital flows proxy turned less bullish for the dollar last year. (5) International reserves holdings by central banks also a good barometer for the dollar. (6) Draghi has done whatever it takes, yet the euro is strengthening again. (7) Are emerging markets less prone to Fed tightening tantrums? (8) Oil and the dollar divergence is unusual.


Currencies I: Our Doves vs Theirs. The neighborhood is improving. Since late last year, the global economy has been showing signs of better growth that seems to be outpacing US growth. That’s most likely why the US trade-weighted dollar is down 7% to 116.90 since peaking at 126.21 on January 11 (Fig. 1). That’s after it rose 26% from 99.89 on July 1, 2014 to this year’s peak, with the rally reflecting the fact that the Fed started to normalize monetary policy during the second half of 2014, while the ECB and BOJ remained committed to maintaining their ultra-easy monetary policies.

The Fed had greater confidence in the US economy than the ECB had in the Eurozone’s economy and the BOJ had in Japan’s economy. So the Fed terminated QE on October 31, 2014, hiking the federal funds rate by 25bps at the end of 2015, and again at the end of 2016. The dollar jumped after Donald Trump’s Election Day victory boosted animal spirits and expectations of stimulative fiscal policies. While those high hopes haven’t been dashed, they certainly have been postponed given the ongoing turmoil in DC that’s weighed on the dollar.

The dollar peaked on January 11 despite another two Fed rate hikes of 25bps so far this year on March 15 and June 14, while the official rates of both the ECB and BOJ remain slightly south of zero (Fig. 2). Furthermore, despite speculation that the ECB and BOJ might soon join the Fed in normalizing their monetary policies, the assets on both their balance sheets continued to grow. They recently exceeded the Fed’s assets, which have been flat around $4.4 trillion since QE was terminated during October 2014 (Fig. 3). As Melissa and I wrote yesterday, both ECB President Mario Draghi and BOJ Governor Haruhiko Kuroda signaled last week that they are in no rush to normalize given that their CPI inflation rates remain below their 2.0% targets.

This suggests that perhaps the dollar might stop falling. We don’t expect it will resume rallying. More likely is that it will move sideways for a while. Consider the following:

(1) Easy does it on Fed tightening. Melissa and I have noted that during her congressional testimony on monetary policy during July 12 and 13, Fed Chair Janet Yellen reiterated that the FOMC is still committed to rate hikes. However, she added that her goal is to reach a neutral level of interest rates that is lower than it has been historically and not so far off from where the federal funds rate is set now.

She thus supported a similar view expressed by her colleague (and BFF) Fed Governor Lael Brainard, who said in a 7/11 speech that “the neutral level of the federal funds rate is likely to remain close to zero in real terms over the medium term.” Considering that, there would not be “much more additional work to do on moving to a neutral stance” from the moderately accommodative stance now. She added that the FOMC “decided to delay balance sheet normalization until the federal funds rate had reached a high enough level to enable it to be cut materially if economic conditions deteriorate.”

(2) Brainard’s dollar dialectic. Brainard’s speech was all about the impact of the Fed’s monetary normalization on the dollar. It was titled “Cross-Border Spillovers of Balance Sheet Normalization,” and mentioned “exchange rate” 47 times in her comments and footnotes, obviously acknowledging that the foreign exchange value of the dollar is now an important consideration in the setting of monetary policy. Brainard seemed to conclude that it is best to lean toward reducing the balance sheet, as it should put less upward pressure on the dollar than raising interest rates, in her opinion. In other words, rate-hiking might end soon once balance-sheet reductions start.

These dovish sentiments have been reflected in the recent weakness of the dollar, in our opinion, while the dollar’s rally from mid-2014 through early 2016 discounted the divergent monetary policy in the US and elsewhere—i.e., the gradual normalization of US policy and the continuation of ultra-easy policy in the Eurozone and Japan. On a relative basis, it seems to us that Draghi and Kuroda are even more dovish than Brainard and Yellen, which is why the dollar should stop falling.

Currencies II: Capital Flows Weaken Dollar. The value of the trade-weighted dollar is driven by the US trade balance with the rest of the world and by US capital inflows and outflows. The US has been running a trade deficit with the rest of the world for many years. The flip side of the US trade deficit is the trade surplus of the world with the US (Fig. 4). This trade surplus provides foreigners with dollars, which they can use to purchase US assets. If they would rather convert them to their own currencies, then the dollar will depreciate, unless foreign central banks intervene by purchasing the dollars and holding them as international reserves. Many foreign central banks have been inclined to do so over the years, supporting the dollar, because otherwise strength in their currencies relative to the dollar might depress the competitive position of their exports in America, the world’s largest market for foreign goods.

Debbie and I calculate implied net capital flows of the rest of the world (ROW) simply by subtracting the ROW’s trade surplus, on a 12-month basis, from the 12-month change in the non-gold international reserves held by the central banks of the ROW (Fig. 5). Our proxy is highly inversely correlated with the trade-weighted dollar on a y/y basis. Let’s have a closer look:

(1) Implied net capital flows & the dollar. Since the financial crisis of 2007/08, there have been a few significant swings in our proxy (Fig. 6). It showed large net outflows from the ROW during 2008, 2012, and 2014/15—coinciding with periods of strength in the dollar. There were net capital inflows for the ROW during 2010/11 and a significant easing in net capital outflows since early 2016—coinciding with weakness in the dollar.

(2) International reserves & the dollar. Most of the volatility in our proxy is attributable to the yearly change in international reserves held by the ROW, which is also highly inversely correlated with the trade-weighted dollar (Fig. 7). When the ROW’s reserves are increasing, that shows that foreign central banks are accumulating reserves mostly in dollars to keep their currencies from appreciating relative to the dollar. Most recently, reserves fell by $877 billion during the 12 months through January 2016, which coincided with the dollar’s strength. Over the past, 12 months through April, the proxy showed net capital outflows of only $49 billion.

Finally, there is even a better fit between the yearly percent change (rather than the y/y change) in international reserves and inverse of the yearly percent change in the trade-weighted dollar (Fig. 8). The former was flat y/y through April, but that’s better than the recent trough of -7.2%.

Currencies III: For Draghi, Strong Euro a Drag. Draghi’s dovish tone last week must have been related to the recent strength in the euro (Fig. 9). It is up from last year’s low of $1.04 to $1.16 currently. To an important extent, Draghi’s rounds of ultra-easy monetary policies were aimed at depreciating the Eurozone’s currency. His “whatever it takes” speech on July 26, 2012 didn’t do that at first, as the euro actually rose from $1.23 on that day to peak at $1.39 during May 6, 2014.

Draghi resorted to a shock-and-awe approach with negative interest rates starting on June 5, 2014 followed by a QE program on January 22, 2015, and an expansion of that program on March 10, 2016. That all worked to bring the euro down to last year’s low of $1.04.

What can Draghi do if the euro continues to strengthen? Not much other than to coo dovishly as often as possible.

Currencies IV: EM Currencies Emerging Again. Perversely, the weakness in the dollar since early this year may have something to do with the Fed’s two rate hikes during March and June. As noted above, Fed officials have been softening the blows by saying that the rate hikes should be gradual, and might be over relatively soon. Furthermore, the dollar may have weakened because the rate hikes haven’t had any adverse impact on the bonds, currencies, and stock markets of emerging market economies. There have been no tightening tantrums in any of those financial markets.

This suggests that emerging markets may be able to handle Fed rate hikes, at least gradual ones, without any adverse consequences. Indeed, the Emerging Markets MSCI stock price index is up 18.9% y/y in local currency through last Friday and 21.7% in US dollars (Fig. 10). The Emerging Markets MSCI Index Currency Ratio is up 2.3% y/y (Fig. 11).

Currencies V: Slippery Slope. The price of a barrel of Brent crude oil has had one of the best inverse correlations with the trade-weighted dollar since 2005 (Fig. 12). However, they’ve diverged so far this year, with the former down 14% ytd, while the latter is down 7% over the same period. In the past, a weak dollar would have been bullish for oil. Since we think causality runs both ways, weak oil prices should be bullish for oil. We think there is a better fundamental case to be made for weak oil prices than for a weaker dollar from this level.


Summertime Lullaby

July 24, 2017 (Monday)

See the pdf and the collection of the individual charts linked below.

(1) Porgy, Bess, and all that bullish jazz. (2) Bull to bear: “Hush up, little baby.” (3) Summertime, and the bears are still hibernating. (4) The 2-by-2-by-2 scenario is the consensus. (5) Worry list: Central banks’ balance sheets, reflation, and the swamp. (6) ECB and BOJ not rushing to normalize. (7) S&P 500 Financials stall on flatter yield curve, lack of volatility for trading desks, and lackluster loans. (8) Movie Review: “Dunkirk” (+ + +).


Strategy I: Jazzy Opera. “Summertime” is the aria in the opera Porgy and Bess (1935) composed by George Gershwin. The song became a popular and much-recorded jazz standard, with more than 33,000 covers by groups and solo performers. During these hot summer days, I sometimes like to listen to Ella Fitzgerald sing: “Summertime, and the livin’ is easy. Fish are jumpin’, and the cotton is high. Oh, your daddy’s rich, and your ma is good-lookin’. So hush little baby, don’t you cry.”

For stock investors, the living has been relatively easy since March 2009, when this great bull market started. It would have been far easier if we all fell asleep since then and just woke up occasionally to make sure we were still getting rich. There have been plenty of reasons to wake up crying. But the bull kept singing a lullaby that hushed us all up. Now it seems that we are all getting lulled to sleep by the monotonous advance of stock prices. They just keep heading to new record highs with less and less volatility (Fig. 1 and Fig. 2). Consider the following:

(1) Vix. The S&P 500 VIX fell to a record low 9.36 last Friday (Fig. 3). It had spiked to 28.14 early in 2016 on fears of four Fed rate hikes that year. The Brexit scare last summer caused it to spike to 25.76.

(2) High-yield spread. The yield spread between the high-yield corporate bond composite and the US Treasury 10-year bond remains extremely low around 325bps despite the recent weakness in the price of oil (Fig. 4). That spread widened dramatically from 253 bps on June 23, 2014 to 844 bps on February 11, 2016, when the price of oil plunged. Not surprisingly, the spread is highly correlated with the VIX (Fig. 5). Both suggest that investors are enjoying a summertime siesta.

(3) Sentiment. So does the Investors Intelligence survey, which shows that only 16.7% of investment advisers are bearish (Fig. 6). This series is also highly correlated with the VIX. The Bull/Bear Ratio was back above 3.00 last week (Fig. 7).

Strategy II: Hot Towns. It certainly is summertime in DC, Baltimore, Wilmington, Philly, and NYC. I was visiting our accounts in those hot cities last week. The heat is making all of us drowsy. That’s especially since the consensus seems to be very much at ease with an economic outlook that’s bullish for stocks. It’s easier to fall asleep when one has few worries. There’s also no noise coming from the VIX to wake us up. However, I found that some accounts are concerned about the lack of volatility and the proliferation of bullish sentiment from a contrarian perspective, but they don’t seem to be losing too much sleep over it.

Almost everyone seems to share my view, which I first mentioned in early 2013, that the risk is a melt-up that might set the stage for a meltdown. A few wondered why I still viewed it as a risk rather than a reality or at least a clear and present danger. Of course, the only trouble with a melt-up is that we must be wide awake to decide when to get out of stocks. I conceded that we might very well be starting a melt-up.

The consensus scenario that seems to be lulling everyone to sleep this summer is as follows: The economy will continue to grow at a leisurely pace, with real GDP rising 2.0% and inflation remaining just below 2.0%. This is certainly not a boom, which therefore reduces the risk of a bust. No boom, no bust (NBx2)! So the economic expansion could last for a long while. Back in 2014, Debbie and I explained why it might last until March 2019. It will be the longest expansion on record if it lasts until July 2019. Everyone has plenty of explanations for why wage inflation hasn’t rebounded and might remain subdued while the unemployment rate is so low and might stay that way. The Fed should continue to raise rates, but monetary normalization will remain very gradual, and the federal funds rate might peak at only 2.00% this cycle.

I am officially dubbing this the “2-by-2-by-2” scenario, with real GDP growing 2.0%, inflation at 2.0%, and the federal funds rate at 2.00%. This is the consensus currently, in my opinion, based on my discussions with some of our accounts, most recently in the Mid-Atlantic states.

So what could go wrong? What might lead to a meltdown (either a nasty correction or a bear market) without a stage-setting melt-up first? Consider the following:

(1) Central bank balance sheets. A few accounts last week raised some concerns about the adverse consequences on the stock and bond markets if the Fed, ECB, and BOJ all were to start to reduce the sizes of their balance sheets from June’s levels of $4.4 trillion, $4.7 trillion, and $4.5 trillion, respectively (Fig. 8). While the Fed is set to proceed, Fed officials seem to be signaling that they might slow or postpone rate hikes once they start to reduce their balance sheet. Neither the ECB nor the BOJ seem to be in any rush to halt their ultra-easy policies.

Last week, ECB President Mario Draghi expressed concern about the risk of a slowdown in bank lending and low annual CPI inflation in the Eurozone (Fig. 9 and Fig. 10). During his 7/20 press conference, Draghi observed that inflation was 1.3% y/y in June, down from 1.4% in May, mainly due to lower energy price inflation. That’s below the ECB’s target of close to, but just below 2.0%. Measures of underlying inflation remain low, he further noted, and do not appear likely to pick up.

Answering a question about inflation expectations, Draghi explained: “[B]asically, inflation is not where we want it to be, and where it should be. We are still confident that it will gradually get there, but it isn’t there yet.” Reiterating his prepared introductory statement, he continued: “Therefore a very substantial degree of monetary accommodation is still needed for underlying inflation pressures to gradually build up and support headline inflation developments in the medium term.”

Draghi added: “But let me just make clear one thing: after a long time, we are finally experiencing a robust recovery, where we only have to wait for wages and prices to move towards our objective. Now, the last thing that the Governing Council may want is actually an unwanted tightening of the financing conditions that either slows down this process or may even jeopardise it.” Reading from the introductory statement again, Draghi repeated: “If the outlook becomes less favourable or if financial conditions become inconsistent with further progress towards a sustained adjustment in the path of inflation, we stand ready to increase our asset purchase programme in terms of size and/or duration.” Citing the Bank Lending Survey for Q2, however, Draghi observed that bank lending rates are currently at supportive levels, credit standards have further eased, and loan growth continues to be supported by demand.

Also last week, despite a recent slowdown in the pace of monthly purchases, the BOJ maintained its annual purchase target of “more or less the current pace” of 80 trillion yen in Japanese Government Bonds (JGBs). The bank also maintained its “QQE with YCC” policy, targeting 10-year JGB yields at around zero percent, with the short-term rate held at -0.1%. No change was made to the inflation target of 2.0%. However, the BOJ lowered its median CPI inflation forecasts last made during April as follow: to 1.1% from 1.4% for 2017, to 1.5% from 1.7% for 2018, and to 2.3% from 2.4% for 2019 (Fig. 11). Excluding the effects of the consumption tax hike, the bank expects CPI inflation to reach just under 2.0% around 2019. While the forecasted growth rates for Japan’s economy were somewhat higher than the previous ones, risks “to both economic activity and prices are skewed to the downside,” according to the BOJ’s “Outlook for Economic Activity and Prices (July 2017).”

(2) Inflation. While the major central banks are struggling to push inflation up to their 2.0% targets, I did run into one person in NYC last week who believes that both growth and inflation soon will make comebacks in the US because he is convinced that the Millennials are on the verge of getting married, having kids, and buying houses. I was skeptical, but remain open-minded about that possibility. I told him when I see it in the data, I’ll believe it.

My friend and I agreed that there are three possible scenarios. There’s the consensus sleepy, but bullish, 2-by-2-by-2 scenario. There’s my sleep-depriving melt-up scenario. There’s his sleep-jarring inflation scenario, which would force the Fed to tighten monetary policy at a more normal rate and might trigger a meltdown. My subjective probabilities on these three currently are 40%, 40%, 20%. I’m thinking about raising the odds of a melt-up above 50%, but the summer heat is slowing me down.

(3) The swamp. It’s certainly the dog days of summer in Washington, DC. President Donald Trump has called on members of Congress not to flee the city to go on their summer vacations but to stay and work until health care reform has been accomplished. It was mighty hot there last week when I stayed overnight at the Watergate Hotel, just for the fun of it. Even hotter is the political fighting between the Republicans and Democrats and infighting among the Republicans. However, the bull market couldn’t care less. There’s always the possibility of a selloff if the latest round of gridlock is so bad that another debt-ceiling deadlock could force yet another government shutdown. Then again, this bull market seems so charged up that a shutdown might be welcomed: If we can’t drain the swamp, then let’s shut it down.

Banks: Hits & Misses. High expectations and low interest rates and volatility are putting a damper on S&P 500 Financials’ Q2 earnings season. While most EPS results beat expectations, they failed to light a fire under the sector’s stock index. While it is up 29.7% y/y through Friday’s close, making it the second-best-performing S&P 500 sector over that period, over the last week the sector fell 0.3%, making it the third-worst-performing sector (Fig. 12).

Here’s the performance derby for the S&P 500 and its 11 sectors over the past week through Friday’s close: Utilities (2.6%), Tech (1.1%), Health Care (1.1), Consumer Discretionary (1.0), Telecom Services (1.0), Real Estate (0.8), Consumer Staples (0.6), S&P 500 (0.5), Materials (0.0), Financials (-0.3), Energy (-0.5), and Industrials (-1.0) (Table 1).

Despite the disappointment, forward earnings expectations for Financials remain optimistic. Analysts expect the sector’s revenues to grow 3.7% over the next 12 months, and earnings to increase by 12.3% (Fig. 13). As a result, Financials boasts the third-highest forward earnings growth of the 11 S&P 500 sectors (Table 2).

At 13.9, the industry’s forward P/E has rebounded from its recessionary lows, which will make further expansion tougher to come by (Fig. 14). However, the sector’s stocks should climb along with earnings, bolstered by higher dividend payments, stock buybacks, and a friendlier political environment. Here’s a quick look at some of the highlights of the Q2 earnings Financials have reported so far:

(1) Flattening spreads. Hopes were high that interest rates on long-term bonds would have risen by now, giving a boost to banks’ net interest margins. However, the 10-year Treasury yield is lower today than it was in December, while short-term interest rates have continued to climb (Fig. 15). As a result, the spread between the fed funds rate and the 10-year Treasury, which ran up to 213 bps on December 14, 2016, fell back to a low of 98 bps during June 26 of this year. The spread widened slightly in recent weeks to 111 bps (Fig. 16).

Bank of America’s Q2 net interest income may have risen by 8.6% y/y to $11.0 billion, but it fell by $72 million from Q1. The bank warned in May that the sale of a business and the interest-rate environment would weigh on results, the 7/18 WSJ reported. Banks earnings have room to improve dramatically if long-term interest rates rise. Their best chance may come this fall if the Fed goes through with reversing quantitative easing. Wall Street remains optimistic about the S&P 500 Diversified Banks industry, penciling in forward revenue growth of 4.0% and forward earnings growth of 12.2% (Fig. 17).

(2) Unprofitable VIX. Record-low volatility in the stock market and a sharp drop in the price of oil combined to hurt trading results for most financial players. As we mentioned above, the CBOE Volatility Index hit its lowest level since 1993 on Friday, July 14, in part because the stock market in the past year has gone only in one direction: up. The three major stock indexes in the US, Europe, and Asia have yet to pull back by 5% or more this year. “Never in at least the past 30 years have all three indexes—the S&P 500, MSCI Europe and MSCI Asia-Pacific ex-Japan—gone a calendar year without falling at some point by at least 5%,” a 7/19 WSJ article reported.

The markets took their biggest bite out of Goldman Sachs’ results; Q2 revenue in its fixed-income, currency, and commodities trading business fell 40% y/y. The declines were less dramatic at other shops, but the area was a drag nonetheless. FICC revenue fell 6% at Citigroup, 14% at Bank of America, and 4% at Morgan Stanley. Goldman still beat analysts’ estimates for the quarter, but leaned on profits from its private equity division to do so.

Wall Street’s analysts are forecasting 6.2% forward revenue growth and 14.4% forward earnings growth for the S&P 500 Investment Banking & Brokerage industry (Fig. 18).

(3) Languishing loans. There has been some concern about slowing loan growth given that we’re in the eighth year of an economic expansion. The y/y increase in C&I loans at banks was 1.4% in mid-July, slower than the 12% increases enjoyed just two years ago (Fig. 19). At BAC, Q2 loan growth was only 1.5% y/y, but at JPMorgan and PNC loans grew a bit faster, at 4.1%. The Pittsburgh-based bank said it expects loans to rise by a mid-single-digit rate for the full year.

Wall Street analysts are projecting some of the strongest results in the Financials sector to come from Regional Banks. Revenues is expected to grow 6.3% over the next 12 months for the S&P 500 Regional Banks industry, and earnings should jump 14.3% (Fig. 20).

Movie: “Dunkirk” (+ + +) (link) is one of the best-made war movies I’ve seen because it depicts the brutal intensity of war with no time for frivolous banter. It certainly shows how, for Britain, World War II was from the start about fighting first for survival, then for victory on the beaches, on the seas, and in the air, just as Winston Churchill proclaimed on May 13, 1940. There are plenty of British heroes, particularly the owners of small boats and ferries who participated in evacuating more than 330,000 mostly British and French soldiers in about 11 days from the beaches of Dunkirk before Hitler’s forces could annihilate them.



July 20, 2017 (Thursday)

See the pdf and the collection of the individual charts linked below.

(1) Can you say “goodbye to cash” in Swedish? (2) “Swish,” “zelle,” or “venmo” it to pay by phone. (3) Fewer hold-ups. (4) Cybercriminals cashing in. (5) It’s gloomy in India. (6) Services rain on India’s agricultural parade. (7) India MSCI not cheap. (8) Modi’s motives are questionable. (9) Cow vigilantes. (10) Economy decelerating in India. (11) RBI under pressure to cut rates as inflation plummets.


Banks: Going Mobile. One of Jackie’s friends is visiting family in Sweden this summer, and her cousin advised against exchanging dollars into krona. Unfortunately, the cousin wasn’t offering to pick up the tab for the visit. She was merely cautioning that cash is rarely used in Sweden. Many shop owners literally don’t accept paper currency. Some local banks don’t even have cash at their branches. Instead, Swedes are using electronic payments or credit cards to purchase just about anything. Electronic payments is just one of the many disruptive technologies that Jackie and I have been monitoring. I asked her to have a closer look—though on her PC in her home office rather with an all-expenses-paid trip to Sweden. Here is what she found:

Instead of using cash, Swedes are increasingly using Swish, an app downloaded to cell phones that lets users make or receive payments directly to or from their bank accounts. Something similar launched in the US last month. It’s called “Zelle,” and it has the backing of some of the largest US banks, including Chase, Bank of America, and Wells Fargo. Here’s a look at the two apps that may make cash as antiquated as gold coins or clam shells in the not-too-distant future:

(1) Swish it. Swish was developed in 2012 by Sweden’s largest banks, including Nordea, Handelsbanken, SEB, Danske Bank, and Swedbank. Only customers of those banks can use Swish—so our American friend will have to use her US credit cards.

The app uses cell phone numbers and an account with a participating Swedish bank to transfer money via cell phone or to make an Internet purchase. Transactions are free to consumers, presumably because it costs banks less money for transactions to occur in the ether than it would were hard currency used. Cash costs banks money. It has to be handled, counted, and transported.

Even Swedish churches have adopted the technology. Churches will display their phone numbers at the end of each service and ask parishioners “to use Swish to drop their contribution into the virtual Sunday collection,” explained a 6/4/16 article in The Guardian.

Using Swish is so popular in Sweden that “Krona notes and coins in circulation have fallen every year for the past decade and accounted for only a fifth of all payments in Swedish stores last year, far below the global average of 75%,” a 7/7 FT article reported.

(2) Fewer stickups, more fraud. The move to a cashless society in Sweden has led to a reduction in physical crime. “The Swedish National Council for Crime Prevention counted only 23 bank robberies in 2014, down 70 percent from a decade earlier. In the same period, muggings dropped 10 percent. While it’s unclear the extent to which the transition to cashless has affected the rate of street crime, police point out that there’s a lot less incentive to rob a bus driver, cabbie, or shopkeeper if they don’t accept cash. Many workers say they now feel much safer,” reported a 5/8/16 article in Wired.

However, having a cashless society may be escalating cybercrime. Fraud in Sweden—usually involving identity theft—has more than doubled, the Wired article continued. And that probably understates the amount of fraud occurring because Swedish banks don’t publicly share how often their customers’ card information is stolen. Privacy advocates have raised concerns that consumers are giving banks and app providers a lot of personal information about what they are purchasing.

(3) Zelle it? For a number of years, US consumers made person-to-person payments with apps like Venmo (a unit of PayPal Holdings), Apple Pay, and Google Wallet. These apps lured away banking clients, especially Millennials, who turned “venmo” into a verb.

But last month, the big banks drew a line in the sand. They launched Zelle, undoubtedly in hopes of retaining customers. Zelle, which seems very similar to Swish, was built by Early Warning Services, a company owned by Bank of America, BB&T, Capital One, JPMorgan Chase, PNC, U.S. Bancorp, and Wells Fargo.

Today, Zelle is being offered by Bank of America, Capital One, Chase, Fifth Third Bank, First Bank, PNC, USBank, USAA, and Wells Fargo. Another 25 banks and credit unions have partnered with Zelle, but haven’t launched yet, according to

Zelle can be used to split a check with your friend or to make a payment to a business. Right now, banks are linking their smartphone apps to the Zelle transfer network, which will eventually be able to reach 86 million consumers. So, for example, Chase QuickPay is now QuickPay with Zelle. Later this year, a standalone Zelle app will be available to consumers and transfers will run on Visa’s and Mastercard’s payment networks.

(4) Zelle versus Venmo. A 2/22 Bloomberg article did a great job explaining the difference between Zelle and Venmo: “Request $40 from a roommate over the Zelle network using BofA's app, and the money shows up in your account within minutes of when he agrees to send it. On Venmo, that $40 would show up in your Venmo wallet right away, but then it stays there. To get the cash into your hands, you need to log into your Venmo account, cash out your balance, and wait—sometimes days—for the money to show up in your bank account.”

Venmo’s appeal is that it doesn’t require two customers to bank at the same institution. The two customers just have to have the Venmo app. Venmo also has a more social bent than Zelle. Venmo users can choose to make their transactions and any related messages public. Users will check their Venmo account just to see what friends are buying.

Which network will come out on top remains to be seen. But if the US market develops at all similarly to the Swedish market, the days of counting your greenbacks may be numbered.

India I: Monsoon Season. As I noted last week, Sandra Ward, formerly of Barron’s, has joined us as a senior contributing editor. She wrote an informative and relatively bullish piece on Brazil last week. This week, she isn’t as upbeat on India. Here is her take:

It’s monsoon season in India, one of the hottest emerging markets and, until recently, the fastest-growing big economy the past three years. The drenching rains tend to send spirits soaring and set expectations for a strong agricultural harvest and subsequent boost in farmers’ fortunes and surge in consumer spending. The giddiness often spills into the stock market, as a 5/10 Times of India article observed at the start of this rainy season. The S&P BSE Sensex set new highs last week, its best weekly showing in four months (Fig. 1). After plunging Tuesday, as tobacco stocks reacted to new taxes, it quickly resumed its bullish track Wednesday.

Anyone betting on a correlation between a good monsoon and good stock market returns may end up all wet. Celebrating its 70th anniversary of independence on August 15, India is a whole lot less reliant on agriculture as an engine of economic growth than previously. Agriculture now represents 17.4% of gross domestic product, according to the World Bank, compared with 51.8% in 1950. The services sector, at 53.8%, is the biggest contributor to India’s GDP, up from 30% in 1950, and attracts the most foreign investment. Still, agriculture was the only sector where growth accelerated—up 4.9% y/y in India’s Q1, ended March—as total GDP growth slowed to a 6.1% pace. All other sectors decelerated, with services gaining 7.2% y/y compared with 10.0% in the previous year, and manufacturing slumping to a 5.3% gain versus an increase of 12.7% in the year-ago period. Construction turned negative, contracting by 3.7% y/y. Without the 31.9% y/y rise in government spending, growth in GDP would’ve been closer to 4.1%, said a 5/31 FT article.

The MSCI India Share Price Index, already up 25.8% in US dollars ytd through Tuesday’s close, looks vulnerable to a correction (Fig. 2). The MSCI India Index is trading at a forward P/E of 18.1, despite a forward earnings growth outlook of 15.5% and revenue growth expectations of 12.2% (Fig. 3 and Fig. 4). Here’s a look at some of the clouds that could rain on India’s economy and stock market:

(1) Modi’s honeymoon ending? Against a backdrop of a slowing economy and an expensive stock market, India’s reform-minded prime minister, Narendra Modi, is undergoing a reappraisal after enjoying an extended honeymoon since his election in 2014 on the promise of improving the business climate and creating jobs. There’s been much ink spilled on whether his bold moves to root out corruption and streamline India’s famously bureaucratic systems—including finally pushing through a unified Goods and Services Tax that was 17 years in the making—have been the right ones.

A 6/24 The Economist cover story criticized the reforms and job creation as illusory. The New York Times echoed those sentiments in a 7/17 editorial. It pointed out that Modi’s election promises have fallen short and voiced concern that the Hindu nationalist tendencies of his Bharatiya Janata Party are on the rise. Modi’s May ban on selling cattle for slaughter was widely seen as anti-Muslim and pandering to conservative Hindus, who hold cows sacred. His delay in condemning attacks by vigilantes on workers in the cattle-slaughter industry reinforced suspicions about the motive for the ban. The move also called into question his commitment to creating jobs and boosting exports: The $16 billion meat and leather industry employs millions and generates $4 billion in exports of beef and $6 billion in leather exports. For now, the ban has been suspended by India’s Supreme Court, a 7/11 Al Jazeera article pointed out.

Sentiment on Modi is souring to such a degree, a story in the 7/12 Indian Express noted, that a prospective bride and groom in the state of Uttar Pradesh called off their wedding after arguing about whether Modi is to blame for the current economic slowdown.

(2) Demon policy. No program, however, has engendered more controversy than Modi’s demonetization policy, instituted in a surprise move on November 8—the same day as US voters elected Donald Trump president. By banning 86% of commonly used bank notes, Modi slammed the brakes on commerce and consumer spending in the traditional cash-based society and has been widely blamed for throwing the economy into a tailspin.

India II: Running Out of Steam? While it’s easy to demonize the demonetization program as the cause of the current economic slowdown, truth be told, the economy began slowing long before demonetization took effect, though the currency ban certainly exacerbated the stresses. Consider the following:

(1) GDP. GDP growth has been decelerating for much of the last year. From a high of 9.1% y/y reported in Q1-2016, growth dropped to 6.1% in Q1-2017, down from 7.0% in the previous quarter, when demonetization began (Fig. 5).

(2) Households. Household consumption growth slowed to 7.3% y/y in Q1 from 11.1% the previous quarter (Fig. 6). Growth in household consumption had been slowing throughout 2016, and the Q4 jump likely reflected a surge in spending ahead of the ban, noted a 7/11 piece in Focus Economics.

(3) Capital spending. Capital spending has been slipping since Q4-2015 and is now firmly in negative territory for the first time since early 2014, contracting 2.1% y/y in the most recent quarter as banks have tightened lending standards and companies continue to be heavily indebted, the Financial Express explained in a 6/1 article (Fig. 7). Capital spending represented 28.5% of GDP in fiscal Q4-2017, down from 31.2% in fiscal Q1-2016.

(4) Government spending. Government spending rose 31.9% y/y in Q1, boosted by a pay raise for the bureaucratic sector, a not-insignificant prop to total GDP (Fig. 8).

(5) Production. Industrial production rose a measly 1.7% y/y in May, with the manufacturing and electricity industries supplying the gains, according to a 5/31 Moody’s Analytics article (Fig. 9). It cited supply bottlenecks and high debt levels as crimping factory output. Moody’s noted that a country the size of India should see industrial production expanding at double-digits.

(6) Inflation. Consumer price inflation reached a record low of 1.5% y/y in June, down from 2.2% a month earlier (Fig. 10). Food prices account for half the CPI, and they continue to drop following last year’s good monsoon season and disruptions in the food supply chain due to demonetization.

The challenges facing the Indian economy clearly are not reflected in the stock market. While Modi’s moves to retool the economy may prove effective in the long run, in the short run they have made a fragile situation more fraught. That’s led to increased pressure on the Reserve Bank of India (RBI) to cut interest rates by another 25 basis points when it next meets in August. The RBI last eased in October, when it cut rates by 25 basis points to 6.25%.

A rate cut could create more exuberance for stocks—and rate-sensitive issues such as banks and real estate would benefit, as would debt-heavy companies. But ultimately, when there’s a slowing economy and a soaring stock market, there will be a day of reckoning.


Gray Swans

July 19, 2017 (Wednesday)

See the pdf and the collection of the individual charts linked below.

(1) The Nirvana scenario. (2) Taleb’s birds. (3) Black Swans don’t have to be bad. (4) An industry of bird watchers. (5) Is predicting Black Swan events an oxymoron? (6) There are a few Gray Swans out there. (7) The Grayest Swan is a melt-up. (8) Healthcare reform is sinking in the swamp. (9) Are consumers retrenching or not? (10) A primer on ETFs and their potential contribution to a meltdown.


Strategy: Pesky Birds. If inflation remains subdued and the economic expansion continues, bond investors should earn yields on their bonds surpassing inflation. If this scenario persists for five to 10 years, they should earn a modest real return as long as their bonds mature over the same period. They are unlikely to have significant capital losses or gains along the way. Stock prices should continue to rise along with earnings and dividends.

Of course, it’s never quite so easy to predict the outlook for bonds and stocks. There are those pesky Black Swans that could show up when they are least expected. Black Swan events were discussed by Nassim Nicholas Taleb in his 2001 book Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets, which focused on financial events. His 2007 book The Black Swan: The Impact of the Highly Improbable generalized the metaphor as follows:

“What we call here a Black Swan (and capitalize it) is an event with the following three attributes. First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme ‘impact’. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable. I stop and summarize the triplet: rarity, extreme ‘impact’, and retrospective (though not prospective) predictability. A small number of Black Swans explains almost everything in our world, from the success of ideas and religions, to the dynamics of historical events, to elements of our own personal lives.”

Since the start of the current bull market, pessimistic prognosticators have industriously been anticipating all sorts of dire Black Swan events, including the disintegration of the Eurozone, a financial crisis in China, currency wars, and many more. Geopolitical crises also might turn into Black Swan events. Not surprisingly, none of these terrible prospects actually happened, since by definition Black Swans are very hard to predict. Despite the symmetry of Taleb’s argument, Black Swans are widely associated with bad outcomes. Plenty come to mind that could trip up bond and stock investors:

(1) Inflation. First and foremost would be a significant revival of inflation. That would force central banks to raise rates. Bond prices would fall, and stock markets might do so once rates got high enough to cause a recession, which might be signaled by an inverted yield curve. I have often discussed in the past all the reasons why inflation might be dead for the foreseeable future.

(2) Monetary policy. The bears are saying that stocks will fall once the European Central Bank and Bank of Japan terminate their QE programs and start to normalize their monetary policies. Then again, they warned that once the Fed terminated its quantitative easing (QE) program, stock prices would fall. The program was terminated at the end of October 2014, yet the S&P 500 rose 21.9% through the latest record high on July 14 of this year.

(3) Geopolitics. Tensions between China and its neighbors, especially the ones allied with the US, could flare up as China continues to build small islands in the South China Sea to claim sovereignty over this important trade route. The Trump administration may take a tougher stance against the nuclear ambitions of North Korea and Iran, raising the chances of a military confrontation. Russian President Vladimir Putin seems intent on reviving the Soviet Union even if that provokes another Cold War, with the potential for dangerous skirmishes with NATO forces. However, in recent years, and certainly during the current bull market, stock investors have learned that selloffs triggered by geopolitical crises tend to be buying opportunities that don’t last long.

(4) Melt-up. In late 2012, a widely feared and anticipated Black Swan event was that the US economy would fall off a “fiscal cliff” in early 2013 because Democrats and Republicans couldn’t agree on a federal budget. When they did so at the start of the new year, I wrote that investors might have tired of looking out for Black Swans. I suggested that the Black Swan this time might be a melt-up in the stock market.

During the first half of 2017, I observed that money was pouring into exchange-traded funds (ETFs). That influx was driving a broad-based surge in stock prices, since the most popular ETFs tend to track the broad market indexes. The problem with the popularity of this investment style is that while it works great on the way up, it has the potential to worsen future corrections and bear markets, as indiscriminate selling of ETFs causes indiscriminate selling of all the stocks they include, no matter their fundamentals. Unlike mutual funds, ETFs don’t hold liquid assets to meet redemption orders; they have to sell stocks when investors decide to redeem.

(5) Contrarian alert. Contrarians were put on high alert at the end of June 2017, when Fed Chair Janet Yellen said at a London conference: “Would I say there will never, ever be another financial crisis? You know probably that would be going too far, but I do think we’re much safer, and I hope it will not be in our lifetimes, and I don’t believe it will be.” Yet she also described asset valuations as “somewhat rich if you use some traditional metrics like price earnings ratios.” Yellen turned 71 on August 13, 2017, so her lifetime may not be as long as yours. For someone who tends to be very precise, her use of “our lifetimes” sure leaves room for interpretation! In any event, her comment is reminiscent of other ill-fated predictions by Fed chairs—like Greenspan’s “once-in-a-century” technology and productivity revolution and Bernanke’s no “significant spillovers” stance on the subprime mortgage debacle.

I’ll go out on a limb and predict that there will be another financial crisis in our lifetimes. However, like previous ones, it likely will offer a great opportunity for buying stocks. For now, I’m seeing lots of White Swans, no Black Swans, and a few Gray Swans.

US Politics: The Swamp Thickens. Yesterday morning, we all learned that the GOP effort to repeal and replace Obamacare in the Senate had collapsed. This is a Gray Swan, I suppose. It doesn’t come as much of a surprise, though it is somewhat surprising that the Republicans can’t get their act together. The stock market presumably rallied following the November 8, 2016 presidential election because Donald Trump, a Republican, won with Republican majorities in both houses of Congress. That seemingly increased the chances that Trump’s Reaganesque policy agenda would get implemented quickly. Not so fast: The Republicans are badly split between moderates and conservatives. So is tax reform now dead too?

Senate Republican Leader Mitch McConnell announced that he was calling the bluff of his fickle GOP colleagues and planning a repeal-only vote, putting them on the line to act on the promise they had repeatedly made in their campaigns, with no excuses: “Regretfully, it is now apparent that the effort to repeal and immediately replace the failure of Obamacare will not be successful. So, in the coming days, the Senate will vote to take up the House bill with the first amendment in order being what a majority of the Senate has already supported in 2015 and that was vetoed by then-President Obama: a repeal of Obamacare with a two-year delay.”

Republican Senators Susan Collins of Maine, Shelley Moore Capito of West Virginia, and Lisa Murkowski of Alaska immediately declared they could not vote to repeal the Affordable Care Act without a replacement—enough to doom the effort before it could get any momentum.

In any event, McConnell may be trying to get the issue buried so he can move on to tax reform, while showing the base he tried everything he could. Some politicos are speculating that the failure of health reform would make tax reform more likely—because of political desperation by Republicans, who’ll need something to run on.

Maybe so, but Joe and I aren’t convinced that the stock market rally since Election Day was all about Trump and his agenda. Corporate profits started to recover last summer from the earnings downturn that was mostly attributable to the energy industry’s recession. S&P 500/400/600 forward earnings all rose to record highs again last week (Fig. 1). In addition, global economic activity has improved since late last year with many overseas stock markets outperforming the US’s since then (Fig. 2). Here is the global performance derby…

(1) … in local currencies since November 8, 2016: Japan (18.0%), EMU (17.8), Emerging Markets (14.9), S&P 500 (14.9), All Country World (14.6), and United Kingdom (8.2).

(2) … in dollars over the same period: EMU (22.3), Emerging Markets (16.5), All Country World (15.3), S&P 500 (14.9), United Kingdom (14.0), and Japan (9.6).

US Consumer: MIA? Another Gray Swan is the puzzling weakness in consumer spending. June’s retail sales remained stalled around record highs, falling unexpectedly for the second month. That’s surprising given that payroll employment rose 222,000 during June following May’s 152,000 gain. Both are solid gains. Could it be that consumers are retrenching because of policy uncertainty in Washington, DC? Will they be relieved that Obamacare remains the law of the land? Or do they recognize that it is no bargain, and may be imploding in any case? Perhaps they’ve been hard hit by higher out-of-pocket costs for health care and are retrenching on discretionary purchases.

June’s total retail sales was down 0.2% m/m following a 0.1% decline in May (Fig. 3). Some of the weakness was attributable to gasoline sales, which declined along with the pump price (Fig. 4). Car sales have stalled in recent months (Fig. 5).

On the other hand, our Earned Income Proxy for private-sector wages and salaries rose to another record high in June, gaining 0.6% m/m and 4.5% y/y. Retail sales excluding gasoline has closely followed our proxy (Fig. 6). Debbie reports that adjusted for inflation, retail sales during the three months through June rose 4.9% (saar) from the previous three months (Fig. 7).

ETFs: 50 Shades of Gray. Equity ETFs are creating a new market structure that hasn’t been seriously stress-tested by a sharp decline in stock prices. Could the recent record inflows into ETFs, which have clearly boosted the stock market over the past year, turn into significant outflows that exacerbate or even cause the next bear market? ETFs still represent a small share of the markets, constituting less than 10% of US equity market capitalization, according to a May 2017 academic paper found on SSRN. That’s too small to matter, assuming all is functioning as it should. But ETFs could turn dysfunctional under stress if hordes of retail investors get spooked and sell their ETF shares all at once. Below, I’ve asked Melissa to have a closer look at this possibility:

(1) Similar shades. Created in the 1990s, ETFs were developed primarily as a vehicle for long-term investors to passively track indexes. Active ETFs have also since come to the markets, but there are a lot fewer of them than passive ones. One selling point of ETFs over their close cousin, traditional open-end mutual funds, for investors is that they don’t have to wait until the end of the day to buy or sell them. ETFs trade all day long, while traditional open-end mutual funds trade only at the market’s close of trading each day at the net asset value (NAV) of the underlying securities (although orders can be placed on traditional open-end mutual funds throughout the day). An ETF’s price, on the other hand, might represent a premium or a discount to the underlying securities, although the goal is to track the designated mix of underlying securities (such as an index in the case of passive ETFs) as closely as possible.

(2) Shadow market. Only those deemed “authorized participants” (APs) by the Securities and Exchange Commission (SEC) with ETF dealer agreements have the power to create and redeem ETF shares. APs buy in the primary market the underlying securities with which to create a basket of stocks at a prescribed mix (e.g., the same as that of the S&P 500 if its being tracked) to form the ETF shares, i.e., “creation units.” The portfolio of assets underlying ETF creation units are held in a trust. The opposite, “redemption units,” are existing ETF shares that APs transform back into the underlying securities, which may be sold back on the primary market. So far, so good.

While the above all occurs in the primary market, most of the action happens in the secondary market, where ETF shares are traded rather than the underlying securities. In fact, only 10% of daily activity in all ETF shares occurs on the primary market, according to a 2015 ICI study. It’s in the secondary market where retail investors can play, buying and selling ETF shares on a stock exchange like the shares of most publicly traded companies.

Here’s where it gets interesting. By nature, the price of ETFs on the secondary market doesn’t always perfectly equal the NAV of the underlying securities—thus creating an arbitrage opportunity for APs, who bring the ETF price back to equilibrium NAV by way of simple supply and demand. Everyone is happy.

By the way, the spread between an ETF’s intraday price and its NAV may also simply be traded away due to normal price fluctuations on the secondary market (“in-kind” between ETF shares), or on the primary market (among the underlying assets) absent any creation or redemption of ETF shares, or arbitrage transaction. It’s also important to note that APs are not under any obligation to engage in these transactions and only do so for their own benefit.

(3) Silver knights. So how does the arbitrage opportunity work? ICI neatly explained it in a 2012 blog post:

“When an ETF is trading at a premium to its underlying value, authorized participants may sell short the ETF during the day while simultaneously buying the underlying securities. At the end of the day, the authorized participant will deliver the creation basket of securities to the ETF in exchange for ETF shares that they use to cover their short sales. The authorized participant will receive a profit from having paid less for the underlying securities than it received for the ETF shares. The additional supply of ETF shares also should help bring the ETF share price back in line with its underlying value.

“When an ETF is trading at a discount, authorized participants may buy the ETF shares and sell short the underlying securities. At the end of the day, the authorized participant will return ETF shares to the fund in exchange for the ETF’s redemption basket of securities, which they will use to cover their short positions. The authorized participant will receive a profit from having paid less for the ETF shares than it received for the underlying security. The lower supply of ETF shares available also should help bring the ETF share price back in line with its underlying value.”

But what happens if a subset of the APs lacks enough incentive to step in? That could be the case either because the risk outweighs the benefit of doing so or because they don’t have the capital or credit to do so. Well, the good news is that the ratio of APs to ETFs is greater than 1 to 1. On average, each ETF has about 34 agreements, according to the previously cited 2015 ICI study. However, they might not all be active. On the other hand, one AP might represent multiple external institutional market-makers that are participating in the arbitrage game through the APs. The point is: if one AP (or market-maker) is out, another will likely step in. For example, when the high-frequency ETF trading market-maker Knight Capital Group experienced a technology glitch in 2012, it severely impaired the firm’s capital base. Consequently, the firm’s ability to provide liquidity in the ETF markets caused ETF spreads to widen. However, the gap was temporary. Knight reportedly enlisted the help of rival market-makers to provide adequate liquidity to restore balance to those shares impacted.

(4) Ashes, ashes. But what if all of the APs decide to take a metaphorical cigarette break at the same time? Well, the odds of that are as slim as a Black Swan event. But it could theoretically happen if investor confidence is so shaken that ETF prices come tumbling down faster than APs would dare to step in. ETF spreads could widen. Retail investors trying sell their ETF shares on the secondary markets might receive only the discounted price for their shares rather than the NAV of the underlying securities.

That situation could be bad for markets, but how bad depends on how big ETFs are relative to the markets, which is not that big. It could get really bad if the situation caused retail investors more broadly to pull their money out the markets. “There is no market mechanism to stop how perceived informed traders can cause other market participants to change behavior and sell alongside,” wrote Dean Barr in a relevant LinkedIn post. But they’d all probably be doing so anyway if they were spooked enough to sell their shares of ETFs en masse in the first place. In other words, we’d probably all have bigger problems than ETFs on our hands in that scenario (a North Korea gone ballistic is one example that comes to mind).

(5) Uncertainty principle. Ari Rubenstein, CEO and co-founder of Global Trading Systems LLC, told lawmakers at a 6/27 House Financial Services Committee hearing: “In some ways the markets are a bit untested … It’s definitely something we should talk about to make sure industry participants are prepared in those instruments.” Rubenstein was apparently referring to the untested nature of ETFs during a period of stress, according to a recent Bloomberg article.

By the way, financial markets blogger “Heisenberg” made a couple of interesting points in a 2/21 article for Seeking Alpha. The article explained that one of the selling points that ETF managers make to investors is that ETFs help to lower market volatility because large blocks of ETF shares can trade on the secondary market without impacting the price of the underlying securities. But that might not be a good thing, according to the author Heisenberg, because if “one day” everyone was “dumping” ETFs, the ETF model “goes out the window.” Ironically, elaborates the author, the advent of ETFs may have worsened the liquidity of the underlying assets by creating demand for the ETF portfolio in lieu of the assets themselves.

(6) Gray area. To address potential liquidity issues, the SEC passed a 400+ page rule pertaining to ETFs at the end of 2016 for which compliance dates begin in 2018. According to a summary of the rule from a March 2017 Morgan Lewis panel, most ETF firms would be required to establish and execute a written liquidity risk management program, required to be disclosed to the SEC.

The rule further stipulates that ETFs are prohibited from acquiring illiquid assets that would cause illiquid holdings to exceed 15% of the fund’s net assets. The SEC’s rule seems like a reasonable step in the right direction. However, some gray area remains, in our opinion. Illiquid assets are well defined as those that would be difficult to sell within seven calendar days at a reasonable price (i.e., not at a fire sale price). However, it seems to us that that it would be hard to predict what would happen if liquidity problems were to occur for assets that were already acquired. The SEC specifies that the rule is not intended to create “fire sales,” but that doesn’t mean that they can’t happen.


Orient Express

July 18, 2017 (Tuesday)

See the pdf and the collection of the individual charts linked below.

(1) Stir-frying China’s economic growth with lots of debt. (2) Don’t bet against a billion people. (3) China following Japan down the same road. (4) Chinese economy getting Botoxed as it ages and slows. (5) Premier Xi doing more of the same. (6) Social financing and bank lending at record highs. (7) A bit of good news: Shadow banking doing less of the lending, and capital outflows slowing. (8) Aging is a drag on China. (9) Improving margins.


China: The Xi Dynasty. China’s real GDP rose 6.9% y/y during Q2 (Fig. 1 and Fig. 2). During the quarter, it rose 6.7% (saar), which it’s been hovering around since the end of 2013. That’s a slowdown from the 10%-plus pace that was the norm in the years prior to the global financial crisis of 2008 and for a couple of years afterwards. Nevertheless, China’s growth rate is impressive compared to those in most other countries in the world. Even more impressive is how much credit it is taking to prop up China’s growth. Of course, this isn’t impressive in a positive way, since economic growth financed by excessive debt often ends badly.

Nevertheless, Melissa and I aren’t among China’s doomsayers. We don’t want to bet against over a billion Chinese people who are mostly hard-working, entrepreneurial, aspirational, and materialistic—kind of like Americans. Instead of a big-bang implosion, China may follow the path of Japan. China is going down the same demographic road as Japan, with a rapidly aging population. Both countries have piled up lots of debt to boost growth. Both are financing their debt extravaganzas mostly internally. Both of their central banks are pumping massive amounts of liquidity into their economies. So, like Japan, China’s economic growth inevitably will slow as the population continues to age. All the injections of debt are akin to injections of Botox, which can make you look younger while you age and slow down. Consider the following:

(1) Social financing. Total social financing over the past 12 months through June rose by a record 19.2 trillion yuan, or a record US$2.8 trillion (Fig. 3). It has been on a tear since the Chinese government pumped up the economy in response to the financial crisis of 2008. The country has become increasingly addicted to debt, and can’t seem to break the habit despite government officials’ previous assurances that will happen. It hasn’t happened so far because the government hasn’t figured out any other way (such as free-market capitalism) to boost growth. Since Premier Xi Jinping assumed command during November 2012, social financing has totaled a whopping $11.2 trillion, with bank loans up $6.4 trillion!

(2) Bank loans & M2. Bank loans are the largest component of social financing. Over the past 12 months through June, they rose by a record 13.2 yuan, or a record US$1.9 trillion (Fig. 4). Astonishingly, bank loans have more than tripled since the end of 2008, soaring by 280% to a record $16.8 trillion during June (Fig. 5).

The good news—we guess—is that all of this bank debt has been financed entirely by an increase in M2. So the Chinese owe it to themselves, similar to what has been happening in Japan for many years.

(3) Shadow banking system. Also mildly encouraging—we guess—is that the authorities seem to be making a bit of progress throttling back the shadow banking system. We estimate shadow banking activity by subtracting bank lending from total social financing (Fig. 6). Doing so suggests that on a 12-month basis, the shadow banks accounted for a record 55.1% of social financing through May 2013 (Fig. 7). That percentage fell to a recent low of 25.1% through July 2016. It was back up to 31.3% in June of this year.

(4) PBOC & capital flows. The Chinese government’s efforts since early last year to stem capital outflows are showing some signs of success. The PBOC’s non-gold international reserves, which peaked at a record $4.0 trillion during June 2014, fell to $3.0 trillion during December 2016 (Fig. 8). It has been stable since then through June. The yuan fell along with reserves, but has firmed up since making a recent low on January 3.

Debbie and I calculate an implied international capital flows proxy by subtracting China’s 12-month trade surplus from the 12-month change in China’s international reserves (Fig. 9 and Fig. 10). It still shows a significant net outflow of $602 billion over the past 12 months through June, but that’s a big improvement from the record $1.18 trillion through January 2016.

(5) Industrial production & trade. Just for fun, we compare the growth rates of China’s bank loans to industrial production and track the ratio of the former to the latter (Fig. 11 and Fig. 12). The ratio of bank loans to industrial production confirms our concerns about China’s increasingly debt-financed growth. All that debt seems to be having a decreasing impact on boosting economic growth. The ratio was relatively stable around 100 from 2000-2008. Since then, it has risen sharply and persistently to a record 170 during June. The Chinese seem to be getting less and less output bang per yuan.

The good news is that China’s trade data (in yuan) has improved significantly since early last year, with both exports and imports near record highs in June (Fig. 13). The y/y growth rates for these categories were strong at 16.9% and 22.6% (Fig. 14). The exports data suggest that the global economy is growing solidly, though some of that may be due to the stimulus provided indirectly by China’s ongoing borrowing binge.

(6) Demographics. Weighing on China’s growth rate is its geriatric demographic profile. The country’s fertility rate dropped below the replacement rate of 2.1 children per woman during 1995, and is expected to remain below that level through the end of the century, according to UN projections (Fig. 15).

The growth rate of the population is projected to turn negative during 2033 (Fig. 16). The growth rate of the working-age population (WAP) already turned negative during 2016 and is expected to remain so through the end of the century—with WAP falling to 558 million from a peak of 1,015 million during 2015 (Fig. 17 and Fig. 18).

(7) MSCI metrics. The China MSCI stock price index (in yuan) is up 29.3% ytd through Friday, and 57.6% from last year’s low on February 12 (Fig. 19). It is selling at a relatively low forward P/E of 12.6 currently (Fig. 20). Weighing on valuation may be the flat trend in forward revenues since early last year (Fig. 21). On the other hand, forward earnings has turned up since late last year. The big story in the MSCI data may be that China’s forward profit margin has been expanding from a low of 3.3% during the week of November 29, 2012 to a nine-year high of 4.1% in early July of this year (Fig. 22).


Bulls Flying with Doves

July 17, 2017 (Monday)

See the pdf and the collection of the individual charts linked below.

(1) Brainard: Leading the dovish pack. (2) Melting up with the doves. (3) Dollar matters to the Fed for a change. (4) Flatter Phillips curve. (5) Still undershooting inflation target. (6) Balancing rate hikes with balance-sheet tapering. (7) Brainard and Yellen agree that neutral federal funds rate is in sight. (8) More Fed fairy dust charges up bull again. (9) Swan song. (10) Not surprisingly, Fed favors discretion over rules.


The Fed I: Brainard’s Dovish Speech. The bull market in stocks is flying high with the doves. On the other hand, the dollar is losing altitude. Last week, the S&P 500 rose 1.4% to 2459.27, setting yet another new record high (Fig. 1). The trade-weighted dollar dropped 1.2% last week to the lowest reading since September 7 of last year (Fig. 2). The S&P 500 is right smack dab in the middle of our 2400-2500 forecast for yearend, and it is only July! On March, Joe and I raised the odds of a melt-up scenario from 30% to 40%, lowering the odds of a gradual ascent in stock prices from 60% to 40%. We raised the odds of a meltdown from 10% to 20%, since a melt-up is typically followed by a meltdown. We’ve been discussing the likelihood of a melt-up since the start of 2013, when the economy didn’t go over the widely feared “fiscal cliff.”

The financial press attributed the latest bullish stock market advance to the dovish congressional testimony of Fed Chair Janet Yellen on Wednesday and Thursday. Melissa and I agree, but we also credit Fed Governor Lael Brainard’s dovish speech on Tuesday. Though it was blandly titled “Cross-Border Spillovers of Balance Sheet Normalization,” the speech significantly discussed the impact of monetary policy tightening on the dollar. In the past, Fed officials rarely discussed the impact of their policies on the dollar. Now, it seems, they are strongly signaling that they don’t want to see the dollar strengthen as they continue to normalize monetary policy.

In her speech, Brainard focused on the Fed’s policy options. Specifically, she weighed the effects of normalizing through the federal funds rate (by hiking it), the balance sheet (by shrinking it), or both in tandem. She discussed several scenarios in a “stylized model” that would have different implications for exchange-rate effects depending on the monetary policy approach. She noted that it is “the commitment adopted by many leading nations to set monetary policy to achieve domestic objectives such that the exchange rate would not be a primary consideration in the setting of monetary policy.” However, she mentioned “exchange rate” 47 times in her comments and footnotes, obviously acknowledging that the foreign exchange value of the dollar is now an important consideration.

Brainard stated: “The balance sheet might affect certain aspects of the economy and financial markets differently than the short-term rate due to the fact that the balance sheet more directly affects term premiums on longer-term securities, while the short-term rate more directly affects money market rates. As a result, similar to the domestic effects, while the international spillovers of conventional and unconventional monetary policy may operate broadly similarly, the relative magnitude of the different channels may be sufficiently different that, on net, the two policy strategies have distinct effects.” Brainard seemed to conclude that it is best to lean toward the balance-sheet approach, as it should have fewer negative transmission effects, in her opinion (Fig. 3).

Oftentimes, Brainard’s remarks tend to foreshadow Fed Chair Janet Yellen’s thinking and the evolving consensus on the FOMC. Consider the following:

(1) Inflationary pressures muted. In a 3/7/16 speech, Brainard anticipated FOMC policy as follows: “If the labor market continues to improve, higher resource utilization should also put some upward pressure on inflation going forward. However, the effect of resource utilization on inflation is estimated to be much lower today than in past decades.” She also said that the FOMC should put a high premium on evidence that actual inflation is firming sustainably before moving to tighten monetary policy. The FOMC waited until the end of 2016 to raise the federal funds rate by 25bps, the same one-and-done hike as at the end of 2015 (Fig. 4).

(2) Phillips curve flatter. In a 9/12/16 speech, she opined that the Phillips curve has flattened, “appearing to be a less reliable guidepost than in the past.” In other words, inflation has remained remarkably subdued given the drop in the unemployment rate. More specifically, she said, “The apparent flatness of the Phillips curve together with evidence that inflation expectations may have softened on the downside and the persistent undershooting of inflation relative to our target should be important considerations in our policy deliberations. In particular, to the extent that the effect on inflation of further gradual tightening in labor market conditions is likely to be moderate and gradual, the case to tighten policy preemptively is less compelling.”

The CPI inflation rate was back below 2.0% during June, with the headline rate down to 1.6% y/y and the core rate down to 1.7% (Fig. 5). This suggests that the core PCED rate, which was 1.4% during May, might have been even lower in June, since it tends to fall consistently below the core CPI inflation rate (Fig. 6).

Meanwhile, wage inflation remains remarkably subdued around 2.5% even though the unemployment rate has been below 4.5% for the past three months through June (Fig. 7). Job openings are plentiful (Fig. 8). When the labor market was this tight by these measures during the past three business cycles, wage inflation was around 4.0%.

(3) Neutral interest rate lower. In her latest speech, Brainard said, “the neutral level of the federal funds rate is likely to remain close to zero in real terms over the medium term.” Considering that, there would not be “much more additional work to do on moving to a neutral stance” from the moderately accommodative stance now. She added that the FOMC “decided to delay balance sheet normalization until the federal funds rate had reached a high enough level to enable it to be cut materially if economic conditions deteriorate.”

The FOMC hiked the federal funds rate again twice this year so far to a target range of 1.00%-1.25%. The federal funds future market is anticipating one more hike over the next 12 months (Fig. 9). We agree, but expect the federal funds rate to flatten out around 2.00% at the end of next year through 2019. Meanwhile, the real interest rate in the 10-year Treasury TIPS market continues to fluctuate between 0.00% and 0.80%, as it has since late 2013 (Fig. 10).

The Fed II: Yellen’s Dovish Testimony. Fed Chair Janet Yellen still knows how to sprinkle the fairy dust. When the Fairy Godmother of the Bull Market speaks, investors listen and get more bullish. The Dow Jones hit a new record high following her semi-annual testimony to Congress on Wednesday, and the S&P 500 did so on Friday. On numerous previous occasions, we have observed that stock prices tend to rise after Yellen speaks (Fig. 11 and Fig. 12).

Confirming Brainard’s comments, Yellen said that her goal is to reach a neutral level of interest rates, which is lower than it was historically and not so far off from where the federal funds rate is set now. Later this year, the FOMC is also expected to begin normalizing its balance sheet, she said, as Brainard discussed a few days before.

(1) Balance sheet. In her opening remarks, Yellen rehashed the outline for the plan for balance-sheet normalization, which was previously provided in greater detail in an addendum with the 6/14 FOMC policy statement. Yellen’s testimony on the subject seemed rather subdued. She said: “The Committee intends to gradually reduce the Federal Reserve's securities holdings by decreasing its reinvestment of the principal payments it receives from the securities held in the System Open Market Account. Specifically, such payments will be reinvested only to the extent that they exceed gradually rising caps. Initially, these caps will be set at relatively low levels to limit the volume of securities that private investors will have to absorb.” She added: “[W]e do not intend to use the balance sheet as an active tool for monetary policy in normal times.”

Brainard had suggested a similarly easy-does-it approach toward balance-sheet normalization in her speech: “In light of recent policy moves, I consider normalization of the federal funds rate to be well under way. If the data continue to confirm a strong labor market and firming economic activity, I believe it would be appropriate relatively soon to commence the gradual and predictable process of allowing the balance sheet to run off.”

(2) Balanced view. Inflation continues to be the sticking point for the Fed’s approach to accommodation in terms of its dual mandate to maintain its stability and maximum employment. The headline unemployment rate has dropped substantially since the Great Recession. At the same time, inflation has remained remarkably low.

In her written testimony, Yellen observed: “It appears that the recent lower readings on inflation are partly the result of a few unusual reductions in certain categories of prices; these reductions will hold 12-month inflation down until they drop out of the calculation.” During the Q&A with lawmakers, Yellen cited temporary influences holding down prices including mobile-phone plans and prescription drugs. She added: “It is premature to reach the judgment that we are not on the path to 2% inflation over the next couple of years.”

Yellen’s remarks on inflation seemed slightly more dovish than during her 6/14 press conference when she harped on temporary influences holding down prices, including mobile-phone plans and prescription drugs. Bloomberg observed that Yellen used the word “partly” to describe the impact of the temporary effects this time versus the word “significantly” last time. Balancing out her remarks, however, Yellen said: “[Several] developments should increase resource utilization somewhat further, thereby fostering a stronger pace of wage and price increases.” That effect is uncertain, though, in her view.

The Fed III: A Dove’s Swan Song. Commencing the balance-sheet unwinding while potentially raising interest rates closer to neutral at the same time could be Yellen’s final act as Fed chair. For now, the markets don’t seem too concerned about who will replace the Fed chair when her term is up in February 2018 if she isn’t reappointed.

Politico reported on 7/11 that National Economic Council Director Gary Cohn could be Trump’s top choice to replace Yellen. But Cohn might not want the job. Also, Cohn’s nomination might encounter resistance from the Senate given his close ties to the banking industry as a former Goldman Sachs executive. No matter what, Trump will probably look to nominate a Fed chair who will maintain stimulative policies at least until fiscal policies can take over. Politico observed that Cohn is “viewed as closer to Yellen’s preference for gradual rate hikes.”

By the way, though Fed officials proclaim their independence from politics, Brainard is a Democrat with a history of working for and contributing to the Democratic party. She doesn’t seem to be going anywhere soon, as her term doesn’t end until 2026, but her influence could be overshadowed by a new boss. It sure would be interesting to see Cohn step into the Fed chair role. Despite his current role in the Trump administration, Cohn is a registered Democrat, and he has no academic, economic, or monetary policy background. In any case, Yellen is the boss for now, and she seems to highly value Brainard’s opinion, which coincides with her own.

The Fed IV: Dove’s Rule. The FOMC’s projections support the views of Yellen and Brainard. On June 14, the FOMC set the federal funds rate in a target range of 1.00% to 1.25%. According to the Taylor Rule, the federal funds rate should be set at about 2.90%, as of Q2 based on the default inputs into the Atlanta Fed’s utility on its website. That figure happens to approximate the Fed’s latest median projection for the federal funds rate by 2019. For 2017, the median projection is just 1.40%.

The Fed’s 7/7 Monetary Policy Report (MPR), which accompanied Yellen’s congressional testimony, included a section titled “Monetary Policy Rules and Their Role in the Federal Reserve’s Policy Process.” The basic message is that the FOMC pays attention to models like the Taylor Rule, which prescribe the level of the federal funds rate, but the Fed’s policymakers believe that these models ignore too many “considerations” that require their judgment when setting the federal funds rate. In the “rules versus discretion” debate, they clearly favor the latter approach. Here are some key points from the MPR:

(1) Too simple. “Each rule takes into account two gaps—the difference between inflation and its objective (2 percent as measured by the price index for personal consumption expenditures [PCE], in the case of the Federal Reserve) as well as the difference between the rate of unemployment in the longer run (uLR) and the current unemployment rate. … The small number of variables involved in policy rules makes them easy to use. However, the U.S. economy is highly complex, and these rules, by their very nature, do not capture that complexity.”

(2) Measuring slack. “[W]hile the unemployment rate is an important measure of the state of the labor market, it often lags business cycle developments and does not provide a complete measure of slack or tightness. In practice, Federal Open Market Committee (FOMC) policymakers examine a great deal of information about the labor market to gauge its health; this information includes broader measures of labor underutilization, the labor force participation rate, employment, hours worked, and the rates of job openings, hiring, layoffs, and quits, as well as anecdotal information not easily reduced to numerical indexes.” A footnote makes reference to the Fed’s Labor Market Conditions Index, which includes 19 components.

(3) Measuring inflation. “[T]here are many measures of inflation, and they do not always move together or by the same amount. … For example, inflation as measured by the consumer price index (or CPI) has generally been somewhat higher historically than inflation measured using the PCE price index (the index to which the FOMC’s 2 percent longer run inflation objective refers). Core inflation, meaning inflation excluding changes in food and energy prices, is less volatile than headline inflation and is often used in estimating monetary policy rules because it has historically been a good predictor of future headline inflation.”

(4) Broader considerations. “Finally, monetary policy rules do not take account of broader risk considerations. For example, policymakers routinely assess risks to financial stability. Furthermore, over the past few years, with the federal funds rate still close to zero, the FOMC has recognized that it would have limited scope to respond to an unexpected weakening in the economy by lowering short-term interest rates.”

(5) Different strokes. “Different monetary policy rules often offer quite different prescriptions for the federal funds rate; moreover, there is no obvious metric for favoring one rule over another.”


There’s an App for That

July 13, 2017 (Thursday)

See the pdf and the collection of the individual charts linked below.

(1) Living in 3D. (2) Want to live in a pretzel? (3) Replacing construction workers with printers. (4) 3D buildings going up in Dubai, China, and Mars. (5) Build your fast-drying home in a day. (6) Pain won’t go away for retailers. (7) Pigs selling discounted lipstick. (9) Bezos and Alexa going after the Geek Squad. (10) Shorting malls is easy: There’s an ETF for that. (11) Make Brazil hot again!


Industry Focus: Construction in 3D. When you think of 3D printing, manufacturing airplane parts may come to mind. Or perhaps manufacturing kids’ toys does. But it’s time to think bigger, much bigger. 3D printing is being used to build homes and buildings around the world.

Sometimes, the printers are housed in a factory where portions of the building are manufactured and then shipped to the construction site. Sometimes, the 3D printer is sent to the construction site, and it is used to make the building right there and then. Typically, a computer program tells the “printer” where to squirt a fast-drying liquid concrete material. It does so repeatedly, in many layers, until the structure is built, often in under a day.

If widely adopted, the benefits to the industry—and humanity—could be huge. Construction would be much less wasteful as well as faster and cheaper to help those in need. Or it could be used in very high-end designs, because anything you create in a computer can be turned into reality via 3D printing. Curved walls or domed ceilings are no problem. That said, the new technology will result in fewer construction jobs. Then again, there certainly is a shortage of construction workers in the US currently.

I asked Jackie to take a tour around the world (on her PC) to see what some of the bigger players in the industry are accomplishing. Some of the sources she references below are unfamiliar to us, so we can’t vouch for their accuracy. That said, there’s enough activity in the space that a trend seems to be solidly underway. If just some of what these articles report is true, the future of 3D construction is building quickly. Here for your wonderment is Edifice Rex:

(1) 3D in the desert. Last year, Dubai launched the Dubai 3D Printing Strategy, which focused on additive printing of medical products, consumer products, and construction. The city aims to have 25% or more of its buildings built using 3D printing technology by 2030.

“The future will depend on 3D printing technologies in all aspects of our life, starting from houses we live in, the streets we use, the cars we drive, the clothes we wear and the food we eat,” said Vice President and Prime Minister of the UAE and Ruler of Dubai, His Highness Sheikh Mohammed Bin Rashid Al Maktoum, according to a 4/27/16 article in Gulf Today. He added, “This technology will create added economic value and benefits worth billions of dollars during the coming period. We should have a share in this growing global market. This technology will restructure economies and labour markets as the use of unskilled labour will come down compared to the current situation, especially in the construction sector. It will also redefine productivity because the time needed for 3D printing of buildings and products will be 10% of the time taken in traditional techniques.”

Just about a year later, a laboratory building, the R&Drone Laboratory, was constructed in Dubai using a 3D printer created by CyBe Construction, a Dutch company, according to a 6/2 article on CyBe’s 3D printer, dubbed the “RC 3Dp,” moves on caterpillar tracks and built the foundation and walls of the 168-square-meter building in three weeks. Another contractor built the roof, stairs, doors, and bathrooms.

One of Dubai’s next projects is a 3D-printed skyscraper by US startup Cazza Construction. The firm plans to use cranes, concrete, and steel rebar, according to a 3/12 article in ConstructionWeekOnline. Cazza’s CEO, 20-year old Chris Kelsey, had previously told ConstructionWeekOnline that the firm’s manufacturing process was capable of providing labor cost savings of up to 90% and could build a 3D-printed, three-story house in two days.

(2) 3D in China. Chinese construction company Winsun made headlines in 2013 for 3D printing 10 standalone houses in China. It followed up by printing a five-story apartment building and an 11,840-square-foot villa. Most recently, Winsun agreed to print 17 office buildings in Dubai and entered into a $1.5 billion contract with Saudi Arabian company, AI Mobty Contracting, to print “at least 30 million square meters of 3D construction projects in Saudi Arabia. The new project is said to have been made to relieve a national housing crisis that has escalated lately,” according to a 3/22 article on

Winsun’s “ink” is made of cement, sand, fiber, and an additive. About half of the materials come from construction waste or mine tailings. The company makes the walls in a factory and assembles the building onsite. Its technology can make hollow structures to accommodate piping, wiring, and insulation.

3D construction cuts down on both labor and the time needed to build a structure. “For example, construction of a two-story 1,100 (square meter) mansion took one day of printing, two days of assembly, with internal bar structures erected in advance, requiring three workmen only,” according to a case study attributed to the Boston Consulting Group as part of the Future of Construction Project at the World Economic Forum. Therefore, the technology can benefit emerging countries, where there can be a shortage of skilled construction workers.

Winsun has also constructed an office in Dubai, on which it claims to have saved about 80% on construction costs, 60% on labor, and 60% on waste. “To date, the company has sold more than 100 houses of various types, many of them in Dubai, the largest with a floor space in excess of 5,000 square meters,” the case study noted.

(3) 3D in outer space. One of the US deans of 3D printing is Dr. Behrokh Khoshnevis, a professor of engineering at the University of Southern California and director of its Center for Rapid Automated Fabrication Technologies (Craft). His printing construction method, called “Contour Crafting,” can build a house in a day and cut down on the construction cost by 30%, according to a 7/20/16 NYT article.

Khoshnevis is also working with NASA to build structures using Contour Crafting on the moon from materials available there. In a 2012 TEDx Talk, he discussed what 3D manufacturing of buildings will mean for the world, including the ability to provide inexpensive housing to folks now living in slums.

(4) Home in a day. Apis Cor, a San Francisco-based company headed by Nikita Cheniuntai, claims to have built a 400-square-foot home in Russia in just 24 hours using 3D printing, at a cost of about $10,000.

According to a 3/7 article on “The company used a mobile 3D printer to print out the house’s concrete walls, partitions and building envelope. Workers had to manually paint it and install the roofing materials, wiring, hydro-acoustic and thermal insulation, but that didn’t take much time.” Don’t miss the video in the link above!

Sector Focus: Retail Reeling. Earlier this week, while Amazon captured upbeat headlines with Prime Day deals, a number of retailers reported dismal news. So while shares were up 4.2% for the week ended Tuesday, the S&P 500 Specialty Stores index fell 6.3%, Apparel Retail dropped 7.4%, and Department Stores lost 7.7% (Fig. 1). Here are some of the low lights of the past week:

(1) The wedding is off. News that Abercrombie & Fitch was unable to sell itself sent the teen-retailer’s shares tumbling 21% to $9.59 on Monday. The company had told the market in May that it was in “preliminary” discussions, and its shares topped $14 for a brief period. Abercrombie is in good company. Neiman Marcus Group and Macy’s have also been unable to find buyers. But things could be worse. Competitors Aéropostale, Wet Seal, and American Apparel have filed for Chapter 11 bankruptcy protection, a 7/10 WSJ article reminds us.

(2) Lipstick on a pig. In an effort to lure shoppers into their stores, department stores are doing the unthinkable: discounting lipstick. Last month, Lord & Taylor offered 15% off almost all cosmetics and fragrances, Bloomie’s gave shoppers a $25 reward card for every $100 beauty purchase, and Macy’s offered 15% off cosmetics, the 7/10 WSJ reported. The news slammed Ulta Beauty’s high-flying stock, which fell 7.6% over Monday and Tuesday. Ulta, a cosmetics retailer, had previously proven immune to competition from Amazon. But investors weren’t anticipating that Amazon’s pressure on department stores would push the department stores to discount cosmetics, which could hurt Ulta.

(3) Piranhas attacking geeks. Best Buy’s Geek Squad service—where employees go to customers’ homes to answer tech questions—was one way the company differentiated itself from Amazon. But Amazon is showing its ability to emulate, in addition to innovate. “Over the last few months, Amazon has quietly been hiring an army of in-house gadget experts to offer free Alexa consultations as well as product installations for a fee inside customer homes,” according to a 7/10 Recode article citing multiple anonymous sources and job postings. “The new offering, which has already rolled out in seven markets without much fanfare, is aimed at helping customers set up a “smart home”—the industry term used to describe household systems like heating and lighting that can be controlled via apps, and increasingly by voice. While Amazon has a marketplace for third parties to offer home services, like TV mounting and plumbing, these new smart-home-related services seem important enough to Amazon that it is hiring its own in-house experts.” Best Buy shares fell 7.2% over Monday and Tuesday.

(4) Shorting bricks & mortar. ProShare Advisors is offering three new ETFs that allow investors to bet against retailers. According to a 7/10 Bloomberg article: “The ProShares UltraShort Bricks and Mortar Retail fund and ProShares UltraPro Short Bricks and Mortar Retail fund will seek to use derivatives to generate daily returns of two or three times the inverse of an index comprising the most at-risk U.S. retailers. … Meanwhile, the ProShares Long Online Short Bricks & Mortar Retail ETF will track an equal-weighted benchmark that includes U.S. and overseas stocks, the filings show.”

(5) Desperate numbers. The damage done to department store stocks can’t be understated. The S&P 500 Department Stores stock price index is down 57.7% from its 2015 peak (Fig. 2). The industry’s forward earnings multiple has shrunk to 10.2, from 16.1 in 2015 (Fig. 3). And analysts expect earnings to fall 2.2% over the next 12 months (Fig. 4).

The S&P 500 General Merchandise Stores index hasn’t fared much better, down 31.8% from its 2016 peak (Fig. 5). The industry’s forward P/E has shriveled from almost 20 in 2015 to a recent 13.6 (Fig. 6). Here too, analysts see earnings dropping 0.4% over the next 12 months (Fig. 7). Investors wisely have avoided the sale on retail stocks.

Brazil: Doing the Bossa Nova. Please welcome Sandy Ward as a Contributing Editor to Yardeni Research. Sandy, like Jackie, was formerly a senior editor for Barron’s. I asked her to start off by bringing us up to speed on a couple of major emerging economies. Here is her piece on Brazil:

While the MSCI Emerging Markets Latin America index has turned in a more-than-respectable performance so far this year, climbing 11.7% in US dollars through Tuesday’s close vs ­­8.3% for the S&P 500, Brazil barely contributed. Argentina delivered blistering gains, posting the top performance among all emerging markets at 40.8%, while Mexico is up 25.6% ytd. Even Chile and Peru have posted double-digit ytd increases.

In contrast, Brazil was the laggard, gaining 5.0% ytd, with 3.7% of that coming on Monday and Tuesday. Only the emerging markets of South Africa, Jordan, Pakistan, and Russia have performed worse than Brazil ytd (Fig. 8). Besieged by the worst recession in 25 years amid a collapse in commodities and beset by political turmoil, it’s no wonder that Brazil has struggled. Still, it was the top performer in 2016, soaring 61.3%, and a look behind the numbers shows encouraging signs that the worst may be over for Latin America’s largest economy.

Indeed, big U.S. multinational firms with sizable business interests in Brazil, such as International Paper and Schlumberger, have said they believe the economy has bottomed. Since late June, Brazil’s MSCI stock market index has turned in a scorching performance, vaulting into positive territory (5.0% ytd as of Tuesday’s close) after being down as much as 18% between its February high and June low. Forward earnings has been climbing, driving share prices higher (Fig. 9). Earnings is forecast to jump by 26.5% this year, yet Brazil’s stock market is trading at 10.8 times earnings (Fig.10).

Bossa Nova, one of Brazil’s best-known musical genres, means “new trends” in Portuguese. In the universal language of the stock market, there clearly are some new positive trends taking place in this Latin American country at long last. Consider the following:

(1) GDP growth. Real GDP continues to recover smartly, boosted by a rise in exports (Fig. 11 and Fig. 12). The 0.4% y/y contraction during Q1 was the best showing in two years.

(2) Real exports and imports. Exports jumped 4.8% in Q1 into positive territory despite a tainted-meat and corruption scandal that has led to widespread bans of Brazilian poultry and meat around the world. The scandal threatens to bring down President Michael Temer, the structural reformer who also has been indicted on charges of taking bribes from meatpacking giant JBS SA after only a year in office. Brazil is the world’s largest exporter of beef and poultry. Powering exports to their biggest gain in two years were sales of oil, iron ore, and soybeans. Imports rose sharply.

(3) Gross fixed capital formation. Capital spending remained in negative territory during Q1 but showed marked improvement as investors continued to gain confidence. During Q2, there’s been a series of deals that suggest a new level of optimism, despite the political turmoil. In late May, Buenos Aires-based venture capital firm Kaszek Ventures said it raised $200 million for a fund that will invest in Internet start-ups focused on agriculture technology, education, and health care. It is Kaszek’s third fund; about two-thirds of the investments across its funds are in Brazil, and that will continue.

“We believe that Brazil will still be the largest recipient of our capital and where we invest the most,” said one of the founding partners, according to the 6/30 NYT article linked above. American investors in the new fund include Sequoia Heritage, a fund of funds connected to Sequoia Capital, and the Dietrich Foundation of Pittsburgh. Another investor: Accel’s Kevin Efrusy, responsible for that firm’s early bet on Facebook. Kaszek’s first two funds focused on financial technology and software services.

Other recent deals: Softbank of Japan said in late May it would contribute $100 million to the privately held 99, a competitor to Uber. And a China-backed $20 billion fund announced last year to help finance the construction of railroads to link agricultural areas to ports started taking investment pitches in late June.

(4) IPOs. More companies have launched IPOs in Brazil this year than in all of 2016, when only one company went public, according to a 4/18 Leaders League post. Azul, the Brazilian airline started by the founder of JetBlue, raised R$2 billion in an early April IPO—the biggest IPO in the country since 2013. That followed on the heels of two other public debuts: Movida, the car rental company, and Instituto Hermes Pardini, a health care company.

Investment bankers estimate that activity will pick up sharply in the year’s second half, and up to 15 or more firms could go public. XP Investimentos, which bills itself as “the Charles Schwab of Brazil,” is expected to go public this month, and Grupo Notre Dame Intermedica, a dental and health care insurer, is also considering a public offering later this year. A sign of things to come: The family that owns Latin America’s largest construction group—Oldebracht SA, known for building airports, highways, and hydroelectric plants around the world—plans to bring all its businesses public in the next three to four years as it seeks to recover from a bribery scandal, reported an article in the 6/30 WSJ.

(5) Foreign direct investment. Regulatory reforms enacted in 2016 to attract more foreign investment are working. In the first two months of this year, US$16.8 billion flowed into Brazil from abroad, a record for the timeframe and up 57% from the same period in the year-ago period. The money flowed to all sectors of the economy, according to the Brazilian government, with the industrial sector topping the list, followed by services and agribusiness & mining. This follows the US$15.4 billion that flowed into Brazil in December 2016, the highest amount since 2010, according to the government. On 4/4, the WSJ reported that Exxon Mobil was in talks to expand in Brazil through joint ventures with the state-controlled Petrobras, gaining access to deep-water oil reserves, as well as with U.S.-based producer Hess.

Economic conditions in Brazil are far from perfect—unemployment is at record highs, and the charges against Temer cast uncertainty on pension and other reforms—but the trends are encouraging enough to dance the Bossa Nova.


Steady Does It

July 12, 2017 (Wednesday)

See the pdf and the collection of the individual charts linked below.

(1) The four seasons. (2) Industry analysts holding onto double-digit S&P 500 earnings growth for 2017 and 2018. (3) Earnings outlook more likely buoyed by improving global economy than by Trump agenda, which is still on the come. (4) Consensus forward revenues and earnings providing bullish guidance. (5) Global PMIs signaling slow, but steady growth. (6) European holiday: lots of festive indicators. (7) French are world-class shoppers. (8) Two drags on growth: labor shortages and subdued wage gains.


Earnings & Revenues: Upbeat Forward Guidance. Earnings seasons are when industry analysts often revise their earnings estimates based on the latest quarterly results reported by their companies. They are also influenced by managements’ conference calls discussing those results as well as their forward guidance on their business prospects. We will see how the Q2-2017 season plays out over the next few weeks.

Joe and I aren’t expecting any significant downside surprises. Au contraire, as the French say, we remain impressed by the recent steadiness of the S&P 500/400/600 consensus earnings expectations for this year (Fig. 1). Industry analysts are currently projecting growth rates of 10.3%, 7.0%, and 6.2% on a pro forma basis for the three S&P indexes. Even more impressive is the steadiness, since last September, of their S&P 500/600 estimates for 2018, while the estimate for the S&P 400 has been on a modest uptrend. The analysts are estimating 2018 growth rates of 12.0%, 14.2%, and 19.3%.

It is quite unusual to see such steadfastness since the coming year’s estimates for the S&P 500 typically tend to fall over time, though there remains plenty of time for them still to do so (Fig. 2). The quarterly estimates for the S&P 500 are also holding up relatively well for the remainder of this year (Fig. 3).

This steadiness, despite a long history of overly optimistic estimates being revised downward more often than not, might be attributable to expectations of a corporate tax cut effective in 2018. A couple of months ago, as Washington’s swamp turned murkier, Joe and I changed our minds about a retroactive cut starting in 2017. But we still expect one for 2018.

Perhaps a more likely explanation for the steadfastness of earnings estimates so far this year is that the global economy is showing signs of improving. This certainly explains why both S&P 500/400/600 forward earnings (which would be directly boosted by a tax cut) and forward revenues (which wouldn’t be directly impacted) all are continuing to rise to record highs (Fig. 4).

So while we await the conference calls and managements’ guidance, the forward guidance provided by S&P 500/400/600 forward earnings and revenues—which are based on analysts’ consensus expectations for this year and next year—remains upbeat.

Our Blue Angels analysis for the S&P 500/400/600 stock price indexes shows that while valuation multiples are high for all three, forward earnings seems to be rising at a faster pace into record territory (Fig. 5).

Global Economy: Growing Steadily. Just about every month, Joe and I note that there is a decent correlation between S&P 500 revenues and the US M-PMI and NM-PMI measures of domestic economic activity. Both were solid in June, which augurs well for revenues. So do the solid PMIs for the global economy during June, with the global composite remaining steady around 54.0 for the past six months (Fig. 6).

Yesterday, Debbie reviewed May’s OECD leading indicators report, which tracks indexes for 32 of the 35 OECD advanced economies, as well as 6 of 15 OECD non-member economies, which include Brazil, Russia, India, and China. They also were mostly on a steady course, confirming that the current slow-but-steady growth of the global economy should continue. On the other hand, if you are looking for somewhat better economic growth than slow-but-steady, then take a European vacation this summer. Here are some of the sights you’ll enjoy:

(1) Pretty PMIs. The Eurozone’s M-PMI rose to 57.4 in June, while the region’s NM-PMI dipped to a still-solid reading of 55.4 (Fig. 7 and Fig. 8). Germany led the way on the M-PMI with a very strong 59.6, while the NM-PMI was led by Spain (58.3) and France (56.9).

(2) Shopping galore. France is also leading the Eurozone in the volume of retail sales (excluding autos). The region’s sales are up 2.6% y/y through May, with solid gains in France (4.2%), Spain (2.9), Germany (2.3), and Italy (1.0) (Fig. 9). New passenger car registrations remain on solid uptrends in the major European economies (Fig. 10).

(3) Lots of oomph. The strongest economy in the Eurozone is Germany’s, where industrial production rose 5.0% y/y during May to a fresh record high (Fig. 11). The country is benefitting from booming exports, which also confirms that the global economy is doing well.

US Economy: Steady Drags. We’ve been bullish since the start of the bull market in equities during March 2009. One day, we will be bearish. That will happen when we believe that a recession is imminent. Hopefully, we will figure that out either before or at least at about the same time as the stock market does so. Meanwhile, to maintain our credibility (and maybe our sanity too), we continue to do the best we can to balance our optimism with a realistic assessment of the risks. For now, we continue to see many more white swans than black swans. Nevertheless, here are a couple of recent concerns:

(1) Labor shortage. One of my daughters recently opened a very successful breakfast and lunch bistro in Petaluna, located in Sonoma County, California. Sarah’s Eats & Sweets has a five-star rating on Yelp with 74 reviews already. The only problem that Sarah has so far is getting help to meet all the demand for her culinary delights. She reports that it doesn’t make sense to try paying more to attract workers. She simply can’t find qualified workers. She is not alone. This is a nationwide problem and may put a lid on economic growth.

The latest survey of small business owners conducted by the National Federation of Independent Business (NFIB) found that 32.3% reported job openings that could not be filled on average over the past three months through June, the highest reading since January 2001 (Fig. 12). This series starts in January 1986 and is highly correlated with the JOLTS data on the national job openings rate, which is available since December 2000, and is in record-high territory.

(2) Subdued wages. So far, the big surprise is that despite all the job openings, wage inflation remains around 2.5%. During the previous three cyclical peaks in jobs openings, wage inflation was around 4.0% (Fig. 13). Even more puzzling is that the national quits rate rose to a new cyclical high in May. Workers usually leave and take another job for better pay (Fig. 14).

If job growth is restrained by a shortage of qualified workers and wages remain subdued, then the probability of faster economic growth is low. Previously, we’ve suggested that wage inflation is being held down by even lower price inflation. That means that real wages are still growing, but not by much, since they are determined by productivity, which isn’t growing by much.

Outbound & Inbound

July 11, 2017 (Tuesday)

See the pdf and the collection of the individual charts linked below.

(1) Size matters. (2) Sum of US exports and imports augurs well for global economy and for US factories. (3) The West Coast’s hip ports are hopping. (4) ATA truck tonnage index rose to record in May. (5) Kudlow says Trump has Putin over a barrel. (6) Flying Transportation stocks. (7) Forward revenues and earnings bullish for Transports. (8) Net Earnings Revisions Index increasingly positive for Transports.


US Economy: America’s Trade Is Great. There’s lots more data covering the US economy than other economies. There are even fewer economic series that add up all the national sources to provide a good picture of the global economy. Given the size and importance of the US economy in global trade, it isn’t surprising that some of our homegrown trade indicators provide excellent insight into the performance of the global economy. Currently, their signals are very upbeat, which might explain why the S&P 500 Transportation Index is at a new record high. Let’s have a look:

(1) Real exports & imports. According to the CPB Netherlands Bureau for Economic Policy, the volume of world exports edged down during April from March’s record high (Fig. 1). The growth rate of this series is highly correlated with the growth of the sum of US inflation-adjusted exports plus imports (Fig. 2). The former was up 3.2% y/y in April, while the latter was up 4.5% in May. Both were closer to zero a year ago.

This augurs well for US industrial production, which is also highly correlated on a y/y basis with both measures of trade growth (Fig. 3). Indeed, US industrial output was up 2.1% y/y through May, the best reading since January 2015. It had been negative from April 2015 through November 2016, mostly as a result of the rolling recession in the global oil industry.

(2) West Coast ports. According to the Beach Boys, the West Coast has the sunshine and hippest girls. It also has ports that do lots of business with Asia. Debbie and I monitor the monthly stats on 20-foot-equivalent containers that go in and out of the ports of Los Angeles and Long Beach (Fig. 4 and Fig. 5). The series are volatile, so we track the 12-month sums. The sum of the outbound and inbound traffic is highly correlated with the sum of real US exports and imports (Fig. 6). Both series are on uptrends and at or near recent record highs.

(3) Rail & truck traffic. Not surprisingly, intermodal container railcar loadings (on a 52-week average basis) is highly correlated with both measures of US trade activity (Fig. 7 and Fig. 8). All those exports and imports need to be moved by rail. Some of them must also be keeping the truckers busy. The ATA truck tonnage index jumped to a record high in May, confirming the recent upturn in intermodal container railcar loadings (Fig. 9).

The bad news for the economy is that railcar loadings of motor vehicles has stalled since late last year (Fig. 10). Motor vehicle sales have dropped from a cyclical peak of 18.4 million units (saa) during December to 16.5 million units during June, the lowest pace since February 2015.

(4) Oil exports & imports. The rebound in US oil field production since late last year has slightly boosted railcar loadings of chemicals and petroleum products in recent weeks (Fig. 11). US exports of crude oil and petroleum products have roughly tripled since the start of the current economic expansion (Fig. 12). Net imports have been cut by about two-thirds since 2007!

Larry Kudlow’s 7/8 commentary on CNBC’s website was spot on concerning how the Trump administration is aiming to undermine both Russia’s Vladimir Putin and Iran’s Mullahs by enabling more oil and gas production in the US. He notes that Trump’s speech in Warsaw included the following key line: “We are committed to securing your access to alternative sources of energy, so Poland and its neighbors are never again held hostage to a single supplier of energy.” That was a direct slap at Russia.

Kudlow explained: “Trump wants America to achieve energy dominance. He withdrew from the costly Paris climate accord, which would have severely damaged the American economy. He directed the EPA to rescind the Obama Clean Power Plan, which would have led to skyrocketing electricity rates. He fast-tracked the Keystone XL pipeline. He reopened the door for a modernized American coal industry. He’s overturning all the Obama obstacles to hydraulic fracturing, which his presidential opponent Hillary Clinton would have dramatically increased. And he has opened the floodgates wide to energy exports.”

Love him or hate him, Trump’s initiatives could push oil prices lower. The geopolitical benefits of defunding and defanging Russia and Iran, both of which are extremely dependent on oil revenues, could be significant. So could the positive impact of lower oil prices on US consumers. There could be a negative impact on energy capital spending in the US, but that might be offset by the new exploration projects that Trump’s policies are enabling.

Strategy I: Transports Flying. All the above provides good fundamental support for the record high in the Dow Jones Transportation Average, which in turn is providing solid confirmation of the bull market in the Dow Jones Industrials Average. There are also lots of upbeat and improving indicators for the fundamental stats on the S&P 500 Transportation stock price index. Consider the following:

(1) Forward revenues. The sector’s forward revenues remain on a solid uptrend, rising to fresh record highs in June (Fig. 13).

(2) Forward earnings. Apparently, the S&P 500 Railroad industry’s forward earnings was hard hit by the energy recession during 2015 (Fig. 14). However, it has been making a comeback since early 2016. The forward earnings of the S&P 500 Airlines industry also has been recovering this year. Meanwhile, Air Freight & Logistics has been rising faster in record territory so far this year.

(3) NERI. The Net Earnings Revisions Index (NERI) of the Transportation sector turned increasingly positive over the past five months through June, following 21 consecutive months of negative readings (Fig. 15). The rebound in NERI has been led by an impressive turnaround in NERI for the Railroad industry (Fig. 16).

Strategy II: Another Earnings Season. Joe reports that as the Q2-2017 earnings season is starting, industry analysts are expecting S&P 500 earnings to be up 7.9% y/y. We are expecting about the same, though the result could be a bit better given that analysts tend to lower their estimates too much in the weeks approaching earnings reporting seasons. They’ve lowered their estimate for Q2 by 3.8% since the start of this year (Fig. 17). Here are the analysts’ current earnings growth expectations for the 11 sectors of the S&P 500: Consumer Discretionary (0.9%), Consumer Staples (3.5), Energy (660.2), Financials (7.5), Health Care (2.3), Industrials (2.4), Materials (4.3), Real Estate (1.9), Tech (11.2), Telecom (1.1), and Utilities (-2.8).

More of the Same

July 10, 2017 (Monday)

See the pdf and the collection of the individual charts linked below.

(1) No surprises in payroll employment. (2) Wage inflation remains subdued but outpacing price inflation. (3) Earned Income Proxy augurs well for consumer spending. (4) Consumers upbeat, especially about here and now. (5) Despite wild swings in CESI, real GDP growth steady around 2.0%. (6) Boom-Bust Barometer and Weekly Leading Indicator remain bullish for equities. (7) Fed’s Fischer has lots to say, but not much is new. (8) Fed remains on slow but steady normalization course. (9) Movie: “The Beguiled” (- - -).


US Employment: Same Old, Same Old. This is starting to get dull. There just isn’t much happening other than more of the same. In the US, private-sector payroll employment has increased 170,800 per month on average during the first six months of the year. Sound familiar? Here are the average gains for 2016, 2015, 2014, 2013, and 2012: 160,700, 216,700, 235,700, 210,200, and 186,800 (Fig. 1). Although the unemployment rate has been below 5.0% for the past 14 months and below 4.5% for the past three months, wage inflation, as measured by average hourly earnings, remains around 2.5% on a y/y basis, as it has since the end of 2015 (Fig. 2). When the unemployment rate got this low during the previous two economic cycles, wage inflation rose to around 4.0%. Here are a few related developments:

(1) Jobs. Interestingly, payroll employment among general merchandise stores, which dropped 63,800 during the first three months of the year, rose during two of the past three months by a total of 19,800 (Fig. 3). In the natural resources industry, payroll employment has increased 56,000 since bottoming during October of last year (Fig. 4). The recovery in construction employment seems to have stalled in recent months, probably reflecting a shortage of workers rather than of work (Fig. 5).

(2) Wages. Helping to keep a lid on wage inflation is that price inflation remains subdued below wage inflation. The PCED headline and core inflation rates were both 1.4% y/y during May, well below the Fed’s 2.0% target (Fig. 6). Using the headline PCED, real average hourly earnings rose to a record high during May (Fig. 7). That’s up 5.7% since the start of the current economic expansion during June 2009, and 13.0% since May 2002. The notion that real wages have stagnated for the past 15 years is an urban legend!

(3) Earned income. It all adds up to yet another new high in our Earned Income Proxy (EIP) for private-sector wages and salaries (Fig. 8). It rose 0.6% m/m during June and 4.5% y/y. Adjusted for the headline PCED, we reckon that the EIP rose 0.7% m/m and 3.3% y/y. This augurs well for consumer spending.

(4) Confidence. The strength of the labor market is buoying consumer confidence. The Consumer Optimism Index (COI), which is an average of the Consumer Sentiment Index and the Consumer Confidence Index, edged down in June, but remained near the recent cyclical high (Fig. 9). The COI’s current conditions component rose to a new cyclical high last month.

The increases in real wages and payrolls and the recent decreases in gasoline prices are boosting confidence. Uncertainty about the fate of the Trump administration’s health care and tax reform policies doesn’t seem to be weighing on overall confidence so far.

US Economy: Staying on Course. Friday’s better-than-expected news on employment followed two solid readings for June’s M-PMI (57.8) and NM-PMI (57.4). Both registered very high readings for their new orders components, at 63.5 and 60.5, while their employment components were also quite good, at 57.2 and 55.8 (Fig. 10). The M-PMI augurs well for the growth rate in S&P 500 revenues since they are positively correlated (Fig. 11).

As Debbie and I have noted before, we don’t get too excited when the Citigroup Economic Surprise Index takes a dive, as it did during the first half of the year (Fig. 12). That’s because it is extremely volatile and cyclical. After it falls, it always rebounds, until it falls again. It may be starting to rebound again. While the latest economic indicators are looking up, there’s no reason to believe that real GDP won’t continue to increase at a relatively leisurely pace of 2.0% on a y/y basis, as it has since the second half of 2010.

Stocks: Still Fundamentally Good. The latest ascent into record-high territory for the S&P 500, with historically high P/Es, naturally has raised fears of a correction, or worse. It seems to Joe and me that the market is doing a very good job of correcting internally on a regular basis without giving up the high ground. The latest example is the recent selloff in technology stocks and rebound in financial ones. That might continue without triggering a market-wide selloff.

Meanwhile, two of our favorite weekly fundamental stock market indicators continue to support the bull market trend. Here is an update:

(1) Our Boom-Bust Barometer (BBB) is simply the ratio of the CRB raw industrials spot price index and weekly initial unemployment claims (Fig. 13). It remains in record-high territory, with a whopping y/y gain of 21%.

(2) Our Weekly Leading Index (WLI) averages our BBB and the Bloomberg weekly Consumer Comfort Index (Fig. 14). WLI tracks the S&P 500 even better than our BBB. It is also up in record territory, with a gain of 13% y/y.

(3) Forward earnings. Both measures have been highly correlated with the S&P 500 since 2000. That’s because both have been highly correlated with the forward earnings of the S&P 500, which rose to yet another record high during the 6/29 week (Fig. 15 and Fig. 16).

Fed’s Fischer: Yada, Yada, Yada. FRB Vice Chairman Stanley Fischer has been a particularly active Fed governor this summer, having given three formal speeches in the past month. Fischer is an important voice on the FOMC whose opinion tends to carry weight across the Committee, especially with Fed Chair Janet Yellen. Though wordy, none of the speeches discussed the direction of monetary policy. Rather, the focus was on Fischer’s concerns regarding the health of the US economy and financial markets.

Importantly, however, there was nothing in Fischer’s recent speeches to suggest that he is wavering from his previous comments on the need for the gradual pace of monetary normalization to stay on course. During April, he said that a continued gradual increase in interest rates (about one more this year) would be appropriate and unaffected by the start of the slow unwinding of the Fed’s balance sheet. Below, we summarize Fischer’s latest speeches, all of which seem to indicate that he expects more of the same:

(1) More melt-up. On June 27 at an IMF workshop in Washington, D.C., Fischer outlined four areas of cyclical vulnerability related to financial stability, including financial-sector leverage, nonfinancial-sector borrowing, liquidity and maturity transformation, and asset valuation pressures. Summarizing his assessment, Fischer said: “[O]verall, a range of indicators point to vulnerability that is moderate when compared with past periods: Leverage in the financial sector is at historically low levels, and ... vulnerabilities associated with liquidity and maturity transformation appear to have decreased. However, the increase in prices of risky assets in most asset markets over the past six months points to a notable uptick in risk appetites, although this shift has not yet led to a pickup in the pace of borrowing or a sizable rise in leverage at financial institutions.”

(2) More low-productivity. “How much does productivity growth matter? The basic answer: simple arithmetic says it matters a lot,” according to Fischer’s concluding remarks at a July 6 forum in Massachusetts. “[T]he U.S. economy has been in a low-productivity growth period since 1974 [except for the mid-1990s]. The record for the past five years has been particularly dismal.” Fischer attributed the recent decline in productivity growth to several factors, including weak private-sector investment, which “may in part reflect uncertainty about the [fiscal] policy environment.”

On the public front, Fischer presented a chart showing that government-funded R&D as a share of GDP is at a record low, which in his words is “disturbing.” Nevertheless, he optimistically concluded: “Governments can take sensible actions to promote more rapid productivity growth.” In other words, Fischer seems to be expecting more of the same productivity growth until fiscal policymakers save the day, a sentiment he has reiterated before.

(3) More to be done. On June 20, at a macroprudential conference in the Netherlands, Fischer homed in on housing and financial stability. Interestingly, he attributed vulnerabilities in housing to low interest rates: “With the recent crisis fresh in mind, a number of countries have taken steps to strengthen the resilience of their housing finance systems. ... But memories fade. Fannie, Freddie, and the Federal Housing Administration are now the dominant providers of mortgage funding, and the FHLBs have expanded their balance sheets notably. House prices are now high and rising in several countries, perhaps as a result of extended periods of low interest rates.”

(4) More communication. How can we be sure that Fischer hasn’t changed his tune? Because he hasn’t given us reason to believe otherwise. In an April 17 speech, Fischer directly informed the markets about his thinking on the Fed’s communication strategy. He asked: “How can the Fed avoid surprising markets?” Then answering his own question, he said: “Clear communication of the Federal Open Market Committee’s (FOMC’s) views on the economic outlook and the likely evolution of policy is essential in managing the market’s expectations.”

Specifically, Fischer spoke about the FOMC’s desire to avoid a repeat of the mid-2013 “taper tantrum.” In his view, such an event is unlikely to happen again because the Fed has given its clear guidance that the unwinding of its asset purchases is likely to begin this year in a slow and painless fashion. So far, he noted, the markets have had a muted reaction to that prospect.

Movie. “The Beguiled” (- - -) (link) is a dark movie directed by Sofia Coppola and starring Colin Farrell and Nicole Kidman. Most of it was filmed at night by candle light, so bring a flash light. It is a remake of a 1971 movie featuring Clint Eastwood and Geraldine Page, and set in an all-girl boarding school in the rural South during the American Civil War. The movie is very slow moving, and all too predictable. There is a subliminal message for stock investors: Beware of a wounded bull that seems to be recovering, only to turn on you.


July 06, 2017 (Thursday)

See the pdf and the collection of the individual charts linked below.

(1) Lots of bucks per bang. (2) Wickedly awesome IPOs. (3) Biotech returns with healthy returns. (4) More Tech IPOs. (5) Not much energy in Energy. (6) Buybacks drown new issues. (7) Banks pass Fed’s stress test and reward investors with dividend hikes and buybacks. (8) Tech should rebound after some profit taking. (9) World semiconductor sales at record high.


Strategy I: IPO Extravaganza. The Fourth of July is a great day for Americans. We celebrate our independence by going to the beach or enjoying a barbeque in the backyard with family and friends. Then we go to see fireworks at the end of the day. Firecrackers come with some great names and can be surprisingly pricey. The Wickedly Awesome 115 shot retails for $199.99, while the Swashbuckler 72-shot is $149.99, according to So perhaps it should be no surprise that the US fireworks industry had $1.2 billion in revenue last year, according to the American Pyrotechnics Association, or—we kid you not.

In our business, there have been some impressive fireworks in the IPO market so far this year. The Renaissance IPO index has returned 20.5% ytd through June 30, surpassing the S&P 500’s 8.2% return over the same period. Likewise, the average IPO gained 11% in Q2, compared to the S&P 500’s 2.3% return. But it’s the top performing IPOs priced in 2017 that have really been on fire, in some cases returning north of 60%. Let’s take a look at what’s been heating up the IPO market so far this year.

(1) Healthy returns. In the first half of 2017, there were 77 IPOs raising $20.5 billion, the best result in the market since 2015, Renaissance Capital reports. With the year only halfway done, the IPO market has raised more than was raised in all of 2016.

The largest number of IPOs in the first half were done in the Health Care sector, which saw 18 deals, according to Renaissance. The sector was also home to the top performing IPO, BeyondSpring, which enjoyed a 141.8% return since its March offering through July 3. The biotech company, which generates no revenue, is testing drugs that it hopes will reduce infection in chemotherapy patients and will treat certain lung cancers. Other Health Care names among the top 10 best performing IPOs priced this year through July 3 are AnaptysBio, up 66.7%, Biohaven Pharmaceutical Holding, up 53.0% and Athenex, up 51.4%, according to The recent upturn in the S&P 500 Biotechnology stock price index suggests that investors are looking for healthy returns from this sector again.

But the Health Care sector also housed a number of the IPO market’s biggest clunkers. Notably, Zymeworks, a biotech company, is down 36.3% from its April IPO and ObsEva S.A., a biotech company developing drugs to increase women’s reproductivity, has lost 50.1% since its January offering.

(2) Home sweet home. Benefitting from the boom in home purchases and renovation, the IPO of Floor & Décor Holdings has gained 82.5% since its April IPO, making it the second best performer of the IPOs priced this year. The company’s “same-store sales have grown by double-digit percentages for eight consecutive years, fueling investor appetite for its initial public offering…” a 5/3 WSJ article reported. The company has 72 locations, but would like to grow to 400 stores by increasing its store base by about 20% a year.

Another consumer goods company, Canada Goose Holdings, was the fourth best performing IPO priced this year. Since its March IPO, shares of the maker of very pricey winter coats have gained 54.8%. Another sign that times are good: Canada Goose returned to the well last Tuesday, selling $259.4 million of shares that were owned by investors in and managers of the company.

(3) Snap, crackle, pop. The Tech sector had the largest dollar-volume of deals in the first half, $5.6 billion, according to the Renaissance report. The tally was boosted by the year’s largest IPO, the $3.4 billion deal from Snap. However bigger doesn’t necessarily mean better. Snap shares have risen only 3.5% since its March IPO. Shares have come under pressure as Facebook has become increasingly competitive in the same space through its Instagram division.

Tech companies developing software to sell to corporations have fared better in the IPO market this year. Shares of Appian, which makes software for developing enterprise applications, are up 47.6% from its May IPO. Shares of MuleSoft, which sells companies software to integrate their applications, have gained 47.2% since a March offering. And SMART Global Holdings, a semiconductor company, has shares that climbed 42.8% just since its May 24th IPO.

This year’s second largest IPO has fared a bit better than the year’s largest offering. Altice USA’s $1.9 billion IPO has gained 6.3% since June 22 offering. A subsidiary of the Netherland’s-based Altice NV, the US company was formed by last year’s merger of Cablevision Systems and Suddenlink Communications.

(4) No energy. With the price of Brent down 13% ytd, it’s not surprising that IPOs in the Energy sector have had a tough time. Shares of Antero Midstream GP, the general partner of Antero Midstream, which owns assets like gathering pipelines and compressor stations, are down 6.8% since its May IPO. The IPO of Select Energy Services, which provides water solutions to US frackers, has dropped 13.4%, and the January IPO of Keane Group, which provides well completion services to fracking companies, fell 14.3%.

(5) Up and down. The Fed’s tally of new nonfinancial corporate equity issuance, which includes initial and secondary stock offerings, has also had a solid rebound, with companies raising $43.1 in the first five months of this year, compared to the $32.4 raised last year over the same period. Activity is slowly climbing back to the elevated levels enjoyed in 2014 and 2015, before the volume of stock offerings dropped sharply last year (Fig. 1).

Despite the elevated IPO and secondary issuance, outstanding equities continue to shrink thanks to share buyback activities. Nonfinancial corporate equities outstanding have shrunk by $550 billion over the past four quarters through Q1-2017 (Fig. 2).

Strategy II: Shifting Sands. As the first half of the year wrapped up, sector leadership took a dramatic turn: The S&P 500 Financials sector suddenly surged ahead and the S&P 500 Tech sector stumbled badly. It’s quite a reversal from earlier in the year. Let’s take a closer look at what’s causing these changes just as the year enters its second half.

(1) Financials gaining. Over the four weeks through July 3, the S&P 500 Financials sector gained 6.8%, making it the best performing S&P 500 sector, while the Tech sector dropped 4.9%, making it the worst performer.

The change in momentum has reduced the ytd (through July 3) return for the Tech sector to 15.4%, but it remains the best performing sector so far this year. Likewise, the Financials sector’s return this year has improved to 7.4%, but it continues to lag behind the S&P 500’s 8.5% ytd performance. The sector that has shown the steadiest returns is the Health Care sector, which is the second best performing sector both ytd—up 15.2%—and over the past four weeks—up 3.1% (Fig. 3).

(2) Passing the test. The industries propelling Financials to the top of the heap over the past four weeks include Diversified Banks (9.8%), Regional Banks (7.9), Investment Banking & Brokerage (7.7), Consumer Finance (7.4), and Asset Management & Custody Banks (6.8). Diversified Banks is the third best performer among the 100 industries that we track and the other Financial industries are among the top 10 performing industries (Fig. 4).

The S&P 500 Financials stock price index was boosted by news last Wednesday that all of the banks taking the annual Federal Reserve stress test passed it and many were given permission to increase their dividends and stock repurchases. It also didn’t hurt that the Federal Reserve raised interest rates by a quarter point on June 14 and has indicated it plans to reduce its balance sheet in the coming months. Fed officials have implied an announcement laying out their plans could come as soon as September, the 7/4 WSJ reported. Financials also improved as the spread between the fed funds rate and the 10-year Treasury yield widened from 98 bps on June 26 to 119 bps on Monday.

The Financials sector remains at the top of the heap on a y/y basis through July 3, up 35.3%, with a nice lead over the Tech sector, which is up 30.6%. Both have far outpaced the S&P 500’s 15.5% return over the same period (Table 1).

Earnings in the S&P 500 Financials sector are expected grow 12.1% over the next 12 months and the sector has a forward P/E of 13.9 (Fig. 5 and Fig. 6). Meanwhile, analysts forecast S&P 500 Tech sector earnings will grow by 11.6% over the next year and it has a forward P/E of 18.1 (Fig. 7 and Fig. 8). Looked at side by side, it’s easy to understand why investors may be willing to give the underperforming Financials sector a go as the year enters the home stretch.

(3) Chips with salsa. Some of the highest flying industries in the Tech sector have fallen the hardest over the past four weeks. The S&P 500 Semiconductor Equipment industry index, which was up 44.4% ytd through June 2, has fallen 12.8% since then. Likewise, the Semiconductors index, which climbed 13.4% ytd through June 2, has fallen 7.3% in the four subsequent weeks. And after climbing 27.7% from the start of the year through June 2, the Internet Software & Services index has dropped 6.0% (Fig. 9).

The recent downward move may be just what some of the Tech industries need to consolidate their gains before moving higher in step with above-average earnings growth. Worldwide semiconductor sales continue to hit new record highs, most recently in April (Fig. 10). The Semiconductor Equipment industry is expected to grow earnings 15.6%, higher than the industry’s forward 13.7 price-to-earnings ratio. And Semiconductors is expected to grow earnings 11.0%, has a forward P/E of 14.9.

The Third Mandate

Jun 29, 2017 (Thursday)

Happy Fourth of July! We will be back on July 6.

See the pdf and the collection of the individual charts linked below.

(1) Fed officials need our attention. (2) Four rate hikes later, no tightening tantrum. (3) Stock and bond investors responding to Fed with benign neglect. (4) Bond yield, yield curve, and expected inflation all telling Fed “no mas.” (5) Fed should fear that halting rate hikes will send stocks to the moon. (6) Melt-ups are not conducive to financial stability. (7) Williams, Fischer, Yellen all weigh in on the subject. (8) The Fed’s “great unwinding” is winding down the road. (9) Furniture sales on flying carpet.


Strategy I: Benign Neglect. Like most of us, Fed officials don’t like to be ignored. A few of them crave attention. That’s why Fed officials love giving speeches and appearing on CNBC. However, over the past year or so, investors have moved on. They seem to have lost their interest in the Fed. That was not the case at the beginning of 2016 when two Fed officials—namely, Fed Vice Chairman Stanley Fischer and FRB-SF President John Williams—warned investors that four rate hikes were likely over the rest of the year. They were hammering home the message of the December 15-16, 2015 meeting of the FOMC, when the committee hiked the federal funds rate for the first time during the current expansion and released a dot plot indicating four rate hikes in 2016.

The S&P 500 plunged 13.3% early last year from its high on November 3, 2015 to a low of 1829.08 on February 11, 2016 (Fig. 1). The two Fed officials realized that they were getting too much attention and backed off, toning down their market-rattling rhetoric in subsequent clarifications of what they really meant. The 25bps rate hike at the end of 2015 to 0.25%-0.50% was followed by another “one-and-done” hike in 2016 to 0.50%-0.75% at the end of 2016, a third hike on March 15 this year to 0.75%-1.00%, and a fourth to 1.00%-1.25% on June 14.

However, there were no tightening tantrums in the financial markets. Investors simply lost interest in the Fed and adopted an attitude of benign neglect, much to the consternation of attention-needy Fed officials. Consider the following:

(1) Stocks. The stock market mostly ignored all those hikes, proceeding to melt up from last year’s low by 34.1% to a record high of 2543.46 on June 19. Yesterday, It closed only 1.4% below that level on Tuesday. The forward P/Es of the S&P 500/400/600 rose from 14.8, 14.8, and 15.2 in early on February 2016 to 17.4, 18.0, and 19.2 on Tuesday (Fig. 2).

The Buffett ratio, which is the market value of US stocks traded in the US divided by GNP, rose to 1.72 during Q1, nearing its record high of 1.80 during Q1-2000 (Fig. 3). The similar ratio of the S&P 500 market capitalization divided by the composite’s revenues rose to 2.00 during Q1, matching the previous record high. A comparable weekly measure using the S&P 500 stock price index divided by forward revenues per share rose to a record 1.95 during the week of June 22 (Fig. 4).

(2) Bonds. Initially, the reaction in the bond market to the Fed’s rate hikes was also extremely benign (Fig. 5). The US Treasury 10-year bond yield plunged 93 bps from 2.30% on December 16, 2015 to a record low of 1.37% on July 8 of last year. The yield curve spread narrowed from 215 bps to 97 bps over this period (Fig. 6). Last year’s lows in both were made on July 8, a few days after the Brexit vote. Yields fell and the yield curve narrowed during the first half of last year because the economy looked weak according to the Citigroup Economic Surprise Index (CESI) (Fig. 7). In addition, inflationary expectations over the next 10 years remained subdued around 1.5% (Fig. 8).

From last year’s low, the bond yield jumped to this year’s high (so far) of 2.62% on March 13. The yield curve spread widened to 196 bps on the same day. The Brexit vote didn’t precipitate a financial crisis as was feared by many. The CESI rebounded smartly from last summer’s low of -25.4 to peak at 57.3 on March 15 of this year as the economy recovered from the energy industry’s rolling recession. Of course, much of the surge in the bond yield and the yield curve spread occurred after Election Day when Donald Trump’s ambitious and stimulative agenda of tax cuts and infrastructure spending suddenly looked possible. Animal spirits soared according to surveys of consumer and business confidence. So did stock prices.

However, the CESI, which peaked on March 15 at 57.9 proceeded to plunge to the most recent low of -78.6 on June 16. The 10-year yield was down to 2.21% on Tuesday, and the yield curve spread was 105, near Monday’s 98, which was the narrowest since right after the Brexit vote! Expected inflation over the next 10 years was 1.73% yesterday, down from the recent peak of 2.08%.

(3) Currencies & commodities. The currency markets have also mostly ignored the Fed. Despite the March and June rate hikes, the JP Morgan trade-weighted dollar peaked on January 6, and fell 17% through yesterday (Fig. 9). The FOMC’s latest Summary of Economic Projections shows that the Committee is aiming to raise the federal funds rate maybe three to four more times to achieve the median projection of 2.1% by the end of next year. Yet the dollar remains weak. Usually, a weak dollar should be bullish for commodities. Instead, the price of a barrel of Brent crude oil has fallen from a recent high of $57.10 to $47.23 yesterday (Fig. 10). Over this same period, the CRB raw industrials spot price index has stalled after rising smartly since late 2015.

Strategy II: Fed Raid. Fed officials may be coming around to believe that further rate hikes may be a mistake given the weakness in the CESI, the drop in bond yields, the flattening of the yield curve, and the decline in expected inflation. However, they may be increasingly concerned that if they signal a halt to rate hikes, stock prices might continue to melt up. Their congressional mandate is to aim for full employment with price stability. Their third, though unofficial, mandate is to maintain financial stability. This would explain the recent spate of comments by Fed officials on this subject. They are clearly trying to get our attention. Consider the following:

(1) Williams. “The stock market seems to be running pretty much on fumes,” FRB-SF President John Williams said in an interview in Sydney, as Reuters discussed on Tuesday. “It’s something that clearly is a risk to the U.S. economy, some correction there—it's something we have to be prepared for to respond to if it does happen,” he said. On the one hand, the bank president said that he is concerned about the “complacency in the market,” citing low measures of market volatility. On the other hand, Williams doesn’t foresee a major crash coming because the market is underpinned by a fundamentally sound US economy, in his opinion.

For Williams, the bottom line seems to be that the course of reducing monetary stimulus will continue to be slow and steady. That would be in keeping with his concerns about the market and remarks he made in a speech in Sydney on Tuesday that the US economic expansion will be sustained, but slow. During his speech, Williams focused on long-term demographic drivers weighing on growth, productivity, and inflation. Prior to his speech, Williams told reporters that just three rate hikes this year and three to four hikes next year would be fine. Williams gets to participate in FOMC meetings this year, but he doesn’t get a vote.

(2) Fischer. FRB Vice Chairman Stanley Fischer has more weight than Williams because he gets a permanent vote on the Committee given his position on the Fed’s Board of Governors. Fischer too warned against market complacency in a 6/27 speech. Fischer’s broad assessment is that leverage and liquidity risk in the financial markets is “relatively low.” However, Fischer seemed to be most worried about the market’s nonplussed attitude toward perceived risks inherent in elevated asset valuations.

Fischer concluded: “Prices of risky assets have increased in most major asset markets in recent months even as risk-free rates also rose. In equity markets, price-to-earnings ratios now stand in the top quintiles of their historical distributions, while corporate bond spreads are near their post-crisis lows. Prices of commercial real estate (CRE) have grown faster than rents for some time … The general rise in valuation pressures may be partly explained by a generally brighter economic outlook, but there are signs that risk appetite increased as well. For example, estimates of equity and bond risk premiums are at the lower end of their historical distributions, and, relative to some non-price-based measures of uncertainty, the implied volatility index VIX is particularly subdued.”

For what it’s worth, as of April, Fischer seemed to be in the three-rate-hikes-this-year camp along with Williams. During mid-June, Fischer spoke about his concerns over assets prices, specifically global housing, but made no mention of the path of rate hikes. Fischer’s most recent speech didn’t mention his thoughts on the course of rate hikes either.

(3) Yellen. Of course, Fed Chair Janet Yellen carries the most weight in the FOMC. Like Fischer, she too spoke on Tuesday, describing asset valuations as “somewhat rich if you use some traditional metrics like price earnings ratios,” according to Bloomberg. She said so when answering audience questions at an event in London. The good news is that she doesn’t foresee another financial crisis “in our lifetime,” reported CNBC. She is a bit older than me, but much older than Melissa.

Fed: The Great Unwinding. Besides rates, several Fed officials have taken a position on what Melissa and I have referred to as the inevitable “great unwinding” of the Fed’s $ 4.4 trillion in assets on the balance sheet. Last month, for example, Williams indicated that the balance sheet will be “much smaller” in about five years than it is today. Tempering the possibility of a repeat 2013 “taper tantrum” when global markets panicked at the mere mention of a possible tapering of asset purchases, Williams said that the Fed will start with a “baby step” likely later this year and be quite “boring” and in the “background.”

FRB-SL Fed President James Bullard, not a voter this year, also said that he has been an advocate for getting started on balance-sheet reduction, in a 6/22 interview with the WSJ. “We’re going to do it in a very controlled and passive way that I think will be easy for markets to digest, and so I’m not expecting anything too dramatic. But I think it is important to create some policy space for the future,” he said.

Melissa and I think that the Fed will probably commence the great unwinding this year, or at least outline a plan for doing so. That insight is based not only on recent comments from Fed officials, but also the latest Statement on Monetary Policy. Depending on the Fed’s approach to the great unwinding, the pace of rate hikes could slow even further, because the Fed will want to avoid a “great unravelling” of markets should the great unwinding unnerve otherwise complacent investors.

Consumer Discretionary I: Furniture Is Flying. Overlooked amid all the gloom and doom in retail is the boom going on in the home furnishings category. It reflects positive trends in housing and the economy, in general, and parallels the favorable fundamentals of the home improvement category. And so far, home furnishings has continued to defy even the Great Disruptor that is Amazon. Fundamentals are expected to stay strong for the industry for the foreseeable future on expectations for higher household formations, increasing home sales, and continued low unemployment. Consider the following:

(1) Sales. US furniture and home furnishings sales have risen every year since 2010 (Fig. 11). During April, they totaled a record $193 billion (saar), with furniture at $110 billion and furnishings at $83 billion. The inflation-adjusted total rose to a record $1,965 (saar) on a per household basis, doubling since November 1999 (Fig. 12).

(2) Orders. New orders in the home furnishings market have been strengthening since August 2016, and a recent survey by accounting and consulting firm Smith Leonard shows that new orders in March were up by 12% y/y, a significant advance from February’s 4% y/y gain.

(3) Online. While online furniture sales—from the likes of Wayfair (W) and Amazon (AMZN) and Williams-Sonoma’s (WSM) West Elm units—still represents only about 10% of total U.S. furniture sales, it’s a swiftly growing segment.

A 5/12 WSJ article quoted a CEO whose trucking company makes large e-commerce deliveries saying “Just in the last year, furniture has taken off.” Furniture is his company's number-one business-to-consumer shipment item, recently usurping TVs.

(4) Hot stuff. What’s flying off stores’ floors? Demand for sofas and bedding is high, in particular, while outdoor furniture and vintage furniture are also popular. The vintage trend is new and noteworthy: Vintage Ikea furniture is fetching big bucks at auctions, and virtually all furniture websites now feature a vintage selection.

(5) Amazing Amazon. Amazon has been turning more attention to its online furniture business. “Furniture is one of the fastest-growing retail categories here at Amazon,” furniture general manager Veenu Taneja told the WSJ in the article cited above. He said the company is expanding its furniture-related offerings, adding custom-furniture design services as well as Ashley Furniture sofas to its lineup. Amazon also has been speeding up delivery to one or two days in some cities.

One well-known furniture retailer has decided that joining forces with Amazon is a better strategy than trying to beat the world’s biggest retailer at its own game: Ethan Allen Interiors (ETH) announced in April that it will launch the Ethan Allen Design Studio on Amazon to sell its furniture.

(6) Good performance. The strong showing hasn’t gone completely unnoticed by investors: Through Tuesday’s close, the S&P 500 Home Furnishings industry, representing manufacturers, is up 16.9% ytd and 26.9% y/y. That’s in line with the performance of the S&P 500 Home Improvement Retail industry (home- and garden-related stores), up 11.8% ytd and 15.4% y/y. In contrast, the S&P 500 Homefurnishing Retail industry (which has home furnishing retailer Bed Bath & Beyond as its sole member) hasn’t fared as well: It’s down 24.4% ytd and 26.6% y/y.

Consumer Discretionary II: Lots of Shoppers. News from many of the publicly traded furniture retailers bears out the positive top-down trends. To furnish some details:

(1) Big Lots (BIG) posted record earnings in its Q1, its sixth straight quarter of positive earnings, and gave an upbeat forecast for the year. It has been expanding its furniture offerings this summer. Company executives recently said that customers are buying higher-quality and higher-priced goods in bed and bath, and the store is selling out items at prices that are higher than it ever carried before, e.g., a $1,000 patio set. As a result, Big Lots is expanding certain departments, including furniture. A newly remodeled Columbus, OH store will feature a new “Store of the Future” format emphasizing its strongest categories—furniture, soft home goods, and décor.

(2) Bassett Furniture (BSET) saw Q1 sales rise 4% y/y, on the strength of products made domestically. Domestically made or finished and assembled products represented 71% of its wholesale shipments. US-made furniture is increasingly perceived as better made and available for faster delivery, a critical feature in an increasingly Amazon Prime-driven one-day shipping world.

(3) TJX Companies (TJX)—parent of off-price retailers TJ MAXX and Marshall’s and one of the few retailers to navigate successfully the wrenching changes in retail—plans to expand its Home Goods chain and launch a related concept called “HomeSense,” which already operates in Canada and Europe but will have a different format in the US.

(4) RH (RH), formerly known as “Restoration Hardware,” is pursuing an “un-Amazonable” strategy and totally redefining its approach to selling furniture. While it posted a 23% Q1 revenue gain, its stock plunged recently on the negative earnings impact from liquidating merchandise and adding restaurants to some of its stores.

(5) Bed Bath & Beyond (BBBY), one of the retailers included in Bespoke Investment Group’s “Death by Amazon” index, bought online furniture seller One King’s Lane last fall as a way to deflect the Amazon threat: The younger shoppers attracted to One King’s Lane tend to shop less at Amazon. It plans to open a pop-up seasonal shop in Southampton, NY this summer, the first brick-and-mortar presence for One King’s Lane, and in a former library no less. Take that, Amazon!

(6) Wayfair (W), the only pure-play online furniture seller, is benefiting doubly from both hot demand for furniture and the online channel’s increasing popularity as a furniture outlet. Furniture is one of the fastest-growing segments of US online retail, growing 18% in 2015, second only to groceries, according to Barclays. Wayfair’s direct retail revenues popped more than 32% in Q1. The S&P 500 Internet and Direct Marketing Retail industry has been a sweet spot, rising 45.9% y/y through Tuesday.

Puzzling Productivity & Profitability

Jun 28, 2017 (Wednesday)

See the pdf and the collection of the individual charts linked below.

(1) Oomph and Oompah in Germany. (2) Lots of reasons why productivity should be growing faster. (3) Technology goes from replacing brawn to brain. (4) Is that good or bad for productivity? (5) Amazon Web Services and UBER reducing demand for servers and autos. (6) Record-high profit margin belies productivity funk. (7) Stagnation is a myth: Real pay is growing. (8) Powerful forces keeping a lid on price inflation. (9) Nonfinancial corporations have lots of cash and are spending it on capex, not just buybacks.


Germany: Oomph! The word “oomph” sounds like it might be of German origin. In fact, it is an American expression dating back to 1935-40. It is imitative of the sound made during physical exertion, as when lifting a heavy object. Then again, Oomph! is a German industrial metal band formed in Wolfsburg, Germany in 1989. Today, the industrial metals business is booming in Germany, and so are many other industries. June’s Ifo Business Confidence Index soared to a new record high, led by its current situation component (Fig. 1). The series is available since 1991. The diffusion indexes for the German manufacturing, construction, wholesale trade, and retail trade components all were very strong this month (Fig. 2).

The German MSCI stock price index (in euros) is up 7.4% ytd and 29.3% y/y, compared to the US MSCI index, which is up 9.1% ytd and 18.8% y/y (Fig. 3 and Fig. 4).

It’s too early for Octoberfest, but not too early to have a couple of steins of beer in a Bavarian Biergärten while listening to an oompah band. If you start dancing, try to avoid the slapdancers.

Perversely, this happy story has yet to show up in Germany’s productivity statistics, which are just as puzzlingly weak as those in the US (Fig. 5 and Fig. 6). Over the past 20 quarters, the German measure was up at an annual rate of 0.4%, while the US rate was 0.7%.

US Productivity: Why the Long Face? Something just doesn’t add up: Despite the weak pace of productivity growth in the US, inflation is very low. Inflation-adjusted pay per worker is at a record high. Measures of corporate profit margins are at record highs. There’s a lot of anecdotal evidence that productivity-enhancing technological innovations are proliferating in many industries. The cloud allows for a much more efficient use of high-tech hardware and software across the economy. Automation and robotics have been integrated over the Internet to communicate and to interact seamlessly. The Great Disruptors—including Alphabet, Amazon, Microsoft, Tesla, and Uber—are forcing all their competitors to boost their efficiency or risk going out of business. Perhaps no industry has made more progress in increasing its productivity than the oil and gas producers, thanks to fracking technologies.

Yet none of these productivity-boosting developments are showing up in the official productivity numbers. Lots of explanations have been proffered by economists and technologists. Economists are well known for making assumptions. The optimists among them assume that the data are wrong, and will eventually be revised higher. That happened in the late 1990s. The optimists say that the government’s bean counters may be underestimating the economy’s output.

The pessimists say we are in a period of secular stagnation. Some of them claim that all the latest and future technological innovations are unlikely to boost productivity to the extent that the truly revolutionary technologies of the past had done—such as the steam engine, electricity, indoor plumbing, automobiles, air conditioning, and computers. They even question whether computers have done much to increase productivity beyond boosting the production of computers.

That’s an interesting point because, after growing rapidly during the 1980s and 1990s, inflation-adjusted capital spending on both information processing equipment and software has slowed significantly (Fig. 7). Yet in current dollars, they now account for 28.4% of total capital spending, up from 17.0% during 1980 and 8.5% during 1960 (Fig. 8).

Could it be that technological innovation aimed at complementing (or un-employing) the brain has a different impact on productivity than innovations that replace brawn? The proliferation of the cloud certainly explains why spending on IT hardware and software has slowed, since we can all rent just what we need from the cloud vendors, who are using their resources much more efficiently than we did when we owned our own software and servers, housed them at server farms, and woefully underutilized them. UBER is undoubtedly increasing the efficiency of the auto fleet while it must be weighing on car sales. How will we even measure the impact of self-driving cars on productivity? Now consider the following related notions:

(1) Inflation & profit margins. Weak productivity growth is boosting labor costs, which is defined as compensation divided by productivity. Over the past four quarters through Q1-2017, productivity in the nonfarm business (NFB) sector rose just 1.2%, while hourly compensation rose 2.3%. The NFB price deflator rose only 1.7% over this period. Yet the S&P 500 profit margin remained in record-high territory above 10.0% for 12 of the past 13 quarters, even as five-year trend productivity growth slowed from 1.5% to 0.7% over this period (Fig. 9 and Fig. 10).

(2) Real wages. In a competitive market economy, nominal wages are determined by the value of marginal productivity. That’s one of the basic principles taught in courses on microeconomics. Sure enough, the data confirm the close relationship between inflation-adjusted hourly compensation and productivity, though it’s very important to use the price deflator of the nonfarm business sector, which determines the value of the marginal product produced by workers, rather than the CPI or PCED when deflating the measure of wages (Fig. 11 and Fig. 12).

Over the past five years, both productivity and real compensation growth rates in the nonfarm business sector have been very weak, averaging 0.7% and 0.9% per year through Q1. However, the widespread view that real wages have stagnated for the past 15-20 years is just dead wrong. Over the past 20 years, real compensation in the NFB sector is up roughly 30% (Fig. 13). The laggard has been manufacturing, yet real compensation is up about 20% over the past 20 years in this sector.

Over this period, real average hourly earnings (using the NFB price deflator) for production and nonsupervisory workers, who currently account for 82% of total private payroll employment, rose 30%, continuing to closely track productivity (Fig. 14 and Fig. 15). Nominal wages are growing remarkably slowly given the tight labor market. However, adjusted for inflation they are keeping pace with productivity, which still has an uptrend. Wages are rising faster than prices, but prices are rising very slowly for reasons that may not have much to do with productivity. Global competition, disruptive technology, and aging demographics may be playing a much greater role in keeping a lid on prices, which is also keeping a lid on wages.

US Corporate Finance: Show Me the Money. Yesterday, we wrote that S&P 500 operating earnings totaled $958 billion over the past four quarters, with buybacks and dividends accounting for 95% of this total. The dividend payout ratio of the S&P 500 remains around 50%. This implies that corporations are spending all their extra cash on buybacks rather than capital spending and wages.

We noted: “The problem with this widely circulated myth is that profits are not the same as cash flow.” The latter is equal to retained earnings (i.e., after-tax profits less dividends) plus the depreciation allowance. When we add the cash flow plus net bond issuance of nonfinancial corporations (NFCs), the resulting series is more often than not very close to capital expenditures plus buybacks (Fig. 16). Here are a few round numbers for 2016 based on data compiled in the Fed’s Financial Accounts of the United States (Table F.103):

(1) Sources of cash. NFCs had reported pre-tax profits of $1,271 billion. They paid $322 billion in taxes and $617 billion in dividends. They had $1,307 billion in capital consumption allowances (CCA). Their internal cash flow, i.e., the sum of their retained earnings and CCA, was $1,639 billion. Their net bond issuance was $268 billion. These sources of cash sum to $1,907 billion.

(2) Uses of cash. Capital expenditures (including inventory investment) totaled $1,670 billion last year. Buybacks totaled $586 billion. These two categories of spending sum to $2,256 billion.

The discrepancy between the sources and uses of cash seems large, but it tends to average out over time. Besides, the analysis above excludes lots of other items in the Fed’s accounting for this sector. The main point is that cash flow is much bigger than after-tax profits less dividends. Companies have been spending a record amount on capex, including on technology, which is cheaper and more powerful than ever.

A Matter of Some Interest

Jun 27, 2017 (Tuesday)

See the pdf and the collection of the individual charts linked below.

(1) Republicans want to eliminate interest expensing, while granting 100% capital spending deduction. (2) Tax code favors leveraged balance sheets. (3) Dividends plus buybacks eating up earnings, but plenty of cash flow left for capex. (4) Tax subsidy worth $5.90 per share for S&P 500. (5) Record bond refinancing boosted profits over the past year. (6) Dividend yield valuation model shows stocks cheap relative to bonds. (7) Japan is the poster child for a geriatric society. (8) Japan’s self-extinction by the numbers. (9) From extended families to one Carebot. (10) Basic Universal Income vs. Basic Fertility Income. (11) Make babies for fun and profit.


Corporate Finance: Buybacks & Interest Expense. The 6/25 WSJ included an article titled “The $1.5 Trillion Business Tax Change Flying Under the Radar.” It noted: “Republicans looking to rewrite the U.S. tax code are taking aim at one of the foundations of modern finance—the deduction that companies get for interest they pay on debt. … Thanks in part to the deduction, the U.S. financial system is heavily oriented toward debt, which because of the tax code is often cheaper than equity financing—such as sales of stock. … Getting rid of the deduction for net interest expense, as House Republicans propose, would alter finance. It also would generate about $1.5 trillion in revenue for the government over a decade, according to the Tax Foundation, a conservative-leaning think tank.”

Eliminating the deductibility of interest expense would be paired with the immediate deductions for capital spending. Dividend payments are not deductible as an expense, but they are subject to personal income taxation. This amounts to the double taxation of dividends. With the subsidization of borrowing, the tax code clearly favors debt over equity financing by corporations. It also favors borrowing money by corporations to buy back their equites, particularly if their after-tax cost of funding is less than their forward earnings yield. Joe and I figure that’s been the case since late 2004, when S&P 500 buybacks took off (Fig. 1). The S&P 500 forward earnings yield has exceeded the pre-tax AA-AAA corporate bond yield since then. The former is currently 5.7%, while the latter is 4.0%.

Almost since the start of the current bull market, we have argued that from a flow-of-funds perspective, it has been driven by corporate cash used to buy back shares and pay out dividends, which often are reinvested in stocks. The correlation between the S&P 500 and the sum of the two corporate cash flows back into the stock market has been very high since 2004 (Fig. 2). Eliminating interest expensing could pose a threat to debt-financed buybacks as a driver of the bull market. However, that hasn’t happened yet, and it might not happen at all. We are monitoring developments in Washington’s sausage factory as best we can.

As Joe reports below, Q1 data for S&P 500 buybacks were released late last week. Here are some top-line observations on this and other corporate finance matters:

(1) Buybacks & dividends. Over the past four quarters through Q1, buybacks totaled $508.1 billion, down 13.8% from the record high of $589.4 billion through Q1-2016 (Fig. 3). Dividends totaled a record $400.0 billion through Q1. S&P 500 operating earnings totaled $958.1 billion over the past four quarters. So buybacks and dividends accounted for 94.8% of this total. The dividend payout ratio of the S&P 500 remains around 50.0% (Fig. 4). The implication is that corporations are spending all their extra cash on buybacks rather than capital spending and wages.

The problem with this widely circulated myth is that profits are not the same as cash flow, which is the sum of after-tax profits and depreciation expense. Capital spending by nonfinancial corporations (NFCs) has been hovering at a record high over the past year because corporate cash flow has been doing the same (Fig. 5). In other words, there has been enough cash for buybacks, dividends, and capital spending!

The effective corporate tax rate for the S&P 500 was 26.4% during 2016 (Fig. 6). S&P 500 companies had pre-tax interest expense of $22.90 per share during 2016 (Fig. 7). This implies that the after-tax interest expense was $16.85 per share during 2016. Their after-tax reported earnings was $101.06 per share, with the expensing of interest benefitting S&P 500 corporations $6.05 last year.

(2) Debt. The Fed’s Financial Accounts of the United States shows that NFCs had a record $8.6 trillion in debt at the end of Q1-2017 (Fig. 8). That included $2.7 trillion in loans and a record total of $5.2 trillion in bonds (Fig. 9). Data available annually show that NFCs had monetary interest expense of $487 billion during 2015, implying that the pre-tax interest rate paid on all their debts was 6.1%, the lowest since 1966 (Fig. 10 and Fig. 11).

(3) Bond issuance. Monthly data compiled by the Fed show that NFCs borrowed at a near-record $855.7 billion during the 12 months through April (Fig. 12). However, quarterly data through Q1 show net issuance of $244.6 billion. We calculate that NFCs refinanced a record $599.5 billion in their bonds over the past four quarters at record-low interest rates (Fig. 13). The resulting reduction in interest expense certainly boosted earnings over this period.

(4) Dividend yield. The dividend yield of the S&P 500 was 1.96% during Q1 (Fig. 14). It has been hovering around 2% since the mid-1990s. This means that the S&P 500 has been growing at the same trend as dividends, which is around 7.0% per year (Fig. 15). Interestingly, the dividend yield has been about the same as the US Treasury 10-year bond yield in recent years for the first time since the late 1950s. In between, the bond yield has always been higher. The higher yield reflected a premium for inflation, which erodes bond coupons but not dividends. That’s because dividends tend to grow along with nominal GDP, while coupons are fixed. Apparently today, investors believe that inflation is dead, so they don’t need an inflation premium in the bond yield relative to the dividend yield. With both yielding around 2.00%, stocks are cheap relative to bonds, since dividends grow while coupons remain fixed.

(5) Forward ho! Meanwhile, as Joe reports below, forward earnings of the S&P 500/400/600 rose to new record highs last week.

Global Demography: Japan’s Carebots. Yesterday, Melissa and I wrote about the inverse correlation between urbanization and fertility rates. As populations become more urbanized around the world, families have fewer children. People are also living longer. So populations are getting older, and there are fewer primary working-age people (15-64 years old) to support seniors (65+).

Among modern industrial economies, Japan is the poster child for the economic impact of aging demographics. Japan’s overall population is now declining at the fastest rate globally. The country sells more adult diapers than baby diapers, and its dearth of workers to support an aging population is depressing economic growth.

Japan’s fertility rate fell below the replacement rate of 2.1 children per woman during 1978 (Fig. 16). Over the past 12 months through November, marriages totaled just 52,000, the lowest on record (Fig. 17). The number of deaths has exceeded the number of births since July 2007 (Fig. 18). The working-age population peaked at a record 87.8 million during 1995 (Fig. 19). It fell to 78.1 million during 2015, and is projected be down to 55.6 million by 2050. In 1955, there were almost 12 workers per senior. Now the ratio is just barely above 2.0.

The good news is that robots may not extinguish lots of jobs done by humans. Instead, they may be vitally important to pitch in as shortages of working human stiffs become more prevalent. Japan is the most automated economy in the world, with a proliferation of robots doing all sorts of jobs, yet the jobless rate in Japan is down to 2.8%. The country is suffering from a chronic labor shortage.

Business Insider reports: “Carebots are robots specifically designed to assist elderly people, and it’s an industry that’s growing in a big way. One-third of the Japanese government’s budget is allocated to developing carebots. The global personal robot market, which includes carebots, could reach $17.4 billion by 2020, according to the Merrill Lynch report.”

There is increasing buzz about the need for Basic Universal Income to support people who can’t compete with robots. Maybe what we need instead is a Basic Fertility Income. We need to subsidize having children. That would provide an incentive for couples to make babies for fun and profit. Otherwise, we are on the road to self-extinction. Remember: Demography is destiny!

Voluntary Self-Extinction

Jun 26, 2017 (Monday)

See the pdf and the collection of the individual charts linked below.

(1) Meet Les U. Knight, who wishes for less humankind. (2) Birth dearth is depressing labor forces around the world. (3) Fertility tends to be higher on farms than in cities. (4) Crop of kids easier and cheaper to grow outside of city limits. (5) Green Revolution on balance depressed population growth. (6) Malthus got it so wrong. (7) Chinese government’s 2-child policy may be undercut by previous 1-child policy. (8) There is still fertile soil in India and Africa. (9) US leading indicators still bullish on real GDP, which is likely to remain stuck growing around 2.0%. (10) NBx2 again. (11) Movie Review: “My Cousin Rachel” (+).


Global Demography: Birth Dearth & Urbanization. The Voluntary Human Extinction Movement (VHEMT) was founded in 1991 by Les U. Knight, a high-school substitute teacher who lives in Portland, Oregon. He and his followers believe that human extinction is the best solution to the problems facing the Earth’s biosphere and humanity. The VHEMT website shows that the group’s motto is “May we live long and die out.” Their Facebook page sells tee-shirts declaring: “When You Breed, the Planet Bleeds.” Another declares: “Thank You for Not Breeding.” Sure enough, the pace of human breeding has slowed, but for reasons that have nothing to do with VHEMT.

All around the world, humans are not having enough babies to replace themselves. There are a few significant exceptions, such as India and the continent of Africa. Working-age populations are projected to decline along with populations in coming years in most of Asia (excluding India), Europe, and Latin America. The US has a brighter future, though the pace of population growth is projected to slow significantly in coming years.

There are many explanations for the decline in fertility rates around the world to below the replacement rate, which is estimated to be 2.1 children born per woman in developed countries. It is higher in some developing countries that have higher mortality rates.

Melissa and I believe that the most logical explanation is urbanization. The United Nations estimates that the percentage of the world population that has been urbanized rose from 29.6% in 1950 to just over 50.0% during 2008 (Fig. 1). This percentage is projected to rise to 66.4% by 2050. The world fertility rate was around 5.0 births per woman in the mid-1950s (Fig. 2). It fell to 2.5 in 2015. The UN projects it will fall to 2.0 by the end of this century.

In our opinion, families are likely to have more children in rural communities than urban ones. Housing is cheaper in the former than in the latter. In addition, rural populations are much more dependent on agricultural employment. They are likely to view every child as contributing to a family’s economic well-being once he or she is old enough to work in the field or tend the livestock. Adult children also are expected to support and to care for their extended families by housing and feeding their aging parents in their own huts and yurts.

In urban environments, children tend to be expensive to house, feed, and educate. When they become urban-dwelling adults, they are less likely to welcome an extended-family living arrangement, with their aging parents living with them in a cramped city apartment. A UN report titled “World Urbanization Prospects: The 2014 Revision,” noted, “The process of urbanization historically has been associated with other important economic and social transformations, which have brought greater geographic mobility, lower fertility, longer life expectancy and population ageing.”

In our opinion, the urbanization trend since the end of World War II was attributable in large part to the “Green Revolution,” the term coined by William Gaud, the former director of the US Agency for International Development, a.k.a. USAID, to give a name to the spread of new agricultural technologies: “These and other developments in the field of agriculture contain the makings of a new revolution. It is not a violent Red Revolution like that of the Soviets, nor is it a White Revolution like that of the Shah of Iran. I call it the Green Revolution.”

In 1970, Norman Borlaug—often called “the Father of the Green Revolution”—won the Nobel Peace Prize. A January 1997 article about him written by Gregg Easterbrook in The Atlantic was titled “Forgotten Benefactor of Humanity.” Easterbrook wrote that the agronomist’s techniques for high-yield agriculture were “responsible for the fact that throughout the postwar era, except in sub-Saharan Africa, global food production has expanded faster than the human population, averting the mass starvations that were widely predicted.” Borlaug may have prevented a billion deaths as a result.

The resulting productivity boom in agriculture eliminated lots of jobs and forced small farmers to sell their plots to large agricultural enterprises that could use the latest technologies to feed many more people in the cities with fewer workers in the fields. Ironically, then, the Green Revolution provided enough food to feed a population explosion. Instead of working the land on family farms, much of the population moved to the cities and had fewer kids! Good old Tommy Malthus, the dismal scientist of economics and demographics, never anticipated ag tech and urbanization. Now consider the following related developments:

(1) China. The fertility rate in China has plunged from 6.0 in the mid-1950s to below 2.0 during 1996 (Fig. 3). It remains below that level and is projected to do so through the end of the century. Initially, the drop had less to do with urbanization than with the government’s response to the country’s population explosion, which was to introduce the one-child policy in 1979. That did slow the 10-year growth rate in China’s population from a peak of near 3.0% at an annual rate during 1968 to 0.5% in 2016. However, it also led to a shortage of young adult workers and a rapidly aging population. So the government reversed course, with a two-child policy effective January 1, 2016.

Meanwhile, urbanization has proceeded apace, with the percentage of the urban population rising from 10.0% in 1950 to 50.0% during 2010 and reaching 57.3% in 2016 (Fig. 4). The urban population increased by 21.8 million that year, which is truly extraordinary, as this category has been increasing consistently by around 20 million per year since 1996 (Fig. 5). To urbanize that many people requires the equivalent of building one Houston, Texas per month! I first made that point in a 2004 study.

In our opinion, the move to a two-child policy is coming too late. China’s primary working-age population (15-64 years old) peaked at a record high of 1.02 billion during 2014 and is projected to fall to 815 million by 2050 (Fig. 6). By 2050, the primary working-age population in China will represent 59.7% of the total population, below the peak of 73.8% during 2010 (Fig. 7). Over the same time span, the elderly dependency ratio, which we define as the primary working-age population divided by the number of seniors (65+), will fall from 8.8 workers/senior to 2.3 by 2050; even more eye-popping is the drop from its peak of 16.2 during 1965 (Fig. 8).

In any event, the fertility rate is unlikely to rise in response to the government’s new policy. Young married couples living in cities are hard-pressed to afford having just one child. An 10/30/15 article in the Washington Post titled “Why many families in China won’t want more than one kid even if they can have them,” observed:

“[F]or many couples, it has become very costly to have kids in China. To prepare a child to succeed in the country’s competitive schools and workplaces, parents must invest lots of time and money in a child—for schooling, extracurricular activities, and outside tutoring, often for college-entrance and English proficiency exams.” Another problem is that most “Chinese of child-bearing age are single kids, and they may forgo having another kid in order to better support their aging parents.” As is written in the Bible, “As you sow, so shall you reap.”

(2) US. The fertility rate in the US was over 3.0 during the second half of the 1950s (Fig. 9). It fell just below 2.0 during 2013, and been hovering around that level since then. The percent of Americans living in rural areas fell from 30.0% during 1960 to 18.4% during 2015 (Fig. 10). The UN projects that the primary working-age population will continue to grow through 2050, though the growth rate will be very low (Fig. 11 and Fig. 12).

(3) Europe. The fertility rate in Europe fell from 2.7 during the late 1950s to below 2.0 during 1980, and has remained below that level ever since; it’s projected to remain below the replacement rate through the end of the century (Fig. 13). Europe’s primary working-age population peaked at a record 503 million during 2010 and is expected to decline to 361 million by the end of the century (Fig. 14).

(4) Africa & India. During 2015, among the highest fertility rates were in India (2.5) and Africa (4.7). They are projected to decline to 1.9 and 3.1 by 2050. India’s primary working-age population is projected to rise from 860 million during 2015 to peak at 1.12 billion during 2050 before heading lower over the remainder of the century. Africa’s primary working-age population stands out, as it is projected to rise from 663 million during 2015 to 1.57 billion during 2050 and 2.84 billion by the end of the century. India and Africa remain predominantly rural.

(5) Latin America. The fertility rate in Latin America was 2.2 during 2015 and is expected to fall to 1.8 by 2050. The region’s working-age population was 422 million during 2015 and is projected to peak during the early 2040s at 500 million before heading downwards to 390 million by the end of the century.

(6) Study guide. The UN also has a report titled “World Fertility Patterns 2015.” Nearly half the world lives in countries with below-replacement levels of fertility. According to the report: “Today, 46 per cent of the world’s population lives in countries with low levels of fertility, where women have fewer than 2.1 children on average. Low-fertility countries now include all of Europe and Northern America, as well as many countries in Asia and Latin America and the Caribbean. Another 46 per cent of the world’s population lives in ‘intermediate-fertility’ countries that have already experienced substantial fertility declines and where women have on average between 2.1 and 5 children.”

Melissa, Mali, and I are working on creating a bunch of global demography chart books for our website’s Global Demography section. So far, we have Global Population, Global Working-Age Population, and Global Elderly Dependency Ratios.

US Economy: Leading the Way. As Debbie reports below, both the Index of Leading Economic Indicators (LEI) and the Index of Coincident Economic Indicators (CEI) rose to fresh record highs during May (Fig. 15). Here are a few top-line impressions:

(1) Previously, we’ve reported that a benchmark analysis of the previous five cyclical upturns in the CEI shows that the average duration of the expansion phase (once the index had recovered to the previous cyclical peak) was 65 months, which would put the next peak during March 2019 (Fig. 16). The average increase during the past five expansions (from the latest peak to the previous one) was 18.6%. The current one is up only 7.8%, so it might have a ways to go on this benchmark.

(2) For the here and now, the CEI is up 2.1% y/y through May (Fig. 17). This growth rate has been highly and closely correlated with the y/y growth rate in real GDP. Both have been hovering around 2.0% since mid-2010.

(3) The ratio of the LEI to CEI is remarkably well correlated with the Resource Utilization Rate, which is the average of the capacity utilization rate and the employment rate (i.e., 100 minus the unemployment rate) (Fig. 18). They’ve both recovered smartly since their 2009 troughs but remain well below their previous cyclical peaks, supporting our No-Boom-No-Bust (NBx2) scenario for now.

(4) The big worry, of course, has been the significant narrowing of the yield curve spread, which is one of the 10 LEI components, in recent weeks. It has been a reliable indicator of recessions when it has turned negative. Keep in mind, though, that it hasn’t turned negative, and that it is only one of the components of the LEI. There are nine others, including the S&P 500, which is at a record high. (See our Leading & Coincident Indicators.)

Movie. “My Cousin Rachel” (+) (link) is based on a novel by the late English author Dame Daphne du Maurier. She wrote romances that rarely had conventional happy endings. At least Romeo and Juliet had a few good moments together before they met their tragic end. For the romantic couples in Daphne’s novels, there are fewer happy moments before it all ends badly. Her novels have been described as “moody.” She spent much of her life in Cornwall, where most of her works are set. This movie, starring Rachel Weisz as the moody “Rachel” of the title, is also set in Cornwall, and has an unsettling beginning, middle, and ending too. It reminds me of our relationship with politicians these days: We want to love them, but they always let us down. Let’s hope they don’t kill us.

Sheik Up

Jun 22, 2017 (Thursday)

See the pdf and the collection of the individual charts linked below.

(1) Opaque oil: Hard to see higher prices. (2) S&P 500 Energy is dead last so far this year. (3) US, Libya, and Nigeria are offsetting OPEC’s production cuts. (4) Tanks and tankers filled to the brim with crude. (5) Saudis give more power to a young sheik. (6) Saudi Vision 2030 plan aims to diversify economy away from oil. (7) Oil weighs less on S&P 500. (8) Saudis selling the family’s jewel. (9) Cheers for S&P 500 Restaurants.


Energy: Crude Reality. Oil investors don’t like what they see: too much supply and not enough demand. They don’t like the growing number of barrels being produced in America, Libya, and Nigeria. Nor are they comforted by the sluggish growth in demand caused by the lackluster pace of global economic activity, increased energy efficiency, and alternative fuels. This one-two-three punch has sent the price of Brent crude oil into its latest bear market, down 21% to $44.92 as of yesterday’s close (Fig. 1).

Energy is the worst-performing S&P 500 sector ytd, down 13.5%, and many of the sector’s industries are doing even more poorly: Oil & Gas Drilling has lost 36.4% ytd, Oil & Gas Exploration & Production has lost 20.5%, and Oil & Gas Equipment & Services is down 19.3% (Fig. 2 and Fig. 3).

Most other S&P 500 sectors have been enjoying much better ytd performances through Tuesday’s close: Tech (18.2%), Health Care (14.4), Utilities (11.0), Consumer Discretionary (10.3), Materials (9.0), Industrials (8.9), S&P 500 (8.9), Consumer Staples (8.8), Real Estate (5.5), Financials (4.6), Telecom Services (-10.5), and Energy (-13.5) (Table). Let’s take a look at the push and pulls affecting the price of black gold:

(1) The US is pumping. In Q1, the amount of oil being produced and the amount of oil being consumed weren’t that far out of whack. Total world demand was 96.5 mbd in Q1, and total supply was 96.6 mbd, according to the International Energy Agency’s (IEA) 5/16 Oil Market Report. That’s a significant improvement from Q4-2016, when demand was 97.7 mbd and supply was 98.3 mbd. OPEC’s production cut of about 1.8 mbd, which began last year and is expected to continue through March 2018, looked like it was balancing the market until recently.

However, continued supply growth out of the US and production rebounds in Libya and Nigeria subsequently have overshadowed OPEC cuts. US crude production hit 9.35 mbd after rising by 20,000 barrels during the week of June 16. As a result, production is not far from the peak amount produced during the week of June 5, 2015, 9.6 mbd (Fig. 4). Production never fell as dramatically as the US oil rig count, as producers managed to coax more oil out of existing wells. And after bottoming in late May 2016 at 316, the number of US rigs has increased to 747 (Fig. 5).

Those rigs have been awfully busy. At the end of May, there were 5,946 drilled-but-uncompleted wells, the most in at least three years, according to estimates by the US Energy Information Administration (EIA). “In the last month alone, explorers drilled 125 more wells in the Permian Basin than they would open, meaning production could surge when they turn on the spigots,” a 6/19 Bloomberg article reported.

The US isn’t the only country increasing production. Libya is producing 902,000 bpd, up about 200,000 barrels since April because two fields returned to production. It’s the most the country has produced since 2013, when production hit 1.13 million bpd, another 6/19 Bloomberg article reported. Libya is exempted from the OPEC production cuts.

(2) Brimming inventories. Excess production has kept US inventories stubbornly high. For the week ending June 16, US crude oil inventories (excluding those in the Strategic Petroleum Reserve) decreased by 2.5 million barrels to 509.1 million barrels, according to yesterday’s EIA report. That still leaves inventories slightly above where they stood last year, at 500.0 million barrels, and far above where they stood in the three years prior to that (Fig. 6).

High inventories in other countries around the world are prompting oil traders to store increasing amounts of oil at sea. “The amount of oil stored in tankers reached a 2017 high of 111.9 million barrels earlier this month, according to Paris-based tracking company Kpler SAS. Higher volumes of storage in the North Sea, Singapore and Iran account for most of the increase,” yet another 6/19 Bloomberg article reported. “As recently as May 1, the average volume was about 74 million barrels, according to Kpler.”

(3) Sluggish demand. Global demand growth for oil in Q1 was only 0.9 mbd, according to an IEA report. However, the agency expects demand to pick up in the second half of the year, bringing full-year demand growth to 1.3 mbd in 2017 and 1.4 mbd in 2018, as worldwide demand reaches a record of 99.3 mbd.

Those projections may be tough to hit if the recent drop in demand for gasoline doesn’t go into reverse. Gasoline usage has dropped to 9.23 mbd during the week of June 16 from a peak of 9.37 mbd last fall. The drop in gasoline usage is of note because the number of vehicle miles traveled has continued to climb to record highs (Fig. 7). It could have much to do with the improved fuel efficiency of US cars. By our calculation, the average miles per gallon is 22.4, near the record hit in October 2013 when gas prices were much higher and there was more demand for smaller cars (Fig. 8).

The number of electric vehicles on the road also bears watching, as it may be affecting demand on the margin. For the year ending November 2016, more than 130,000 hybrid or battery-powered vehicles were sold in the US, almost double the 73,000 vehicles sold in 2012, notes a 12/21 Recode article. That’s still far from the average 17 million total cars sold in each of the past three years in the US. But the number may be about to jump once again, as Tesla’s $35,000 Model 3 is expected to hit the market this year.

(4) Prince of Arabia & Vision 2030. According to Time: “Undoing decades of royal tradition, Saudi Arabia’s King Salman appointed his 31-year-old son Mohammed Bin Salman to be next in line for the throne on Wednesday, signaling a historic political shift in one of the Middle East’s key regional powers.

“A rising star within the Saudi royal family, Mohammed Bin Salman was already one of the kingdom’s most powerful leaders. He advocates a forceful Saudi foreign policy and is also leading a massive overhaul of the Saudi economy. As the country’s defense minister, he is in charge of Saudi Arabia’s two-year-old air war in Yemen, where more than 10,000 people have died in one of the world’s most dire humanitarian crises.”

In 2016, the prince-in-waiting implemented Vision 2030, a plan to restructure the economy away from its dependence on oil exports. It states: “Diversifying our economy is vital for its sustainability.” On Monday, we advised OPEC countries with large oil reserves as follows: “Rather than propping up the price, maybe OPEC should sell as much of their oil as they can at lower prices to slow down the pace of technological innovation that may eventually put them out of business.” That’s so obvious that a smart young man like Mohammed Bin Salman probably gets it.

(5) Less influence. The S&P 500’s ability to remain near record levels given the selloff in the Energy sector is reasonable—so far. The S&P 500 Energy sector’s market weighting in the S&P 500 has shrunk to 6.0% from its peak of 16.1% in July 2008. Likewise, the amount of earnings it contributes to the broader index is now 4.3%, down from 21.3% then (Fig. 9). So while crude has entered a bear market, its influence on the broader index has fallen as the S&P 500 has continued to hit new highs, Bloomberg rightly noted on 6/20.

The question will be whether the oil bear market will lead many energy companies to shut down production if drilling becomes uneconomic at these lower prices. A 6/19 WSJ article said many shale producers had lowered their production costs so that they could be profitable when oil fetched $50 to $60 a barrel, and a handful could even turn a profit if the price fell to $40. That certainly isn’t good news for the upcoming Saudi Aramco IPO. Saudi Arabia’s ruling family undoubtedly is watching. There is usually an obvious reason for selling the family jewels.

Restaurants: Tech on Tap. In our 3/24 Morning Briefing last year, we took a trip down Memory Lane and wrote about Horn & Hardart’s Automat, where in the early 1900s, customers could find their prepared meal behind small glass windows and buy it for under $1 by placing coins in a slot. Today, many restaurants are taking a page out of the Automat’s playbook, often in an effort to reduce labor costs.

We mentioned Eatsa, a California eatery where customers order on an iPad, then visit a wall to retrieve their meal. Panera Bread and McDonald’s have been rolling out kiosks where customers can order and pay, avoiding the line—and the human—at the register. Jackie reports that her local TCBY has a wall of soft-ice-cream dispensers that lets customers take as much ice cream as they can fit into oversized cups. It’s a disastrous format for dieters but brilliant for business, she notes.

Now there’s a new twist on wall dispensers for the 21-and-over crowd. Instead of a wall of soft-serve ice cream, Randolph Beer in Brooklyn is offering a wall of beer taps. Customers hand over a credit card and receive an ATM card that can activate 24 self-service taps, according to a 6/9 article in Metro, brought to our attention by ZeroHedge. A screen over each tap displays the beer’s name, brewer, and country of origin as well as notes on how the beer tastes.

Randolph Beer hasn’t abandoned the “Cheers” model altogether; however, its traditional bar and bartender can only serve one customer at a time, not 24. A “Norm” might not like the change, but the easily accessible taps mean that Randolph Beer can serve many more beverages during Happy Hour without having to hire another “Sam.”

The S&P Restaurant index, up 17.9% ytd as of Tuesday’s close, has risen twice as much as the S&P 500 (Fig. 10). Much good news is priced into the industry, which sports a forward P/E of 24.4, close to the highest P/E the industry sported in 2015 and 2016, 25.3, and not far from its highest P/E ever, 28.5 in April 1999 (Fig. 11).

Earnings Boom

Jun 21, 2017 (Wednesday)

See the pdf and the collection of the individual charts linked below.

(1) Among the weakest economic expansions, weighed down by both consumer and business spending. (2) The Trauma of 2008 was traumatizing. (3) No boom, no bust: Only 25 months to go to make this the longest expansion. (4) Profits performance remarkably good considering weakness in nominal GDP. (5) Profit margins still aren’t reverting. (6) There is a boom in our Boom-Bust Barometer, which remains bullish for earnings. (7) Forward earnings are flying high in numerous S&P 500 industries.


Earnings I: Diverging from GDP. The current economic expansion has been among the weakest on record. More specifically, of the seven cyclical upturns in real GDP since 1961, it has been the second weakest (Fig. 1). The big drag has been consumer spending (Fig. 2). Interestingly, real consumer outlays on goods has been the third weakest, while real consumer expenditures on services has been the weakest among these seven expansions (Fig. 3 and Fig. 4). Weighing on services this time are spending on health care services, housing & utilities, and financial services & insurance.

Capital-spending growth also has been subpar during the current expansion, led by weakness in technology equipment, structures, and intellectual property (which includes software). On the other hand, spending on transportation equipment has been the strongest among all the expansions since 1961. Government spending on goods and services in real GDP has been the weakest. (See our GDP Expansion Cycles.)

During most of the current bull market, Debbie and I have argued that subpar economic growth should be bullish for stocks. In our opinion, the Trauma of 2008 was a major contributor to the subsequent slow pace of growth. Both consumers and businesses were traumatized by the event, and were likely to proceed with much more caution than in the past. Such conservative behavior reduced the inflationary potential of the current expansion. It also lowered the odds of speculative excesses. We’ve dubbed this our “NBx2” scenario, i.e., No Boom, No Bust. This implies that the expansion could be among the longest. It already is the third longest since World War II. It only has to keep going another 25 months through July 2019 to surpass the longest one from March 1991 to March 2001.

Yet despite the subpar pace of nominal GDP, corporate profits have performed remarkably well. The rise in the GDP price deflator during the current expansion is the weakest since 1961 (Fig. 5). The expansion in nominal GDP is also the weakest over this same period (Fig. 6). Now consider the remarkable performance of various measures of corporate profits:

(1) Trends. From 1960 through 2008, nominal GDP and corporate profits as measured in the National Income & Product Accounts (NIPA) rose together along a trendline of 7% (Fig. 7). They’ve diverged since then, with profits continuing to grow along the 7% trendline while nominal GDP growth has fallen below it. Other measures of profits such as S&P 500 reported, operating, and forward earnings are still tracking the 7% trendline. The first two are available quarterly and arguably aren’t tracking quite as well as forward earnings, which is available monthly and weekly (Fig. 8).

(2) Cycles. Comparing the profits expansions since 1961, using the profit-cycle troughs as the starting points, we see that the current one is the third best so far of the seven (Fig. 9). Granted, that’s not a fair comparison, because it says more about the depth of the profits recession during 2008 than the strength of the profits expansion.

(3) Profit margins. Nevertheless, there’s no denying that the current profits upturn has been boosted not only by the cyclical rebound in profit margins to record highs, but also their ability to maintain those highs for so long. In the past, the forces of reversion-to-the-mean would have started to erode margins by now as boom-time conditions fed on themselves by stimulating more (margin-reverting) business spending than we are seeing this go-round (Fig. 10 and Fig. 11).

(4) Boom-Bust Barometer. While there is neither a boom nor a bust in the overall economy, our Boom-Bust Barometer (BBB) continues to boom (Fig. 12). It’s gone vertical since early 2016. We calculate it simply as the weekly average of the CRB raw industrials spot price index divided by the four-week average of initial unemployment claims. The numerator is a gauge of global economic activity, while the denominator is a measure of labor market tightness in the US.

Previously, we have shown that our BBB is highly correlated with S&P 500 forward earnings, i.e., the time-weighted average of analysts’ consensus earnings expectations for the current year and the coming year (Fig. 13). They are still highly correlated and rising together in record-high territory.

Earnings II: Where Eagles Dare. Jackie, Joe, and I regularly monitor our S&P 500 Sectors & Industries Forward Earnings (Indexed). This chart publication compares the performances of the forward earnings of the 10 S&P sectors and numerous industries since the start of the current bull market. We find it to be a handy way to pick out where industry analysts are seeing outperformance and underperformance in their estimates of earnings. Here are some of our latest findings:

(1) Sectors. Excluding autos (because the industry lost so much money during the Great Recession), S&P 500 forward earnings is up 95.3% since the week of March 5, 2009 (Fig. 14). Leading the way higher, especially since early 2016, is the IT sector, which is now up 209.6%. Coming from behind since September 22, 2016 is the Financials sector, which now ties the Consumer Discretionary (ex-Autos) sector for second place, with a gain of 157.7%. It was boosted last year when REITs were removed to create an 11th sector for the S&P 500. The laggard and only loser is Energy, with a decline of 33.9%.

(2) Consumer Discretionary. Among the big winners in this sector that continue to show plenty of upside forward earnings momentum are Hotels, Resorts, & Cruise Lines; Home Improvement Retail; Movies & Entertainment; and Restaurants. The clunkers are Apparel, Accessories & Luxury Goods; Department Stores; and Specialty Stores.

(3) Consumer Staples. Tobacco has been on fire since early 2015. Drug Retail has been making a comeback this year after slipping last year from record highs. Packaged Foods & Meats has been making new highs at a leisurely pace since last summer. Soda has lost its fizz.

(4) Financials. Leading the sector’s rebound since early last year are Diversified Banks, Investment Banking & Brokerage, and Asset Managers. They all are at record highs.

(5) Health Care. This sector’s standout winner since the start of the bull market is the Managed Health Care industry (Fig. 15). It has gone nearly parabolic since the start of 2014. Health Care Equipment has resumed its climb to new record highs this year, while Pharmaceuticals has stalled since last year. Biotech seems to be recovering from its freefall earlier this year.

(6) Industrials. The standouts in this sector are Industrial Conglomerates, Industrial Machinery, and Aerospace & Defense. All three are on uptrends and making new highs. Rebounding from weakness over the past couple of years are Railroads and Construction Machinery & Heavy Trucks.

(7) Information Technology. Leading the way higher in this sector have been the Semiconductor Equipment and Semiconductor industries (Fig. 16). That’s been especially so since early 2016. Making an impressive comeback after a brief fall in late 2015 is Technology Hardware, Storage & Peripherals.

(8) Materials. In this sector, among the hot industries have been, and continue to be, Diversified Chemicals and Specialty Chemicals. Steel has been making a comeback of sorts over the past year. Fertilizer & Agriculture Chemicals remains in the dumps.

Second Thoughts

Jun 20, 2017 (Tuesday)

See the pdf and the collection of the individual charts linked below.

(1) Dealmakers sinking in the swamp. (2) Animal spirits remain mostly aroused. (3) Back to new normal real GDP growth. (4) Cruising along at 2%. (5) Citigroup Economic Surprise Index fluctuates. (6) Housing starts depressed by fewer DIYs. (7) Not-so-bad retail sales and production indicators. (8) Looking up in NY and Philly districts. (9) Record highs for forward revenues and earnings. (10) It all adds up to our No-Boom-No-Bust scenario, which remains bullish for stocks.


US Economy: Animals Dispirited? Following Election Day, there was a widespread jump in consumer and business confidence. It was widely deemed that this reflected the unleashing of “animal spirits” when Donald Trump won with majorities in both houses of Congress. Suddenly, his campaign promises, which included tax cuts for individuals and businesses, seemed quite doable. So did his plan to repatriate $2.5 trillion of corporate cash stashed overseas, as well as his commitment to slash business regulations. Debbie and I argued that, perhaps most significantly, the election marked a remarkable regime change. Over the past eight years, we’ve had government by community organizers, who were mostly lawyers with lots of government experience but almost no business experience. Trump and his Cabinet are dealmakers with lots of business experience but very little government experience.

A 1/5 FT article by Gillian Tett titled “Donald Trump unleashes business’s animal spirits” reported that Trump’s top eight officials (president, vice-president, chief of staff, attorney-general, and secretaries of State, Commerce, Defense, and Treasury) had only 55 years of government experience but 83 years in business. Obama’s comparable team had 117 years in government, but ONLY five years in business IN TOTAL.

Debbie and I argued that some of the aroused animal spirits might be reflecting the regime change, with many of the optimists excited about simply having a very pro-business administration. If so, then actually implementing the full Trump economic agenda might not be crucially important for sustaining animal spirits. After all, the economy is at full employment, and more economic stimulus is not an urgent priority. The stock market has been moving into record-high territory since July 11, 2016. The Fed started to normalize monetary policy by raising the federal funds rate in late 2015 at a gradual pace. Fiscal stimulus would most likely be offset by a more aggressive normalization of monetary policy.

So here we are with an administration full of dealmakers and very few deals to show for it so far. Perhaps some are in the works. Trump also promised to “drain the swamp.” So far, it looks like the swamp is deeper than he thought, and he seems to be sinking in it. In any event, animal spirits mostly remain elevated, as evidenced by the latest “soft data” that we continue to monitor in our Animal Spirits chart book. However, the hard economic data remain relatively soft. Consider the following:

(1) Real GDP. After Trump’s election, Debbie and I raised our real GDP forecast for this year from 2.5% to 3.0%. That’s on a Q4-to-Q4 basis. Now we are lowering it to 2.1%. It’s been growing around 2.0% since Q2-2010 (Fig. 1). Even during Q1-2017, which was up just 1.2% (q/q saar), it rose 2.0% y/y! If it continues to do so, that would imply q/q growth rates for Q2-Q4 of 1.8%, 3.5%, and 2.1% (Fig. 2).

Previously, we’ve observed that from H2-2010 to H1-2015, real GDP was growing around 3.0% excluding spending by federal, state, and local governments (Fig. 3). Government spending in real GDP is on goods and services, not on entitlement programs, which redistribute income. These programs may now be so large that they are putting a lid on government spending on goods and services, which certainly explains the awful condition of infrastructure in the US. In any case, the weakness in government spending in real GDP has been an unusual drag on the current expansion (Fig. 4). The good news is that it turned positive on a y/y basis from Q4 2014 through Q4-2016, though it was down again during Q1-2017 by a modest 0.5%. The bad news is that excluding government, real GDP growth seems to have slowed from 3.0% closer to 2.0% since mid-2015.

By the way, on Friday, the Atlanta Fed’s GDPNow reported: “The GDPNow model forecast for real GDP growth (seasonally adjusted annual rate) in the second quarter of 2017 is 2.9 percent on June 16, down from 3.2 percent on June 14. The forecast for second-quarter real residential investment growth decreased from 1.8 percent to 0.4 percent after this morning's housing starts release from the U.S. Census Bureau. The forecast of the contribution of net exports to second-quarter growth declined from -0.23 percentage points to -0.34 percentage points after yesterday's Import/Export Price Index release from the U.S. Bureau of Labor Statistics.”

(2) Economic surprise index. Among the softest of the hard data indicators is the Citibank Economic Surprise Index (Fig. 5). It continued to plunge last week, falling from a recent high of 57.9 on March 15, 2017 to -78.6 last Friday. That’s the lowest since August 19, 2011. The good news is that this is a highly cyclical series with lots of short-term swings. In the past, when it has dropped this much this fast, it has tended to rebound strongly.

For now, it is showing that expectations that the rebound in animal spirits would boost the actual economy haven’t been realized. As expectations turn more moderate, they are more likely to be realized or exceeded.

(3) Housing starts. As Debbie discusses below, housing permits and starts have been weaker than expected recently for both single-family and multi-family units (Fig. 6). Single-family housing starts remain on an upward trend. However, so far, they have recovered only to previous cyclical lows.

Contributing to the slow housing recovery is that fewer individuals than ever before are building their own homes. We can track the do-it-yourself trend by monitoring the difference between new single-family home completions and new single-family home sales (Fig. 7). The 12-month moving sum of this volatile series has remained below 200,000 since the start of the current recovery. That’s the lowest pace on the record, which starts in 1968!

(4) Retail sales & production. The good news is that the recent spate of bad news wasn’t so bad. While retail sales fell 0.3% m/m during May, the three-month change in the three-month average of inflation-adjusted retail sales was 3.9% (saar), the best pace since September 2016 (Fig. 8). Industrial production was unchanged during May, yet the three-month change in the three-month average was 3.8% (saar), the best since July 2014! This augurs well for a pickup in real GDP growth during the current quarter.

(5) Animated animal spirits. Meanwhile, animal spirits haven’t retreated much even though Trump seems to be thrashing about in Washington’s swamp waters. The latest reading we have on business conditions comes from the June district surveys conducted by the Federal Reserve Banks of NY and Philly. The average of their general business conditions indexes rose to 23.7 during June, up from 18.9 last month (Fig. 9).

The Business Round Table reports that the CEO Economic Outlook Index was 93.9 during Q2, exceeding Q1’s 93.3 reading, with both well above Q4’s 74.2 tally (Fig. 10). That augurs well for capital spending.

(6) Forward revenues & earnings. Debbie and I are big fans of the soft data that Thomson Reuters I/B/E/S compiles of forward revenues and forward earnings for the S&P 500 (Fig. 11). These series are time-weighted averages of industry analysts’ consensus forecasts for the current year and the coming year. Both tend to be very good leading indicators for S&P 500 revenues and earnings. They are highly correlated with numerous business-cycle indicators. Their only flaw is that they don’t see recessions coming. However, if there isn’t likely to be one over the next 52 weeks, then they are signaling that the economy continues to expand into record-high territory.

(7) Bonds & stocks. Finally, we need to consider the mixed message coming out of the bond and stock markets. The recent decline in bond yields and narrowing of the yield curve spread suggest weaker economic growth. That doesn’t seem to be fazing the stock market, which continues to make new record highs.

Our interpretation is that they are both consistent with our NBx2 scenario for the economy, i.e., No Boom, No Bust. In this scenario, inflation is likely to remain subdued. If so, there might be only three more 25bps hikes in the federal funds rate, to 2.0% by the end of next year, then that might be it for a while.

Wonder Men & Women

Jun 19, 2017 (Monday)

See the pdf and the collection of the individual charts linked below.

(1) Warrior women. (2) Jeff Bezos is Amazon Man. (3) A one-man inflation killer. (4) Elon Musk & Orphan Annie: The sun will come out tomorrow. (5) Frackers are freaking out OPEC. (6) Disinflation again. (7) Takeout food. (8) Oil’s slippery price slope. (9) Bonds signaling that inflation is dead in long run. (10) The Fed’s Wonder Woman. (11) Mr. Wonderful. (12) Movie Review: “Wonder Woman” (+ +).


US Economy: Inflation, RIP? No one knows whether Amazon women ever existed. These warrior women were first mentioned by ancient Greek poet Homer in the Iliad, set during the Bronze, or Heroic, Age. He referred to them as “antianeirai,” meaning “those who go to war like men.” Ancient Greek historian Herodotus describes them as “androktones,” meaning “killers of males.” The name “Amazon” is believed to come from the Greek word “amazoi,” which means “breast-less,” as young female warriors’ right breasts were removed to facilitate their drawing of the bow, according to legend. Besides bows and arrows, their main weapon, Amazons wielded swords and double-sided axes while carrying a distinctive crescent-shaped shield. Most of their fighting was done from horseback.

Could Jeff Bezos be Amazon Man? He certainly has the killer instinct, and continues to slaughter his competitors. Jackie and I have been following his exploits for some time and have concluded that he is also killing inflation. He has brought deflation to the book industry, mall retailers, and the cloud. Now he is doing the same to grocery stores, with the biggest losers likely to be their vendors, i.e., manufacturers of consumer brands, particularly staples.

Bezos is not alone in his battle to disrupt and destroy business models, with deflationary consequences. Elon Musk is also an Amazon Man, who intends to harvest solar energy on the roofs of our homes, storing the electricity generated in large batteries while also charging up our electric cars. Meanwhile, the frackers are using every frick in their book to reduce the cost of pumping more crude oil. Pharmaceutical companies are under lots of political pressure to stop hyper-inflating drug prices. Telecom services prices are falling as a result of intense competition. With price inflation remaining subdued, it’s no wonder there isn’t a lot of upward pressure on wage inflation even though the labor market is obviously very tight. Consider the following:

(1) Disinflation. On a y/y basis, the headline and core CPI inflation rates both fell back below 2.0% (the Fed’s target for the PCE price deflator) in May to 1.9% and 1.7% (Fig. 1). On a three-month basis and annualized, they were -1.0% and 0.0% through May (Fig. 2). Showing outright deflation on a y/y basis are wireless telephone services fees (-12.3%), used car prices (-4.3), airfares (-2.9), and furniture & bedding (-1.4) (Fig. 3 and Fig. 4). Even the medical-care CPI inflation rate has dropped from a recent high of 4.9% to 2.7% in May, led by falling inflation rates for physician services and even drugs (Fig. 5).

(2) Food fight. Online shopping now accounts for a record 29.7% of GAFO sales (i.e., sales of goods typically found in department stores) (Fig. 6). That’s up from about 5% in 1992. It was 9.0% when Amazon went public during May 1997. The company clearly has taken lots of growth and market share away from the department stores. It’s been doing the same to the warehouse clubs and super stores since 2009.

Now Bezos is going after the grocery business. It’s a huge one, with sales totaling a record $939 billion (saar) during April. The warehouse clubs and super stores have increased their share of this business from 7.0% in 1992 to a peak of 27.2% during June 2008 (Fig. 7). That share was down to 23.8% during April, and is likely to continue falling as Amazon Man enters the fray. Bezos plans to do so by purchasing Whole Foods and using its stores as fulfillment centers for food sold by his company online, with the assistance of voice-activated Alexa.

(3) Drowning in oil. OPEC oil producers continue to put a lid on their output in an effort to prop up prices. Yet the price of a barrel of Brent crude oil is back down to $47.37, below its recent high of $57.10 on January 6 (Fig. 8). That’s comfortably in the $40-$50 price range that Debbie and I have been expecting for this year. Despite the 76% plunge in the price of oil from June 19, 2014 to January 20, 2016, US crude oil production fell just 12% from the week of June 5, 2015 through the week of July 1, 2016 (Fig. 9). Since then, it is up 10% to 9.3mbd.

Interestingly, weekly production held up relatively better in Texas and North Dakota than in the rest of the country when total output was declining (Fig. 10). However, the rebound in US oil production has been led by the rest of the country, excluding Texas and North Dakota. Could it be that frackers figured out how to lower their costs in the two states where they’ve been most active, and taken their innovations to the other states? Maybe.

Meanwhile, the 52-week average of gasoline usage in the US is down 0.7% y/y (Fig. 11). This may or may not be a sign of a slowing economy. It is undoubtedly a bearish development for oil prices.

Saudi Arabia, Russia, Iran, and other major oil producers, with large reserves of the stuff, should be awfully worried that they are sitting on a commodity that may become much less needed in the future. As long as the sun will come out tomorrow (as Little Orphan Annie predicted), solar energy is likely to get increasingly cheaper and fuel a growing fleet of electric passenger cars. Rather than propping up the price, maybe they should sell as much of their oil as they can at lower prices to slow down the pace of technological innovation that will eventually put them out of business.

(4) Bond vigilantes. The bond market certainly confirms that the disinflation story remains a credible one. The yield spread between the US Treasury 10-year bond and its comparable TIPS is deemed to be a measure of inflationary expectations over the next 10 years. It soared following Election Day, from 1.73% on that day to a recent peak of 2.08% on January 27 (Fig. 12). It was back down to 1.67% on Friday, the lowest since October 24. The yield curve spread between the 10-year bond yield and the federal funds rate has narrowed from a recent high of 213bps on December 14, 2016 to 100bps near the end of last week, the lowest since July 8, 2016 (Fig. 13).

There is mounting concern that the bond market may be signaling that even slower economic growth is ahead. Perhaps. More likely, in our view, is that long-term bond investors are coming around to our view that inflation may be dead. There are some very powerful structural forces that should continue to keep it from rising from the dead. If so, then the bond vigilantes can relax.

(5) Deflationary drivers. Intensifying competition, technological innovation, and aging demographics are the structural forces that are keeping inflation in check. They’ve done so despite the ultra-easy monetary policies of the major central banks. Here is a brief list of some of the main events that have broken the back of inflation, which is likely to remain flat on its back: Walmart goes public (August 1972), Volcker clobbers inflation (October 1979), Reagan fires PATCO (August 1981), the end of the Cold War (November 1989), Amazon goes public (May 1997), China joins the WTO (December 2001), Amazon Web Services opens the cloud (August 2006), the oldest Baby Boomers turn 65 (January 2011) (Fig. 14).

The Fed: Wonder Woman. In her press conference last week on Wednesday, Fed Chair Janet Yellen confirmed in her prepared remarks that the Fed believes that the economy’s weakness during Q1 and recent easing of inflation are likely temporary developments, which is why the FOMC proceeded with a 25bps hike in the federal funds rate to a range of 1.00%-1.25%. She noted that consumer and business spending seem to be firming. She expects that labor market indicators will continue to improve.

Yellen said, “The recent lower readings on inflation have been driven significantly by what appear to be one-off reductions in certain categories of prices, such as wireless telephone services and prescription drugs.” She added, “Finally, the median inflation projection is 1.6 percent this year and rises to 2 percent in 2018 and 2019.” In other words, the FOMC is sufficiently comfortable with the underlying strength in the economy in general and the labor market in particular that the committee had no qualms about raising the federal funds rate for the fourth time since the end of 2015, even though inflation remains below its 2.0% target.

Yellen reiterated that more rate hikes are likely, but “the federal funds rate would not have to rise all that much further to get to a neutral policy stance.” She observed, “The median projection [of the FOMC] for the federal funds rate is 1.4 percent at the end of this year, 2.1 percent at the end of next year, and 2.9 percent at the end of 2019, about in line with its estimated longer-run value.”

Melissa and I reckon that Yellen & Co. are aiming to raise the federal funds rate to 2.0% by the end of next year. If so, that would take only three more hikes to get there. That certainly would be consistent with their pledge to normalize monetary policy at a gradual pace. There’s already some pushback from Fed watchers who say that the FOMC is making a mistake tightening further given the slow pace of growth and subdued inflation. We don’t agree. So far, the Fed’s normalization hasn’t caused any “tightening tantrums” in financial markets. The Fed should take this opportunity to proceed with normalization.

The big question is whether President Donald Trump will reappoint the Fed’s Wonder Woman for another term when her current one expires on February 3, 2018. He might.

Stocks: Mr. Wonderful. Anyone who invested in Amazon since it went public must think of Jeff Bezos as Mr. Wonderful. The stock price is up a whopping 50,293% from its offering price on May 15, 1997. His competitors must see him as the Grim Reaper. Of course, there is another Mr. Wonderful. That is the nom de guerre of Kevin O’Leary, who is one of the sharks on “Shark Tank.” I appeared with Mr. Wonderful on CNBC on June 9. When I said that ETFs are attracting lots of money away from mutual funds, which might explain why the FAANG stocks were leading the stock market to new highs, he chortled, “Wonderful, wonderful.” During July 2015, O’Leary offered a menu of five exchange-traded funds to the public. They’ve attracted lots of funds and performed wonderfully.

While flow-of-funds analysis is important for understanding what’s driving the stock market, so are earnings. As Joe reviewed last week, the forward earnings of the S&P 500/400/600 all rose to fresh record highs during the first week of June (Fig. 15). That’s quite impressive given the powerful forces of disinflation.

Movie. “Wonder Woman” (++) (link) is one of the better action hero flicks. That’s partly because it isn’t all carnage all the time. There is actually some dialogue. Most of it is hokey, but some of it is mildly amusing. In any event, it was good to see Wonder Woman coming around to realize that utopian visions of peace on Earth can’t be achieved simply by killing the God of War. However, she does conclude that love conquers all, which may work in bilateral relationships but is less reliable otherwise.


Jun 15, 2017 (Thursday)

See the pdf and the collection of the individual charts linked below.

(1) Business sales suggest solid growth for S&P 500 revenues. (2) Inflation-adjusted retail sales showing a Q2 rebound. (3) Atlanta Fed raises Q2 real GDP to 3.2%. (4) Online shopping accounts for record 29.7% of GAFO sales. (5) Health Care getting out of bed. (6) Biotech and Managed Care looking especially fit. (7) Grocery war is heating up fast. (8) Consumers win as consumer staples brands lose.


Business Sales: Not Bad. Yesterday, we learned that business sales of goods by manufacturers and distributors rose 5.6% y/y through April. This augurs well for aggregate S&P 500 revenues, which rose 5.1% y/y through Q1-2017 (Fig. 1). So does the retail sales component of total business sales of goods, which is available through May, when it was up 4.0% y/y (Fig. 2).

As Debbie explains below, while May’s retail sales report seemed weak, the three-month average adjusted for inflation rose 3.9% (saar). Real core retail sales—excluding autos, gasoline, building materials, and food services—jumped 7.5% (Fig. 3). The Atlanta Fed’s GDPNow forecast for Q2 real GDP growth was raised from 3.0% to 3.2% yesterday on the news: “The forecast for second-quarter real consumer spending growth increased from 3.0 percent to 3.2 percent after this morning’s retail sales report from the U.S. Census Bureau and this morning’s Consumer Price Index release from the U.S. Bureau of Labor Statistics.”

Meanwhile, consumers continue to shop online from the comfort of their homes and/or with the ease of their smartphones from wherever they might be. Online shopping accounted for a record 29.7% of in-store GAFO (i.e., the kind of merchandise typically sold in department stores) and online retail sales (Fig. 4). They continue to take share away from both department stores as well as warehouse clubs and super stores.

As Jackie updates below, the grocery business is facing competition not only from online vendors but also from foreign ones entering the US market. The great disruption in the grocery business occurred during the 1990s and 2000s, when the market share of warehouse clubs and super stores rose from 8.1% in 1992 to 27.2% during June 2008 (Fig. 5). Amazon is entering the fray for consumer grocery bucks. So are foreign grocers such as Aldi and Lidl. The sure winners will be consumers. The sure losers are likely to be consumer staples companies that depend on branded product sales.

Health Care: Revival Time. The Health Care sector is suffering from many ailments. Last year, new drug approvals were scant and the high price of existing drugs drew critical scrutiny. Insurers are dropping out of the Patient Protection and Affordable Care Act (ACA) like flies. And if the House of Representatives’ plan to revamp the ACA succeeds, there will be 23 million fewer patients covered under the ACA. That might be good for the federal budget, but bad for the bottom line of health insurance companies and providers.

But despite the bevy of bad news, Health Care stocks are showing signs of life. The S&P 500 Health Care sector is the second-best-performing sector ytd. Here’s how the S&P 500 sectors stack up since the start of the year through Tuesday: Tech (18.6%), Health Care (12.2), Consumer Discretionary (11.4), Materials (10.4), Utilities (9.6), Consumer Staples (9.3), S&P 500 (9.0), Industrials (8.6), Real Estate (4.9), Financials (4.7), Telecom Services (-9.6), and Energy (-11.1) (Fig. 6).

Health Care’s performance this year is quite a reversal from 2016, when it was the worst-performing sector, falling 4.4% compared to the S&P 500’s 9.5% return (Fig. 7). Its revival may continue because the Health Care sector kicks in 15.5% of the S&P 500’s earnings but represents only 14.0% of the S&P 500’s market capitalization (Fig. 8). Only three of the 11 S&P 500 sectors have earnings contributions that are well above their market-cap representation in the S&P 500. The other two sectors: Financials, which historically doesn’t garner a market cap greater than its earnings contribution, and Telecom, which has the smallest capitalization in the S&P 500, at 2.2%.

Here’s a quick look at some of the Health Care sector’s vitals:

(1) Fewer new drugs. The sector’s strong returns this year are notable because two of its largest constituents are underperforming. The S&P 500 Pharmaceuticals index is up 6.9% ytd, and the Biotechnology index is 6.5% higher so far this year, but both lag behind the S&P 500’s 9.0% ytd return (Fig. 9). The two industries represent just over half of the Health Care sector’s total market capitalization.

These two industries may be lagging because fewer new drugs passed inspection last year, according to the FDA’s website. Twenty-two new drugs were approved in 2016, down from 45 drugs in 2015, 41 in 2014, 27 in 2013, 39 in 2012, and 29 in 2011. The slowdown last year can be blamed on fewer applications (36, down from 40 in 2015) and the delayed approval or outright rejection of more drugs last year, a 1/9 article in FierceBiotech explained. Approvals may pick up this year, as there already are 21 drugs approved with six more months left to go in 2017.

(2) Bitter pills. Pharma and Biotech also have a PR problem. Investors may be excited that Pfizer raised the US price of nearly 100 drugs by an average of 20% so far this year (as reported by a 6/2 FT article), but that headline doesn’t play well in Peoria or in the halls of Congress.

President Trump said earlier this year that his administration plans to push for lower drug prices, implying that it could do so by negotiating better prices for Medicare and Medicaid. More recently, his FDA commissioner said he plans to do what’s possible to “facilitate entry of lower-cost alternatives to the market, and increase competition,” the 5/25 WSJ reported. That translates into making it easier for generic drugs to enter the market and compete with existing drugs.

(3) Growth challenges & opportunities. Earnings growth in the S&P 500 Pharma industry has come down sharply, but so too has its earnings multiple. The industry’s forward earnings growth estimate stands at 7.5%, up from its post-recession low of -1.3% but a far cry from the 14%-15% earnings growth it enjoyed from 1998 through 2001 (Fig. 10). Its forward P/E ratio has followed a similar path, peaking at 34.4 in March 1999, bottoming around the time of the recession at 8.8, and recovering to the current 15.3 (Fig. 11). Because the industry’s earnings growth and forward P/E have moved in tandem, the industry’s PEG ratio is at 2.0 today, just about where it was when Pharma’s P/E was much higher in 1999 (Fig. 12).

The Biotechnology industry looks extremely interesting given that its forward P/E has fallen to 13.3, close to the lows it hit in the wake of the recession (Fig. 13). There’s also a very large gap between the industry’s forward earnings growth estimate of 2.4% and the 13.8% earnings growth that analysts are calling for over the next five years (Fig. 14). If the dearth of drug approvals is a blip rather than a trend, investors could return to the industry.

(4) ACA blues. Washington has not managed to come up with a replacement to the ACA, also known as “Obamacare.” The House proposal would result in 23 million fewer Americans having health care coverage by 2026, and the Senate has yet to formulate a bill. While the politicians dither, insurers are dropping out of the ACA, claiming that they’re unable to make profits under the current system in certain locations.

Surprisingly, Managed Health Care stocks have fared fabulously so far this year. The S&P 500 Managed Health Care index (AET, ANTM, CI, CNC, HUM, and UNH) is up 18.3% ytd. Standouts include Centene, up 38.1% ytd through Tuesday’s close; Anthem, up 30.2%; and Cigna up 24.9%.

Centene, an insurer that focuses on Medicaid, has been able to make profits in the ACA and has announced plans to expand its offerings in three new states—Kansas, Missouri, and Nevada—and within states where it already does business. The company is dropping out of Massachusetts due to low enrollment.

Centene’s ACA plan enrollment grew to 1.2 million as of the end of March, up from 537,000 at the end of 2016, the 6/13 WSJ reported. That runs counter to UnitedHealth Group, Aetna, and Humana, which have pulled back sharply from ACA business or plan to exit next year. Investors appear to be discounting the fact that President Trump’s proposed budget would cut Medicaid by more than 40% over a decade.

Over the next 12 months, the Managed Health Care industry is expected to grow revenues by 6.1% and earnings by 13.2%, which is below the sector’s forward P/E of 17.0 (Fig. 15 and Fig. 16).

(5) Picture of health. Beyond Managed Health Care, the other industries driving the Health Care sector’s strong performance include Health Care Technology (CERN), up 40.3% ytd and the third-best-performing industry in the S&P 500 so far this year, and Life Sciences Tools & Services (A, ILMN, PKI, TMO, and WAT), up 29.3% and the sixth-best-performing S&P 500 industry that we track. Not far behind are Health Care Equipment (22.9%) and Health Care Supplies (XRAY) (20.6). It looks like rumors of the sector’s death have been greatly exaggerated.

Consumer Staples: Another Foreign Elephant. Last week, we observed that investors looking for safety in the Consumer Staples sector might be disappointed as competition in the grocery business heats up, putting pressure on prices (6/8 Morning Briefing). Our case was bolstered earlier this week by news that German grocery chain Aldi plans to open 900 stores in the US, to bring its total up to 2,500 by 2022. Doing so would make it the country’s third-largest grocer, the 6/11 WSJ reported. The news comes after Lidl, another German discount grocery store, said it would open its first 10 stores in the US this month.

Aldi has been in the US since 1976, focusing on lower-income shoppers, but last year it started pushing into suburban, middle-income, or higher-income neighborhoods, the 10/16 WSJ wrote. It described Aldi’s stores as “no frills” with skimpy in-store marketing. It stocks fewer items, about 1,300 versus 30,000 in an average grocery store, and roughly 90% of its products sold are private label.

The company runs its operations quite differently to save on labor. Items are displayed in the cardboard boxes in which they were shipped, and customers can take empty boxes to carry home their groceries. Customers bag their own groceries in bags they’ve brought from home or they pay to buy new bags in the store. In addition, consumers pay a quarter to take a shopping cart, which is returned if the cart is returned to its holding area.

Aldi stores are typically open during peak shopping hours, not 24 hours a day. And employees are trained to do many jobs, so cashiers stock shelves. In addition, items may have many barcode labels so that they can be scanned faster at checkout. Although Aldi pays its employees above-market wages, the grocer is still able to offer prices that are 25% to 40% lower than traditional grocers’, the WSJ article explained.

While time will tell whether US consumers will adapt to save money, those in the UK certainly did. Aldi entered the UK market roughly four years ago, and it is now the country’s fifth-largest supermarket. “Rivals trying to compete on price have seen margins on earnings before interest and taxes fall from 5 percent to 2 percent in four years,” the 6/12 FT explained. In the wake of increased competition, Tesco has shut poorly performing stores, ended night shopping, and sold its South Korean business, Homeplus. US grocers and the companies that fill their shelves with goods should be on high alert.

Small Is Beautiful

Jun 14, 2017 (Wednesday)

See the pdf and the collection of the individual charts linked below.

(1) S&P 1500 is up $16.7 trillion since start of bull run. (2) Small companies have lots of employees. (3) Might small company hiring explain weak productivity? (4) Profits driving business cycle as profitable companies continue to expand payrolls and capacity. (5) Earnings of S&P 400/600 well outpacing S&P 500 earnings. (6) May survey finds small businesses’ earnings improving on balance. (7) Finding qualified applicants for job openings is a major challenge.


Small Business I: SmallCaps Are Big Employers. The S&P 1500 stock price index has 1,500 companies. On June 12, it had a total market capitalization of $23.3 trillion. Remarkably, this index’s market cap is up 251.9% since March 9, 2009, by a whopping $16.7 trillion from a low of $6.6 trillion (Fig. 1). It is up 48.5% from the previous bull market’s peak. Weighing in at $20.9 trillion currently, the S&P 500 accounts for nearly 90% of the S&P 1500’s market cap (Fig. 2).

The S&P 400 MidCaps and S&P 600 SmallCaps currently have market values of $1.7 trillion and $0.7 trillion, respectively. They account at present for just 7.2% and 3.1% of the S&P 1500 (Fig. 3). The S&P 500 comprises corporations with market caps of at least $6.1 billion. MidCaps represent those with market caps of $1.6-$6.8 billion, and Small Caps $450 million-$1.8 billion.

Yet small and medium-sized companies are disproportionately big employers according to ADP’s monthly tally of payrolls. In May, the former accounted for 41.3% of private-sector payrolls, while the latter accounted for 36.0% (Fig. 4). So large companies employed just 22.7% of all private-sector employees.

The ADP data by company size start in 2005. So there isn’t much history. Since then, total employment is up 13.0 million, led by gains of 6.3 million and 5.4 million among small companies and medium-sized ones (Fig. 5). Employment at large companies rose only 1.3 million over this period.

This might be one plausible explanation for the significant slowing in productivity growth in the US. Consider the following:

(1) Smaller outfits that are growing probably can do so mostly by hiring more workers, while larger companies may have access to more productive ways of expanding their capacity and output. It’s hard to test this hypothesis since we don’t know whether smaller firms were outsized employers or not prior to 2005, when productivity was growing at a faster clip.

(2) ADP data are available since 2001 for employment by goods-producing and service-producing companies (Fig. 6). The former is actually down 4.2 million over this period through May of this year, while the latter is up 16.8 million. This suggests that productivity has weakened in recent years mostly because service companies with small and medium-sized payrolls have done all of the hiring. The big problem with this theory is that manufacturing productivity growth has averaged zero for the past five years (Fig. 7)!

Small Business II: Profits Cycle Booming. Debbie and I believe that the profits cycle drives the business cycle. Profitable companies expand their payrolls and capacity, while unprofitable ones are forced to retrench. Obviously, during economic expansions, there are many more profitable than unprofitable companies.

The forward earnings data for the S&P 1500 and its three major components show that all are rising in record-high territory (Fig. 8). Since the start of the weekly data at the beginning of 1999 through early June of this year, the forward earnings of the S&P 500/400/600 are up 168.1%, 349.6%, and 327.7% (Fig. 9).

The monthly survey of small business owners conducted by the National Federation of Small Business (NFIB) includes a question on whether earnings are higher or lower over the past three months. The resulting net earnings series is volatile from month to month, with the 12-month average very much driven by the ups and downs of the business cycle (Fig. 10). The series starts during September 1974, and has been negative since then. In other words, on balance more small business owners lose than earn money!

Nevertheless, the 12-month average of this series is highly correlated with the 12-month average of the percent of small business owners who plan to increase employment (Fig. 11). In May, the former rose to the highest since May 2007, while the latter rose to the highest since September 2007.

Small Business III: Help Wanted. The problem with all this wonderful news is that the economy is running out of warm bodies to employ as Debbie and I have been arguing of late. May’s NFIB survey found that 34.0% of small business owners had one or more job openings, the highest since November 2000 (Fig. 12). Furthermore, 51.0% said that there were few or no qualified applicants for the positions.

The three-month average of the NFIB job openings series is highly inversely correlated with both the unemployment rate and the jobs-hard-to-get series included in the monthly consumer confidence survey (Fig. 13 and Fig. 14). The bottom line is that the labor market is tight, and may pose a challenge for the expansion plans of small businesses and dampen the growth rate of the overall economy.

Tech Now & Then

Jun 13, 2017 (Tuesday)

See the pdf and the collection of the individual charts linked below.

(1) The life and death of bulls. (2) Matadors and recessions. (3) An aging bull that remains frisky. (4) Charge of the bullish brigade. (5) Tech now and in 1999/2000. (6) Beware of sectors with too much market cap. (7) Tech’s valuation and LTEG aren’t excessively high. (8) There’s lots of jalapenos in the salsa dip for chips. (9) Semiconductor forward earnings flying with worldwide sales.


Strategy I: Hard-Charging Bull. Bulls tend to live 18-22 years. The average age of the past 22 equity bull markets since 1928 has been 1,007 days, or 33 months (Fig. 1). (See our S&P 500 Bull & Bear Markets Table.) The current one has lasted for 3,007 days, or 99 months. So far, it is the second-longest bull market since 1928. The previous longest ones lasted for 4,494 (150 months) and 2,954 days (98 months).

Bulls die of old age, unless they are prematurely killed by a matador in a bull ring. Bull markets don’t die of old age. Instead, they terminate when the economy falls into a recession (Fig. 2). So far, while the current economic expansion has been among the slowest on record, it has lasted 96 months, which makes it the third-longest one since 1928. (See NBER US Business Cycle Expansions and Contractions.) The previous longest expansions lasted 120 and 106 months.

As Debbie and I discussed yesterday, using the average of the past five business expansions to benchmark the current one, we pinpoint the next recession to start during March 2019. That doesn’t come with a money-back guarantee. It is simply a benchmark based on the average experience of recent business-cycle history. However, we will guarantee that the next recession will kill the current bull market.

Meanwhile, the old bull continues to age and to charge ahead despite his advanced age. For example, here is the performance derby of the S&P 500 and its 11 sectors since last year’s low on February 11, 2016 through Friday of last week (Fig. 3 and Table 1): Financials (51.1%), IT (50.3), Materials (40.0), Industrials (36.9), S&P 500 (33.0), Consumer Discretionary (32.1), Health Care (22.0), Energy (19.8), Real Estate (19.3), Utilities (17.0), Consumer Staples (14.9), and Telecom Services (1.5). That’s an impressive performance for an old-timer.

Of course, the charge since March 9, 2009, when the current bull market began, is truly superb (Fig. 4 and Table 2): Consumer Discretionary (471.2%), Financials (380.3), Information Technology (379.8), Industrials (336.6), S&P 500 (259.4), Health Care (253.0), Materials (214.2), Consumer Staples (191.0), Utilities (137.8), Telecommunication Services (81.5), and Energy (56.5).

Strategy II: Relative Exuberance. Is it 1999/2000 all over again for the S&P 500 Information Technology sector? Not so far. Consider the following:

(1) First vs third place. During the bull market from October 11, 1990 through March 24, 2000, the sector soared 1,697.2%, well ahead of the 417.0% gain in the S&P 500 and all the other sectors (Fig. 5). During the current bull market, it is in third place.

(2) Market-cap and earnings shares. At the tail end of the bull market of the 1990s, the S&P 500 IT sector’s share of the overall index’s market capitalization rose to a record 32.9% during March 2000 (Fig. 6). However, its earnings share peaked at only 17.6% during September 2000. This time, during May, the sector’s market-cap share rose to a cyclical high of 22.9%, while its earnings share, at a cyclical high of 22.0%, was much more supportive of the sector’s market-cap share. As a rule of thumb, Joe and I get nervous when a sector’s shares of either or both rise close to 33%. We aren’t nervous yet about IT, though we are just a little twitchy.

(3) No contest on valuation basis. During the second half of the 1990s through the early 2000s, the forward P/E of the Tech sector soared relative to the broad index (Fig. 7). The former peaked at a record 48.3 during March 2000. That same month, the forward P/E of the S&P 500 was 22.6. Both then proceeded to trend lower through 2008, when they finally converged. During the current bull market, the Tech sector’s forward P/E hasn’t diverged much at all from that of the overall index. Last month, the former was 18.1, while the latter was 17.3.

(4) Less irrational exuberance about long-term growth. Joe and I regularly monitor LTEG for the S&P 500 and its 11 sectors and 100+ industries. LTEG is analysts’ consensus long-term earnings growth expectations over the next five years at an annual rate. It soared to a record high of 18.7% during August 2000 for the S&P 500, up from 11.5% at the start of 1995 (Fig. 8). Keep in mind that the historical trend growth in the S&P 500 during economic expansions tends to be around 7% (Fig. 9)! The ascent in this growth expectation trend for the S&P 500 during the second half of the 1990s was led by an even more wildly irrational rerating of expected LTEG for the Tech sector from 16.6% at the start of 1995 to a record high of 28.7% during October 2000.

Since those peaks, both LTEGs have come back down closer to the Planet Earth. During April, they were 12.3% for the S&P 500 and 12.7% for the IT sector. Those are still more optimistic than what is likely to be delivered, but at least they are back to the rationally exuberant normal bias of analysts.

(5) Less air in this bubble so far. All of the above suggests that the Tech sector is trading much closer to realistic expectations for fundamentals than during the bubble of the 1990s. The S&P 500 IT stock index nearly exceeded its March 27, 2000 high for the first time just last week on June 8 (Fig. 10). The sector’s forward earnings rose to a record high at the start of June, exceeding the 2000 peak by 168.6% (Fig. 11).

The sector has the highest forward profit margins among the S&P 500 sectors. It has been at a record high around 20% since late last year, up from a cyclical low of around 12% at the start of 2009 (Fig. 12).

(6) Chips with salsa. Among the 10 top-performing S&P 500 industries since last year’s February 11 low are Semiconductor Equipment (#1 with a gain 142.9%) and Semiconductors (#9, 67.4%) (Fig. 13 and Fig. 14). The forward earnings of the former has gone vertical, doubling since early last year (Fig. 15). As a result, the forward P/E of this high-flying but cyclical industry was only 14.7 at the beginning of June.

The forward earnings of the Semiconductors industry has also been like eating chips dipped in salsa with extra hot jalapenos. Not surprisingly, it is highly correlated with worldwide sales of semiconductors, which rose to a record $376 billion (saar) during April (Fig. 16).

White Swans

Jun 12, 2017 (Monday)

See the pdf and the collection of the individual charts linked below.

(1) Bullish chowder. (2) Frothy valuations. (3) Swamp sickness. (4) Betting on downsized Trump agenda. (5) Benchmark model pinpoints next recession in March 2019. (6) NBx2 scenario: No Boom, No Bust! (7) Price inflation is keeping a lid on wage inflation. (8) Are bond investors seeing less growth or less inflation or both? (9) Big Three central bank balance sheets remain ultra-easy, on balance. (10) Fed’s priority is probably to raise rates more before reducing balance sheet. (11) Update of quarterly valuation ratios shows mixed picture.


Strategy I: New England Is Bullish. I visited with some of our institutional accounts in New England last week. I am sensing that a consensus is emerging among them and our other accounts in the US and abroad. They are less concerned about frothy valuation multiples in stocks, and less bearish on bonds than they were earlier this year. They are much less concerned about the Fed too, figuring that rate hikes will remain very gradual and that the central bank won’t shrink its balance sheet for a while. In any event, they see better values in European and EM stock markets. They have mixed views on the FAANGs.

No one was able to come up with any new and credible black-swan event that might trip up the bull market in stocks. I observed that white swans typically outnumber black ones over time. We all agreed that one possible perverse black swan might be a melt-up that leads to a meltdown. Investors increasingly are either irritated or bored with the daily swamp opera in DC, and mostly tuning it out. There usually aren’t any swans of any color in swamps, just too many swamp people and alligators. Investors aren’t betting the farm on Trump’s economic agenda. If a significantly downsized version is eventually enacted, that’s okay. If nothing changes, so be it. There’s plenty to keep the bull charging ahead.

Investors seem to be coming around to our long-held view that this economic expansion could last for a very long time. In other words, they are considering the possibility that the biggest surprise might be how long the current bull market lasts. In this scenario, both inflation and interest rates would remain surprisingly low for a surprisingly long time. Valuation multiples might stay high for a long time too. Again, historically speaking, white swans tend to outnumber black swans.

Debbie and I have been arguing that the Trauma of 2008 reduced the likelihood of a boom-bust scenario for the economy as both consumers and businesses remained relatively cautious and conservative in their spending and borrowing activities. Among the most telling confirmations of our hypothesis is that wage inflation, as measured by the yearly growth rate in average hourly earnings, remains around 2.5%. In the past, the current record number of job openings and the cyclical low in consumers reporting that jobs are hard to get was associated with wage inflation of 3.0%-4.0% or higher (Fig. 1 and Fig. 2). This is consistent with our NBx2 scenario, i.e., No Boom, No Bust.

About two and a half years ago, back on October 27, 2014, Debbie and I first discussed the possibility that the current economic expansion might last until March 2019. That was based on a simple benchmark model of the business cycle. We noted that during the previous five business cycles, the recovery periods lasted 26 months on average, measured from the trough of the Index of Coincident Economic Indicators back to the previous cyclical peak (Fig. 3). The remaining expansion phases lasted 65 months on average after the recovery phase. That would put the next cyclical peak during March 2019.

Traditional business-cycle economists have been expecting tighter labor market conditions to boost wages, which would lift price inflation. This is based on the classic demand-pull and cost-push models of inflation, including the Output Gap and Phillips Curve. These inflation models don’t recognize the possibility that there may be powerful secular forces keeping a lid on price inflation, which keeps a lid on wage demands even in a tight labor market. These forces include competition resulting from globalization, inherently deflationary technological innovations, and demographic drag from aging populations. The proof is in the numbers: Since the mid-1990s when the three forces started to kick in, price inflation remained below, and tended to act as an anchor for, wage inflation, which has been much more sensitive to the business cycle (Fig. 4).

Strategy II: Are Bonds Bearish? In my meetings last week, one of the concerns we discussed was the drop in the US Treasury 10-year bond yield from a recent high of 2.62% on March 13 to last week’s low of 2.14% on Tuesday (Fig. 5). That’s the lowest since November 9, the day after Election Day. A related concern was frequently expressed about the flattening of the yield curve from a recent high of 213 bps on December 14 to last week’s low of 123 bps on Tuesday (Fig. 6). That’s the narrowest since October 3. Both suggest a much weaker assessment of economic growth than in the weeks following Election Day. On a short-term basis, both are responding to the plunge in the Citigroup Economic Surprise Index from a recent peak of 57.9 on March 15 to Friday’s reading of -43.4, near last Monday’s -44.7, which was the lowest since February 18, 2016 (Fig. 7).

According to the Bond Vigilante Model, the 10-year bond yield is the fixed-income market’s assessment of the current growth rate in nominal GDP on a y/y basis (Fig. 8). The former is currently about half as much as the latter, which was 4.1% during Q1 of this year. There are alternative possible explanations for the drop in the bond yield other than the bond market predicting a significant drop in already weak economic growth. Consider the following:

(1) Falling inflationary expectations. It may be that some investors see much more risk in stocks, given their historically high valuations, than in bonds. However, bonds certainly don’t look cheap, unless bond investors are reassessing the long-term outlook for inflation. As noted above, competition, technology, and demography are powerful secular forces subduing inflation. Sure enough, expected inflation, as embedded in the yield spread between the US Treasury 10-year bond and its comparable TIPS, dropped from a recent high of 2.08% on January 27 to 1.78% at the end of last week (Fig. 9).

(2) Near-zero yields abroad. Of course, the US bond yield, at 2.21%, still looks awfully attractive compared to the 10-year government bond yield in Germany at 0.26% and Japan at 0.07% (Fig. 10). Last Thursday, the ECB dropped its downside risk warning for economic growth, saying the risks were now “broadly balanced.” It also dropped its guidance that interest rates might be cut again, while scaling back its inflation forecasts for the next two years. Nevertheless, ECB President Mario Draghi remained very dovish, saying that the ECB will continue its quantitative easing program of bond-buying for the foreseeable future and adding that it “will be in the market for a long time.”

The Fed ended its QE program at the end of October 2014. Since then, it has rolled over its maturing securities so that the Fed’s assets have remained around $4.4 trillion since then (Fig. 11). Meanwhile, over the same period, the ECB has increased its assets by $2.0 trillion to $4.6 trillion, while the BOJ’s assets are up $1.8 trillion to $4.5 trillion. So the total of the three major central banks is up $3.8 trillion since October 2014 to a record $13.5 trillion (Fig. 12).

Last Thursday, BOJ Governor Haruhiko Kuroda said, “While the policy approach has steered Japan’s economy in the right direction, our intellectual journey has not yet been completed. The rate of change in the consumer price index recently has been around 0 percent and there is still a long way to go until the price stability target of 2 percent is achieved.” Now in the fifth year of its unprecedented quantitative easing, the BOJ has expanded its balance sheet to nearly the same size as Japan’s economy.

(3) Fed’s balance sheet. In Boston last week, I was asked a couple of times about when the Fed might start to reduce its balance sheet. It seems to me that in normalizing monetary policy, Fed officials are probably most interested in raising the federal funds rate back closer to 2.00%. It is currently 0.88%. If so, then they are likely to signal that they are in no hurry to reduce their balance sheet since that might make it tougher to raise rates. Melissa and I will be paying close attention, along with everyone else, to the Fed’s communication on this subject following the FOMC meeting on Wednesday, June 14.

We do expect a quarter-point rate hike at this meeting. While it is true that payroll employment has been surprisingly weak in recent months (averaging just 162,000 per month from March-May), that may be because the economy is at full employment. In other words, employment is weak because we’ve run out of warm bodies to hire rather than because of weak demand for workers.

Perhaps the best way to think about full employment is this: Full employment occurs when the number of job openings equals the number of unemployed workers. During April, the former was a record 6.0 million during April, while the latter was 7.1 million. The ratio of unemployed workers to job openings was 1.17, the lowest since January 2001. April’s unemployment rate of 4.4%, therefore, mostly reflected so-called “frictional” unemployment caused primarily by geographic and skills mismatches. Besides, the financial markets were very calm about the rate hike earlier this year. Fed officials would be foolish to let this opportunity to normalize some more slip by.

The bottom line is that the US Treasury bond yield mostly remained in our 2.00%-2.50% range during the first half of 2017. We still expect a range of 2.50%-3.00% during the second half of the year. That’s because we expect that the Fed remains committed to gradually raising the federal funds rate.

Strategy III: Quarterly Valuation Ratios. The Fed updated its Financial Accounts of the United States publication last week with Q1-2017 data. It shows that the value of all equities in the US rose to a record $40.8 trillion (Fig. 13). That’s up a whopping $27.4 trillion since the bear market low during Q1-2009. The Q1-2017 total includes $33.1 trillion in US equities and $7.7 trillion in foreign issues. US residents held 18.7% of their equity portfolios in foreign stocks during the first quarter (Fig. 14). By the way, the S&P 500 rose to a record-high market capitalization of $20.7 trillion at the end of May, up $13.8 trillion since March 2009. Now consider the following valuation metrics:

(1) The Buffett Ratio, which divides the market cap of all stocks less foreign ones by nominal GNP, rose to 1.72 during Q1-2017 (Fig. 15). That’s the highest since Q1-2000, and is fast approaching that quarter’s record high of 1.80. Meanwhile, the comparable ratio for the S&P 500 using the market cap of the index divided by its aggregate revenues rose to 2.00 during Q1-2017, matching its record high during Q4-1999.

(2) The Laffer Ratio is similar to the Buffett Ratio but uses after-tax corporate profits from current production in GNP rather than GNP (Fig. 16). It edged up to 21.1 during Q1-2017. That’s the highest since Q4-2015, but well below its record high of 36.5 during Q1-2000. (For more on Laffer’s valuation measure, see Jon Laing’s 1/5/2004 Barron’s article titled “Altitude Adjustment.”)

(3) The Tobin Ratio is also relatively subdued on the valuation question (Fig. 17). It is the ratio of the market value of equities to the net worth of corporations, including real estate and structures at market value and equipment, intellectual property products, and inventories at replacement cost. It edged up to 1.04 during Q1-2017, still well below the record high of 1.61 during Q1-2000.

(4) The forward P/S is available weekly and is highly correlated with the Buffett Ratio (Fig. 18). This is the forward price-to-sales ratio of the S&P 500. It was awfully high at 1.93 at the start of June.

The bottom line is that stocks are extremely overvalued based on the Buffett Ratio. The same can be said of stocks using both the S&P 500 market-cap-to-revenues ratio and the forward price-to-sales ratio. On the other hand, stocks seem somewhat more reasonably priced using the Laffer Ratio and Tobin Ratio.

In our opinion, the longer that the current expansion continues with inflation and interest rates remaining subdued, the more bullish it is for stocks.

Beware of Fighting Elephants

Jun 08, 2017 (Thursday)

See the pdf and the collection of the individual charts linked below.

(1) Proverbial elephants. (2) Clash of the titans: Amazon vs Walmart. (3) Food at home is over $900 billion industry. (4) Prime service for less-than-prime customers. (5) Food stamps for online groceries. (6) Playing ball with a big elephant. (7) Amazon banning CR*P products. (8) Consumer Staples: Paying up for safety. (9) Beer, cigarettes, and drugs.


Consumer Staples: Getting Trampled. Proverbs are great at conveying big ideas simply but colorfully. Consider this African proverb: “When elephants fight, it is the grass that suffers.” Simple, yet colorful.

Fighting elephants came to mind when Amazon announced this week its plans to offer folks on government assistance a reduced rate to become Prime members. It’s the latest salvo in the battle between Amazon and Walmart to dominate Internet shopping. While the two have been tusking for years, the fight has intensified in recent months, and their suppliers and competitors alike are likely to get trampled in the grass beneath them.

You’d never know the elephants are fighting by looking at the industries in the S&P 500 Consumer Staples sector, where many of the suppliers and competitors are housed. Many of them have outperformed in recent weeks and trade at lofty multiples relative to low-single-digit earnings growth expectations. Investors may be turning to the sector because it has historically been a safe haven during times of turbulence, and offers dividends that look attractive in today’s low-interest-rate environment. Could this be the quiet before many of the Consumer Staples industries get trampled? Let’s look:

(1) The grocery showdown. There’s no mistaking it: Amazon and Walmart are making a big push to dominate Internet grocery shopping. They’ve both introduced a laundry list of new programs in an effort to woo customers. Personal outlays on food consumed at home totaled $939 billion (saar) during April (Fig. 1). Retail sales of food and beverage stores totaled $713 billion (saar) the same month. The difference between the two series is likely to be mostly the grocery sales of the warehouse clubs and super stores (Fig. 2). In other words, it’s a huge and natural arena for fighting elephants.

Amazon earlier this week offered a reduced rate for Prime membership—$5.99 a month instead of $10.99 a month—to customers on government assistance. The move comes as Amazon, Walmart, and seven additional retailers are participating in a pilot program that will allow food stamps to be used to purchase groceries online beginning next year, according to the US Department of Agriculture.

In addition, Amazon opened two grocery pickup locations in Seattle recently, and it lowered its free shipping threshold to $25—after Walmart lowered its threshold to $35, Recode reported on 6/6. Meanwhile, Walmart bought Internet retailer for $3.3 billion last year, and it added discounts for anyone picking up packages in the store. Walmart is also testing a program where its workers are paid if they drop off packages ordered online on their way home from work.

The rapid succession of new initiatives gives the impression that both companies are throwing food at the wall to see what sticks. In the meantime, other retailers—whether they be grocery stores like Kroger, larger-format stores like Target and Costco, or dollar stores—have to be wondering what the grass will look like after the elephants finish fighting.

(2) Price slashing. Margins are already notoriously thin in the grocery business. But as Walmart and Amazon get even more competitive, they reportedly are asking suppliers to cut prices. According to a 3/30 Recode article, Walmart told some of its largest suppliers that it wants to have the lowest price on 80% of its sales.

“To accomplish that, the brands that sell their goods through Walmart would have to cut their wholesale prices or make other cost adjustments to shave at least 15 percent off. In some cases, vendors say they would lose money on each sale if they met Walmart’s demands,” the Recode article stated. “Brands that agree to play ball with Walmart could expect better distribution and more strategic help from the giant retailer. And to those that didn’t? Walmart said it would limit their distribution and create its own branded products to directly challenge its own suppliers.”

Amazon is also twisting arms. The Recode 3/30 article reports that Amazon has software that finds the lowest price online for an item and then matches it on Amazon, even if it means the sale is unprofitable. “Unprofitable items are known inside Amazon as [CR*P] products—the acronym stands for ‘Can’t Realize a Profit.’ … When Amazon warns suppliers that a product is pre-[CR*P], meaning it’s in jeopardy of being kicked off the site for profitability issues, it makes demands. Oftentimes, to lower wholesale prices. But that doesn’t always work, especially if a brand has the leverage of also selling into Walmart, which is still the biggest retail customer for many manufacturers.” So Amazon may move the product to a different part of its site that charges an additional shipping fee or prevent advertisement of the product on its website.

(3) Safety sells. Despite the upheaval in the retail space, the S&P 500 Consumer Staples index has turned in a strong performance over the past four weeks along with Utilities as defensive sectors have outperformed and Treasury yields have dropped. Here’s the performance derby of the S&P 500 sectors for the four weeks through Tuesday’s close: Utilities (4.7%), Consumer Staples (3.9), Tech (3.4), Materials (1.8), Health Care (1.7), Real Estate (1.6), S&P 500 (1.4), Telecom Services (0.9), Industrials (0.5), Consumer Discretionary (0.2), Financials (-1.6), and Energy (-2.3) (Table).

During the past four weeks, numerous industries in the Staples sector have outperformed the broader market, including: Tobacco (7.6%), Soft Drinks (5.0), Distillers & Vintners (4.8), Personal Products (4.5), Packaged Foods & Meets (4.1), Hypermarkets & Super Centers (3.8), Household Products (3.7), and Brewers (3.5). Meanwhile, the S&P 500 has returned 1.4% over the same four-week period from May 9 through Tuesday.

Before jumping into Consumer Staples, remember that the elephants are fighting and the sector’s forward P/E, at 20.5, is almost three times the 7.2% earnings growth analysts are expecting over the next 12 months (Fig. 3 and Fig. 4). That’s pricier than the multiple of earnings that investors are paying for stocks broadly: The S&P 500 sports a lower forward P/E of 17.6 yet higher forward earnings growth of 11.3%.

(4) Food retailers. Given the battle between Walmart and Amazon, it’s ironic that one of the Consumer Staples’ industries with the most stretched valuation is S&P 500 Food Retail (KR, WFM). It has forward earnings growth of only 3.4%, yet the shares trade with a forward multiple of 15.4 (Fig. 5 and Fig. 6). Its earnings growth rate has come down from north of 10%, where it routinely stood from 2012 to 2014. The last time earnings growth was this low was in 2009, when the P/E was much lower at 8.7.

In addition to the Amazon/Walmart battle, there’s a new company entering the fray. German grocer Lidl is opening its first 10 stores in the US this month. Over the next year, the company plans to open a total of 100 stores, and its ultimate goal is to have 600 stores in the US to complement the 10,000 stores it has in 27 European countries, according to a 5/17 Business Insider article. Food retailers have been slashing prices in response to increased competition. Declining prices led Kroger to report its first earnings decline in 13 years for Q4-2016, the 3/2 WSJ reported.

Hypermarkets & Super Centers (COST, WMT), which is expected to grow earnings by 5.0% over the next 12 months, sports a forward P/E of 20.8 (Fig. 7 and Fig. 8). Dollar stores and Target are in the Consumer Discretionary sector, but we thought we’d mention them anyway. They’re in the S&P 500 General Merchandise Stores industry (DG, DLTR, and TGT), which has already fallen 12.4% ytd. Analysts are calling for forward earnings in the industry to fall 1.4%, and the industry’s P/E has dropped to 14.6 from a recent high of 19.6 in 2015 (Fig. 9 and Fig. 10).

(5) Pricing pressures? As Walmart and Amazon race to offer Internet shoppers products with the lowest prices, their suppliers’ profits are at risk of being squeezed. Yet investors in the S&P 500 Consumer Staples Household Products index (CHD, CL, CLX, KMB, PG) don’t appear concerned. The industry has a forward P/E of 22.1, even though it’s expected to grow earnings by only 6.6% over the next year (Fig. 11 and Fig. 12).

Along the same lines, the S&P 500 Soft Drinks industry (DPS, KO, MNST, PEP) is projected to boost earnings by 4.8% over the next year, but it has a forward P/E of 22.8 (Fig. 13 and Fig. 14).

(6) Better prospects. There are some Consumer Staples industries that offer faster growth and lower multiples than the ones mentioned above. Not surprisingly, many of them don’t sell their products through Walmart or Amazon. Agricultural Products (ADM), for example, has a forward P/E below its earnings growth rate. The industry is expected to grow earnings by 16.6% over the next year and has a forward P/E of 14.6 (Fig. 15 and Fig. 16).

Similarly, the S&P 500 Brewers (TAP) is expected to grow earnings by 23.8% over the next 12 months because Molson Coors Brewing acquired SABMiller’s 58% stake in MillerCoors. The industry has a forward P/E of 14.2 (Fig. 17 and Fig. 18). As the deal is anniversaried, the industry’s earnings growth rate is expected to decelerate to 6.5% in 2018. Shares of Molson Coors fell 6.5% yesterday after the company said costs would rise this year and its EBITDA margin estimate disappointed investors, the FT reported.

Two other industries with lower valuations are Drug Retail and Tobacco. The S&P 500 Drug Retail index (CVX, WBA) peaked in 2015 and has fallen 25.0% since then (Fig. 19). When the shares were at their peak, the industry’s forward P/E was roughly 21. Today, its forward P/E has fallen to 13.6, and earnings growth has tumbled to 6.8%, down from double digits in years past (Fig. 20 and Fig. 21).

The best-performing Consumer Staples industry is Tobacco, up 22.5% ytd, followed by Distillers & Vintners (20.1%) and Personal Products (18.5) (Fig. 22). Tobacco companies have had strong results in the US because they’ve increased prices to more than offset declining volumes of cigarettes sold. “The number of cigarettes sold in the U.S. fell by 37% from 2001 to 2016, according to Euromonitor. Over the same period, though, companies raised prices, boosting cigarette revenue by 32%, to an estimated $93.4 billion last year. An average pack in the U.S. cost an estimated $6.42 in 2016, up from $3.73 in 2001, according to TMA, an industry trade group,” the 4/23 WSJ reported.

In addition, Tobacco stocks have been helped by M&A activity. There is speculation that Philip Morris International will buy Altria, and Reynolds American is in the midst of being acquired by British American Tobacco. Companies are also developing products that heat tobacco and release nicotine in a vapor. “Philip Morris says its internal studies have shown that by avoiding combustion, the product prevents or reduces the release of many harmful compounds. The company has asked the FDA for authorization to market IQOS as less harmful than cigarettes through a partnership here with Altria,” the WSJ article stated. Even though vaping products are not marketed to kids, kids are vaping, presumably drawn to the practice by fruity flavors and the desire to be like their friends. Hopefully, history isn’t about to repeat.

The S&P 500 Tobacco industry (MO, PM, RAI) is expected to boost earnings 9.4% over the next year, and its forward P/E has climbed to 23.0, the highest it has been over the past 22 years (Fig. 23 and Fig. 24).

All-Consuming Questions

Jun 07, 2017 (Wednesday)

See the pdf and the collection of the individual charts linked below.

(1) Running out of warm bodies? (2) Three measures of payrolls. (3) One job open for every jobless worker. (4) One-third of small businesses have jobs they can’t fill. (5) Half of small businesses say no qualified candidates for unfilled positions. (6) Wages should be up 3.0%-4.0% rather than 2.5%. (7) Vehicle miles traveled at record high. (8) Gasoline usage falling recently. (9) Has Trump’s “America First” pitch made America last for tourists?


US Labor I: Help Wanted. Is the US economy running out of warm bodies to hire? The answer is no, yes, and maybe; it depends on the data series used to answer this question. Last week on Thursday, ADP reported that private-sector payrolls rose by 253,000 during May, averaging a solid monthly gain of 240,000 since the start of the year (Fig. 1). Then on Friday, the Bureau of Labor Statistics (BLS) reported that private-sector employment increased 147,000 during May, averaging just 161,000. Yesterday, the BLS JOLTS report showed that hirings less separations totaled 78,000 during April, with the monthly gain averaging only 150,500 since the start of the year.

Debbie and I are big fans of the ADP series since it is based on actual paychecks data. It also doesn’t get revised as much as the BLS payroll data. It suggests that companies are hiring at a rapid clip and are finding workers to keep up the impressive pace. However, one out of three isn’t a winning combination. The other two measures of employment clearly suggest that more help is wanted than there are helpers who want jobs, or have the skills that match the open positions. Consider the following:

(1) Job openings. As Debbie discusses below, job openings rose to a record 6.04 million during April (Fig. 2). The ratio of unemployed workers to job openings fell to 1.17, the lowest since January 2001! In other words, there’s a job out there somewhere for every jobless American wherever they might be. Of course, for various reasons, job seekers aren’t matching up with the available jobs.

The JOLTS job openings rate, which is job openings as a percent of the sum of employment plus job openings, is highly correlated with the percentage of small business owners reporting they have one or more job openings, both as 12-month moving averages (Fig. 3). The former has leveled out at a record high around 4.0% for the past two years. This series starts during December 2001. The small business series, which is compiled by the National Federation of Independent Business (NFIB), is available since December 1986. In May, it rose to 29.8%, the highest since July 2001.

Using the monthly NIFB data, we see that during May the percent of firms with one or more job openings rose to 34%, the highest since November 2000 (Fig. 4). This series is highly correlated with the percent of small business owners who say that there are few or no qualified candidates for their job openings. This percentage rose to 51% in May, which slightly exceeds the past two cyclical peaks.

(2) Hiring. According to the latest JOLTS report, total new hires fell sharply during April (Fig. 5). Given the abundance of job openings this drop is more likely to reflect the shortage of employable workers rather than a sudden weakening in the labor market. However, the monthly data are quite volatile. On a 12-month-sum basis, new hires have been very stable around 63.0 million since last summer, while separations have also stabilized around 60.5 million (Fig. 6).

This implies that the labor market is aligned to provide 2.5 million jobs at an annual rate, or a bit over 200,000 per month. It hasn’t been doing that recently, suggesting that past performance is no guarantee of future performance. In other words, if it is getting harder to find warm bodies, then lots of employers may have more unfilled openings.

US Labor II: The Wage Question Again. A shortage of employables could slow consumer spending and the economy. In the past, tight labor markets boosted wages, which sustained the growth of consumer incomes and spending, at least in nominal terms. The surprise this time is the subdued pace of wage inflation.

In the past, there was a strong correlation between the growth rate of average hourly earnings of production and nonsupervisory workers, on a y/y basis, and job openings (Fig. 7). There are lots of possible explanations that Melissa and I have discussed in the past. In fact, we did it again on Monday, when we examined the latest BLS employment report. In any event, the fact remains that wage inflation remains around 2.5%. It isn’t 3.0%-4.0%, as suggested by the past relationship between wages and measures of labor market tightness.

US Consumers: Driving Less. While we are worrying about consumers, let’s go for a drive with them. The good news is that over the past 12 months through March, vehicle miles traveled in the US rose to a record high of 3.18 trillion miles (Fig. 8). The bad news, at least possibly, is that gasoline usage has been falling since the week of October 28 based on the 52-week series for millions of barrels per day. In fact, this series is down 0.5% y/y, the lowest since mid-July 2013 (Fig. 9).

I’m hearing more chatter recently about a significant drop in foreign tourism so far this year. Many would-be tourists from abroad might have been turned off by Trump’s “America First” rhetoric. Spring and summer tend to be the months when foreign tourism is especially strong. Tourists tend to drive a lot to see the sites. So it’s possible that the recent drop in gasoline usage reflects the weak-tourism phenomenon rather than anything more worrisome about the US consumer.

A 5/25 story reported: “A new study finds international tourism to the U.S. has dropped in the Donald Trump era. America's share of international tourism saw a 16 percent decline in March when compared to the same month last year, according a data analysis released on Wednesday by Foursquare, a technology company with a focus on location intelligence.

“The decline dates to October 2016, one month before the U.S. presidential election that pitted Republican President Donald Trump against Democratic challenger and former U.S. Secretary of State Hillary Clinton, according to the study. The decline has been steady with leisure tourism-related traffic to the U.S. falling an average of 11 percent between October and March, compared to the same period a year before.

“Conversely, Foursquare analysts found tourism in the rest of the world increased 6 percent year-over-year during that same period.”

Chirping Canaries

Jun 06, 2017 (Tuesday)

See the pdf and the collection of the individual charts linked below.

(1) Animal spirits still mostly animated. (2) Hard data remain soft. (3) Home in the range for the S&P 500. (4) Hannibal’s FAANG elephants leading the bulls to new heights. (5) Adding sentinel animals to the zoo. (6) Go Global beating Stay Home so far this year. (7) Solid global PMIs. (8) Lots of happy canaries in Europe and Asia. (9) Global trade growth picking up. (10) Asian exports also showing signs of life. (11) Forward earnings for major overseas MSCI indexes increasingly upbeat.


US Economy: Thin Air. Since Election Day, there has been lots of chatter about “animal spirits.” The evidence of animated animal spirits has come mostly in the form of “soft data” based on surveys of consumers and businesses that showed remarkable jumps in confidence following the election. So far, the euphoria hasn’t trickled down to the US economy’s hard data, as most recently evidenced by May’s weaker-than-expected employment report released last Friday. May’s Consumer Optimism Index, which averages the Consumer Sentiment Index and Consumer Confidence Index, remained near its recent cyclical high during March (Fig. 1). So did April’s Small Business Optimism Index (Fig. 2).

Yet the Citigroup Economic Surprise Index (CESI) dropped to -40.9 on Friday (Fig. 3). That’s down sharply from a recent peak of 57.9 on March 15, and the lowest reading since February 18, 2016. That has helped to bring the US Treasury 10-year bond yield down from a recent high of 2.42% on May 9 to 2.18% yesterday (Fig. 4). The 13-week change in this yield tends to be highly correlated with the CESI (Fig. 5). The Treasury yield curve spread has narrowed from a recent high of 213bps to 124bps at the end of last week, the lowest since October 3 (Fig. 6).

Yet the S&P 500 continues to chalk up new record highs, rising to 2439.07 on Friday, already putting it comfortably within our yearend target range of 2400-2500! Yesterday, Joe and I chalked this accomplishment up to “Hannibal spirits,” which is the relentless drive to scale the Alps even with a herd of elephants. More specifically, we observed that money is pouring into ETFs at a record pace.

The biggest elephants in the stock market are the five FAANG stocks, which now account for 11.9% of the S&P 500’s market capitalization, up from 5.8% on April 26, 2013. Collectively, over this period, they’ve accounted for $1.6 trillion of the $6.9 trillion increase in the S&P 500! Their collective forward P/E is now 27.1 and 42.8 with and without Apple, respectively. The S&P 500’s forward P/E is 17.7 and 16.9 with and without the FAANGs. These elephants continue to sprint up mountains, leading the market’s bulls, even though the air is getting thinner.

Yesterday, we wrote that money coming out of actively managed equity mutual funds into passive equity ETFs might be more bullish for the largest-cap stocks, like the FAANGs, than for the rest of the market. One of our accounts told us that only makes sense if money is coming out of mutual funds that have underperformed because they’ve underweighted FAANGs. That’s certainly a possibility.

Global Economy: Fresh Air. Today, we would like to bring “sentinel animals” into our discussion of financial-markets zoology. They are used to detect risks to humans by providing warning of a danger. The classic example is canaries in a coal mine. While a few canaries in the US seem to be having trouble breathing, most of them continue to chirp without a care in the world. The ones in other parts of the world are especially chirpy. This might explain why the major stock indexes in the US and Europe are rising in record-high territory. Global economic growth seems to be improving, while inflation remains subdued. Central bankers may be looking for ways to unwind their ultra-easy monetary policy, but they are likely to do so very gradually. This is a very bullish scenario for stocks.

So far this year, that’s been especially so for the outperforming EMU MSCI and EM stock price indexes because their forward P/Es are lower than the one for the US MSCI (Fig. 7 and Fig. 8). Here is the performance derby ytd of the major MSCI stock price indexes in dollars through Friday: EMU (18.4%), Emerging Markets (17.7), All Country World (11.3), Japan (11.1), UK (10.1), and US (9.2). Now consider the following:

(1) Commodity prices. There’s no boom in our trusty CRB raw industrials spot price index, nor is there a bust. It has stalled in recent weeks, but remains 27% above its most recent cyclical low at the end of 2015.

(2) PMIs. As Debbie reviews below, the global composite PMI was 53.7 during May, remaining between 53.0 and 54.0 since October (Fig. 9). The M-PMI of the advanced economies has been especially steady at a robust level around 54.0 for the past six months. The same can be said for the NM-PMI of the advanced economies. Emerging economies have shown some weakness in recent months for the M-PMI, while the NM-PMI has been rising.

(3) Eurozone business. Eurozone M-PMIs were exceptionally strong last month, with the following readings: Germany (59.5), Eurozone (57.0), Spain (55.4), Italy (55.1), and France (53.8). So were the region’s NM-PMIs during May as follow: Spain (57.3), France (57.2), Eurozone (56.3), Germany (55.4), and Italy (55.1).

(4) World trade. Debbie and I believe that among the most reliable indicators of global economic activity are the ones based on merchandise trade data. The CPB Netherlands Bureau for Economic Policy compiles a monthly composite of the volume of world exports. Its growth rate on a y/y basis is highly correlated with the comparable growth rate in the sum of inflation-adjusted US exports plus imports (Fig. 10). The former was up 6.1% during March, the best performance since April 2011. The latter was up 4.4% during April, which was well ahead of the 2.0% decline recorded a year ago.

(5) Asian trade. Debbie and I closely monitor and compare the exports data coming out of Asia, in dollars and on a y/y basis. Many of the region’s economies have become highly integrated with one another. China, obviously, ties them all together given the size of its imports and exports. Among the most closely tied to China are South Korea, Taiwan, and Singapore. Their exports have been mostly on uptrends since early 2016 (Fig. 11). The same can be said about the exports of India, Indonesia, Malaysia, and Thailand (Fig. 12).

(6) Forward earnings. Confirming the global happy-canaries scenario is our analysis of forward earnings for the All Country-World ex-US MSCI stock price index in local currency (Fig. 13). It was mostly flat to down from mid-2011 through early 2016. It was gasping for air for sure, while forward earnings for the US MSCI continued to rise to new record highs before stalling during the second half of 2014 through 2016, as a result of the recession in the energy sector.

Since early 2016, both measures of forward earnings have been rising. The US is back in record territory, while the overseas measure is the highest since November 2008. It’s more or less the same story for the Developed Countries ex-US MSCI and the Emerging Markets MSCI, both in local currencies (Fig. 14 and Fig. 15).

Hannibal Spirits

Jun 05, 2017 (Monday)

See the pdf and the collection of the individual charts linked below.

(1) Hannibal and his animals. (2) Climb every mountain. (3) Annual meeting of Bahre’s often bearish strategists. (4) Air is getting thin up here. (5) Record net inflows into equity ETFs, while equity mutual funds continue to hemorrhage. (6) White-hot FAANGs. (7) Earned Income Proxy at another record high. (8) Fewer labor force dropouts, a.k.a. NILFs. (9) Baby Boomers were careerists and materialists. Millennials are lifestylists and minimalists. (10) There’s more to life than money. (11) “Get Out” (+).


Strategy: Mountain Climbing. Hannibal, the Carthaginian general, was one of the greatest military strategists of all times. The city of Carthage in ancient Roman times was in the spot of modern-day Tunis, in Tunisia. Hannibal was so feared by the Romans that a common Latin expression to express anxiety about an impending calamity was “Hannibal ante portas!,” which means “Hannibal is at the gates!” He studied his opponents’ strengths and weaknesses, winning battles by playing to their weaknesses and to his strengths.

One of Hannibal’s most remembered achievements was marching an army that included war elephants over the Pyrenees and the Alps to invade Italy at the outbreak of the Second Punic War. He occupied much of Italy for 15 years but was unable to conquer Rome. A Roman general, Scipio Africanus, counter-attacked in North Africa, forcing Hannibal to return to Carthage, where he was decisively defeated by at the Battle of Zama. Scipio had studied Hannibal’s tactics and devised some of his own to defeat his nemesis.

So far, the current bull market has marched impressively forward despite 56 anxiety attacks, by my count. (See our S&P 500 Panic Attacks Since 2009.) They were false alarms. At the annual gathering of investment strategists and portfolio managers hosted by Gary Bahre last week, the other strategists were mostly concerned about the overvaluation of stock prices and believed that “something bad” always unexpectedly brings an end to bull markets. No one expects an imminent recession. One rather lame scenario offered by the bears was a massively disruptive cyberattack. Most of them have been bearish on stocks since the beginning of the bull market.

I remain bullish. However, when asked for my what-could-go-wrong scenario, I said that my long-held concern is that the bull market might end with a melt-up that sets the stage for a meltdown. Indeed, on March 7, I raised my subjective odds of a melt-up from 30% to 40%. I lowered the odds of a sustainable bull run from 60% to 40%. So I increased the odds of a meltdown from 10% to 20%. In my mind, a melt-up would set the stage for a meltdown. However, in this scenario, the meltdown might be a 10%-20% correction or a short bear-market plunge of 20%+, but it would not necessarily cause a recession. So the bull market could resume relatively quickly.

The latest valuation and flow-of-funds data certainly suggest that the melt-up scenario may be imminent, or actually underway. Consider the following:

(1) Valuation melt-up. The Buffett Ratio is back near its record high of 1.81 during Q1-2000 (Fig. 1). It is simply the US equity market capitalization excluding foreign issues divided by nominal GDP. It rose to 1.69 during Q4-2016. It is highly correlated with the ratio of the S&P 500 market cap to the aggregate revenues of the composite (Fig. 2). This alternative Buffett Ratio rose to 2.00 during Q1 of this year, matching the record high during Q4-1999. It is also highly correlated with the ratios of the S&P 500 to both forward revenues per share and forward earnings per share (Fig. 3 and Fig. 4). All these valuation measures are flashing red.

(2) ETF melt-up. The net fund flows into US equity ETFs certainly confirms that a melt-up might be underway. Over the past 12 months through April, a record $314.8 billion has poured into these funds (Fig. 5). That was led by funds that invest only in US equities, with net inflows of $236.4 billion, while US-based ETFs that invest in equities around the world attracted $78.4 billion in net new money over the 12 months through April.

Some of the money that went into equity ETFs came out of equity mutual funds (Fig. 6). Over the past 12 months through April, net outflows from all US-based equity mutual funds totaled $155.3 billion, with $163.7 billion coming out of US mutual funds that invest just in the US and $8.4 billion going into those that invest worldwide.

So the net inflows into all US-based equity mutual and indexed funds totaled $159.4 billion over the past 12 months, $72.7 billion going into domestic funds and $86.7 billion into global ones (Fig. 7). These totals don’t seem to be big enough to fuel a melt-up. However, the shift of funds from actively managed funds to passive index funds is significant and could be contributing to the melt-up. That’s especially likely since money is pouring into S&P 500 index funds, which are market-cap weighted. This certainly explains why big cap stocks, like the FAANGs, are outperforming.

(3) FAANG-led melt-up. Since the start of the year, the market-cap weighted S&P 500 is up 8.9%, while the equal weighted index is up 7.2% (Fig. 8). Joe calculates that the market cap of the FAANGs is up 41.4% y/y to a record $2.49 trillion, while the market cap of the S&P 500 is up 14.3% to $20.95 trillion over the same period (Fig. 9). In other words, the FAANGs account for 27.8% of the $2.6 trillion increase in the value of the S&P 500 over the past year.

US Economy: Warm Bodies. Is the US economy running out of warm bodies to employ? The unemployment rate is down to 4.3%. Job openings are at record highs. Payroll employment gains have slowed significantly over the past three months. Demographic trends may be exacerbating the situation.

The Baby Boomers are retiring. At the start of their careers, they mostly expected to work for one company over their entire careers. Of course, that was not the case for many of them, but they did mostly have a “careerist-materialist” attitude about their jobs and lives. The Millennials aren’t rushing into the labor force as did the Baby Boomers. More of them are going to college, especially the women among them. When they land a job, they aren’t as committed to keeping it for the rest of their careers. They may be willing to accept lower wages in exchange for more flexible (and less demanding) work. They have a more “lifestyles-minimalist” attitude. Melissa and I have been studying these trends. Let’s analyze the latest employment report with this perspective in mind:

(1) Earned Income Proxy. First, let’s not get too carried away by the weakness in May’s payrolls. They were up only 138,000, and the previous two months were revised down by 66,000 in total, as Debbie reports below. Private-sector payrolls are up only 126,300 per month on average from March through May. Yet over this same period, the ADP measure of private-sector payrolls is up 227,300 per month on average (Fig. 10).

Our Earned Income Proxy, which tracks private-sector wages and salaries in personal income, rose 0.3% m/m during May to a new record high (Fig. 11). It is up solidly by 4.3% y/y, auguring well for consumer spending.

(2) Labor force. Again, the actual data belie some of the concerns about a shortage of warm bodies to hire. The y/y growth of the labor force, based on the 12-month average, has exceeded 1.0% for the past 10 months (Fig. 12). That’s holding around its best performance since the fall of 2007. Workers are still dropping out of the labor force. However, the y/y growth of NILFs (i.e., the working-age population not in the labor force), based on the 12-month average, fell to 0.5% in May, the lowest since March 1998 (Fig. 13). The growth of NILFs who are 55 years old and older was 2.4% over the past 12 months, while younger NILFs fell 1.8% (Fig. 14).

The percent of the labor force with a college degree was a record 34.5% during May (Fig. 15). That’s up from 25.1% when the oldest Millennials (born in 1981) turned 18 years old during January 1999. This certainly implies that more young adults are going to college and adding to the number of NILFs while they are doing so.

(3) New normal. Despite the cyclical improvement in the growth of the labor force recently, the new normal in the labor market may be slower growth in both the labor force and employment, as low as 50,000 to 110,000 added per month. According to a FRB-SF paper from last October, such a pace would maintain a near-natural rate of unemployment around 5%, taking into account lower labor force participation rates resulting from retiring Baby Boomers over the next decade.

(4) Wages. Given that the job market appears to be so tight, the puzzle is that the pace of wage growth has remained so slow. Average hourly earnings for all employees on private nonfarm payrolls has risen just 2.5% y/y through May. It seems plausible that wages could be suppressed as retiring Baby Boomers with a lot of experience, and, thus higher salaries, are handing off the baton to younger less experienced workers. At the same time, job openings are at record highs. And small businesses, which make-up the lion’s share of the US economy in terms of jobs, are complaining that good employees are hard to find.

So employers are probably being forced to hire some employees that are not totally qualified, or just not that good. And employers might not be willing to pay those sorts of folks the big bucks. Thinking out loud, something else that could be at play is that Millennials who are entering the workforce now as the Baby Boomers retire might also not be demanding the big bucks. Some may prefer a more balanced lifestyle to a high-paying, high-stress job. Millennials and their inclination for minimalism and life experiences over “stuff” is a trend we have spotted and discussed previously.

In any event, employers are reporting that lots of low-wage workers today aren’t very loyal and don’t even show up, according to a 6/2 WSJ article. In it, the owner of a staffing agency was paraphrased as saying that “workers who skip out of jobs, whether to hang out with friends or care for family members, face little repercussion. With the unemployment rate so low, they can quickly find another low-wage job when they are ready to work.”

Nevertheless, the article observed that the “national tilt toward low-wage job growth now shows signs of shifting, which could lead to bigger increases in national pay raises.” During the past year, better-paying fields like health care and professional & business services have increased payrolls, while lower-wage retail payrolls have been cut. For example, payroll employment at all retail stores fell 80,100 over the past four months through May.

Movie. “Get Out” (+) (link) is not explicitly about the stock market. However, it is a movie worth watching as a cautionary tale. Sometimes, it is just so obvious that it’s time to go. For example, if you are meeting your girlfriend’s parents in their rural home for the first time, and you notice something odd about the maid and the caretaker…get out. Or, if her psychologist mom hypnotizes you involuntarily…get out. Or, if a bunch of old couples show up for a Sunday cocktail party to admire your physique…get out. We may be starting to see similar clues in the stock market. So why are we all still staying?

United Tech, Divided Transports

Jun 01, 2017 (Thursday)

See the pdf and the collection of the individual charts linked below.

(1) FAANG and headless headlines. (2) 10 Bennies for 1 Amazon. (3) Amazon is in the wrong aisle. (4) Active managers overweighting FAANG. (5) Tech accounts for a bit more than a fifth of S&P 500 earnings and market-cap shares. (6) Dow Theory remains bullish. (7) Rails are back on fast track. (8) Airlines have lots of passengers they can drag off planes. (9) Trucking industry’s freight tonnage stalled at record high. (10) Truck prices falling.


Technology Sector: FAANG Fans. Large, round numbers make for eye-catching headlines. They may not be as infamous as the New York Post’s “Headless Body in Topless Bar,” but as the bull market climbs ever higher, index milestones garner their fair share of attention. The fanfare continued in May as the S&P 500 broke through 2,400 for the first time.

The latest leg up in the market owes much to the FAANG stocks, including Amazon, which landed in the headlines because its stock price briefly crossed past $1,000 on Tuesday. That 10-Benjamins threshold brought into sharp focus the stock’s impressive 50,920% return since its IPO at a split-adjusted $1.96 on May 15, 1997. Amazon is the stock every investor would like to say they were smart enough to buy and hold through good times and bad.

Amazon’s ascendancy also reflects the enthusiasm that has returned to the S&P 500 Tech sector. Yes, we know that Amazon is officially in the Consumer Discretionary sector. However, it’s easily argued that the stockwith its focus on the Internet, software, and cloud serviceslooks, swims, and quacks more like a Tech stock.

The S&P 500 Tech sector index has risen 20.0% ytd through Tuesday’s close, far outpacing its fellow S&P 500 sectors: Consumer Discretionary (11.4), Health Care (9.6), Utilities (9.6), Consumer Staples (9.1), S&P 500 (7.8), Industrials (6.9), Materials (6.1), Real Estate (3.3), Financials (0.5), Telecom Services (-10.4), and Energy (-13.2) (Fig. 1).

The tech trade certainly isn’t undiscovered. “Funds tracked by Bank of America Corp. own the highest percentage of technology stocks on record compared to their benchmark. … And it’s giving active managers a boost they haven’t seen in more than two years,” a 5/30 Bloomberg article reported.

The article went on to say that 71% of active fund managers are now overweight the FAANG stocks. The returns of Facebook (up 27.6% y/y through Tuesday’s close), Amazon (39.9), Apple (53.1), Netflix (58.0), and Google (33.2) account for more than a quarter of the S&P 500’s 15.0% y/y return through Tuesday’s close.

But even the strong FAANG stock returns understate the enthusiasm that investors have had for the true go-go stocks in the Tech sector. Leading the pack are semiconductor stocks like Nvidia, up 215.6% over the past year, Micron Technology (149.4%), and Advanced Micro Devices (141.7), to name a few of the industry’s most impressive returns.

The stock of Autodesk, which develops software to create things, gained 90.7% over the past year. And straggling behind are the gaming software companies Electronic Arts and Activision Blizzard, which have posted 49.1% and 48.9% one-year gains.

The S&P 500 Tech sector (which, again, does not include amazing Amazon) sports a forward P/E of 18.5, slightly above the S&P 500’s forward P/E of 17.7 (Fig. 2). However, both the Tech sector and the S&P 500 are expected to have earnings growth of 11.2% on average over the next 12 months (Fig. 3). Nervous bulls might be glad to learn that the S&P 500 Tech sector’s share of the S&P 500’s market capitalization, at 23.1%, is only slightly above the sector’s share of the S&P 500’s earnings, 22.0%. At the peak of the 2000 bubble, the Tech sector’s market-cap share was 32.9%, and its contribution to S&P 500 earnings was only 15.4% (Fig. 4).

Transportation Industry: Taking Different Roads. The Dow Jones Industrial Average also found itself in the headlines last month as it crossed past 21,000 once again. The index reached its highest price of 21,115 on March 1, and it has edged down 0.4% since then. Dow Theory adherents undoubtedly were happy to see that on the same day, the Dow Transports hit a new high of 9,593, confirming the move in the DJIA. The Transports have also fallen back a bitby 4.5%since then (Fig. 5).

The new high in the Transports is impressive given the bifurcated performance of the industries in the index. While the airlines and rails have enjoyed stellar performances over the past year, the truckers and marine companies have dropped or simply underperformed, holding the index back. I asked Jackie to have a look at why the Transport industries are producing such different returns:

(1) Rails on fast track. In 2010, Warren Buffett made a $26 billion bet on the rails by buying Burlington Northern Santa Fe. So far, so good. The S&P 500 Railroads industry is one of the best-performing industries in the S&P 500, up 18.1% ytd and 48.4% over the past year (Fig. 6).

The industry has recovered nicely from sharp declines in coal shipments that ran from 2009 through last year (Fig. 7). With coal volumes bottoming and shipments of chemicals, plastics, and petroleum on the rise, overall rail shipments should start growing again. Excluding coal, railcar loadings have plateaued (Fig. 8).

Shares of CSX have been the best performer in the railroad industry, up 50.9% ytd and 108.4% y/y, as Hunter Harrison was brought in by an activist investor to be CEO. Harrison is known as a turnaround pro and has already instituted a plan to improve the railroad’s efficiency by idling 550 locomotives and 25,000 railcars, the 3/6 WSJ reported.

The S&P 500 Railroad industry is expected to post strong results this year. Revenue is expected to grow 5.6% in 2017, compared to the 7.1% decline last year. Likewise, this year’s earnings are expected to grow 13.6%, following last year’s 15.9% gain (Fig. 9). Analysts’ earnings expectations for the rails have been improving all year long (Fig.10). However, the industry’s valuation bears watching: While its forward P/E has come down from a record high of 20.2 during January to 18.0, the multiple remains higher than it has been going back to the mid-1990s (Fig. 11).

(2) Airlines flying high. Airlines should be wary of the turbulence that analysts are expecting this year and next. While revenues are expected to climb 4.7% over the next 12 months, earnings are expected to grow only 1.9% (Fig. 12).

But despite that tepid forecast, S&P 500 Airlines’ shares have gained 6.5% ytd, perhaps because earnings growth is expected to pick up next year to 15.5% (Fig. 13). Recently, American Airlines and United indicated that the supply of seats in the industry remains tight relative to the number of customers looking to book tickets. United Airlines, which recently found itself in the headlines after a customer was dragged off a plane, said it expects passenger revenue for each seat flown a mile to rise by 1%-3% y/y. Likewise, American Airlines predicted passenger revenue per seat would increase 3.5%-5.5%.

“The new forecasts signal increased confidence by American that it will post unit-revenue gains for a third straight quarter, after a 2015 discount war and excess capacity had forced ticket prices down for about two years. Higher average fares and lower estimated fuel prices led to the improved outlook, American said,” according to a 5/9 Bloomberg article.

(3) Truckers stopped. The trucking industry has hit a pothole. The S&P 500 Trucking index has risen only 1.4% y/y, and it has fallen 11.3% ytd (Fig. 14). Investors may be somewhat concerned that trucking volumes have plateaued at a high level over the past year after soaring from 2009 through 2015 (Fig. 15). Additionally, the declining price of used trucks is hurting the value of trucking companies’ assets, all while the long-running lack of drivers is forcing companies to increase wages.

A few years ago, when volumes were growing strongly, trucking companies went on a truck-buying spree. Large, long-haul trucking companies typically use a truck for three to five years and then trade it in before the warranty expires. Now, as they’re ready to trade in the trucks, overcapacity is causing the price of used trucks to decline, putting pressure on the overall value of the companies’ truck portfolios (Fig. 16).

“Over the past two years, the average retail price for a used Class 8 sleeper, the heavy-duty tractor used for long-haul routes, has plunged about 22% to about $49,000 in March, according to J.D. Power Valuation Services. That translates into a decrease of some $140 million across a fleet of 10,000 trucks,” the 5/12 WSJ reported. The number of new trucks sold never rose as high as it did in previous cycles, and truck sales may have bottomed out at a higher level as well.

Perhaps smelling opportunity, Swift Transportation and Knight Transportation announced in April plans to merge. At the time, both companies had similar market caps, however, Swift is the fifth largest trucking company by revenue, and Knight is the 22nd largest, the 4/10 WSJ reported. Knight’s CEO will lead the merged company, as Knight is considered a better operator with better margins.

The trucking industry has also been increasing wages in an effort to ease a driver shortage. But it’s tough to see why someone would consider making truck driving a career if autonomous trucks are in the industry’s future. Tesla has said it plans to unveil in September an electric truck, which analysts believe will be at least partially autonomous, Bloomberg reported on 4/13. And they’re not alone. Starsky Robotics is a startup working on the problem, and Uber bought Otto last summer to get a jumpstart in the industry, according to a 3/30 FT article.

The S&P 500 Trucking industry is expected to grow revenues by 6.4% over the next 12 months, but earnings expectations have come down sharply over the past year, leaving growth estimates for the next 12 months at 3.0% (Fig. 17 and Fig. 18). Despite the below-market earnings growth, the industry’s forward P/E, at 17.7, remains near the highs of this cycle, and not far from the S&P 500’s multiple (Fig. 19).

A Memorable Earnings Season

May 31, 2017 (Wednesday)

See the pdf and the collection of the individual charts linked below.

(1) Seasonal drop, but y/y growth. (2) Forward earnings at record highs. (3) Tax cuts wading through the swamp. (4) Winning streak: Profit margin remains at record high. (5) A traumatic legacy. (6) Resource utilization rate still below previous cyclical peaks. (7) NBx2 scenario: No Boom, No Bust. (8) Double-digit earnings growth for S&P 500 Financials, IT, and Materials. (9) Revenue growth rising along with other measures of economic activity. (10) Aggregate vs per-share growth.


Strategy: Revenue Growth Rebounding. Joe reports that Q1 revenues, earnings, and margins are now available for the S&P 500. Revenues per share dropped 2.7% q/q during Q1. Earnings per share, based on Thomson Reuters I/B/E/S (TR) data, fell 1.3% q/q. So in what sense was the Q1 reporting season “memorable,” as stated in the title of today’s commentary?

For starters, the S&P 500 rose to a new record high of 2415.82 on May 26 (Fig. 1). The S&P 400 and S&P 600 stock price indexes continued to mark time at their recent record highs. Industry analysts remained upbeat about earnings for this year and next year, as reflected by the record highs in the S&P 500/400/600 forward earnings (Fig. 2).

This all happened despite a growing realization that President Trump’s economic agenda is likely to be slowed by Washington’s swampy ways. Joe and I came to that epiphany on May 18 and pushed the corporate tax cut into 2018 from 2017. Without a tax cut, we estimate that S&P 500 earnings per share will be $130.00 this year and $136.75 next year. With the tax cut in 2018, our estimate for next year gets raised to $150.00. (See YRI S&P 500 Earnings Forecast.) Let’s have a closer look at the results of the latest reporting season:

(1) Good growth. Of course, the apparent weakness in Q1’s revenues and earnings on a q/q basis is mostly seasonal in nature. The first quarter of the year tends to be the weakest one of the year (Fig. 3 and Fig. 4). On a y/y basis, revenues per share rose 6.9%, the fastest since Q4-2011 (Fig. 5). Earnings per share rose 14.5% y/y, the best growth since Q3-2011 (Fig. 6).

Joe and I argued that the S&P 500 revenues recession during 2015—when y/y growth rates were down each quarter—was mostly attributable to the plunge in the revenues of the energy sector. The revenue growth rates, which turned slightly positive during Q1-2016, have been increasing since then. It was last summer that we declared the end of the earnings recession. The y/y growth rate of earnings turned positive during Q3-2016 at 4.2%, rose to 5.9% during Q4-2016, and chalked up 14.5% at the start of this year.

(2) High & stable margin. The profit margin of the S&P 500, based on TR data, rebounded sharply from a record low of 2.4% during Q4-2008 back to its previous cyclical peak of 9.6% during Q3-2011 (Fig. 7 and Fig. 8). There was lots of growling by the perma-bears that it would soon revert to its mean. Instead, it continued to rise to a new record high of 10.7% during Q3-2016. It has remained around there since then, registering 10.5% during Q1.

Joe and I argued that following the Trauma of 2008, company managements would do whatever they could to raise and maintain their profit margins by remaining conservative in their spending plans despite record profits. We aren’t saying that the profit margin will never revert again. It will do so come the next recession. But that downturn may not come for a while because companies are being conservative.

In the past, the profit margin would often peak before recessions as companies went on hiring and capacity expansion sprees (Fig. 9). The resulting boom would create the borrowing and inflationary excesses that set the stage for the inevitable bust. This time, the economy isn’t booming the way it often has at this late stage of an expansion. No boom, no boost … at least not in the foreseeable future.

There is some correlation between the profit margin (using GDP data, which have a much longer history than the S&P data) and the economy’s resource utilization rate (RUR), which is the average of the capacity utilization rate and the employment rate (Fig. 10). RUR is near its 2014 cyclical high, but below all previous cyclical highs since 1967. No boom, no bust. We’ve written about this scenario over the past couple of years. We are christening it our “NBx2” scenario.

(3) Sectors. Joe analyzes the earnings of the S&P 500 sectors using both TR and S&P data (Fig. 11). Both are on an operating (pro forma) rather than reported (GAAP) basis. The TR composite is based on the estimates of industry analysts who tend to be more liberal than the S&P’s internal estimates of one-time expenses and income.

Focusing on the TR earnings data, Joe reports the following y/y earnings growth rates for the S&P 500 sectors, from best to worst: Financials (28.4), Tech (21.1), Materials (20.6), Health Care (6.4), Consumer Staples (5.6), Consumer Discretionary (5.4), Industrials (1.6), Utilities (1.1), and Telecom (-5.0). Energy has come back from the dead impressively, recording earnings at a six-quarter high versus a loss a year ago. But the double-digit growth rates of Financials, Information Technology, and Materials are also impressive. Health Care’s mid-single-digit growth rate is lackluster. Industrials’ low-single-digit gain is disappointing, but should improve in coming quarters.

(4) Correlations. We aren’t surprised by the solid rebound in S&P 500 revenues because its y/y growth rate tends to be nearly the same as the comparable growth rate for manufacturing and trade sales, even though this series is limited to goods and does not include services (Fig. 12). Aggregate (not per-share) revenues was up 5.2% y/y during Q1, while business sales rose 6.4% through March.

Revenues per share on a y/y basis tends to lag the US M-PMI (Fig. 13). The latter remains relatively high and consistent with revenue growth around 5%.

Not surprisingly, there is a decent correlation between the y/y growth rate in nominal GDP and aggregate S&P 500 revenues (Fig. 14 and Fig. 15).

(5) Aggregate vs per share. By the way, on a y/y basis through Q1, S&P 500 revenues grew 5.2% in aggregate and 6.9% per share (Fig. 16). Operating earnings (using TR data) increased 12.7% in aggregate and 14.5% per share (Fig. 17).

Steady Eddie

May 30, 2017 (Tuesday)

See the pdf and the collection of the individual charts linked below.

(1) Cruising at a safe speed. (2) Real GDP growth looks nice and steady on y/y basis. (3) GDP growth is higher excluding the government. (4) Steady, Fast, and Crazy Eddies. (5) Larry Summers says he told us so. (6) Demography is weighing on working-age population and labor force growth in US. (7) Age wave analysis shows younger workers growing faster. (8) Japan’s death cross. (9) Global trade indicators showing improving economic activity.


US Economy I: Still Cruising at Stall Speed. The title of today’s commentary isn’t meant to describe our forecasting style, though Debbie and I try to be as steady as possible. Rather, we’re thinking about the remarkable stability of the growth in real GDP in the US. That may seem odd given the erratic growth rates of real GDP on a quarter-over-quarter, seasonally adjusted annual rate basis over the past five quarters from Q1-2016 through Q1-2017: 0.8%, 1.4%, 3.5%, 2.1%, and 1.2% (Fig. 1). However, the underlying growth rate measured on a year-over-year basis has been remarkably stable around 2.0% since Q1-2010, within a range of 1.0% and 3.3% (Fig. 2). It was exactly 2.0% during the first quarter.

We recall that starting in 2010, perma-bears warned that 2.0% was the economy’s “stall speed.” They were right about the past: During previous economic expansions, whenever real GDP growth slowed to 2.0% on a y/y basis, the economy subsequently fell into a recession (Fig. 3). So far, they’ve been wrong about the current expansion. It continues apace, growing around 2.0% without stalling. Perhaps that’s because real GDP excluding government spending has been growing around 3.0% since 2010 (Fig. 4). It was 2.6% during the first quarter. The growth rate of government spending in real GDP (which does not include spending on income redistribution programs) has been mostly negative since the start of the current expansion (Fig. 5). That’s unusually weak and may reflect the fact that spending on entitlements is so huge now that it is crowding out government spending on goods and services.

Nevertheless, this proves that the economy can grow just fine without the help of government spending. While we are digressing: Eddie Clarence Murray was a former Major League Baseball player, who was known as one of the most reliable hitters of his time and hence was nicknamed “Steady Eddie.” He was elected to the Baseball Hall of Fame in 2003. “Fast Eddie” was the nickname of Eddie Parker, the accomplished pocket billiards player memorialized in the movie “The Hustler.” Eddie Antar owned Crazy Eddie, a chain of electronics stores in the Northeast, until he was charged with fraud and spent eight years in prison.

Steady Eddie was clearly the most respectable and predictable of the three Eddies. The economy’s Steady Eddie performance is gaining more respect. No one is warning about stall speed. Fewer economists are calling it the “New Normal,” since it isn’t so new anymore. Few are calling it “secular stagnation,” with the exception of Larry Summers, who revived this post-WWII scenario in a 11/25/13 speech at the IMF. He did it again in an interview with David Wessel that was summarized in a 5/25 WSJ article titled “‘Secular Stagnation’ Even Truer Today, Larry Summers Says.” Here are a few key points:

(1) Victory lap. Summers took a victory lap, claiming, according to Wessel, “that he has been vindicated by slow economic growth, low inflation and low interest rates, which many forecasters now expect to persist. Today, he is more convinced than ever that secular stagnation is the defining economic problem of our time—one that won’t be easily defeated as long as fiscal authorities are overly preoccupied with debt and central bankers are overly focused on keeping inflation at low levels.”

(2) Explaining stagnation. Summers rattles off lots of reasons for the slowdown in economic growth and for historically low nominal and real interest rates. Demography is important. So are increased risk aversion and a shortage of safe assets. Income inequality and a higher propensity to save are also on his list. Lenders are less willing and/or less able to lend. Corporations aren’t spending enough.

(3) Demand vs. supply. Summers acknowledges that secular stagnation might not be all about insufficient demand. Nevertheless, he concludes, “So, first, more public investment I think is a good thing.” Spoken like a true Keynesian fiscal stimulator.

US Economy II: Demography Is Destiny. There may be lots of reasonable explanations for the slowdown in economic growth. They may all be valid. However, we think that demographic trends account for most of the slowdown. Nevertheless, as noted above, the private sector has been growing at a respectable rate notwithstanding all the angst about secular stagnation. The record high in stock prices certainly shows that investors aren’t particularly concerned about chronically weak growth.

Still, there is no getting around the demographic facts. Consider the following:

(1) Population. The 10-year growth at an annual rate of the working-age population fell to 1.0% in April, the lowest since the start of the series in the late 1950s (Fig. 6). More significant is that the working-age population 16-64 years old grew just 0.5% per year on average over the past 10 years, through April. That’s the lowest on record!

(2) Labor force. The civilian labor force that is 16-64 years old rose just 0.3% at an annual rate over the past 10 years (Fig. 7). That’s the lowest on record, which starts in 1958.

(3) Age waves. The demographic trends shown by the population and labor force data have been very much impacted by the Baby Boom. In addition, fertility rates have declined, while people are living longer. The growth rates of the labor force by age cohorts looks like a wave pattern on an old-fashioned oscilloscope (Fig. 8).

The important observation is that the 25- to 34-year-old segment of the labor force is growing, while the 35-44 and 45-54 groups are declining. They are declining partly because there may be more dropouts than in the past. However, the main reason for their declines is that the Baby Boomers are aging into the 55-64 and 65+ cohorts.

The rising growth rate of younger workers and the declining growth rates of older workers can easily explain why productivity growth is weak and why wage inflation remains subdued despite a tight labor market. They can also explain why demand growth might remain lower than in the past.

Japan: Death Cross. In many ways, Japan is the poster child of a modern industrial economy that is struggling with secular stagnation. The Japanese government has tried numerous rounds of fiscal and monetary stimulus without much success. The problem is a rapidly aging population that is also shrinking. Japan “is currently the oldest nation in the world and is projected to retain this position through at least 2050,” notes the Census Bureau’s March 2016 report An Aging World: 2015. Japan’s elderly population percentage increased from 12% in 1990 to 25% in 2014. The working-age population percentage fell from 69% to 62% over this same period. Since July 2007—when the number of deaths exceeded the number of births for the first time, with the gap between the two continuing to widen—Japan’s population declined by 1.0 million through May 2017 (Fig. 9).

Global Economy: Less Stagnation! Now the good news: It’s a big world out there, with lots of aspirational workers and materialistic consumers. Demographic forces will continue to weigh on economic growth worldwide, because fertility rates are down while longevity is up almost everywhere. However, around the world, particularly in emerging market economies, there are still plenty of people who want a better standard of living.

We have found that one of the best ways to track global economic activity is with the yearly percent change in the sum of US exports and imports, both adjusted for inflation (Fig. 10). It is highly correlated with the yearly percent change in the volume of world exports. The former was up 5.0% through March, holding near its best growth rate since December 2014, while the latter was up 6.1% over the same period, its best rate since April 2011. Global economic activity is clearly improving.

Fueled by Apple Juice

May 25, 2017 (Thursday)

See the pdf and the collection of the individual charts linked below.

(1) The Great Race to be the Apple of the auto industry. (2) How much metal and rubber are in the code? (3) Ford: Hackett’s job as Fields put out to pasture. (4) Andreesen Pac Man Theory of software. (5) Who will be the Nokia of the auto industry? (6) Can we get Trump to pitch for YRI? (7) The best defense is more weapons for US allies. (8) Disappointing budget for US defense spending. (9) Bitcoin’s fans and fiends.


Auto Industry: Racing To Be Apple. Could our cars evolve into commoditized metal vessels that are distinguished primarily by the software they run? That should be the nightmare keeping auto executives awake at night, as Silicon Valley titans like Google, Tesla, and Uber all are working furiously—and committing billions of dollars—to become the Apple of autos.

The ripple effects of the car-tech tsunami reached Detroit this week when Ford and its CEO Mark Fields parted ways. It’s not that Fields wasn’t making software and tech inside cars a priority. He was. The car company had made a number of acquisitions, including the purchase of Chariot, a van ride-sharing service, and Argo AI, with its autonomous software-writing employees. Ford has a plan to introduce an autonomous vehicle by 2021 and, like most of the other major auto companies, opened offices in Silicon Valley.

But regardless of these progressive moves, Ford stock fell by roughly a third over the past three years through Tuesday’s close. Over the same period, GM shares fell much less, -1.2%, and the S&P 500 is up 26.2% (Fig. 1). The real kicker: Tesla’s stock is up 46.6% over the past three years, and its market cap eclipses Ford’s despite Tesla’s lack of profits.

Fields was replaced by Jim Hackett, former CEO of Steelcase, an office furniture company. Hackett had been on the Ford board of directors from 2013 to 2016, and last year moved on to head Ford’s Smart Mobility unit, where he was tasked with turning Ford into the auto company of the future. As he embarks on his new road trip, Hackett might want to listen to Barry Ritholtz’s recent interview with legendary high-tech venture capitalist Mark Andreesen on Bloomberg. Here are some highlights:

(1) It’s the software, Stupid. In the interview, Andreesen revisited the ideas he laid out almost six years ago in an 8/12/11 WSJ essay dubbed “Why Software is Eating the World.” In it, he argues that every product or service that can become software will become software. Therefore, every company that makes those products or services will become a software company first and foremost. Accordingly, in any industry, the best company will be the one that writes the best software.

(2) Apple envy. His theory applies to the movie industry (Netflix), the retail industry (Amazon), and now the auto industry. The most successful company in the auto industry will be the one that has the best software, he speculated. And he who writes the best software will reap most of the profits from the sale of the car.

The situation may be analogous to the cell phone industry. A mobile phone can be manufactured for about $5 in Asia. But Apple captures the remaining profits by writing the software for the phone and the software for the apps ecosystem. Ford—and GM, for that matter—don’t want to become the Nokia of the auto industry. They want to become the Apple of the auto industry.

The problem is that so does every other tech titan with a dream of developing automated cars. And tech companies aren’t saddled with a legacy car manufacturing business that could potentially hold back their progress.

(3) Slowing sales. Ford and GM are facing a market where traditional auto sales look like they’re plateauing or about to decrease slightly as easy auto loan financing goes away and pent-up demand has been satiated. Ford’s earnings are expected to plateau in 2018 and 2019. Analysts expect revenue in the S&P 500 Automobile Manufacturers industry (F and GM) will decline by 0.8% this year and decline by 1.8% in 2018. Meanwhile, earnings this year are expected to fall 5.8% and to increase slightly, by 3.2%, in 2018 (Fig. 2). That’s a tough environment in which to revolutionize one’s company. But that is indeed the environment Hackett faces.

Defense Industry: Salesman-in-Chief. As President Trump toured the Middle East this week, it was clear he is the nation’s top traveling salesman, and the Aerospace & Defense industry is enjoying the benefits. One of the best-performing S&P 500 Industrials’ industries, Aerospace & Defense, has gained 13.1% ytd through Tuesday’s close, almost twice the S&P 500’s 7.1% return (Fig. 3). Let’s take a look at how the industry has benefitted from having the President in its corner:

(1) Saudis spending. President Trump visited Saudi Arabia with the CEOs of Boeing, Lockheed Martin, and Raytheon in tow. The visit launched defense deals for roughly $100 billion. Granted, that figure includes some deals that were already in the works during the Obama administration, proposed sales, and deals that need final approvals. But it’s an eye-popping sum nonetheless.

Saudi Arabia is the world’s second-largest arms importer by value, according to a 5/21 WSJ article. And US contractors should make hay while the sun is shining, because the Saudis aim to build their own defense industry. The Saudi’s goal: to source “half of its defense requirements from domestic suppliers, compared with just 2% at present.”

Lockheed Martin stated that it received $28 billion of potential new business from Saudi Arabia, including littoral combat ships and Black Hawk helicopters. Boeing is selling the country helicopters.

(2) NATO pays attention. Early in his administration, President Trump made headlines by scolding North Atlantic Treaty Organization (NATO) members for not spending the required amounts on defense. It looks like his tough love didn’t fall on deaf ears.

According to another 5/21 WSJ article, NATO members are being “required to submit national blueprints detailing how they will meet alliance targets, which say each country should devote 2% of economic output to military spending. In addition, they are to specify how money will be used to fill existing gaps in weaponry identified by the alliance, such as shortages of warships, air-defense systems and advanced tanks. The plans will also track commitments of troops to NATO missions.” The plans are to be submitted in time for Trump’s meeting with NATO today.

Five NATO countries spend 2% of GDP on defense: US, UK, Greece, Poland, and Estonia. Romania, Latvia, and Lithuania should hit 2% by next year. France’s new President Emmanuel Macron says the country will get to the required amount by 2025, and Germany is increasing its defense spending by 8% annually.

(3) Questionable proposal. The Trump administration’s budget proposal for fiscal 2018 got a Bronx cheer from Washington’s politicians, primarily because it slashed costs radically to balance the budget. While it is very unlikely to survive in its present form, the budget does provide insight into the President’s priorities. His proposal slashes spending, maintains Social Security spending, and modestly increases defense spending.

The budget requests $575 billion to spend on the military and an additional $65 billion for overseas contingency operations, i.e., US operations in Afghanistan, Iraq, and elsewhere. The $575 billion budget is a 10% increase from the current fiscal year’s budget. That’s a solid increase, but less than some had hoped Trump would ask for given his speeches about bolstering the country’s defenses. The request is about $15 billion more than former President Barack Obama’s administration had forecast for FY2018, the 5/23 WSJ reported.

The proposal includes spending to build two submarines, two Aegis destroyers, and a littoral combat ship. However, more was expected, as Trump has suggested that the Navy fleet needed to grow from roughly 280 today to at least 350 ships. The budget also buys 70 new F-35 joint strike fighters, nearly 1,400 new Hellfire missiles, 34 Tomahawk cruise missiles, and 12,822 smart bombs.

(4) The numbers. All in all, the week was a good one for the S&P 500 Aerospace & Defense industry index, which continued its streak of outperformance. Over the week, the Aerospace & Defense industry index gained 1.1% vs the S&P 500’s 0.1% decline, and y/y the industry has risen 27.4%, well above the S&P 500’s 17.1% gain.

Analysts are penciling in numerous years of improving growth for the industry. They’re expecting revenues to grow 2.2% this year and 4.4% in 2018. Likewise, earnings growth of 6.5% this year is expected to be followed by 10.4% earnings growth in 2018 (Fig. 4).

The industry’s forward P/E remains near its highs, at 18.6 (Fig. 5). While that may limit multiple expansion, industry shares should continue to climb with earnings, something we’ve maintained since the 2/23 Morning Briefing. As long as the Republicans—and Trump—remain in control of Washington, DC, and the world remains a dangerous place, higher spending levels are likely.

Bitcoin: Double-Edged Currency. Bitcoin has made numerous headlines recently. Some good, some bad. The price of one bitcoin surged past $2,000 to a new record last week, and Fidelity’s CEO revealed the firm accepts bitcoin in its cafeteria. Then again, hackers have made bitcoin their currency of choice when demanding ransom. Let’s take a look:

(1) New heights. After tumbling for most of 2014 and 2015, bitcoin has regained favor in the markets, rising more than 125% ytd to a new high of $2,291.48 as of Tuesday’s close (Fig. 6).

Why the surge of popularity? One might look to Japan, where the yen is the largest currency being exchanged for bitcoin, according to a 5/20 article on More than 45% of the money flowing into bitcoin has been exchanged for yen. The US dollar has been exchanged for about 30% of the bitcoins.

CoinDesk attributes the jump in yen transactions to the country’s bitcoin regulation: “This increase in the use of the Japanese yen comes after Japan moved to formally recognize bitcoin as a legal method of payment starting 1st April. The country's lawmakers enacted legislation that both classified the cryptocurrency as a type of prepaid payment instrument, and also caused it to fall under anti-money laundering and know-your-customer rules.”

That said, all cryptocurrencies are on fire. The market cap of digital currencies has risen more than 50% to more than $90 billion over the past seven days, a 5/24 Bloomberg article reported. These currencies, with snazzy names like Zcash, Monero, and Ethereum, may be benefitting from increased adoption of the technology and from the political uncertainty around the world.

(2) Abigail is a fan. Fidelity’s CEO Abigail Johnson’s enthusiasm for bitcoin was apparent in a speech she delivered to a bitcoin conference last week. While acknowledging the currency’s flaws, she said she is “still a believer.”

“Fidelity has worked with bitcoin platform Coinbase Inc. to allow charitable giving in bitcoin and enabled bitcoin payments in its cafeteria. Ms. Johnson said the firm will soon make it possible to display bitcoin assets held through Coinbase on,” a 5/23 WSJ article reported. It continued, “Yet fewer than 100 employees at the firm have completed bitcoin transactions, she said. Potential users of the technology, she said, are also confused or frustrated by it. Ms. Johnson’s speech stopped short of making firm recommendations on ways to make the currency more mainstream.”

(3) The dark side. Bitcoin followers have a little problem. Bad guys are hijacking the currency. The hackers are demanding that victims pay in bitcoin if they want their computers unlocked. They’re using bitcoin because it’s hard to detect who owns the accounts.

The hackers behind the worldwide WannaCry ransomware infection earlier this month demanded payment in bitcoin from users looking to free their computer systems. There was $51,000 deposited in bitcoin accounts as of 5/15, but that amount hadn’t yet been taken out of the accounts, perhaps for fear of detection after the incident alerted law enforcement and financial regulators around the world, a 5/15 WSJ article reported.

But many hacks are much smaller. We personally have heard of one individual and one small company whose computers were frozen and bitcoin demanded as payment to unlock the computers. Those incidents didn’t make headlines, but they happened nonetheless.

The 5/15 WSJ explained, “Ransomware dates to the late 1980s, but attacks spiked last year amid the growing use of bitcoin and improved encryption software. According to the U.S. Department of Justice, ransomware attacks were on a pace to quadruple in 2016 from a year earlier, averaging 4,000 a day, according to a Wall Street Journal article last August.”

Even the largest of companies can find itself vulnerable. Disney confirmed that its film, Pirates of the Caribbean: Dead Men Tell No Tales was taken by hackers who threatened to release it in small increments over the Internet before Disney’s planned release date. The hackers were demanding an “enormous amount” be paid in bitcoin, according to a 5/15 article in Deadline. Disney refused to pay. Next time, the hackers should poach a film with better reviews.

Global Synchronized Moderate Growth

May 24, 2017 (Wednesday)

See the pdf and the collection of the individual charts linked below.

(1) Wish for better earnings has come true. (2) S&P 1500 rising in record territory. (3) S&P 500 earnings estimates for 2018 high and dry. (4) S&P 500/400/600 all had upside earnings hooks during Q1 reporting season. (5) Altogether now. (6) A world of upbeat PMIs. (7) Real GDP tracking 2% in major economies. (8) Germany’s business confidence is soaring. (9) Aging is a drag on growth. (10) Less secular growth until further notice.


Strategy: Stable Earnings Squiggles. Our Blue Angels analysis of the S&P 500/600/400 stock price indexes and their forward earnings and forward P/Es shows that stock prices peaked at record highs in mid-2015, then stalled for about a year before climbing to new record highs during the second half of 2016 (Fig. 1). A closer look shows that during the stall period, stock prices actually swooned, with the S&P 1500 stock price index falling 14.7% from its record high on May 21, 2015 to last year’s low on February 11, 2016 (Fig. 2).

Back then, investors were worried that the earnings recession in the energy sector might spread to other industries. They also worried that it might cause another financial crisis as yields soared in the high-yield bond market, led by junk bonds issued by energy companies. Everyone was yearning for good earnings. Their wishes came true as the price of oil rebounded during the first half of 2016, and earnings started to grow again on a y/y basis during the second half of last year. Valuation multiples also rebounded.

For the S&P 1500, forward earnings fell 4.1% from the week of October 9, 2014 through the week of March 3, 2016 (Fig. 3). Since then, it has rebounded 11.4% through mid-May of this year to a new record high. Joe and I continue to be impressed by how well analysts’ consensus earnings estimates for 2018 are holding up (Fig. 4). Here are a few more happy observations on the latest weekly earnings data:

(1) Earnings growth. We track the weekly data on analysts’ consensus earnings expectations for the current year and coming year for the S&P 1500/500/400/600. We also track their forward earnings, which are the time-weighted averages of the current-year and coming-year forecasts. With all these data points, we can easily calculate analysts’ earnings growth expectations. Doing so for the S&P 500 for each year since 2011 shows a downward trend for each year through this year. So far, 2018’s expected growth is holding up remarkably well around 12% (Fig. 5).

(2) Forward earnings. The forward earnings of the S&P 500/400/600 all continue rising in record-high territory (Fig. 6). The same can be said of forward revenues.

(3) Earnings hooks. Often during earnings seasons, actual results for the S&P 500/400/600 tend to beat analysts’ expectations, resulting in an upward hook for the weekly series we track for each quarter (Fig. 7). That happened again for the Q1-2017 earnings season, resulting in better-than-expected y/y growth rates of 14.3%, 12.3%, and 8.9% y/y for the S&P 500/400/600.

Global Economy I: Synchronized Moderate Growth. The upbeat outlook for 2018 earnings isn’t happening only in the US. Consensus expected earnings estimates are actually rising for both 2017 and 2018 overseas (Fig. 8). As a result, forward earnings (in local currency) of the All Country World ex-US MSCI rose in mid-May to the highest level since November 2008. Our Blue Angels analysis shows that this stock price index is up 7.6% ytd through Monday and is closely tracking the index’s Blue Angels forward earnings (in local currency), with a forward P/E of 14.4 (Fig. 9). That’s below the US MSCI’s forward P/E of 17.6.

The EMU MSCI’s forward earnings is contributing to the global rebound in the broader overseas earnings measure (Fig. 10). At the same time, the EMU MSCI forward P/E has rebounded from 13.3 in December to 15.0 currently. As a result, this stock price index is up 10.0% ytd in euros, outperforming (in local currencies) the US MSCI (7.1), the UK MSCI (5.0), and the Japan MSCI (2.3). The latest batch of global economic indicators shows plenty of slow but steady growth, with some better-than-expected numbers out of Europe:

(1) PMIs. As Debbie discusses below, the Eurozone C-PMI (56.8), M-PMI (57.0), and NM-PMI (56.2) all were strong in May (Fig. 11). In the US, the C-PMI (53.9) recovered some ground that was lost at the start of the year, led by the NM-PMI (54.0), while the M-PMI (52.5) fell for the fourth month in a row. Japan’s M-PMI (52.0) edged down in May, but has exceeded 50.0 for the past nine months.

(2) GDP. The latest y/y growth rates for Q1 real GDP for the UK (2.1%), Eurozone (2.0), US (1.9), and Japan (1.6) suggest that the global economy is enjoying global synchronized growth that is between a boom and a bust (Fig. 12). There is more divergence within the Eurozone as follows: Spain (3.0%), Germany (1.7), France (0.8), and Italy (0.8) (Fig. 13).

(3) German Ifo. Below, Debbie also reviews May’s German Ifo Business Confidence survey. The overall index soared to the highest reading in the history of the survey going back to 1991, led by the current situation index, which also rose to the highest on record (Fig. 14)!

Global Economy II: New Normal Is the Norm. Debbie and I aren’t seeing as much discussion about the New Normal recently as in the years following the Great Recession. We and other economists also have been spilling less ink on the concept of “secular stagnation.” Could it be that we all have resigned ourselves to accept that economic growth is likely to remain relatively subdued compared to past growth? It seems so, with one important exception: President Donald Trump still believes that his policies will revive economic growth in the US from 2% per year back up to 3%-4%.

We wish him well. However, while his election seems to have revived lots of dormant animal spirits, Trump may be fighting the forces of demography. Mother Nature usually wins in this case. Fertility rates have plunged below the replacement rate almost everywhere around the world. People are living longer. Consequently, populations are aging. Melissa and I updated our analysis of these global demographic trends in the 11/3/16 Morning Briefing.

The Census Bureau released a thorough report on this subject in March titled “An Aging World: 2015.” The conclusion is as follows:

“When the global population reached 7 billion in 2012, 562 million (or 8.0 percent) were aged 65 and over. In 2015, 3 years later, the older population rose by 55 million and the proportion of the older population reached 8.5 percent of the total population. With the post World War II baby boom generation in the United States and Europe joining the older ranks in recent years and with the accelerated growth of older populations in Asia and Latin America, the next 10 years will witness an increase of about 236 million people aged 65 and older throughout the world. Thereafter, from 2025 to 2050, the older population is projected to almost double to 1.6 billion globally, whereas the total population will grow by just 34 percent over the same period.”

Our conclusion is that these demographic trends are weighing on global growth and will continue to do so. They may also be weighing on productivity, as older experienced workers retire and are replaced by younger inexperienced ones. This may also explain why wage inflation remains low, especially in the United States, because the latter are bound to get paid less than the former. This is the gist of a 3/7 FRBSF Economic Letter titled “What’s Up with Growth?”

To monitor these trends, we are tracking real GDP trend growth rates over 40-quarter periods (10 years) at annual rates for the US, Germany, Japan, and the UK (Fig. 15). The trend across all four has been for a noticeable slowing in secular growth.

(A) Few Differences This Time?

May 23, 2017 (Tuesday)

See the pdf and the collection of the individual charts linked below.

(1) Not all valuation measures are flashing red. (2) Misery Index near previous cyclical lows. (3) Misery-adjusted forward P/E around its mean. (4) Rule of 20 no longer bullish. (5) Buffett isn’t giving much weight to his ratio. (6) Price-to-sales ratio awfully high. (7) Fed Model says stocks cheap compared to bonds. (8) China’s demography remains bullish for growth. (9) China’s population growth slows. (10) But China’s rural-to-urban migration continues apace.


Valuation: A Less Miserable Measure. Almost all valuation multiples are flashing that stocks are dangerously overvalued. Are there any valuation models suggesting that the danger signals might be false alarms? There is one. It shows the inverse relationship since 1979 between the S&P 500 forward P/E and the Misery Index, which is the sum of the unemployment rate and the CPI inflation rate. Let’s have a look at it and compare it to a few of the other valuation indicators:

(1) Misery Index very bullish. During April, the Misery Index was down to 6.6%, near previous cyclical lows (Fig. 1). That’s down 6.3ppts from its most recent cyclical peak of 12.9% during September 2011. Over this same period, the forward P/E has risen from roughly 10 to 17, well above its average of 13.8 since September 1978 (Fig. 2).

The theory is that less misery should justify a higher P/E. A low unemployment rate should be bullish for stocks unless it is accompanied by rising inflation, which could cause the Fed to tighten to the point of triggering a recession and driving the jobless rate higher. Nirvana should be a low unemployment rate with low inflation, which seems to be the current situation. In this happy state, a recession is nowhere to be seen, which should justify a higher valuation multiple.

Joe and I construct a “misery-adjusted” P/E simply by summing the S&P 500 forward P/E and the misery index (Fig. 3). It has been trendless and highly cyclical since September 1978, with an average of 23.9. Its low was 18.5 during November 2008, and its high was 33.0 during March 2000. During April, it was 24.3, in line with its average. That’s somewhat comforting.

(2) Rule of 20 no longer a buy signal. Less comforting is the Rule of 20, which tracks the sum of the S&P forward P/E plus the CPI inflation rate (Fig. 4). So it is the same as the misery-adjusted P/E less the unemployment rate. I moved to CJ Lawrence in 1991. My mentor there was Jim Moltz, who devised the Rule of 20, which states that the stock market is fairly valued when the sum of the P/E and the inflation rate equal 20. Above that level, stocks are overvalued; below it, they are undervalued.

The rule was bearish just prior to the bear market at the start of the 1980s. It was wildly bullish for stocks in the first half of the 1980s. It turned very bearish in the late 1990s and bullish again a couple of years later in mid-2002. Those were all good calls. However, like most other valuation models, it didn’t signal the bear market that lasted from October 9, 2007 through March 9, 2009. At the end of 2008, the Rule of 20 was as bullish as it was in the early 1980s. That was another very good call. By early 2017, it was signaling that stocks were slightly overvalued for the first time since May 2002.

(3) Buffett ratio sees no bargains. Another valuation gauge we follow is the price-to-sales (P/S). The S&P 500 stock price index can be divided by forward revenues instead of forward earnings (Fig. 5). However, the forward P/S ratio is very highly correlated with the forward P/E ratio. So it doesn’t add much to the assessment of valuation.

A variant of the P/S ratio is one that Warren Buffett said he favors. It is the ratio of the value of all stocks traded in the US to nominal GDP (Fig. 6). The data for the numerator is included in the Fed’s quarterly Financial Accounts of the United States and lags behind the GDP report, which is available a couple of weeks after the end of a quarter on a preliminary basis. Needless to say, it isn’t exactly timely data.

However, the forward P/S ratio, which is available weekly, has been tracking Buffett’s ratio very closely (Fig. 7). In an interview he did with Fortune in December 2001, Buffett said, “For me, the message of that chart is this: If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%—as it did in 1999 and a part of 2000—you are playing with fire.” That’s sage advice from the Sage of Omaha. His ratio was at 1.69 during Q4, while the P/S was 1.90 in mid-May, suggesting that we are playing with fire.

On the other hand, a year ago in a 5/2 CNBC interview, Buffett said, “If you had zero interest rates and you knew you were going to have them forever, stocks should sell at, you know, 100 times earnings or 200 times earnings.” He was speaking hypothetically, of course. More recently, this year in a 2/27 CNBC interview, Buffett said that US stock prices are “on the cheap side,” and added, “We are not in a bubble territory.” He also announced at the time that he had more than doubled his stake in Apple since the new year and before the tech giant reported earnings on January 31.

(4) Fed model still bullish. To round out the discussion, we should mention that the Fed’s Stock Valuation Model showed that the S&P 500 was undervalued during April by 61.9% using the US Treasury 10-year bond yield and 24.9% using a corporate bond yield composite (Fig. 8). This confirms Buffett’s assessment that stocks are relatively cheap compared to bonds. If more investors conclude that economic growth (with low unemployment) and inflation may remain subdued for a long while, then they should conclude that economic growth and inflation remain historically low. That’s a Nirvana scenario for stocks, and would be consistent with valuation multiples remaining high.

China: More Urban, Less Rural. Demography has played a much bigger role in China’s economy than in any other. That’s because China has had the biggest population of all other countries. Economists usually ignore demographic factors because they tend to play out over long periods. In China’s case, demographic factors are among the most important in assessing the country’s economy. They remain very important in explaining why China is likely to continue growing faster than most any other countries for a while.

In December 1978, two years after Mao Zedong died, China’s communist leadership decided that it was time to modernize the country’s economy. Deng Xiaoping, China’s new leader, announced an Open Door Policy that aimed to attract foreign businesses to set up manufacturing operations in Special Economic Zones (SEZ). This was the first step along the path that eventually led China to join the World Trade Organization (WTO) in 2001. Along the way, market reforms were implemented and foreign trade expanded.

I first started to study China’s demographic developments in my November 7, 2003 Topical Study titled “China for Investors: The Growth Imperative.” I observed that the Chinese regarded joining the WTO as their most important economic reform in 20 years. To join, they were required to accept numerous agreements to open their domestic markets to more competition from abroad. I posed a rhetorical question: “Why would the communist regime in Beijing agree to the capitalistic codes of conduct required to be a member of the WTO?” It would speed modernization, which was essential to creating enough jobs for the rapidly expanding population, which was rapidly urbanizing.

In a follow-up analysis dated January 21, 2004, I explained that rapidly increasing farm productivity in China was causing a huge migration from the agrarian sector to the cities. To avoid massive social upheaval, the Chinese needed to create lots of jobs in manufacturing, construction, and services. Joining the WTO was seen as an essential way to create more factory jobs among exporters. I saw that the Chinese government was becoming increasingly obsessed with what I called the “Growth Imperative.” I wrote in that second China Topical Study: “I believe that China is driven by a ‘Growth Imperative.’ I believe the country must grow rapidly to absorb the huge number of new entrants into the labor force every year and to meet the needs of the large number of people who are leaving the rural areas and moving to the urban centers.” The government fully realized that failure to expand employment could have serious consequences for the country’s social and political stability.

I bolstered my argument by noting that to accommodate the roughly 20 million people per year migrating to the cities, the Chinese in effect had to build one Houston, Texas, every month! Allow me to update China’s extraordinary demographic story:

(1) Population. China’s population rose to a record-high 1.38 billion during 2016 (Fig. 9). It was up 8 million y/y. It was up 68 million over the past 10 years (Fig. 10). That increase is about equal to the population of France. However, it is significantly slower than the peak of 204 million in the 10-year population explosion during 1974.

(2) Rural migration. The percentage of the population living in rural areas dropped from 88.8% during 1950 to 82.1% during 1978, when China announced the Open Door Policy (Fig. 11). Then it fell to 62.3% in 2001, when China joined the WTO, and tumbled to 42.7% last year.

(3) Urbanization. The percentage of the population that was urbanized rose to 50% during 2010, and was 57.3% last year. Last year, the urban population increased by 21.8 million (Fig. 12). That is truly extraordinary, as this category has been increasing consistently around 20 million per year since 1996. Again, to urbanize that many people requires the equivalent of building a Houston per month!

Where Is This Leading?

May 22, 2017 (Monday)

See the pdf and the collection of the individual charts linked below.

(1) The latest panic attack lasted one day. (2) Keeping a diary of anxiety attacks. (3) VIX taking regular doses of Valium to stay calm. (4) Pills for the President. (5) One monthly and two weekly LEIs all at record highs. (6) CEI benchmark model sees next recession starting March 2019. (7) CEI confirming 2% trend growth in real GDP. (8) Resource Utilization Rate and LEI/CEI ratio are bullish for profit margin. (9) Yield curve signaling neither boom nor bust. (10) NY & Philly Fed surveys showing animal spirits remain spirited.


Strategy I: Vix on Valium. Joe and I long have characterized the current bull market as a series of panic attacks followed by relief rallies to new cyclical highs and then to new record highs since March 28, 2013. We are adding the 1.8% drop in the S&P 500 last Wednesday to our list of panic attacks even though it only lasted one day (so far). It was triggered by a wave of hysteria about the possibility of President Trump getting impeached for obstructing justice in the matter of Michael Flynn. We’ve been keeping track of the anxiety attacks since the start of the bull market in our chart publication titled S&P 500 Panic Attacks Since 2009.

We now count 56 of them. Of this total, four were “official” corrections, with the S&P 500 down between 10% and 20%, and six were mini-corrections, registering declines of 5%-10% on the panic spectrum (Fig. 1). We haven’t attempted to predict when these bouts might occur, but we’ve viewed them all as buying opportunities. We remain on the lookout for a bear market, which most likely would be caused by a recession. However, we don’t see either calamity anytime soon, as confirmed by our analysis of the leading indicators below.

Another way to identify panic attacks is by tracking the S&P 500 VIX, which is widely known as the “fear index” (Fig. 2). On this basis, the Trump scare is minor, with the VIX rising to just 15.59 on Wednesday. It spiked to 22.51 just before last year’s election on concerns that the FBI was coming after Hillary Clinton again. Before that, it spiked to 25.76 in late June on Brexit, which was just a two-day selloff.

It was relatively easy to panic investors following the Trauma of 2008. It’s been almost nine years since then. Time heals all wounds, as long as they aren’t fatal ones. Following the fiscal-cliff nonevent at the start of 2013, I wrote that investors might be getting “anxiety fatigue.” They seem to be less panic-prone, as evidenced by the shortness of the most recent attacks.

I’m thinking of applying for a permit to practice psychiatry so I can prescribe Valium for our accounts if they get too jittery. Someone needs to get some pills for the President. He really needs to calm down and tone it down.

Strategy II: Looking Up. While the headlines continue to be all about the swamp people in Washington on a 24/7 basis, the Index of Leading Economic Indicators (LEI) continues to climb to new record highs, and so does the Index of Coincident Economic Indicators (CEI) (Fig. 3). That news came out last Thursday, but it certainly didn’t make the front pages. Debbie and I aren’t surprised by the news because our YRI Weekly Leading Indicator continued to soar into record-high territory through early May, as it has been doing since early last year (Fig. 4). The same can be said about the Weekly Leading Index compiled by the Economic Cycle Research Institute (Fig. 5).

Joe and I aren’t surprised because the weekly S&P 500 forward earnings is also highly correlated with the LEI (Fig. 6). The former has been climbing rapidly into record territory since March 10, once the energy-led earnings recession ended and stopped weighing on earnings. The weekly S&P 500 forward revenues series has also been climbing to new highs. Let’s take a dive into the wonderful world of the leading and coincident economic indicators:

(1) LEI/CEI. Debbie and I also track the ratio of the LEI to the CEI (Fig. 7). It’s actually a useful leading indicator that is mostly cyclical without the uptrend of the LEI. It rose to 1.102 during April, the highest since November 2007, but remains below all the previous cyclical peaks since 1959. This could be a harbinger of a longer-than-average economic expansion.

(2) CEI. Also auguring for a long economic expansion is our analysis of the past five cycles in the CEI (Fig. 8). We’ve previously noted that the expansion phases, following the recovery phases back to the previous peak, lasted 65 months on average. That would put this cycle’s peak in March 2019. This isn’t a model but rather a benchmark based on recent history. Given our view that inflation is likely to remain subdued with Fed policy raising interest rates very gradually, we remain in the lower-growth-for-longer camp.

(3) GDP. The CEI and LEI are designed to time the peak and troughs of the business cycle, not the growth rate of real GDP. However, we’ve found that the y/y percent change in the CEI tracks the comparable growth in real GDP quite closely (Fig. 9). The former was up 2.0% during April. It has been fluctuating around this level since mid-2010, which is the same story for real GDP.

The yearly growth rate in the LEI has a much greater cyclical amplitude than the growth in real GDP (Fig. 10). However, it can be used to gauge whether the underlying economic momentum is rising or falling. It has been improving in recent months.

(4) Resource utilization. The LEI/CEI ratio is a leading indicator of the Resource Utilization Rate (RUR) (Fig. 11). We construct RUR by averaging the capacity utilization rate and the employment rate, which is 100 minus the unemployment rate (Fig. 12). Both measures confirm that the expansion is maturing. However, both also remain below previous cyclical peaks.

(5) Profit margin. The recent upturns in the LEI/CEI and RUR are good signs for corporate profit margins (Fig. 13 and Fig. 14).

(6) Yield curve. There are three financial components among the 10 components of the LEI. The S&P 500 is one of them. The other two are the yield-curve spread between the US Treasury 10-year bond yield and the federal funds rate, and the Leading Credit Index, which the Conference Board compiles using six different financial indicators (Fig. 15 and Fig. 16). It tends to spike prior to and during recessions. It doesn’t do much in between the spikes. It actually seems to be more of a coincident indicator, in our opinion.

The yield-curve spread, on the other hand, has a long history of accurately predicting recessions when it turns negative. As long as it remains positive, all should be well. However, if it is falling toward zero, it certainly should get our attention. Currently, there isn’t much to worry about. However, there is some concern that after the spread’s Trump-bump widening from 136bps during October to a recent peak of 195bps during December, it was back down to 140bps during April.

Of course, while the LEI uses the monthly yield-curve spread, it is also available daily. It was 147bps on Election Day, rising to 213bps on December 14 and falling back down to 132bps on Friday.

(7) Regional surveys. Below, Debbie reviews the regional business surveys conducted by the NY and Philly Feds. She reports that the average of their composite indexes dipped from a recent high of 31.0 during February to 18.9 during May, though that was up from April’s 13.6. That’s still well above last October’s 2.8 average, before the November 8 election results boosted animal spirits.

Fall from Grace

May 18, 2017 (Thursday)

See the pdf and the collection of the individual charts linked below.

(1) Yesterday’s fall. (2) Seeking impeachable offenses. (3) Loose Lips Donald. (4) White House busy playing whack-a-mole all day. (5) Keeping targets for S&P, but swapping 2017 & 2018 for earnings. (6) Adam & Eve & Trump. (7) The Swamp of Eden. (8) Tech has been chosen for great things. (9) Software for the cloud. (10) Chips for the cloud.


Strategy: Original Sin. Yesterday was the first day since Election Day that stock market investors started to discount the possibility that everyone in Washington is losing their minds. The place has been unhinged for a very long time, but it seems to have gotten much worse since Donald Trump occupied the White House on January 20. Indeed, there seem to be a very large contingent of Democrats who believe that it is an occupation and that Trump’s presidency is illegitimate. Their not-so-subtle objective seems to be to get him impeached.

During World War II, posters warned American citizens: “Loose Lips Sink Ships.” Now there is buzz that Trump’s loose lips could sink his presidency from the get-go, before he gets to go on with his agenda. Everything he says or tweets triggers a daily firestorm of media pundits declaring that Trump has gone too far. For many of them, Trump was always a sinner, so from their perspective he had already fallen from grace. White House spokespersons have been ineptly playing whack-a-mole, trying to beat down the latest innuendos inspired by their all-too-talkative commander-in-chief.

I am not a preacher, so I don’t do right vs wrong. As an investment strategist, I do bullish vs bearish. Up until yesterday, the stock market seemed to tune out the ear-splitting noise coming out of Washington since Election Day. Instead, investors focused on the signal, which has been Trump’s commitment to cut corporate taxes. Now that Trump seems to be increasingly getting sucked up by the swamp rather than draining it, investors are losing confidence in his ability to get much of anything done for a while. The one important exception is deregulation, which remains a bullish development for the stock market. Furthermore, as Joe and I have been chronicling, the US and global economies are growing, and so are S&P 500 revenues and earnings.

So, notwithstanding the worsening cacophony coming out of our nation’s capital, Joe and I are sticking with our S&P 500 stock price target of 2400-2500 for this year. On Monday of this week, the index closed at a record high of 2402.32. Under the circumstances, we must change our S&P 500 earnings forecasts. We still expect a significant corporate tax cut, but it is less likely to boost earnings this year than next year. If earnings are not boosted until next year, then instead of $142.00 per share this year, our estimate would be $129.00. But next year, earnings could be $150.00 rather than $136.75. That would bring us closer in line with the latest consensus of industry analysts for this year and next year at $131.57 and $147.10.

The Founding Fathers created a political system of checks and balances, which is often called “gridlock” these days. Ironically, it may be more gridlocked now than ever before, even though the Republicans have the White House and majorities in both chambers of Congress as well as the Supreme Court! The Founders were realists and recognized that humans are not angels. So they designed a political system to govern humans, whom they judged had long ago fallen from grace. It all started when Adam and Eve disobeyed the Good Lord and ate the apple from the Tree of Knowledge.

Trump’s adversaries are hoping for a similar “gotcha moment.” They seem to believe that they have it in “Comey’s Revenge,” which is reportedly a note-to-self written by the Trump-ousted former FBI director. Second-hand sources claim that the note claims that Trump asked James Comey to stop investigating former National Security Adviser Michael Flynn shortly after Flynn had resigned. If true, that would clearly be an obstruction of justice by the President. Not so clear is why Comey kept the note on file until he was fired, and whether a request is the same as an order. This may or may not be the beginning of Trump’s expulsion from the Swamp of Eden.

Tech I: The Chosen One. If you believe in market lore, Apple has a lot stacked against it. It’s the most valuable company in the S&P 500, and it just opened a swanky headquarters that cost roughly $5 billion to build. To a contrarian, those are warning signs of immense proportions. A company never holds the “Largest Market Cap” title forever, and shiny new headquarters often precede corporate downfalls. Apple may have just taken a bite out of the forbidden fruit!

For the past five years, Apple has had the S&P 500’s largest market cap, according to Joe’s figures. Before that, ExxonMobil was the top dog from 2006 through 2011 as oil prices surged. From 1993 through 1997 and then again in the early years of this century, General Electric had the largest market cap. Its tenure was interrupted by Microsoft in 1998, 1999, and 2002. Go back further, and you’ll find IBM and AT&T once had the S&P’s largest market caps. Now neither stock cracks the top 10.

What’s interesting about today’s market is that if Apple does lose its top-market-cap title, the mantle will probably pass to yet another tech titan. Alphabet, parent to Google, has the second-largest-market capitalization, and in third and fourth places are Microsoft and Amazon, which technically is a Consumer Discretionary stock but arguably has more in common with its tech cousins. Right behind them in fifth place is Facebook.

Fortunately for our market-cap-weighted indexes, these tech giants are in serious rally mode. On Tuesday, Nasdaq hit its 33rd record this year. It’s up 14.6% ytd through Tuesday’s close and 30.8% y/y. While stellar, Nasdaq’s performance understates the strength of Tech. The S&P 500 Tech sector is the top-performing sector over the past year, up 37.9%, more than double the S&P 500’s 17.3% return over the same period.

Here’s how the S&P 500 sectors have performed over the past year through Tuesday’s close: Tech (37.9%), Financials (28.0), Industrials (19.3), S&P 500 (17.3), Materials (15.5), Consumer Discretionary (14.9), Health Care (9.0), Utilities (4.3), Consumer Staples (3.7), Energy (2.7), Real Estate (-1.8), and Telecom Services (-6.6) (Table 1).

The S&P 500 Tech sector is also one of only four sectors that have enjoyed total returns that bested the S&P 500 since the market bottomed in 2009. The S&P 500 Consumer Discretionary sector has outperformed the S&P 500 by 222.3% since 2009. Other sectors outpacing the index include Financials (122.4), Tech (118.4), and Industrials (95.1). The other sectors have underperformed the S&P 500 since 2009: Health Care (-18.8%), Materials (-57.6), Consumer Staples (-63.4), Utilities (-103.6) Telecom (-152.2), and Energy (-226.9) (Fig. 1).

There were some significant haircuts as a result of yesterday’s selloff. Here’s Wednesday’s performance derby: Real Estate (0.6%), Utilities (0.2), Consumer Staples (-0.2), Energy (-1.1), Health Care (-1.3), Consumer Discretionary (-1.6), Telecom Services (-1.8), S&P 500 (-1.8), Industrials (-2.1), Materials (-2.1), Information Technology (-2.8), and Financials (-3.0). For now, let’s take a look at what’s driving some of Tech’s amazing outperformance over the past year:

(1) Rising revenue. The Tech sector is expected to have revenue growth of 8.0% over the next 12 months, the second best among the 11 S&P 500 sectors and behind only Energy, which is poised for a revenue rebound now that the price of oil has bounced back from the low of $27.88 per barrel in January 2016. Here’s how the S&P 500 sectors’ forward revenue growth stacks up: Energy (14.6%), Tech (8.0), Real Estate (5.9), S&P 500 (5.3), Materials (5.3), Consumer Discretionary (4.8), Health Care (4.8), Utilities (4.0), Industrials (3.8), Financials (3.6), Consumer Staples (2.8), and Telecom (-0.9) (Table 2).

(2) Great margins. One of the benefits that many Tech industries enjoy is strong profit margins. Many Tech companies produce software, whether it be Microsoft, Google, or Facebook. Their lack of physical inventory typically results in above-market margins. The Tech sector is expected to have profit margins over the next 12 months of 20.3%, better than any other sector in the S&P 500. Here are how the sectors’ margins rank: Tech (20.3%), Real Estate (16.9), Financials (16.3), Telecom (11.4), Utilities (11.0), S&P 500 (10.9), Health Care (10.5), Materials (10.4), Industrials (9.4), Consumer Discretionary (7.6), Consumer Staples (6.9), and Energy (5.2).

(3) Charged-up earnings. Strong revenue growth plus market-leading margins means healthy earnings growth should be in the cards. The Tech sector is expected to grow earnings 11.1% over the next 12 months, behind only the Financials, Materials, and Energy sectors. Here what’s expected for forward earnings in the S&P 500 sectors: Energy (122.9%), Materials (13.5), Financials (12.4), S&P 500 (11.2), Tech (11.1), Consumer Discretionary (9.2), Industrials (8.8), Consumer Staples (7.0), Health Care (6.8), Utilities (2.7), Telecom Services (0.3), and Real Estate (-16.6) (Fig. 2).

Analysts have revised upward their expectations for Tech forward earnings by 1.3% over the past four weeks, Joe points out. That’s a bit less than the upward revisions enjoyed by Real Estate (2.6%), Industrials (2.6), Energy (2.5), and Materials (1.4), but it’s on par with the S&P 500 (1.3) and ahead of the other sectors: Financials (1.2), Health Care (1.1), Consumer Discretionary (1.0), Utilities (0.8), Consumer Staples (0.7), and Telecom (-1.4).

The Tech sector has pumped out better earnings growth than other sectors for most of the past eight years if the Auto industry is excluded from the Consumer Discretionary sector. The exceptions: 2010 and 2011, when the Materials sector outperformed (Fig. 3).

(4) In-line valuation. The Tech sector’s forward P/E has improved from 11.8 on April 18, 2013, but it remains only slightly ahead of the broader market’s multiple. The Tech sector’s forward P/E is 18.4 as of May 11 vs the S&P 500’s forward P/E of 17.6. Here’s the P/E performance derby for the rest of the gang: Real Estate (38.4), Energy (25.8), Consumer Staples (20.1), Consumer Discretionary (19.6), Tech (18.4), Industrials (17.7), Materials (17.7), S&P 500 (17.6), Utilities (17.6), Health Care (15.7), Financials (13.5), and Telecom (13.0) (Fig 4, Fig. 5, Fig. 6, and Fig. 7).

Tech II: Heavenly Cloud. Like most sectors, Tech has some industries that are performing much better than others. Just looking at the next 12 months, Tech industries with the fastest consensus expected earnings growth include S&P 500 Application Software (20.6%), Electronic Equipment & Instruments (16.9), Semiconductor Equipment (15.8), Data Processing & Outsourced Services (14.2), Technology Hardware, Storage & Peripherals (12.3), and Semiconductors (12.0). Let’s take a look at what’s driving some industries boasting the fastest earnings growth:

(1) Heading to the clouds. It’s no longer enough to write excellent software programs. Today those programs have to be available for purchase or for subscription in the cloud. The transition isn’t always easy, but done well it can be profitable. Among the companies in the Application Software Industry, the top performer over the past year has been Autodesk, up almost 70%.

Once known for making technical drawings, the company has evolved into one that creates industrial-design software for engineers, game developers, and movie special effects artists that can be bought outright or as a subscription. The shares were also pushed ahead by the involvement of activist firm Eminence Capital.

Autodesk also has a hand in the world of artificial intelligence with its Dreamcatcher system. “The system creates designs after users enter certain performance desires, materials and the tooling available,” explains a 3/12 WSJ article. “Researchers at Autodesk created a proof-of-concept car part that was about 35% lighter than the original that could be used to connect a vehicle chassis to the wheel. Autodesk has also used Dreamcatcher to design a chair inspired by Hans J. Wegner’s Elbow chair and is working with design company Hackrod to create a car.”

Investors have recognized the growth potential in the S&P 500 Application Software industry, which has risen 32.6% over the past year through Tuesday’s close (Fig. 8). Revenues over the next year are expected to grow 12.8%, and, as we mentioned above, earnings are forecasted to rise 20.6% (Fig. 9). That has left the industry’s forward P/E at a lofty 35.6—which is in the area where it has traded over the last three years, but higher than any multiple investors had given it in the prior decade (Fig. 10).

(2) Hot semis. It doesn’t matter whether a company designs semiconductors or makes the equipment to produce them, anything related to semiconductors has been hot for the past year. Investors are salivating over the increasing number of semiconductors that will be needed to run robots and drones, not to mention autonomous cars. The semiconductor dollar content per smartphone is roughly $50 vs more than $350 per car, according to a 4/10 article on

Over the past year, S&P 500 Semiconductor Equipment was the top-performing industry with a gain of 103.8%, driven by the performance of Applied Materials and Lam Research (Fig. 11). The industry’s forward revenue is expected to climb 10.2%, and forward earnings are thought to rise 15.8% (Fig. 12). As a result, the industry’s forward P/E of 15.1 is actually less than its anticipated earnings growth (Fig. 13).

A 4/23 WSJ article suggested that these cyclical stocks still had room to run because of a new production process being rolled out. The article explained: “Most different this time is the market for flash memory, which is in the midst of shifting to a new production process called 3D NAND. This has caused a supply shortage that has boosted NAND spot prices by 42% over the past 12 months, according to DRAMeXchange. It also has spurred demand for equipment as memory makers upgrade their fabs. Wes Twigg of Pacific Crest projects that capital expenditures for Flash memory production will jump 25% this year. Atif Malik of Citigroup said he expects the current supply-demand balance to ‘remain tight’ through 2018, which will likely keep pricing strong through then.”

Not far behind is the S&P 500 Semiconductors industry index, up 48.5% y/y, making it the fifth best-performing industry we track (Fig. 14). The industry’s average performance hides the outrageous returns of names like Nvdia, up more than 200%, and Micron Technology, up almost 190%.

Nvdia specializes in graphics chips typically in high-end computers used for gaming. “But they are also well suited to many of the types of tasks required for the machine learning that makes artificial intelligence possible. They can also accelerate the performance of CPUs of the type made by Intel. This gives (Nvdia’s chips) a growing role in data centers,” stated a 5/16 WSJ article, which explained how Nvdia invaded Intel’s turf. Intel shares are only up 18.4% over the last year.

Semis are expected to grow revenues by 6.5% and earnings by 12.0% over the next 12 months (Fig. 15). At 14.7, the forward P/E is right in the middle of the 10 to 20 P/E range that the industry has held had for most of the past 10 years (Fig. 16).

Back in the Cage?

May 17, 2017 (Wednesday)

See the pdf and the collection of the individual charts linked below.

(1) Swamps, zoos, and Washington, D.C. (2) City slicker in White House doesn’t know much about swamps. (3) Less mojo in soft data, which are mostly holding onto post-election bounces. (4) Economic Surprise Index showing weaker-than-expected hard data. (5) Key rail and truck gauges have stalled. (6) Business loans rise to record high despite slow pace of growth. (7) Plenty of good news in earnings. (8) Smooth sailing for stocks in the swamp, so far.


Strategy: The Zoo. Washington is often compared to a swamp, especially by the current occupant of the White House. After Election Day, the US economy was getting compared to a zoo where the animals had been let out of their cages. So-called “animal spirits” were running wild. To keep track of all the commotion, Debbie and I compiled a chart publication of all the “soft,” survey-based data showing a remarkable and widespread surge in consumer and business confidence. That was also reflected in the post-election rally in the stock market.

Trump has occupied the White House now for 118 days. The swamp waters seem to be rising rather than receding. Apparently, there are many more swamp people than he ever imagined. He alienated them from Inauguration Day when he promised to drain the swamp. Now they are doing their utmost to drown him in the swamp. Having been a real estate tycoon in NYC most of his adult life hasn’t prepared Trump for surviving in the swamp, let alone for draining it.

Surprisingly, most of the soft data remain elevated, though they’ve lost their post-election mojo. So far, there hasn’t been strong evidence that the initial surge in confidence has boosted economic growth (i.e., the hard data) much. Consider the following:

(1) Business surveys mixed. On the weak side is the May regional business survey conducted by the FRB-NY (Fig. 1). The general business conditions index is down from a recent peak of 18.7 during February to -1.0 during May, the lowest since October. At the start of this month, we learned that the national M-PMI dropped during April to 54.8 from a recent peak of 57.7 during February (Fig. 2).

(2) Consumer confidence upbeat. Measures of consumer confidence are holding up relatively well. That might have more to do with the tightness of the labor market than the election results. Our Consumer Optimism Index, which is the average of the Consumer Sentiment Index and the Consumer Confidence Index, edged down in April to 108.7 from the previous month’s cyclical high of 110.9 (Fig. 3).

The strong demand for labor is certainly boosting confidence. During April, more than 30% of small business owners said they have positions they can’t fill (Fig. 4). Last month, 19.1% of consumers said that jobs are hard to get, barely budging from March’s 19.0%, which was the lowest such reading since July 2007.

(3) Surprise index freefalling. The Citigroup Economic Surprise Index continues to fall (Fig. 5). It recently peaked at 57.9 on March 15. Yesterday, it was down to -37.6, the lowest since May 12, 2016.

(4) Railcars not so loaded. Transportation indicators have stalled recently. Debbie and I track the 26-week moving average of railcar loadings of intermodal containers (Fig. 6). We do so to smooth out this volatile series. This is the time of year when it usually increases as retailers stock up for summer sales. Instead, it has been edging down in recent weeks. This series is also highly correlated with the ATA Truck Tonnage Index, which is seasonally adjusted, but can still be volatile from month to month. Nevertheless, it has clearly been stalled at a record high for the past 14 months.

We also track the 26-week moving average of railcar loadings of motor vehicles, which is highly correlated with monthly auto sales (Fig. 7). The former series rose to a cyclical peak during the week of July 2, 2016, and has been on a slight downward trend since then.

(5) Business loans at record high. The bad news is that the y/y growth rate in commercial and industrial (C&I) loans plus nonfinancial commercial paper dropped to 1.9% in mid-April, the weakest since early March 2011, and held around that rate through early May (Fig. 8). The good news is that the actual level of this series rose to a new record high that same week (Fig. 9)! This suggests that some of the anxiety about its recent slowdown might have been overdone.

(6) Industrial production is up. As Debbie reports below, despite the slowdown in short-term business borrowing and April’s decline in the M-PMI, industrial production rose by a better-than-expected gain of 1.0% m/m in April, with factory output also up 1.0%. The gains were widespread. Production gains were solid for both consumer- and business-related goods.

(7) S&P earnings continue record run. Most importantly for the stock market, industry analysts remain upbeat about the outlook for earnings. During the week of May 11, the forward earnings of the S&P 500/400/600 remained in record-high territory and on solid uptrends (Fig. 10). For the S&P 500, consensus earnings estimates remain remarkably stable around $147 per share for 2018 (Fig. 11). That’s 11.8% above the current estimate of $131.57 for this year, which is up 11.5% from last year’s result.

The Q1-2017 earnings season is ending with a whimper as many retailers posted disappointing results. Nevertheless, thanks to upside surprises in other industries, there were solid upside hooks in actual earnings compared to estimates at the beginning of the latest season (Fig. 12).

(8) Stocks treading swamp water. So why are stocks holding up so well in record territory if Trump is either struggling or drowning in the swamp? The widespread view has been that the post-election Trump bump discounted his tax-cutting agenda, which might take longer to achieve if it happens at all. That’s true, but it also discounted that a very pro-business group of people would be running the executive branch for the next four years. That branch of government includes all the regulatory agencies, which will either eliminate or simply not enforce lots of regulations that business managers deem unnecessary, onerous, burdensome, and costly.

Besides, earnings are growing, and industry analysts remain optimistic about the outlook through 2018, though they may be assuming some boost from tax cuts. The stock market rallies overseas suggest that global investors are turning more optimistic on global economic growth. Adding to the animal spirits in the global stock markets may be a sense that inflation and interest rates may stay subdued for a long time, so the economic expansion might last a long time as well.

Also bullish in this “Seinfeld market” is that bad things aren’t happening. The Eurozone isn’t on the verge of disintegrating now that populists have been defeated in recent elections. The Eurozone’s economic performance is improving. China’s recent credit tightening hasn’t rattled global markets, while its Silk Road mega-project is attracting lots of interest from companies that want a piece of the action. The Fed will probably hike the federal funds rate at the June meeting of the FOMC, and probably nothing bad will happen.

US Underperforming

May 16, 2017 (Tuesday)

See the pdf and the collection of the individual charts linked below.

(1) Dipping vs. plunging offshore. (2) Go with the flows for now. (3) US fund flows can’t explain US underperformance. (4) Global investors must be bullish on global growth, and betting on it with cheaper foreign stocks. (5) Bullish on a world that can deal with gradual Fed tightening. (6) Overseas forward earnings turning up so far this year. (7) Too many eggs in Emerging Markets MSCI basket? (8) The case for actively managing an EM portfolio. (9) Fragile Five are less fragile now.


Global Strategy I: Follow the Money. Joe and I have been advocating a “Stay Home” investment strategy for some time rather than a “Go Global” one. Late last year, we started dipping our toes into offshore waters. With the benefit of hindsight, we should have plunged right in. That’s what global investors have been doing over the past year, increasingly so since the start of the year. We would go with the flows for now—the flows of investment funds.

These flows may be increasingly driven by passive investors who are pouring cash into global ETFs. That’s not so obvious by looking at flows for US-based ETFs. Over the past 12 months through March, the ones that invest solely in domestic equities attracted a record $230.3 billion, while the ones that invest in equities around the world attracted $64.8 billion (Fig. 1). However, there were large outflows out of US-based mutual funds over this period, led by domestic funds with outflows of $163.4 billion compared with a $2.8 billion trickle out of world funds (Fig. 2). Altogether through March, US-based mutual funds and ETFs that invest in the US had net inflows of $66.9 billion, while those that invest internationally had net inflows of $62.0 billion (Fig. 3).

These flows aren’t big enough to explain the outperformance of offshore vs onshore equities. Clearly, investors around the world have concluded that the global economy is likely to continue growing for the foreseeable future without any major risks of a recession. Both world industrial production and the volume of world exports rose to record highs at the beginning of this year, up 3.0% and 2.5% y/y through February (Fig. 4 and Fig. 5).

Apparently, global investors have favored foreign stocks because they are deemed to be cheaper than US ones. Consider the following:

(1) Major markets. Joe and I have observed that the forward P/Es of the MSCI stock price indexes for the UK, the EMU, and emerging markets (EMs) have been below the US valuation multiple since the start of the bull market (Fig. 6). (Japan has been cheaper since 2014.) It’s possible that investors are feeling that at current valuation multiples there is more risk in US equities than foreign ones, and are narrowing the valuation gaps (Fig. 7).

(2) All Country World. At the start of May, the US forward P/E was 17.8, while the All Country World ex-US was at 14.2 (Fig. 8). The ratio of the two was relatively high at 1.25.

(3) EMU & UK. At the start of May, the ratio of the forward P/E of the US and the one for the EMU (14.8) was 1.20. That is relatively high, but falling (Fig. 9). The ratio with the UK (14.3) is relatively wide currently at 1.24 (Fig. 10).

(4) Japan. The forward P/E of Japan has often exceeded, and sometimes matched, the one for the US (Fig. 11). However, since 2014, the US has exceeded Japan (now 13.9), with the ratio of the two currently at 1.28.

(5) EMs. The ratio of the forward P/E of the US to the one for the EMs (12.0 now) is currently at 1.48, which is quite high (Fig. 12).

(6) Forward earnings. You may be wondering what sparked the outperformance of the rest of the world over the past year. Obviously, one factor has been the widespread recognition that foreign equities are cheaper than American ones, as we just reviewed. Another important development has been the gradual tightening of US monetary policy, which started in late 2014 without triggering any serious problems for the global economy. Most importantly, forward earnings overseas, which had fallen sharply in late 2014 and throughout 2015, stopped doing so last year and has moved higher so far this year (Fig. 13).

Global Strategy II: No Contest. Joe and I monitor the relative performance of the US stock market in our daily publication titled US MSCI Stock Price Index vs Rest of the World. We see that the ratio of the US MSCI to the All Country World ex-US MSCI peaked at a record on December 27, 2016 in US dollars and on June 16, 2016 in local currency. Now let’s drill down to the major equity market indexes abroad, comparing them to the US MSCI stock price index gain of 17.0% y/y and 6.9% ytd:

(1) Eurozone. The EMU MSCI stock price index has risen 23.7% y/y in euros and 19.6% in US dollars through Friday’s close. It is up 11.5% ytd in euros and 15.4% in US dollars.

(2) UK. The UK MSCI stock price index has risen 21.1% y/y in pounds and 8.7% in US dollars through Friday’s close. It is up 4.1% ytd in pounds and 8.6% in US dollars.

(3) Japan. The Japan MSCI stock price index has risen 18.5% y/y in yen and 13.5% in US dollars through Friday’s close. It is up 3.2% ytd in yen and 6.3% in US dollars.

(4) EMs. The EM MSCI stock price index has risen 21.7% y/y in local currency and 25.9% in US dollars through Friday’s close. It is up 12.2% ytd in local currency and 16.2% in US dollars. The EM MSCI currency index is up 5.5% y/y and 5.4% ytd.

Emerging Markets: Eggs in a Basket. Is now a good or bad time to buy EM stocks? Two WSJ headlines offered conflicting answers: “Why Emerging Markets Are Looking Better Than the USA” was the title of a 3/31 article. On 4/17, the other article was titled “This Is a Dangerous Time to Own Emerging Markets.” Last week on Monday, at the Sohn conference, DoubleLine Capital’s Jeffery Gundlach chimed in, recommending that investors go long on EM exchange-traded funds (ETFs) and short on the S&P 500, reported Bloomberg.

But those might be alternative answers to the wrong question. Sure, US stocks aren’t cheap—giving EMs more fundamental appeal at a macro level. Lumping EM opportunities into one basket, however, could be dicey. Cherry-picking among specific countries offers the real opportunity.

As Melissa and I discussed on Wednesday, an analysis from the International Monetary Fund’s (IMF) latest World Economic Outlook indirectly endorsed actively managing EM investments. The report suggested that countries could “extract” more from growth and minimize downside risk if certain domestic attributes are present—namely, open trade policies, solid legal frameworks, and sound monetary and financial systems. Seeking out those countries for investment and avoiding any that make headlines for political crises or violent uprisings, in our view, seems to be the ticket to maximizing returns and minimizing downside. Consider the following:

(1) Capital inflows. According to the International Institute of Finance, EM stocks and bonds realized a net capital inflow of $29.8 billion from foreign investors during March, the highest monthly total since January 2015. Capital pouring into EMs suggests that a search for yield could be “trumping traditional metrics like a country’s economic and political outlook,” according to the 4/17 WSJ article.

(2) Active wins. A recent blog post from Columbia Threadneedle’s Emerging Perspectives observed: “Although the fourth quarter finished just slightly positive for the EM category as a whole, passive EM ETFs saw inflows totaling +$1.7 billion, while actively managed mutual funds experienced net outflows of almost -$3 billion.” Maybe investors have either defaulted to passive EM funds or pulled out of EM assets all together because the group is so diverse and complex.

That’s too bad, because those willing to invest actively in EMs could see better performance over the long run. Pensions & Investments made the case for actively managing EM investments in a late 2015 article. It highlighted long-term performance data from Mercer Manager Performance Analytics: “The median emerging market active managers have generated, on average, a rolling five-year excess return of more than 200 basis points vs. the MSCI [EM index] in U.S. dollar terms over the 15 years ended Sept. 30, 2014.”

A 4/16 WSJ article highlighted EM debt opportunities. It pointed out: “[I]n a year when emerging markets are in the spotlight as big winners, underperformance by the ETFs is also raising concerns over whether they are suitable instruments for betting on volatile developing nations.” According to data from MorningStar, the average EM bond ETF has returned over a five-year period 1.66% annually, while their active counterparts returned 1.95%. Further, EM ETFs in particular might be prone to tracking errors, discussed an April note in ETF Trends.

(3) Narrow MSCI. Passive investment in the Emerging Markets MSCI might lead to missed opportunities and unintentionally high exposure to certain countries, sectors, and companies, because the index is somewhat narrow in scope. BRIC represents 47.49% of the MSCI EM index, with this breakdown by country: China (26.98%), India (8.45), Brazil (8.19), and Russia (3.88).

Furthermore, taking a passive approach would mean that investors would have no exposure to EM countries excluded from the index. Investors tracking the index would be limited to the 23 countries represented within it. Compare that to the 69 countries listed in the IMF’s table of countries with persistent acceleration episodes (which doesn’t even represent all of the countries examined in the WEO analysis).

(4) Small diversity. A January 2017 Forbes article observed that the broader MSCI EM index is heavily concentrated in the top 10 constituent companies, with the top four in the technology sector. The author suggests that one way to increase diversity in EM investments is to track the less concentrated MSCI SmallCap index, with more than double the number of stocks as the broader index. Less than 3% of the SmallCap index is concentrated in the top 10 companies, according to the article, and the sector focus is tilted more toward consumer stocks dependent on domestic demand.

Of course, investing in the EM MSCI SmallCap index technically is still passive investing (despite choosing actively to do so!). Valuations and opportunities vary greatly within the index. For example, EM MSCI Consumer Staples with a forward P/E multiple of 21.4 is priced well above Information Technology stocks at 13.7. (See our Emerging Markets MSCI Sectors.) So taking a passive stake in an EM index is no guarantee of capitalizing on the sectors and companies with the most attractive valuation or conversely avoiding the dogs.

(5) Buyer beware. By the way, the 3/31 WSJ article warned investors in EMs to be aware of what they’re buying. Companies in EMs that do much of their business elsewhere might not be representative of the conditions sought in that economy. For example, one of the largest stocks in India “derives roughly 97% of its revenues from outside its home country.” This, therefore, would not be a vehicle for investing in India itself.

(6) Go Boring! One strategy for investing in EMs is to “Go Boring” by seeking to invest in countries where political strife and violent outbreaks are relatively less rampant. In retrospect, the EM winner of 2017 so far is a bit of a surprise: Poland, where equities are up 21.4% ytd in local currency and 31.0% in US dollars through Friday’s close. Barron’s wrote on 3/25: “The Central European nation’s advance had been helped by projected economic growth of 3.3% this year, following last year’s 3.1% gain in gross domestic product.”

Poland isn’t a country that has made the major financial media news headlines all that often this year. Now that doesn’t mean that the country is immune to political crises or drama. But if you google “Mexican politics,” for example, you’d get a lot more recent hits discussing greater turbulence. For comparison, the Mexico MSCI has returned 7.2% ytd in local currency and 17.6% in US dollars. In short, we recommend going active and staying as boring as possible when investing in EMs.

(7) Fragile Five. When the financial media starts covering a trend, it tends to signal that an opportunity has topped out. Is that the case for EMs? Maybe not. Not all the media coverage on the topic is bullish. Last week, Bloomberg ran an article titled “This Is What Can Kill the Emerging Market Rally.” It noted that higher rates, a stronger dollar, weaker commodities, and China’s deleveraging could create a less supportive environment for EMs. Despite the apparent risks, we think that EMs offer plenty of opportunities, especially where the valuation is right and domestic attributes are solid or improving.

We aren’t alone. In tune with Gundlach’s call at Sohn, Pimco and BlackRock are buying “Fragile Five” assets, according to a 5/10 Bloomberg article. In 2013, five EM economies earned the “Fragile Five” distinction as they “struggled to attract foreign capital to finance trade deficits.” But now, current account and fiscal deficits in South Africa, Brazil, Turkey, India, and Indonesia have shrunk to “less than half their size four years ago.” A Pimco portfolio manager recently said, “They’re no longer so fragile.” Furthermore, in its WEO report, the IMF emphasized that EMs still have plenty of room to catch up to developing nations.

Death by Amazon

May 15, 2017 (Monday)

See the pdf and the collection of the individual charts linked below.

(1) Dropping anchors. (2) Piranhas like fresh water and red meat. (3) Reading the business obituaries. (4) Eating someone else’s lunch. (5) Amazon expanding C2B and moving into B2B. (6) Media man says Amazon is “ridiculously scary.” (7) Clothes on demand. (8) A deflationary cloud. (9) Death by Amazon is a spreading plague. (10) Bricks-and-mortar getting hammered in stock market. (11) Buffett, saying Amazon hurting IBM, cuts his position by 1/3. (12) Business demand for computers has been flat after AWS opened the cloud. (13) Movie review: “The Dinner” (- -).


Amazon I: Anchors Aweigh. An anchor store is one of the larger stores in a shopping mall, usually a department store or a major retail chain. Shopping malls were first developed in the 1950s. Their developers signed up large department stores to draw retail traffic that would result in visits to the smaller stores in the mall as well. The anchors usually paid heavily discounted rents.

Amazon is a river in South America. It is the largest one in the world by discharge of water and the longest in length. A piranha is a freshwater fish with sharp teeth and a powerful jaw that inhabits South American rivers, including the Amazon. If you happen to fall off a riverboat steaming down the Amazon, the piranhas will pick your bones clean.

Amazon is also a piranha-like corporation that eats up retailers, particularly the anchor stores, and doesn’t even leave the bones. Jackie and I have been picking apart this story for a while. For example, see our 3/30 Morning Briefing titled “Jeff Bezos, The Terminator.” We were quoted in a 5/12 IBD article on the subject as follows:

“‘Amazon is killing lots of businesses. In the process, it may also be killing inflation,’ Ed Yardeni, noted economist and president of Yardeni Research, said in a recent report. Using Chief Executive Jeff Bezos’ playbook, Amazon has pummeled rivals with price cuts enabled by its smart logistics and relentless drive toward efficiency. Labor-displacing warehouse robotics give Amazon a cost advantage, and it aims to one day deploy delivery drones to extend its edge all the way to the customer’s doorstep. Amazon’s casualty list already is formidable. Over the years, Amazon has left consumer-facing retailers such as Borders, Circuit City and Sports Authority in the dust. Department chains have been closing stores, unable to answer the e-commerce challenge.”

Amazon II: Everything Must Go. The IBD article reported that Amazon’s piranhas are about to chew up other businesses. Consider the following:

(1) Big-box retailers & grocers. Amazon is going after big-box retailers like Wal-Mart and Costco by leaning on their consumer staples vendors to sell their products, which are packaged in big boxes, to consumers directly through Amazon’s distribution system. The $1.3 trillion US grocery market could be Amazon’s biggest potential source of revenue upside. IBD noted, “Amazon hopes to eliminate store cashiers at Amazon Go convenience stores now being tested. Amazon Go stores use sensors to track items as shoppers put them into baskets. The shopper’s Amazon account gets automatically charged.”

(2) B2B. Yardeni Research already has received mailings inviting us to set up an Amazon Business account for our office needs. IBD observed: “The online sales channel for business customers is sending prices down for industrial products, pressuring companies like W.W. Grainger.”

(3) Entertainment. Amazon is also going head-to-head with Netflix and all of Hollywood, by producing and distributing movies. The CEO of the entertainment provider Liberty Media, Greg Maffei, called Amazon a “ridiculously scary” rival at a financial conference on May 9. He presciently explained that Amazon’s competitive advantage is that it “has an ability, because of its scale, to invest at incredibly low or negative rates of return—because they can cross-subsidize, and the market is willing to suspend disbelief in future profitability.”

(4) On-demand & logistics. IBD reported: “Amazon recently was granted a patent for automated, ‘on-demand apparel manufacturing.’ The patent highlights plans to go beyond clothing into other fabric-based products, such as footwear, bedding and home goods. … Amazon is also bringing more of its logistics and delivery operations in-house.” This means that it is aiming to compete with, and eventually chew up, the airfreight, trucking, and home delivery industries.

(5) Cloud. In March 2006, Amazon officially launched Amazon Web Services (AWS). We signed up in 2008 for this fantastic cloud service, which has been remarkably reliable and very cost effective for us. IBD reported:

“As corporate America outsources more computing work to AWS and other highly automated cloud services, companies buy less hardware and software for internal data centers and cut back on IT staffing. In the March quarter, IBM’s (IBM) hardware business fell nearly 17% to $2.5 billion year-over-year, reflecting the impact of cloud adoption. How do the likes of IBM, Cisco Systems (CSCO) and Hewlett Packard Enterprises (HPE) fight back? By cutting prices. ‘Cloud is deflationary and collapses markets,’ said a Citigroup report in April. ‘Labor, with 85% deflation in the cloud, has the most significant disruption from cloud economics,’ says the Citi report. It says 15 IT staffers in a public, shared cloud service can replace 100 in a private data center.”

According to Citigroup, AWS will rake in some $37.5 billion in revenue by 2020, up from $17 billion this year. IBD quoted me as follows: “Perhaps most importantly, AWS’ juicy operating profit margin of more than 25% gives Amazon a way to fund its new ventures and a retail business that has notoriously skinny margins. The cash and financial flexibility AWS provides ensure that Amazon will be a lethal competitor in the retailing industry for many years to come.”

Amazon III: Body Count. In other words, “Death by Amazon” is a plague that will continue to afflict more and more businesses and industries. We can keep track of the mounting body count with a few economic indicators and by reading the business obituary page:

(1) Retailing. In March, online shopping rose to a record 29.7% of all online and in-store sales of GAFO, i.e., general merchandise, apparel and accessories, furniture, and other sales (Fig. 1). That’s up from just above 5.0% in 1994, when Jeff Bezos founded Amazon on July 5 that year. Over this same period, department stores’ share of GAFO plummeted from 34.3% to 12.5% currently. The box retailers saw their share rise from about 7.0% in 1992 to peak at 27.2% during January 2014, and ease back down to 25.3% currently.

The 5/8 issue of Bloomberg Businessweek features a picture of Bezos on the front cover with a story titled “They’re Coming for You, Bezos!” Both Wal-Mart and Costco are moving forward with plans to counter Amazon’s onslaught.

The department stores are like deer in the headlights. Their stock prices certainly suggest that investors are worrying that more of them will be roadkill. The S&P 500 Department Stores stock price index (JWN, KSS, and M) dropped 14.7% last week to its lowest level since July 20, 2009, and is down 57.5% from its recent peak on April 8, 2015 (Fig. 2). Industry analysts have cut their forward earnings for the industry by 27.4% since August 6, 2015 (Fig. 3). Investors have knocked down the industry’s forward P/E from a recent high of 16.1 in April 2015 to 10.9 currently (Fig. 4).

(2) Technology. In a 5/4 CNBC interview, Warren Buffett said he sold off about a third of his company’s 81 million shares of IBM since the start of the year. “I would say what they’ve run into is some pretty tough competitors,” Buffett said. “IBM is a big strong company, but they’ve got big strong competitors too.” In a 5/8 CNBC interview, Buffett was asked why he didn’t own any Amazon shares. He had a simple one-word answer: “Stupidity.”

Buffett explained, “I was impressed with Jeff [Bezos] early. I never expected he could pull off what he did ... on the scale that it happened.” He added, “At the same time he’s shaking up the whole retail world, he’s also shaking up the IT world simultaneously.”

In the nominal GDP data, Debbie and I see that capital spending on software and on information processing equipment both rose to record highs during Q1-2017 of $346.2 billion (saar) and $334.3 billion (Fig. 5). Computers and peripheral equipment, which is included in the latter category, has been virtually flat in both current and inflation-adjusted dollars since Q4-2010 at around $82 billion (saar) (Fig. 6). This flattening out after rapidly increasing since the early 1980s coincides with Amazon leading the expansion of the cloud business since 2006. Companies don’t need to buy computers when they can sign up for the computing power and storage they need on the cloud, which uses the available hardware much more efficiently.

Movie: “The Dinner” (- -) (link), starring Richard Gere, is about two couples getting together for a family dinner at an haute-cuisine French restaurant. Don’t go before dinner because it will make you very hungry. Yet the wonderful six-course meal goes to waste because the four dinner companions are so busy shouting at one another and leaving the table that they don’t get to enjoy it. The acting is good, but interrupted by the film’s jerky editing, with flashbacks to Gettysburg and an ATM machine. If you weren’t hungry in the first place, you’ll leave the theatre hungry at least for a good, less depressing movie. Skip “The Dinner” and just go out to dinner at a good restaurant instead.

On the Road Again

May 11, 2017 (Thursday)

See the pdf and the collection of the individual charts linked below.

(1) Leaving home. (2) Time for fun. (3) Cruising for dollars. (4) Spending on lasting memories on the high seas. (5) More Asians with wanderlust. (6) The hotels are occupied. (7) Having magical days at the theme parks. (8) More CEOs talking about wage pressures. (9) Labor shortages. (10) Peak plastic? (11) India going from cash to mobile pay. (12) Selfie Pay: Look into my eye.


Industry Focus: Hospitality Sweet. With the Great Recession all but a faded memory and summer rapidly approaching, staycations are out and vacations are in! Almost 80% of individuals contacted plan to take at least one weekend trip in 2017 and nearly two-thirds of them plan to travel more than 150 miles from home, according to a 12/21 survey by Enterprise Holdings.

Fun-related industries have had some of the best performances so far this year. S&P 500 Casinos & Gaming is the best-performing industry, up 42.7% ytd, while S&P 500 Hotels, Resorts & Cruise Lines has risen 25.2%, and S&P 500 Restaurants is up 14.9%. This implies that consumers are spending, just not at the mall. Strong Q1 earnings results out of some of the largest names in the travel industry drove home the strength in the market. Let’s look at the results out of Royal Caribbean, Marriott International, and Disney:

(1) Smooth sailing. Royal Caribbean Cruises beat Q1 earnings expectations, and management boosted the company’s 2017 forecast, saying its ships are booking up faster than last year, yields came in better than expected, and costs were lower than expected.

CEO Richard Fain spoke a bit about how consumer demand had evolved during the company’s Q1 conference call. A few years ago, if you asked consumers what they wanted, they might have said a flat-screen TV or a better car. Now people prefer to spend time with family, doing things that will make lasting memories. I do think that [this is] somewhat of a culture shift and I think we’re benefitting from that, said Fain. This trend has increased demand for vacations that include multiple generations of families, and it has boosted demand for excursions on cruises.

Royal Caribbean is also benefitting from the wanderlust of the rapidly expanding Chinese middle class, which will be bigger than the entire population of the US or Europe within the next few years. Right now, business in China is challenged by that county’s directive to cruise operators to stop selling trips that stop at South Korea. Tensions between the two countries rose after South Korea deployed a US missile defense system. Royal Caribbean redirected its ships to Japan, and any Q1 weakness in China was offset by strength in Europe and elsewhere.

The cruise operator said adjusted net income rose 73.1% y/y to $214.7 million and EPS rose to 99 cents, up from 57 cents and nine cents higher than the company’s guidance. The company lifted its full-year EPS estimate by 10 cents to $7.00-$7.20. It also announced a new $500 million stock repurchase program.

Shares of Royal Caribbean and other cruise operators also have benefitted from rumors that China’s HNA Group might be interested in buying a major cruise line, according to a 5/1 report in Cruise Industry News. HNA, which has a cruise brand in China, purchased a 16.8% stake in Dufry, which runs duty-free shops around the world, and purchased a stake in Rio’s airport last month.

Investors will need to watch how expanding capacity in the industry from newly built ships being delivered in the next few years is absorbed. As of December, 26 new ocean and river cruise ships were on order, followed by another 17 ordered for 2018 and 22 for 2019, according to the State of the Cruise Industry published by the Cruise Lines International Association. But for the moment anyway, investors should enjoy these halcyon days.

(2) No room at the inn. Marriott also reported stronger-than-expected Q1 earnings and increased future earnings guidance. The company credited its strong performance to more customers staying at its hotels, higher room rates, more hotel rooms in its system, and a late Easter.

Marriott’s worldwide revenue per available room (RevPAR) in constant dollars rose 3.1% in Q1. The gain is impressive given that the company added more than 17,000 rooms in the quarter. It also increased its development pipeline by nearly 10,000 rooms. Q1 adjusted net income was $395 million, a 36% increase assuming the September merger with Starwood occurred at the start of 2015 and excluding merger costs. Adjusted EPS jumped 38% to $1.01, above the company’s 87-91 cent guidance.

Marriott increased its expectations for 2017 RevPAR in the US, Europe, and Asia. However, it left expectations unchanged in the Middle East, where geopolitical unrest, low oil prices, and lower government spending continued to depress results. All in all, the company increased its 2017 worldwide RevPAR estimate by 50bps from its previous guidance to 1%-3%. Company shares rose 6.4% in the wake of the report.

Similar to the cruise industry, the future of the hotel industry rides on whether demand will keep up with new supply. There are 560,199 US hotel rooms in 4,621 projects under construction or in planning stages as of December, a 19.4% y/y increase in the number of rooms, according to a 1/16 article in

(3) Happiest place on earth. Weakness at ESPN may have captured the headlines about Disney’s fiscal Q2 earnings, but the strength at the company’s theme parks saved the day. Revenue at the parks increased 9% to $4.3 billion, and operating income jumped 20% to $750 million. Results were helped by a 4% increase in attendance at the US parks and the opening of Shanghai Disney last year, the company reported.

(4) By the numbers. Hotels, Resorts & Cruise Lines has been one of the S&P 500’s top-performing industries, gaining 25.2% ytd through Tuesday’s close (Fig. 1). The industry has outperformed each of the S&P 500’s sectors, including Technology.

Here is how the sectors have fared ytd: Tech (17.1%), Consumer Discretionary (11.6), Health Care (9.6), S&P 500 (7.1), Industrials (6.6), Consumer Staples (6.2), Materials (5.7), Utilities (5.3), Real Estate (2.0), Financials (1.7), Telecom (-10.6), and Energy (-10.8) (Table).

The Hotels, Resorts, & Cruise Lines industry (CCL, MAR, RCL, and WYN) is expected to grow revenue 9.6% over the next 12 months and earnings 13.7% (Fig. 2). The industry’s forward P/E of 17.1 is modestly below a recent peak of 22.2 in 2013 (Fig. 3).

The S&P 500 Casinos & Gaming industry, which counts Wynn Resorts (WYNN) as its sole member, has enjoyed a revival thanks to booming business in Las Vegas and Macau. Macau’s gross gambling revenue was up 18% in March, continuing a recovery that began last August. The Casinos & Gaming industry is expected to grow revenue 17.4% over the next 12 months and earnings 30.2% (Fig. 4). Its forward P/E, at 24.5, is less than its anticipated earnings growth over the same period (Fig. 5).

Earnings: Pay Hikes. One of the interesting nuggets shared by Marriott’s CEO Arne Sorenson in the company’s Q1 conference call was about the labor market. Construction costs have moved higher and we’ve seen some project delays in North America due to shortages of skilled subcontractors, he said.

His comments were the latest anecdotal evidence that the labor market is getting tighter. Modest wage increases have started to show up in the official data. Hourly compensation in nonfarm businesses rose 3.9% y/y during Q1 (Fig. 6). Here are some additional anecdotes:

(1) Competitive landscape. Rising wages were mentioned by executives at more than 24 large companies as part of discussions about Q1 earnings results. The companies were scattered among industries as diverse as financials, services, and manufacturers, the 5/4 WSJ reported.

State Street raised base salaries by an average of 3%, effective in April, following years of small increases. We thought it was important given the competitive landscape and the importance of keeping our top talent, said State Street’s CFO Michael Bell.

LyondellBasell Industries is seeing wages escalate as it is expanding an ethylene plant, and other companies have plans for similar projects. Robert Half International saw rising pay for the temp workers it supplies to clients. And Avery Dennison reported that productivity gains and sales growth narrowly outpaced higher employee wages.

(2) Contractors scrambling. As business picks up, contractors in the commercial real estate industry are seeing shortages of electricians, carpenters, and other subcontractor workers, the 5/6 WSJ reported. Commercial construction employment has almost returned to levels last seen in 2008, just as the country’s unemployment rate has fallen to 4.4% and business has picked up.

The trade association Associated Builders and Contractors Inc. estimates that the industry needs 500,000 more workers. The group estimates an additional 600,000 workers will be needed if President Trump pushes through a $1 trillion infrastructure building and improvement package. As a result of the tight labor market, construction labor costs are rising by an average of 4% to 5% annually, the article reported.

(3) Fewer H-1Bs. Indian information technology outsourcing companies have applied for fewer H-1B visas this year due to uncertainty about what the Trump administration will do to the program, according to a 5/7 WSJ article. Conversely, the number of applications by US tech companies has remained steady, the article stated. Overall, applications fell 16% this year.

Yet to be seen is whether the Indian outsourcers will opt to hire Americans, outsource the work to India, or replace US workers with technology. Infosys announced plans to open a center in Indiana in August that will create 2,000 jobs for Americans by 2021. However, Artificial intelligence, cloud technologies and bots now allow computers to do many of the routine tasks traditionally done by low-level IT workers such as monitoring servers, resetting passwords, fixing basic computer problems and providing tech support.

Payments Technology: Peak Plastic? Changes are coming fast to the world of payments. In India, use of mobile payments is growing faster than all other forms of payment and Mastercard is introducing iris scans to improve security when making a mobile payment. Let’s take a look:

(1) Leapfrogging. Mobile payments are taking off in India, propelled by the government’s decision to replace its largest bank notes with newly designed ones. The government was aiming to curb corruption, counterfeiting, and boost its tax base.

“The value of mobile money transactions has more than doubled since the nullification of 86% of India’s cash in circulation in November, while those made with credit and debit cards has fallen, and check purchases have barely budged. Mobile payments still make up only a small percentage of overall transactions, but their surging popularity is being noticed,” the 4/29 WSJ reported. The article speculated that India might move right from cash to mobile payments, skipping credit cards, just as some emerging markets skipped using phone land lines and went directly to adopting mobile phones.

Mobile payments are attractive to India’s mom-and-pop businesses, which don’t want to spend money on phone lines and swiping machines needed for credit cards. The expense seems unnecessary given that fewer than 5% of Indians have a credit card. Paytm is the leading mobile wallet in India, with 218 million wallets, and it counts Alibaba Group Holding as one of its investors.

Everyone wants into the market that grew 104% from October through February. Facebook, Amazon, Samsung, and Apple are either looking at the market or have launched a product. Meanwhile, the credit card companies have developed a system that allows users to scan a code with their phones to make a payment.

(2) Hello, James Bond. Mastercard CEO Ajay Banga discussed plans to use iris scans to improve mobile transaction security during the company’s Q1 conference call. The technology is the latest advancement in Mastercard Identity Check, better known as “Selfie Pay,” an app rolled out last year. It initially used facial recognition and fingerprints to confirm identities. Now iris scanning technology will also be available later this year.

To use facial recognition, consumers simply take a selfie of themselves. The phone won’t confuse the user and a picture of the user because it requires the user to blink. Likewise, the app can tell the difference between a human and a video because it can sense depth.

The advent of iris scans brings reality awfully close to fiction. Recall that the character Tom Cruise played in the movie “Minority Report” used eye transplants to trick identifying eye scanners. You know it’s only a matter of time.


May 10, 2017 (Wednesday)

See the pdf and the collection of the individual charts linked below.

(1) Ka-ching: Equity ETF inflows at record high. (2) Double-digit gains for S&P 500/400/600 since Election Day. (3) Analysts see double-digit earnings growth in 2017 and 2018. (4) Significant upside hooks during Q1 earnings season. (5) Alpha, beta, and SmallCaps. (6) Buddy, can you spare some time (to work)? (7) Europe is hot, hot, hot. (8) Eurozone’s economic indicators are strong. (9) IMF recommends actively managing EM portfolios, and provides investment guidelines.


Earnings: Small Is Beautiful. The money keeps pouring into equity ETFs. The latest data from the Investment Company Institute shows that they attracted $38.1 billion during March, $98.6 billion during Q1, and $198.7 billion since November, when Donald Trump was elected president (Fig. 1). Over the past 12 months through March, equity ETFs attracted a record $295 billion (Fig. 2). No wonder the S&P 500 is up 7.1% ytd through Tuesday’s close and is just 0.1% below Monday’s record high. It is up 12.0% since Election Day (Fig. 3).

Just as impressive, the S&P 400 MidCaps and S&P 600 SmallCaps stock price indexes are up 14.2% and 16.7% since Election Day. The stock market rally since then has been attributable to a combination of higher forward P/Es and increases to record highs in the forward earnings of the S&P 500/400/600 (Fig. 4). The current bull market has been especially good for MidCap and SmallCap investors. Consider the following:

(1) Performance & earnings derby. The S&P 500/400/600 price indexes are up 254.3%, 327.0%, and 366.0% since March 9, 2009 (Fig. 5). That’s because the forward earnings of the three composites are up 107.2%, 132.8%, and 161.4% over that same period (Fig. 6).

(2) Valuation derbies. All three started the bull market with forward P/Es just above 10.0, specifically at 10.3, 10.1, and 11.1, respectively (Fig. 7). These valuation multiples for the S&P 500/400/600 are currently 17.5, 18.3, and 19.4.

(3) Earnings in 2017 & 2018. Analysts’ consensus expectations in early May showed earnings growth for the S&P 500/400/600 of 11.4%, 10.5%, and 9.8% this year. Next year, they expect estimate growth rates will be 11.9%, 13.6%, and 19.8% (Fig. 8). Interestingly, their expectations for 2018 have been remarkably stable since late last year for the LargeCaps and SmallCaps, while their MidCap consensus forecast has been rising.

(4) Q1 upside hooks. Now that the Q1 earnings season is almost complete, we see upside hooks in the results relative to expectations at the start of the season for all three composites (Fig. 9). The S&P 500/400/600 Q1 actual/blended numbers now show y/y gains of 13.9%, 10.5%, and 6.3%. In other words, LargeCap investors have something to brag about for now. (By the way, at the beginning of the current earnings season, the estimates were 9.2%, 6.7%, and 2.1%.)

(5) Alpha & beta. The reason that small companies grow faster than large companies is that if they survive, they tend to grow into bigger companies, while the large ones may have hit their critical mass many years ago. There is more alpha in small companies, and more beta in large companies. “Alpha” refers to company-specific developments, while “beta” refers to economy-wide ones that impact all companies. Of course, this can be a curse during recessions when both alpha and beta fall apart for many small companies, while large companies mostly take a beta hit.

Currently, the big problem for all companies is a shortage of workers. This hits smaller companies harder because they need to increase their payrolls to grow more so than large ones. The NFIB survey of small business owners released yesterday for April showed that 31.7% are not able to fill open positions, using the three-month average to reduce m/m volatility in this series (Fig. 10). That’s the highest since February 2001. On the other hand, 17.5% of them are saying that government regulation is their number-one problem, down from a recent peak of 22.2% during May 2015 (Fig. 11). SmallCaps and MidCaps are likely to benefit more than LargeCaps from President Trump’s economic agenda to reduce regulations and cut corporate taxes.

Europe: Liberation Days. Europe is hot, and it isn’t even summer yet. The EMU MSCI is up 11.6% in euros and 15.6% in US dollars since the start of the year through Monday (Fig. 12). The US MSCI is up 7.3% ytd, significantly underperforming the Eurozone’s index (Fig. 13). Debbie and I started to warm up to the Eurozone’s economy late last year. However, Joe and I had some concerns about the downside for stocks if scheduled elections gave anti-EU populists political control. More importantly, we observed that the relative valuation case wasn’t all that compelling since the EMU tends to sell at a P/E discount to the US.

Mainstream political parties remain in power in the Eurozone, most significantly in France. The forward P/E of the EMU MSCI has increased from 14.3 at the end of last year to 14.9 currently (Fig. 14). The ratio of the US to EMU forward P/Es is down to 1.2, the lowest since early 2016 (Fig. 15). The region’s latest economic indicators are strong:

(1) Economic sentiment & PMIs. The Eurozone Economic Sentiment Indicator rose during April to the highest reading since August 2007 (Fig. 16). It is highly correlated with the region’s real GDP on a y/y basis. The region’s C-PMI (56.8), M-PMI (56.7), and NM-PMI (56.4) all were solidly above 55.0 last month (Fig. 17).

(2) Retail sales & auto registrations. The volume of Eurozone retail sales excluding motor vehicles rose during February to a new record high. In the European Union, new passenger car registrations on a 12-month basis rose to the highest pace since September 2008.

(3) Credit. Loans in the Eurozone rose 1.9% y/y during March, or €198 billion. That may not seem like much, but the growth rate is the highest since October 2011.

Emerging Markets: IMF Recommends Active Management. During the 1950s and 1960s, they were called “less developed countries,” or “LDCs.” During the 1970s and 1980s, they were renamed “developing countries.” During the 1990s through now, they are called “emerging market economies” or “emerging markets.”

The International Monetary Fund (IMF) indirectly endorsed active investment management for emerging markets in its World Economic Outlook, April 2017. The report’s Chapter 2 focused on growth in emerging markets in a complicated external environment. Its introductory paragraph stated: “After a remarkable period of synchronized acceleration in the early 2000s and broad resilience immediately following the global financial crisis, growth across emerging market and developing economies in recent years once again displays heterogeneity—a mix of tapering, standstills, reversals, and continued strength in some cases.” In other words, there are opportunities to be found among emerging markets, but not in all of them. Taking a historical purview, the IMF conducted analyses to identify criteria that correlate with medium-term growth, and also the likelihood of persistent accelerations or reversals.

One could envision a table with a column at the left listing each of these criteria and a row at the top listing emerging market regions and economies, with tick marks to correspond to positive or negative attributes. Though beyond the scope of the IMF’s report and today’s Morning Briefing, such an exercise undoubtedly would reveal a divergent picture across emerging markets. Since the IMF’s report could be useful for screening emerging market opportunities, I asked Melissa to cull out the top-level criteria from the 56 pages of the report’s Chapter 2:

(1) External conditions. According to the IMF, three sets of external conditions—external demand conditions, external financial conditions, and terms of trade—can manifest differently for individual countries. The IMF finds that “all three external conditions have economically and statistically significant effects on emerging market and developing economies’ medium-term growth.” Specifically, a 1ppt increase in country-specific conditions related to external demand, external financing, and terms of trade is associated with a 0.4ppt, 0.2ppt, and almost 0.5ppt increase in medium-term growth.

Rather than making subjective assessments, the IMF has assigned discrete metrics to each external condition. External demand conditions are measured by the export-weighted growth rate of domestic absorption of trading partners. External financing conditions are proxied by a quantity-based measure of capital flows to peer economies as a share of their aggregate GDP. Terms-of-trade conditions are based on international commodity prices to provide an indication of the gains and losses as a share of GDP associated with changes in those prices.

(2) Accelerations & reversals. Each of these criteria also influence the likelihood of experiencing growth accelerations and reversal episodes for emerging economies, observes the IMF. During persistent acceleration episodes, the median annual growth rate of the sample was approximately 5.5%. During reversals, the rate was -3%. The IMF’s filters picked up significant variation in the occurrence of growth episodes. There were 127 growth acceleration episodes for the IMF’s sample from 1970 to 2014, with 95 of them representing persistent accelerations and 32 non-persistent. Of the 32, 12 were associated with subsequent reversals. In terms of reversals, the IMF identified 125 episodes over the period examined.

In terms of accelerations, a 1ppt increase in trading partner demand raises the probability of accelerations by 3.9ppts. An increase in regional capital flows relative to GDP of 1ppt raises the probability of persistent accelerations by 2.6ppts. While improved terms of trade don’t correlate with a higher probability of acceleration over the sample of emerging economies under all conditions, there are circumstances where terms of trade matter more, specifically: Trade windfalls have triggered temporary accelerations in some countries, and commodity-export-heavy countries with open terms of trade have experienced persistent accelerations.

(3) Domestic attributes. In the IMF report, Figure 2.19 lists the specific domestic attributes that contribute to emerging economies ability to “extract the most out of external conditions.” These include: (a) the openness and depth of financial systems in terms of trade agreements, bank assets, sound credit growth, and capital accounts; (b) initial conditions present in the current account balance and external debt; (c) policy frameworks such as exchange-rate flexibility and public debt; and (d) structural characteristics like regulation and legal systems and property rights.


Each of these factors presents a statistically significant influence on accelerations or reversals. But by far, sound credit growth ranks highest in influence over persistent accelerations—specifically, “[t]he probability of a persistent acceleration when external financial conditions are supportive is about 7 percentage points higher when domestic credit has been growing at a healthy pace as opposed to under credit-boom conditions.”

China Down

May 09, 2017 (Tuesday)

See the pdf and the collection of the individual charts linked below.

(1) Bulls and bears in china shop. (2) China’s credit tightening is #1 concern currently. (3) Chinese stocks mixed. (4) Chinese officials go to war against shadow banking system. (5) Are Wealth Management Products weapons of mass financial destruction? (6) Lots of yuan in grey areas. (7) Don’t trust entrusted investments. (8) Shadow banks account for almost 1/3 of “social financing.” (9) China isn’t as fragile as some fear. (10) Plenty of growth in exports and imports. (11) Capital outflows still a problem.


China I: Bear in a Bullish Market? Urban Dictionary defines “A bull in a china shop” as “a simile used to describe an extremely rough or dangerous person in a place where gentleness is a must. It brings to mind the image of a huge rodeo bull exploding into a tiny curio store and throwing his weight around in a berserk rage, annihilating every last teacup.”

When I ask our accounts lately which major threat to the bull market in stocks they most fear, the number-one reply is a meltdown in China. That’s the bear that could trip up the bull market in the US and around the world. Of course, there are other concerns, such as a rebound in inflation, a stalling of US economic growth, and the failure of Washington to implement President Trump’s tax reform agenda. However, China is the number-one concern, especially since the second half of April, when Chinese officials started a new round of credit tightening.

The Shanghai Stock Price A-Share Index peaked last month on April 11, and fell 5.7% through Friday (Fig. 1). That’s a minor decline so far, especially compared to the 48.6% plunge from its record high on June 12, 2015 through January 28, 2016. Meanwhile, both the Hong Kong Hang Seng China Enterprises Index and the China MSCI stock price index are above their April highs, and up 11.3% and 14.8% ytd, respectively (Fig. 2).

So why the long face (as the bartender asked the horse, who stepped up to the bar for a drink)? Here is the recent litany of worrisome developments in China:

(1) War on debt. A 5/5 WSJ article titled “China’s War on Debt Causes Stocks to Drop, Bond Yields to Shoot Up and Defaults to Rise” summarized the recent woes nicely: “A wave of regulations aimed at cutting risk in China’s financial system is rippling through the country’s markets and sending banks and companies scrambling for funds. During the past month, Chinese shares have fallen nearly 5%, draining almost half a trillion dollars out of the country’s markets. Bond yields have shot up to their highest levels in two years, and bond defaults hover at record levels. The uncertainty has also weighed on metals and commodity prices, already hurt by doubts around China’s growth momentum. The price of iron ore plunged 8% on Thursday, the daily trading limit.”

(2) Xi’s ultimatum. Chinese President Xi Jinping recently called for greater stability, warning finance regulators not to miss “a single risk” or “hidden danger.” The message was heard loud and clear. For example, the chairman of the China Banking Regulatory Commission (CBRC) said, “Strong medicine must be prescribed. If the banking industry gets into a mess, I will resign.” More likely, he will be fired.

(3) Lurking in the shadow. The problem in China is a huge shadow banking system that sells so-called “wealth management products” (WMPs) to the public and then lends the money to risky companies without setting aside any capital for possible losses. WMPs are debt or debt-like instruments that pay out higher interest rates to investors. Banks have kept them off their balance sheets. However, the People's Bank of China just put them on its macroprudential assessment of banks' risks.

The WSJ article cited above reported, “Such grey-area investments reached nearly 20 trillion yuan ($2.8 trillion) at the end of last year, says Fitch Ratings, or about 26% of China’s gross domestic product in 2016, up from less than 10% three years earlier. They now represent an average of 19% of small and midsize banks’ total assets, compared with about 1% for big state banks, according to Fitch.” Fitch says total debt reached 258% of China’s GDP last year, a ratio it expects will grow this year and next.

(4) Not so trusted. The CBRC is also cracking down on the practice of banks’ lending to external managers money for “entrusted investments.” Banks have been lending to brokerage firms with high interest. The brokerages then lend to customers, often allowing leverage to be extended to customers if they have a problem. The brokerages make their money from trade execution and sharing in returns. So, they get paid first.

(5) Deadbeats. During the first four months of this year, 12 companies, including steelmakers and construction firms, defaulted on their corporate bonds because they couldn’t refinance their debts. That matches the record hit during the same period last year, when China was under great stress from accelerating capital outflows.

(6) Dimon sounds alarmed. On May 1, Jamie Dimon, the CEO of JPMorgan, told a crowd at the Milken Institute's Global Conference that China has him worried. What scares Dimon is that China’s latest campaign to rein in credit excesses, if done too quickly, may drain too much liquidity from the system, killing smaller players and grinding things to a halt.

China II: By the Numbers. Not surprisingly, there isn’t much data on China’s shadow banking system. However, some insights can be gleaned from the monthly release of “social financing,” which includes bank loans and lots of other categories. Consider the following:

(1) Bank loans as a percentage of total social financing fell from 91.9% at the start of 2003 to 68.1% during March of this year (Fig. 3). This implies that the shadow banking system’s share of social financing has increased from just 10.3% at the start of 2003 to 31.9% currently (Fig. 4).

(2) In US dollars over the past 12 months through March, social financing totaled a whopping $2.7 trillion (Fig. 5). Bank loans increased $1.9 trillion over the same period, while all social financing excluding bank loans was $795 billion (Fig. 6 and Fig. 7).

(3) Entrusted loans totaled $336 billion over the past 12 months through March (Fig. 8).

China III: CorningWare. Debbie and I aren’t too concerned about China just yet, though we are paying more attention to developments over there. Yes, the price of iron ore in China has plunged 37% since February 21 (Fig. 9). However, our trusty CRB raw industrials index is down only 3% from its recent high on March 15 (Fig. 10). China’s economy isn’t as fragile as fine dinnerware china. It’s at least as strong as CorningWare. While banking regulators may be pumping on the brakes, the government is proceeding with lots of huge building projects.

The latest one was announced in early April as reported by “A hitherto anonymous region near China’s smog-choked capital has been overrun by house buyers after Beijing unveiled ‘historic’ plans to build a new city there in a bid to slash pollution and congestion. Plans for the Xiongan New Area, a special economic zone that authorities say will eventually cover an area nearly three times that of New York, were announced by the Communist party’s top leaders on Saturday with a flurry of government propaganda.”

Official news agency Xinhua exuberantly reported, “In terms of national significance, the area parallels the Shenzhen Economic Zone and Pudong New District, China's successful test beds for reform and opening up. The area will operate as a new growth pole for the country's economy, and also aim to curb urban sprawl, bridge growth disparities and protect ecology. It is unprecedented to have a special zone with such inclusive development value. It is of huge significance as coordinated and sustainable growth is so important for the country. The area is about 100 km southwest of downtown Beijing and will become home to facilities not related to the capital that were relocated from Beijing, where breakneck urban growth has given rise to ‘urban ills’ such as traffic congestion and air pollution.”

Meanwhile, the latest batch of economic indicators shows that China’s economy continues to expand at a reasonably solid pace:

(1) Purchasing managers. The official M-PMI and NM-PMI both edged down last month, but remained solidly above 50.0 with readings of 51.2 and 54.0, respectively (Fig. 11 and Fig. 12). The Caixin/Markit measures were weaker with readings of 50.3 and 51.5, respectively.

(2) Trade. In yuan and on a seasonally adjusted basis, Chinese exports and imports both edged down in April, but their y/y growth rates were in the double digits at 15% and 19%, respectively (Fig. 13 and Fig. 14).

(3) Reserves & capital flows. Our capital flows proxy shows that China continues to have significant outflows, though the situation isn’t worsening as it had during most of 2014 and 2015. The country’s non-gold international reserves rose by $32 billion in the three months through April to $3.0 trillion, after declining for seven consecutive months. The trade surplus stopped narrowing (Fig. 15). Consequently, the proxy showed 12-month net capital outflows of $653 billion through April, the same as in the previous two months (Fig. 16).

(4) Hedge clause. One day, there could be a China Syndrome event in China. However, rather than a definitive meltdown, China could follow the path of Japan. Both have similar issues with aging populations and rising debt burdens, which are weighing on their economic growth rates. Both owe much of their debt to themselves. China’s bank loans are more than covered by the country’s M2. Both depend on exporting to others. Both really need to focus more on reviving their fertility rates and improving standards of living for their citizens.

Bali Hai

May 08, 2017 (Monday)

See the pdf and the collection of the individual charts linked below.

(1) Bond Vigilantes Model too bearish on nominal GDP. (2) Ignore q/q real GDP. Focus on stronger y/y comps. (3) Variations on a theme: Lower-for-longer growth, no-boom-no-bust, inflation is dead. (4) FOMC says Q1 slowdown was temporary. (5) Welcome to Bali Hai, with ideal weather conditions for investors. (6) Just beware of the dormant volcano. (7) Wage and price inflation remain as calm as the trade winds on a South Pacific island. (8) Earned Income Proxy is smoking. (9) Storm clouds in the commodity pits? (10) Chinese officials pumping the brakes while stepping on accelerator.


US Economy: Dormant Volcano. Everyone seemed to be bummed out by the 0.7% growth in real GDP during Q1 (Fig. 1). It was awfully weak given that it is a seasonally adjusted annualized rate. Then again, it wasn’t a surprise given that the widely followed Atlanta Fed’s GDPNow had nailed it. Furthermore, the Citibank Economic Surprise Index (CESI) dropped from a recent peak of 57.9 on March 15 to a recent low of -21.5 on May 2 (Fig. 2). Over that period, it tracked the weaker-than-expected reports of many of the indicators that were used to calculate Q1 real GDP.

The US Treasury 10-year bond yield certainly didn’t confirm the strength shown by all the “animal spirits” reflected in the soft data (i.e., consumer and business surveys) since Election Day. The Bond Vigilantes Model tracks the relationship between this yield and the y/y growth rate in nominal GDP (Fig. 3). Some fixed-income strategists believe that the 10-year yield is the bond market’s current assessment of the growth in nominal GDP. If so, then it hasn’t been very accurate.

For example, despite the weakness in the quarterly real rate, nominal GDP rose 4.0% y/y during Q1, well above the 2.31%-2.62% range of the yield during Q1. On a quarterly average basis, the bond yield was 153 basis points below the growth of nominal GDP (Fig. 4). That’s because the bond market may be focusing more on the benign outlook for the inflation component of nominal growth than on total nominal growth.

In any event, the economy may not be as weak as suggested by the quarterly real GDP stat. While the data are seasonally adjusted, there has been a funky tendency for the Q1 numbers to be among the weakest ones since the start of the current economic expansion. That’s why Debbie and I prefer to give more weight to the y/y comparison, which showed a gain of 1.9% over the past four quarters, consistent with the roughly 2.0% growth in this measure since 2010 (Fig. 5). As for the CESI, it tends to be extremely volatile and cyclical; after going down sharply for a few weeks, it tends to go back up sharply for a few weeks. It’s good at spotting soft patches, which more often than not are followed by hard patches.

Can you think of a more bullish environment for both stocks and bonds at the same time than the current one? “Lower-for-longer growth” has been a profitable mantra for both. “No boom, no bust” is another variation on this theme, which Debbie and I have been promoting during most of the current economic expansion. In this scenario, inflation is dead (or at least dormant), interest rates remain low, and the expansion continues at a leisurely pace.

The FOMC statement released last Wednesday confirmed that Fed officials remain in gradual rate-hiking mode, even though they believe that the economy is stronger than suggested by Q1 indicators: “The Committee views the slowing in growth during the first quarter as likely to be transitory and continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace, labor market conditions will strengthen somewhat further, and inflation will stabilize around 2 percent over the medium term. Near-term risks to the economic outlook appear roughly balanced. … The Committee expects that economic conditions will evolve in a manner that will warrant gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.”

We may be in “Bali Hai.” This name refers to a mystical island, visible on the horizon but not reachable. It is a very mellow show tune from the 1949 Rodgers and Hammerstein musical South Pacific. The risk is that more and more investors will crowd into the lush tropical island, causing a melt-up in the island’s dormant volcano. (Work with us here.)

US Employment: No Hot Lava. The US labor market remains hot, but the heat isn’t showing up in any of the wage or price data. It is certainly Bali Hai in the labor markets. Consider the following:

(1) As Debbie discusses below, the unemployment rate was only 4.4% in April. It was just 4.0% for adults, the lowest since June 2007 (Fig. 6). Yet average hourly earnings for production and nonsupervisory workers, who account for 70% of total payroll employment, rose merely 2.3% y/y during April (Fig. 7 and Fig. 8). On the other hand, nonfarm business hourly compensation rose 3.9% y/y during Q1, though the series is quite volatile even on a y/y basis. The Employment Cost Index was up only 2.3% y/y during Q1 (Fig. 9).

(2) Wage and price inflation remain subdued, with the former outpacing the latter. So real hourly wages for all workers is up 0.7% y/y through March to a record high, and 5.2% since the start of 2009 (Fig. 10). The notion that real pay has stagnated for years is a myth. The unemployment rate is at a cyclical low for adults of just 4.0%, with the headline rate below 5.0% for the past 12 months. Full-time employment jumped 480,000 last month to the highest reading on record (Fig. 11).

(3) The good news for the economy is that wages of all workers have been rising faster than consumer prices for the past 54 consecutive months. The former rose 2.5% y/y during April, while the personal consumption expenditures deflator rose 1.8% in March (Fig. 12). Also uplifting is that our Earned Income Proxy for private-sector wages and salaries rose 0.8% m/m and 4.2% y/y during April (Fig. 13). This augurs well for retail sales and overall consumer spending in April (Fig. 14).

Global Economy: Commodity Clouds. The problem with tropical islands in the South Pacific is that the gentle trade winds can sometimes bring rough weather that is anything but pacific. In 1519, Portuguese navigator Ferdinand Magellan began a journey across the Atlantic Ocean to seek a western route to the Spice Islands via South America. In November 1520, after braving perilous seas and navigating through what are now known as the “Straits of Magellan,” his small fleet entered an unfamiliar ocean, which seemed relatively calm at the time. So he named it the “Pacific Ocean.”

Investors already are fretting that a storm is coming to Bali Hai. They are troubled by the recent drop in commodity prices. Debbie and I aren’t fretting just yet. Our trusty CRB raw industrials spot price index remains 26% above its recent low at the end of 2015 (Fig. 15). The JP Morgan Global M-PMI edged down to a still-solid reading of 52.8 during April from a high of 53.0 the prior two months (Fig. 16).

The recent weakness in commodity prices, particularly iron ore, indicates that traders have learned to react very rapidly to changes in credit policies in China. During the second half of April, Chinese banking officials moved to rein in speculative excesses in the shadow banking system and in wealth management accounts. These officials have had a tendency to pump the brakes occasionally, only to step on the accelerator again at the first signs of an economic slowdown.

Where Credit Is Due

May 04, 2017 (Thursday)

See the pdf and the collection of the individual charts linked below.

(1) Coffee, tea, or plastic? (2) A flight with no fights. (3) Auto and student loans leading consumer credit to new highs. Revolving credit lagging. (4) Consumer delinquencies rising back to old normal. (5) No signs of trouble in debt-servicing ratio. (6) Dearth of deadbeats. (7) Payments processing is a great business. (8) But beware of the Great Disruptor. (9) Some cracks in commercial real estate’s foundation. (10) Want to buy the Brooklyn Bridge and get a free taxi medallion?


Consumer Credit: Hard-Charging. When flying, you expect a flight attendant to offer coffee and tea. But Jackie was surprised last month when flight attendants on an American Airlines flight she was on between LaGuardia and Charlotte pitched an American Airlines credit card. How’s that for low-cost advertising to a captive audience?! Jackie was happy to report that there was no violent outbursts on her flight.

The sales pitch did prompt us to have a closer look at the credit card business. Recent earnings out of Synchrony Financial (spun out of GE Capital) and Capital One Financial gave investors the jitters, as both sharply increased their reserves. However, economic data show that monthly payments remain manageable. Let’s take a look:

(1) Growing quickly. As you’d expect, most consumer loan balances, except for student loans, shrank during the previous recession. Total consumer credit fell $147 billion (or 5.5%) from July 2008 through August 2010 (Fig. 1). Since then, consumer credit has increased rapidly, by $1.27 trillion to a record high of $3.79 trillion, up $1.13 trillion (or 42%) from 2008’s peak. Leading the advance have been auto loans and student loans, which are included in the Fed’s “nonrevolving credit” category (Fig. 2). Lagging has been “revolving credit,” which consists mostly of credit card balances. It’s up 20% through February since bottoming during April 2011, and remains slightly below its 2008 record high. The data suggest that consumers remain more cautious about using their credit cards but have been loading up on auto and student debt.

(2) Back to normal. In Q1 results, Synchrony and Capital One both reported increases in reserves and in charge-offs that caught investors by surprise. Synchrony increased its provision for loan losses by 45% to $1.31 billion, and its net charge-offs in Q1 came in at 5.33%, up from 4.74% a year earlier. For the full year, management expects net charge-offs to be in the low 5%s, edging up to the low-to-mid-5% range in 2018.

The company did not lower its lending standards. Instead, it attributed the need to boost provisions to lower recoveries on defaulted loans, to growth in the overall loan portfolio, and to “normalization trends”—which implies that defaults were abnormally low in the early years of the recovery and now are returning to more normal levels. At Synchrony, loan receivables grew 8.0% in 2015 y/y and 11.3% in 2016. That’s much faster than consumers’ incomes grew, 4.0% in 2015 and 3.6% in 2016.

Capital One’s Q1 charge-off rate in its domestic credit card business was 5.14%, up 0.48ppts from Q4. The company now sees the 2017 charge-off rate on US credit cards in the high-4% to 5% range, up from earlier expectations for the rate to be around mid-4%. “Over the past year and a half, we have seen increasing competitive intensity, a growing supply of credit, and rising consumer indebtedness,” observed CEO Richard Fairbank in the company’s Q1 earnings call transcript. Later on the call, he said, “We continue to be concerned about the supply of credit in the marketplace. Revolving credit grew at about 6.5% year-over-year, the seventh consecutive quarter it has grown much faster than household income. Against this background, we have been tightening our underwriting.”

(3) Not too many deadbeats. There is some good news. Data from the FRB-NY backs up these CEOs’ assertions. The percentage of credit card balances that are delinquent by 90 days or more has fallen to levels well below where it stood in the years leading up to the 2008 recession (Fig. 3). So it’s certainly possible that delinquencies will return to more normal levels and then stop deteriorating.

Another optimistic nugget is that household debt service payments as a percentage of disposable personal income was only 10.0% in Q4 , below the 13.2% peak just before the 2008 recession and lower than the 10.4% level seen back in Q2-1993 (Fig. 4). This is largely thanks to the low interest rates we’ve enjoyed for the past eight years. Credit quality in credit card portfolios may not be improving anymore. But as long as rates stay low and jobs remain plentiful, default-rate “normalization” shouldn’t turn into a spike in the credit card default rate. Just what will happen to the student loan market, where delinquencies now are far higher than during the recession, is a story for another day.

(4) Taking stock. The S&P 500 Consumer Finance stock index is down 11.0% from its cyclical high on May 2, 2016 (Fig. 5). The index has been depressed by the 20.3% decline in Synchrony, the 12.5% drop in Capital One, and the 13.0% drop in Discover Financial since March 1. Analysts still forecast that the Consumer Finance industry will grow revenue by 5.0% over the next 12 months and grow earnings by 7.7% (Fig. 6). The industry’s forward P/E has come down a touch to 11.5, which is high relative to where the multiple has been over the past 16 years but low compared to the highest multiples that the industry has commanded during the best of times over the past 20 years (Fig. 7).

(5) What’s in your wallet? Higher credit card volumes are good news for Mastercard and Visa, which process credit card transactions but don’t hold the outstanding credit card debt. On Tuesday, Mastercard reported that Q1 net revenue rose 12% y/y and adjusted net income increased 13%. Earnings per share rose more than net income, by 16%, due to a reduced share count. Last month, Visa reported that earnings excluding restructuring charges for fiscal Q2 were 86 cents a share, up 27% y/y.

Both companies benefitted as more traffic traveled over their payment systems. At Mastercard, the gross dollar volume on the company’s worldwide network rose 4.7% y/y to $1.2 trillion, including a 2.0% increase in the US. The US volume includes a 5.4% increase in Mastercard’s credit and charge programs and an 0.8% decline in its debit program. The shares of both companies have had a great start to the year.

Visa’s traffic jumped even more dramatically, as it won some large new clients, including Costco Wholesale. The company’s payments volume grew 37.2% y/y to $1.7 trillion, assuming a constant dollar. Visa shares are up 18.6% ytd through Tuesday’s close, and Mastercard’s shares have added 14.4%.

The two companies are members of the S&P 500 Data Processing & Outsourced Services stock index, which has had an amazing run since 2009, climbing 423.0% (Fig. 8). The industry includes Automatic Data Processing, Fiserv, PayPal Holdings, and Paychex along with others. It’s expected to grow revenues by 11.7% over the next 12 months and earnings by 14.2% (Fig. 9). Investors will need to pay up for the above-market earnings growth, as the industry trades at 23.1 times forward earnings (Fig. 10).

(6) The Great Disruptor. Amazon has been around since 1994 and creating headaches for other retailers for many years. But in recent months, it seems that the number of store closures has accelerated as a number of retailers have given up the fight. Even Synchrony CEO Margaret Keane said on the Q1 conference call: “The retailers are going through a transformation. But I would say, as per our reading, it’s definitely accelerated coming out of the holiday season.”

And that presumably means that Synchrony cannot depend on consumers going into a retailer and opening up a credit card to gain customers. So Synchrony is undergoing its own transformation. The company is “making sure we can really attract those customers through the online channels, whether it’s through their iPad or on their mobile phone.” In Q1, 26% of retail-card penetration was online.

The company purchased GPShopper, a mobile app developer, in Q1 for an undisclosed amount. Synchrony made an initial investment in the company in 2015, and subsequently they developed a plugin that allows retailers’ credit cardholders to shop, redeem rewards, and manage and make payments to their accounts with their smartphones, according to a 3/22 article in the Stamford Advocate. More than retailers need to learn how to find customers online.

Commercial Real Estate: Soft Spots. The rash of store closures this year is also affecting landlords and investors in retail real estate investment trusts (REITs). Lower-end malls have been struggling for years to replace tenants, but even the hottest spots to shop are showing some signs of weakness, and investors have headed for the hills. Things have gotten so bad that the CEO of GGP recently suggested he’d consider selling the REIT that specializes in malls. Let’s take a look at some of the soft spots in commercial real estate:

(1) NYC rents falling. Average commercial rental prices have decreased and availability increased in many of NYC’s toniest shopping areas. “Average asking rents for direct ground-floor leases in Manhattan rose 95% from the first quarter of 2011 to the first quarter of 2014, according to real-estate services firm CBRE Group Inc. Average prices during that period rose to a peak of $1,073 a square foot. Since that high point, average asking rents across the 16 areas tracked by CBRE have decreased 21% to $850 a square foot,” a 4/30 WSJ article reported.

(2) Shorts circling. Short sellers have pounced on the debt and the equity of retail REITs, betting that cash flows could decline as more stores close and as landlords need to spend more to keep their malls looking attractive in order to retain current tenants and replace those that have closed. “The amount of so-called short interest, a measure of short-selling activity, on retail-focused REITs increased to $7.6 billion as of March 6 from $5.6 billion as of the end of December,” the 3/7 WSJ reported, citing data from S3 Partners, a financial analytics firm.

Mall debt is also being shorted. “Losses on securitized mortgages tied to retail property rose to $1.7 billion last year from $1.3 billion in 2015, the only property segment that showed an increase in losses, according to Moody’s Investors Service,” the WSJ article continued. “Spreads on the BBB-rated CMBS deals that have more retail real-estate exposure are widening, according to Trepp LLC, a real-estate data service. Widening spreads indicate the perceived risk of default is rising.”

(3) Seeking alternatives. GGP CEO Sandeep Mathrani said on Monday that the mall owner, formerly known as General Growth Properties, was exploring strategic alternatives, and didn’t rule out a sale of the company. “Mathrani told analysts in a conference call that the combined value of GGP's properties is much higher than its stock market value, one reason it's weighing its options. After hitting a post-recession high of $31.97 last July, the firm's shares have fallen 32 percent, closing April 28 at $21.61, their lowest price in more than three years,” according to a 5/1 article in Crain’s Chicago Business.

GGP reported Q1 funds from operations (FFO) of 36 cents a share, down from 40 cents a year earlier. ”The break-up value is more than the current market capitalization. Business is strong. We will pick a path soon,” said Mathrani, according to the Crain’s report.

Great Disruption: Medallion for Losers. The surge in rides available through Uber and Lyft has been a boon for consumers, but it has been a nightmare for traditional taxi drivers. A NYC taxi medallion recently sold for $241,000, down sharply from 2013 when some medallions sold for more than $1.3 million, reported a 4/5 New York Post article.

The pain was also felt by lenders to those buying medallions at top prices. Capital One’s Q1 report notes that the firm has $655 million of loans in its commercial taxi medallion lending portfolio, down from $873 million a year earlier. The nonperforming loan rate on that portfolio is 52.7%, up from 29.9% in Q1-2016, according to the company’s Q1 earnings presentation. These loans are an extremely small portion of Capital One’s total loan portfolio—0.27%—but they were cited as one of the reasons why charge-offs increased a number of times over the past year. And they do show how disruptive ripple effects can show up in surprising places.

Seinfeld’s Market

May 03, 2017 (Wednesday)

See the pdf and the collection of the individual charts linked below.

(1) Jerry & George pitch a sitcom about nothing. (2) The Trauma of 2008 may be finally wearing off. (3) Counting anxiety attacks. (4) Fully invested bears are less panic prone. (5) Other than earnings rising, nothing much is happening for stock investors to get excited about one way or the other. (6) In case you missed them: Recent commotions in Greece, China, and Washington were largely ignored. (7) Breadth remains bullish. (8) Are the rich paying their fair share of taxes?


Strategy I: Nothing Bad Happening. “The Pitch” is the 43rd episode of the TV sitcom Seinfeld. It is the third episode of the fourth season. It aired on September 16, 1992. In it, NBC executives ask Jerry Seinfeld to pitch them an idea for a TV series. His friend George Costanza decides he can be a sitcom writer and comes up with the idea of “a show about nothing.”

The bull market in stocks since March 2009 has had a fairly simple script too. As a result of the Trauma of 2008, investors have been prone to recurring panic attacks. They feared that something bad was about to happen again, so they sold stocks. When their fears weren’t realized, the selloffs were followed by relief rallies to new cyclical highs and to new record highs since March 28, 2013. Their jitters are understandable given that the S&P 500 plunged 56.8% from October 9, 2007 through March 9, 2009 (Fig. 1).

From 2009 through 2016, there were four major corrections and several significant scares. Joe and I kept track of them and the main events that seemed to cause them. By our count, there were 57 panic attacks from 2009 through 2016, with 2012 being especially anxiety-prone with 12 attacks. (See our S&P 500 Panic Attacks Since 2009.)

From 2010 through 2012, there were recurring fears that the Eurozone might disintegrate. There were Greek debt crises and concerns about bad loans in the Italian banking sector. Investors were greatly relieved when ECB President Mario Draghi pledged during the summer of 2012 to do whatever it takes to defend the Eurozone. China also popped up from time to time as concerns mounted about real estate bubbles, slowing growth, and capital outflows over there. At the end of 2012, fear of a “fiscal cliff” in the US evaporated when a budget deal was struck at the start of 2013 between Democrats and Republicans. I expected it, though I certainly had no idea that it would be worked out between Vice President Joe Biden and Senate Minority Leader Mitch McConnell. In a November 9, 2013 Barron’s interview titled “Lifting the Odds for a Market Melt-Up,” I observed:

“I have met a lot of institutional investors I call ‘fully invested bears’ who all agree this is going to end badly. Now, they are a bit more relaxed, thinking it won’t end badly anytime soon. Investors have anxiety fatigue. I think it’s because we didn’t go over the fiscal cliff. We haven’t had a significant correction since June of last year. We had the fiscal cliff; they raised taxes; then there was the sequester, and then the latest fiscal impasse. And yet the market is at a record high. Investors have learned that any time you get a sell-off, you want to be a buyer. The trick to this bull market has been to avoid getting thrown off.”

There was another nasty selloff at the start of 2016 as two Fed officials warned that the FOMC was likely to follow 2015’s one rate hike at the end of that year with four hikes in 2016. Debbie and I had predicted “one-and-done” for 2015 and again for 2016. Contributing to the selloff in early 2016 was the plunge in the price of oil, which had started on June 20, 2014 (Fig. 2). That triggered a significant widening in the yield spread between high-yield corporate bonds and the US Treasury 10-year bond yield from 2014’s low of 253 basis points on June 23 to a high of 844 basis points on February 11, 2016 (Fig. 3). The widening was led by soaring yields of junk bonds issued by oil companies. There were widespread fears that all this could lead to a recession. In addition, the Chinese currency was depreciating amid signs of accelerating capital outflows from China (Fig. 4).

I remained bullish. In a February 6, 2016 Barron’s interview titled “Yardeni: No U.S. Recession in Sight,” I reiterated my opinions that the Fed was unlikely to hike the federal funds rate more than once and that the secular bull market remained intact. Joe and I argued on Monday, January 25 that “it may be too late to panic” and that the previous “Wednesday’s action might have made capitulation lows in both the stock and oil markets.” Sure enough, the price of a barrel of Brent crude oil did bottom on Wednesday, January 20. The S&P 500 bottomed on February 11, the same day that the high-yield spread peaked. The S&P 500 Energy sector dropped 47.3% from its high on June 23, 2014 to bottom on January 20, 2016 (Fig. 5). During the summer of 2016, we perceived the end of the energy-led earnings recession and projected that the bull would resume his charge.

Following the surprising Brexit vote that summer, the stock market declined for just two days despite lots of gloomy predictions. Just prior to the presidential election, I argued that the rebound in earnings, following the recession in the energy industry, would likely push stock prices higher no matter who won. After Donald Trump did so, I raised my outlook for the S&P 500, expecting that a combination of deregulation and tax cuts would boost earnings. The latest bull market was still going strong in early 2017.

I was interviewed again in the February 4, 2017 issue of Barron’s saying, “It would be a mistake to bet against what President Trump might accomplish on the policy side. I’m giving him the benefit of the doubt, hoping good policies get implemented and bad ones forgotten. We could get substantial tax cuts. All his proposals don’t need to be implemented for the Trump rally to be validated. If you get $1 trillion to $2 trillion coming back from overseas because of a lower tax on repatriated corporate earnings, that would be very powerful in terms of keeping the market up.”

So far, investors are relieved that the bad outcomes predicted by the naysayers about Trump in the White House haven’t happened. The anticipated bullish outcomes are also still mostly on-the-come. Nothing really terrible or wonderful is happening other than that earnings are rising in record-high territory again, as we discussed just yesterday (Fig. 6).

By the way, in case you missed it, you might be relieved to know that Greece and its international creditors yesterday reached a preliminary deal allowing the country to receive yet another round of bailout payments in exchange for promises to raise taxes and to further cut pensions and social spending. Chinese stocks seem to be stabilizing this week, having dropped sharply during the second half of April after officials slammed what they called short-term speculators. This past Sunday evening, congressional leaders reached an agreement on a spending deal that would fund the government through the end of September and avoid a looming shutdown. This weekend, the French are likely to elect a President who is all for the EU and euro. These developments should all be a relief, though no one really worried much about any of them this time. Nothing bad is happening, which is good news for stocks.

Strategy II: Good Breadth. A glance at some of the more widely followed technical indicators of the stock market shows that the bull remains on solid ground because nothing bad is happening. The S&P 500 VIX was down to 10.11 on Monday, the lowest since February 19, 2007 (Fig. 7). It is well correlated with Investors Intelligence weekly reading of bearish sentiment, which remained relatively low at 17.9% at the end of April.

In some ways, it almost seems like a new bull market started in early 2016 once the price of oil bottomed. The percentage of S&P 500 stocks that had positive y/y comparisons plunged to 28% on February 12, 2016 (Fig. 8). This measure of breadth rebounded to 90% on February 10. That was the highest reading since September 5, 2014, just before oil prices plunged. In late April, 77% of the S&P 500 stock prices were still up on a y/y basis.

US Taxes: Fair Shares. Most Americans believe that the wealthy among us don’t pay their fair share of income taxes. Melissa and I have been looking at the data and conclude that the rich are not guilty as charged. In fact, the evidence suggests that top earners pay more than their fair share, actually paying above half of US personal income taxes. Last week, President Donald Trump released guidelines for a tax plan that would lower tax rates for all income levels. Some have characterized the plan as slanted in favor of the top income brackets. For example, look no further than the 4/27 New York Times cover story titled “Tax Overhaul Would Aid Wealthiest.” But of course, an across-the-board tax cut would benefit disproportionately those who pay the bulk of the taxes! Let’s have a look at the data:

(1) Wealthy shares. We track the Internal Revenue Service (IRS) annual data in our Income Taxes Paid By Income Level. US taxpayers with adjusted gross income (AGI) over $200,000 paid 58.3% of total income taxes in 2014 (Fig. 9). That compares to their 34.2% share of total AGI that year (Fig. 10). So top earners paid a higher share of total income taxes than the share of AGI they earned.

Meanwhile, the opposite was true for lower income groups. Taxpayers earning between $100,000 and $200,000 annually paid 21.6% of all income taxes, while their share of total AGI was 24.2%. Those earning under $100,000 paid 20.2% of all income taxes, while their share of AGI was 41.6%.

Similar insights can be gleaned from a June 2016 Congressional Budget Office (CBO) report titled The Distribution of Household Income and Federal Taxes, 2013. During 2013, according to the CBO, households in the highest income quintile paid 69.0% of federal taxes while they received an estimated 52.6% of before-tax income. “In all other quintiles, the share of federal taxes was smaller than the share of before-tax income,” according to the report. In the bottom quintile, households received 5.1% of income and paid 0.8% of taxes. Households in the middle quintile received 13.9% of income and paid 8.9% of taxes.

(2) Net recipients. A public policy blog from the American Enterprise Institute (AEI) did some number-crunching based on the CBO data. According to AEI’s arithmetic, only the two highest income quintiles were actually net tax payers. The average net federal tax rates after government transfers for the highest to lowest quintiles were as follow: 21.8%, 2.5%, -11.2%, -25.7%, and -34.6%. The effective rates for the lowest, second, and middle income quintiles are negative because those groups received more in government benefits (i.e., Social Security, Medicare, Medicaid, unemployment insurance, etc.) than they paid in taxes.

AEI cleverly outlined another way to think about the burden of the “net payer households” in the top income quintile. The average US household in the top income quintile in 2013 paid $57,700 in taxes. But think of it as if they wrote four checks—three in the amounts of $8,800, $12,200, and $7,800, representing the average net transfer payments to a household in the lowest, second, and middle-income quintiles (i.e., the “net recipients”), and a fourth check for the balance of $28,900 that would go directly to the federal government. Considered this way, the highest income quintile is financing the “system of transfer payments” and “funding the operation of the federal government.”

(3) Unfounded perception. Notwithstanding what the data show, 63% of Americans who responded to Gallup’s 2017 Economy and Finance Survey said that upper-income people pay too little in taxes and 48% said that lower-income people pay too much in taxes. To the same question, 51% of respondents said that middle-income people also pay too much in taxes.

Brookings Institution fellow Vanessa Williamson published a book of interviews about how Americans feel about taxation. According to the 3/29 Washington Post, Williamson said: “If you ask people what bothers them most about taxes, the most common answer is that they think … the wealthy aren’t paying their fair share. But people tend to understand this as a problem of loopholes. They think that the reason rich people aren’t paying enough is that they have access to all these special deductions.”

Again, the data tell a different tale. In 2014, taxpayers earning $0 to $50,000 had deductions equivalent to 11.9% of their AGI (Fig. 11). That was almost exactly the same percentage as those earning over $500,000, at 11.6%! The group that benefited most from deductions was the second to lowest income group, earning $50,000 to $100,000 with 32.8% in deductions relative to their AGI.

Rolling Recessions & Recoveries

May 02, 2017 (Tuesday)

See the pdf and the collection of the individual charts linked below.

(1) The long good buy. (2) The oil industry’s rolling recession has come and gone. (3) Texas and North Dakota are not the only oil-producing states. (4) Warehouse clubs, super-stores, and online retailers killing department stores. (5) The auto industry may be next on the disassembly line. (6) Another happy hook for another earnings season. (7) Broad-based earnings recovery. (8) Q1 consumer spending disappointing, but household formation is looking better. (9) Increase in households led by owner-occupiers rather than renters. (10) Record-high standard of living for average American household.


US Economy: A Different Business Cycle. The US economy may be in the midst of a very long economic expansion because it is experiencing rolling recessions now, which reduce the chances of an economy-wide recession in the foreseeable future. A rolling recession is a downturn that hits an industry or sector while the overall economy continues to grow. The oil industry fell into a rolling recession during the mid-1980s when the price of oil fell following the second oil crisis and price shock of 1979. That dragged down the economies of oil-producing states like Texas. Let’s examine today’s rolling recessions:

(1) Energy industry. The oil industry did it again from mid-2014 through early 2016. It fell into a severe recession that coincided with the 76% plunge in the price of oil over this period. Amazingly, the oil-producing states remained remarkably resilient because they are more diversified now than they were during the mid-1980s. That’s evident in the downward trend in initial unemployment claims in the oil-producing states even during the latest oil industry recession (Fig. 1 and Fig. 2).

Most impressive is how rapidly the oil industry restructured its operations and financing to cut costs and shore up profitability. That can be seen in the remarkable roundtrip in the yield spread between high-yield corporate bonds and the US Treasury 10-year bond from 2014’s low of 253bps on June 23 to a high of 844bps on February 11, 2016, back down to 333bps on Friday of last week (Fig. 3). That was mostly due to the roundtrip in oil companies’ junk bond yields.

Also quite remarkable is that US oil field production only declined by 12% during the latest oil recession despite an 80% drop in the US active oil rig count (Fig. 4). Interestingly, the biggest rebound in oil production occurred in recent weeks in oil-producing states other than Texas and North Dakota (Fig. 5)!

(2) Retailing industry. The current rolling recession is hitting the brick-and-mortar retailing industry. Among the general merchandise stores, the department stores have been losing sales to the warehouse clubs and super-stores since the early 1990s (Fig. 6). However, in recent years, they have both lost market share to online retailers, who have doubled their share of total in-store and online “GAFO” sales (i.e., of department-store-type merchandise) from 15.0% during February 2006 to 29.5% during February (Fig. 7). Over this same period, the share of department stores fell from 20.0% to 12.4%, while the share of warehouse clubs and super-stores rose from 22.4% to 25.8%, though it’s been stuck around 26% since 2008. Payroll employment at general merchandise stores peaked at a record high of 3.2 million during October 2016, and is down 90,000 since then through March (Fig. 8).

(3) Auto industry. The auto industry may be next in line for a rolling recession. Motor vehicle sales are down 10% from a cyclical peak of 18.4 million units (saar) at the end of last year to 16.6mu during March (Fig. 9). The immediate problem seems to be that lenders are tightening auto loan terms as delinquencies increase, particularly among subprime auto loans. Exacerbating the problem for lenders is that used car prices continue to decline, with the personal consumption expenditures deflator for used cars down 3.8% over the past six months through March (Fig. 10).

According to the FRB-NY, delinquent auto loans have reached levels not seen in over eight years. Auto loan delinquencies of 30 days or more reached $23.27 billion, the highest since the $23.46 billion registered in Q3-2008. The seriously delinquent fraction of these loans, defined as those at least 90 days past due, reached $8.24 billion. The delinquency level is only at 3.8%, a small fraction of the $1.16 trillion in total outstanding auto loans. But the Fed’s latest survey of senior loan officers showed that they tightened lending terms somewhat during Q4-2016.

US Strategy: Seasonal Earnings Hook. The rolling recession in the oil industry certainly roiled S&P 500 operating earnings, which declined on a y/y basis from Q3-2015 through Q2-2016, based on Thomson Reuters data. Last summer, Joe and I declared that the energy-led earnings recession was over. So far so good: S&P 500 earnings rose 4.2% and 5.9% y/y during Q3- and Q4-2016.

We are starting to see the typical earnings hook during the current earnings season for Q1-2017 (Fig. 11). The blend of actual and estimated earnings numbers was up 11.5% y/y last week versus a low of 9.2% at the start of last month, when the earnings season began (Fig. 12).

Industry analysts currently expect S&P 500 operating earnings to rise 11.1% this year and 12.1% next year (Fig. 13). Next year’s estimate has been remarkably stable since last September around $150. Forward earnings for the S&P 500/400/600 all are at record highs (Fig. 14).

In other words, the energy-led earnings recession has given way to a broad-based earnings recovery. The forward earnings of most of the 11 S&P 500 sectors are at either record highs or cyclical highs (Fig. 15).

US Demography: Prosperous Households. Despite a solid gain in Q1’s real wages and salaries (1.7% saar) and high consumer confidence, the advance in real personal consumption expenditures was very weak (0.3). The weakness in spending was led by outlays on durable goods (down 2.6), particularly on motor vehicles & parts (down 16.1). However, also weak was growth in outlays on nondurable goods (1.5) and services (0.4) (Fig. 16). Even the personal consumption expenditures deflator showed some moderation in consumer inflation, with a gain of 1.8% y/y through March, while the core rate rose by 1.6%.

The good news is that while cyclically low unemployment and solid employment gains haven’t boosted consumer spending much recently, they may be starting to lift household formation, especially among homeowners. During Q1, the number of households increased 1.2 million y/y, led by homeowners, up 854,000, while renters lagged behind with a gain of 365,000 (Fig. 17). That was the best such gain for owner-occupied households since Q3-2006.

Meanwhile, the data Debbie and I calculate to measure the average (rather than the median) standard of living show that American households have never been better off, on average. At or near record highs during March, on a per-household basis, were inflation-adjusted personal income ($124,047, up 1.7% y/y), disposable personal income ($108,654, up 1.5%), and consumption ($98,645, up 1.9%) (Fig. 18).

Hot Money

May 01, 2017 (Monday)

See the pdf and the collection of the individual charts linked below.

(1) Definitive definitions of meltdown and melt-up. (2) The numbers game. (3) Trump’s YUGE tax-cut plan cut from 3½ pages to 1 page. (4) Statutory vs effective corporate rates. (5) In my dreams: 15% tax rate on sole proprietorships. (6) Nervous about sky-high valuations, but even more nervous about missing more gains. (7) Equity ETF bubble continues to inflate. (8) Animal spirits a bit less spirited, but still high given softness in hard data. (9) Stocks’ pep rally led by spirited actual and expected earnings. (10) Movie review: “The Lost City of Z” (- -).


US Strategy I: ‘Yuge’ Cut. In the past, the word “meltdown” was defined as “an accident in a nuclear reactor in which the fuel overheats and melts the reactor core or shielding.” Since the 1987 stock market crash, the word has also been defined as “a disastrous event, especially a rapid fall in share prices.” Of course, stressed humans can sometimes exhibit signs of a meltdown, a phenomenon that can coincide with a meltdown in one’s stock portfolio.

The phrase “melt-up” is unambiguously associated with soaring stock prices. It is defined as “the informal term used to describe markets that experience a rapid rise in valuations due to a stampede of investors anxious not to miss out on a rising trend. Gains caused by melt-ups are usually followed quite quickly by meltdowns.”

On March 7, Joe and I raised our odds of a melt-up from 30% to 40% and our odds of a subsequent meltdown from 10% to 20%. As a result, our odds of a Nirvana scenario (i.e., a leisurely bull market) dropped from 60% to 40%. We did so because we detected that the “animal spirits” unleashed by Trump’s election were driving stock valuations higher. That might turn out to be perfectly okay if the Trump administration succeeds in slashing tax rates, particularly the corporate tax rate. Indeed, Joe and I responded to Trump’s victory by raising our S&P 500 earnings forecast for this year from $129 per share to $142. That led us to raise our 2018 number from $136 to $150. (See YRI S&P 500 Earnings Forecast.)

We also raised our S&P 500 forecast from 2300-2400 to 2400-2500 for the end of this year. If the market gets to the top end of this range by mid-year, we’ll conclude that it is a melt-up, though it might not necessarily be immediately followed by a meltdown if Trump delivers “YUGE” tax cuts. Consider the following:

(1) Corporate tax rate. Trump’s “massive” tax plan was released last week. It wasn’t a plan so much as a one-page outline of goals or discussion points or opening negotiating positions. It was actually just a sketchy update of a previous sketchy three-and-a-half-page outline. They both specifically mention lowering the corporate tax rate to 15% and providing a one-time tax break to stimulate repatriation.

When we raised our earnings and stock price targets, we assumed that the corporate tax rate would be cut significantly. The statutory rate is currently 35%. The effective rate during Q4-2016, according to the National Income and Product Accounts, for all corporations was 23.6% (Fig. 1). For the S&P 500, the effective rate was 27.5% during 2015 (Fig. 2). Trump is aiming to cut the statutory rate to 15%. That would also be the effective rate with all exemptions and deductions eliminated, as they obviously would have to be. So some companies will actually pay more in corporate taxes, while most would pay less.

If the corporate tax cut occurs later this year but isn’t retroactive to 2017, then the impact would remain bullish, since the market shouldn’t care much whether it is implemented this year or next year, in our opinion. If it doesn’t happen at all, the Trump melt-up in stock prices would leave valuations at or near record highs, making the market vulnerable to a meltdown (Fig. 3 and Fig. 4).

(2) Repatriated earnings. Contributing to the melt-up scenario is the possibility that Trump will succeed in lowering the tax rate on repatriated earnings, causing some large fraction of the estimated $2.6 trillion sitting overseas to come back to the US—making America’s valuation multiples even greater if the funds are used by companies mostly to buy back their shares.

(3) Proprietors’ income. Widely discussed but not mentioned in last week’s one-pager was the idea that the 15% rate would apply to so-called “mom-and-pop” businesses, i.e., solely owned companies. The three-and-a-half-pager spelled it out as follows: “This lower tax rate cannot be for big business alone; it needs to help the small businesses that are the true engine of our economy. Right now, freelancers, sole proprietors, unincorporated small businesses and pass-through entities are taxed at the high personal income tax rates. This treatment stifles small businesses. It also stifles tax reform because efforts to reduce loopholes and deductions available to the very rich and special interests end up hitting small businesses and job creators as well. The Trump plan addresses this challenge head on with a new business income tax rate within the personal income tax code that matches the 15% corporate tax rate to help these businesses, entrepreneurs and freelancers grow and prosper.”

That would be a YUGE tax cut for them from the 39.6% rate they pay, which is the top marginal tax rate on personal income. It isn’t widely known that pre-tax proprietors’ income, which is included in personal income, is almost as big as the pre-tax profits of corporations (Fig. 5 and Fig. 6). The problem is that nearly everyone paying more than a 15% tax rate would scramble to reclassify their tax status as sole proprietors. There are ways to write rules that would limit who could pay the lower rate, but the tax code is clearly one of the deepest areas of the swamp and particularly hard to drain.

US Strategy II: Hot Lava. In recent meetings with several of our accounts, I frequently was asked whether our other accounts are bullish or bearish. I observed that they all are nervous about the extremely elevated level of valuations, but they are fully invested. That’s because they are even more nervous about raising cash and missing a continuation of the bull market if Trump succeeds in cutting taxes and repatriating earnings. I pointed out that another reason for the melt-up is the surge in animal spirits visible in equity ETFs data reported last week for March:

(1) Equity ETFs. During March, equity ETFs issued $38 billion in net shares, implying a similar net inflow from investors. From November through March, $199 billion has poured into these funds, and $295 billion over the past 12 months (Fig. 7 and Fig. 8).

(2) Equity mutual funds. Some of those animal spirits came out of equity mutual funds, which lost $4 billion during March, $12 billion since November, and $166 billion over the past year.

In our 4/3 Morning Briefing, we wrote: “So there you have it: The bull may be chasing its own tail. We know that image doesn’t quite jibe with the bull charging ahead, but work with us here. The bull has been on steroids from share buybacks by corporate managers, who have been motivated by somewhat different and more bullish valuation parameters than those that motivate institutional investors, as we have discussed many times before. Most individual investors seemingly swore that they would never return to the stock market after it crashed in 2008 and early 2009. But time heals all wounds, and suddenly some of them may have turned belatedly bullish on stocks after Election Day. Add a buying panic of equity ETFs by individual investors to corporations’ consistent buying of their own shares, and the result may very well be a melt-up.”

US Economy I: Not As Hot. Flipping through our Animal Spirits chart publication, Debbie and I see that the post-election euphoria is easing off a bit but remains elevated. April’s Consumer Optimism Index, which Debbie and I construct by averaging the Consumer Sentiment Index and the Consumer Confidence Index, remains near the previous month’s cyclical high (Fig. 9). There was a drop in the average of the composite indexes of the six regional business surveys during April to 15.2 from a recent high of 21.8 during February (Fig. 10). The average of the new orders indexes fell to 16.0 in April from 24.9 during March. However, both averages remain high, and the average of the six employment indexes rose to 11.6, the highest since July 2014.

On the other hand, the latest batch of hard data is very soft. The Citigroup Economic Surprise Index fell to -4.8% on Friday, down from a recent high of 57.9% on March 15 (Fig. 11). As Debbie discusses below, real GDP rose just 0.7% (saar) during Q1, up only 1.9% y/y (Fig. 12). It’s a bit better-looking excluding government spending with a 2.5% y/y gain. The Employment Cost Index remains subdued, rising 2.3% y/y through Q1, with the wages and salaries component up 2.6% and the benefits component up 1.9% (Fig. 13).

So why are all the stock market bulls in such high spirits? Earnings have recovered nicely from the profits recession that lasted from Q3-2015 through Q2-2016. Industry analysts are currently expecting S&P 500 operating profits to show a gain of 10.3% y/y during Q1, 11.0% during 2017, and 12.1% during 2018. As a result, their forward earnings estimate for the S&P 500 has been rising sharply this year into record-high territory with a current reading of $135.90 per share (Fig. 14). This measure tends to be a very good leading indicator of actual operating earnings over the coming four quarters as long as there is no recession over that period.

US Economy II: Taxing Matters. When Melissa and I learned on Friday, April 21 that President Trump would be releasing his tax reform plan on Wednesday, April 26, we along with many market participants were expecting more details. We all were disappointed at the lack of substance in the one-page outline. However, the breezy format and its vagueness also seem to suggest that the Trump administration is open for discussion on tax matters. The format also speaks to the administration’s goal to streamline the tax code, effectively allowing Americans to be able to do their own taxes on one large index card.

Reading in between the bullet points, it seems that Trump already has moderated some of the aggressive tax agenda he floated on the campaign trail. (Here is the old plan from candidate Trump’s website, and here is the new one.) To get a better understanding of last week’s proposal, let’s refer back to two relevant analyses that we previously reviewed. One is from the Tax Policy Center (TPC) titled: “An Analysis of Donald Trump’s Revised Tax Plan” dated 10/18/16. The other is also from TPC and titled “An Analysis of the House GOP Tax Plan” dated 9/16/16, based on the House GOP’s “A Better Way” tax plan, which was released on 6/24/16. Melissa prepared a one-page table comparing the TPC’s estimates for the two plans.

The plans had lots of overlap. They also had a few significant differences. Trump’s bottom line, according to the TPC’s estimates, would add nearly $6 trillion to the federal debt over the next 10 years, while the House GOP’s proposals would add less than half of that, or $2.5 trillion. Let’s review how Trump’s latest one-pager might change the math:

(1) Corporate tax-rate cut! Trump remains committed to his campaign promise to lower the federal statutory corporate income tax rate to 15%. The GOP had proposed a rate of 20%, which would cost about $500 billion less over 10 years than Trump’s rate according to the TPC’s estimates. Worth noting also is that most Republicans continue to agree that the alternative minimum tax (AMT) should be repealed for businesses and individuals.

(2) Territorial system. The one-pager stated that business reform would include a “[t]erritorial tax system to level the playing field for American companies.” That would mean that US companies would owe US tax only on what they earn domestically. As for profits that were earned overseas by US multinational corporations and were technically never brought back to the US, Trump will call for a low, one-time tax on the $2.6 trillion.

(3) BAT off the table? On January 16, Trump said that he didn’t like the idea of a border adjustment tax (BAT) because it sounded complicated. The latest one-pager ignored the subject. Last Wednesday morning, Treasury Secretary Steve Mnuchin said, "We don't think it works in its current form, and we will have discussions with [House tax writers] about revisions.” Using the GOP’s approach, BAT would generate $1.2 trillion in tax receipts according to the TPC.

(4) Individual rates tweaked. TPC estimated around the same cost of $1.5 trillion for both initial plans to lower tax rates and reduce the tax brackets for individuals. But Trump tweaked the individual income tax rates from his original one-pager to the latest one. It reduced the rate for the lowest income tax bracket to 10% from 12% and increased it for the highest income tax bracket from 33% to 35%. The middle bracket stayed the same at 25%.

Importantly, Trump’s latest one-pager didn’t specify to what income brackets those rates would apply. So it’s impossible to quantify the impact on Trump’s bottom line. In any event, the tweaks could be an attempt to show that Trump is willing to do more for lower-income earners.

(5) Deducting deductions. Also excluded from the one-pager were details on exactly how itemized deductions would be reduced. We expected Trump would be more aggressive on them in order to offset some of the revenues lost from the individual tax rate reductions. Comparing the TPC estimates for Trump’s original approach versus the GOP’s yields a sizable $1.3 trillion difference.

The GOP plan sought to repeal virtually all itemized deductions except for the mortgage interest and charitable contribution. Trump initially proposed capping deductions rather than repealing most of them. According to the latest one-pager, Trump will seek to “protect the home ownership and charitable gift tax deductions.” Does that mean that all other itemized deductions would go? The wording vaguely suggests so. In any event, the one-pager proposes to double the standard deduction, which would greatly reduce the need to itemize for many taxpayers.

By the way, Trump also happened to exclude any reference to repealing personal exemptions, a provision that was included in his campaign proposal and also in the GOP’s plan. That’s significant because the provision would offset the tax receipts lost from increasing the standard deduction. We will have to wait and see whether that’s revisited. We will also have to wait and see whether interest deductions (for individuals with pass-through business income or corporations that opt to expense investments) are disallowed in the final version of the plan, since no indication was given in the one-pager.

(6) Passing over pass-throughs. Trump’s latest one-pager is silent on the treatment of pass-through business income included on individual returns. On April 25, before it was released, the WSJ reported that White House officials said that Trump was planning to seek a top tax rate of 15% on owner-operated businesses. But again, that wasn’t specifically confirmed in the latest official talking points.

Nevertheless, we suspect that pass-through business income is yet another area where the Trump administration might moderate its latest stance. The GOP plan had put a cap on the pass-through business income tax rate at 25% versus Trump’s original 15% proposal. That had contributed to a $1.1 trillion difference in the cost to the government from the two plans.

Movie. “The Lost City of Z” (- -) (link) is a somewhat interesting story about a rather uninteresting British explorer obsessed with finding a lost city in the jungles of Amazonia during the early 1900s. He is a controversial member of the Royal Geographical Society, who is derided for believing in El Dorado, the mythical hidden city of immense wealth. The film is loosely based on the true-life drama of Col. Percival Fawcett, who disappeared during his last foray into the steamy forest on his ill-fated quest. It’s a good movie to catch up on some Zs.

Earnings Boosting Stocks

April 27, 2017 (Thursday)

See the pdf and the collection of the individual charts linked below.

(1) Nasdaq titans breach 6000. (2) Yet Industrials and Materials are leading April run in S&P 500 so far. (3) Beating expectations and raising guidance. (4) Finding more traction in the slippery oil patch. (5) CAT purring with Asian tigers. (6) Solstice: One of Honeywell’s sweet spots. (7) Are Millennials childish or adultish? (8) The basement suburban legend. (9) Education matters. Having children not so much.


Sector Focus: Industrious Industrials. Apple, Facebook, Netflix, and other tech titans helped the Nasdaq breach the 6,000 level for the first time on Tuesday. However, in the month of April so far, Tech has not been the leading sector in the S&P 500. It’s the mundane Materials and Industrials sectors leading the way. A pop in basic metals prices, a surge in US fracking activity, and strong economic activity in Asia have boosted the two basic sectors.

Here’s how the 11 sectors in the S&P 500 have performed in April through Tuesday’s close: Materials (2.4%), Industrials (2.3), Consumer Staples (1.8), Tech (1.8), Consumer Discretionary (1.7), Real Estate (1.4), Utilities (1.3), S&P 500 (1.1), Financials (0.5), Health Care (0.4), Energy (-1.6), and Telecom (-3.3) (Table).

A string of strong earnings reports has been bolstering the performance of Industrials, as many results have beat Street expectations. Just over half (57%) of large-cap Industrials have reported Q1 earnings as of Wednesday morning, and they’ve beaten earnings forecasts by 10.0% and revenue forecasts by 1.4%, according to Joe. Those results are well ahead of the S&P 500’s aggregate surprises of 6.0% above earnings estimates and 0.9% above revenue estimates.

Looking ahead, the news gets even better: With strong Q1 results as a foundation, a number of companies proceeded to push up earnings guidance for 2017. If President Trump manages to lower the corporate tax rate to 15%, investors will have yet another positive development to embrace, as many Industrials have corporate tax rates that are well north of 20%. Let’s take a look at some of the positivity emanating from the Industrials sector in recent days:

(1) Improving oil patch. The price of oil may be far from what the fuel fetched in the heady days at the start of this decade, but it has bounced 87% from its low of $27.88 a barrel on January 20, 2016 to $52.10 recently (Fig. 1). The jump in prices seems to have been just enough to get US frackers to start drilling again. US oil field production has rebounded 10% from its recent low of 8.43 million barrels per day during the week of July 1, 2016 to 9.27mbd through the week of April 21 (Fig. 2). The US Baker Hughes oil rig count has increased to 688 from a low of 316 during May 2016 (Fig. 3). That has led to a bounce off the lows in related hiring and equipment purchases (Fig. 4 and Fig. 5).

Dover has benefitted from the drilling revival. Energy, one of Dover’s four divisions, develops pumps, sensors, and monitoring solutions to boost the efficiency and safety of extracting oil and gas. So more rigs in service is very good news for the company. After reporting Q1 results, Dover boosted its FY earnings guidance to $4.05 to $4.20 a share, up from prior guidance of $3.40 to $3.60 a share. The jump was attributed to the “solid first quarter performance, higher expectations in Energy, and overall strong bookings activity,” explained the Q1 press release. CFO Brad Cerepak said Dover’s energy segment is now expected to grow 20%-23% organically in 2017, thanks to growth in drilling and production and automation businesses. That growth is up seven percentage points compared to the forecast given in the company’s Q4 conference call.

The number of new rigs put to work should continue to increase but at a slower rate, predicted CEO Bob Livingston, according to the Q1 earnings conference call transcript. However, the number of uncompleted wells has been growing in Q1, so well completion activity should pick up, “especially in the second half of the year,” he said. “I think it really is setting this energy segment up well for continued well completion activity into 2018 and perhaps even beyond.” Analysts have increased their 2017 consensus EPS estimate for Dover to $3.98, up from $3.57 a month ago, but that’s still below the company’s new, rosier forecast. Dover’s Q1 tax rate: 25.7%.

Dover is part of the S&P 500 Industrial Machinery index, which has risen 60.4% from the January 20, 2016 low (Fig. 6). The industry is expected to grow revenues by 5.4% over the next 12 months and earnings by 10.1% (Fig. 7). The forward profit margin has improved from a cyclical low of 9.8% at the end of 2015 to a record high of 10.7% (Fig. 8). The shares have priced in much of the good news, with the industry’s forward P/E at 19.2, near the top of the range its traded in over the past 20 odd years (Fig. 9).

(2) Roaring Asian tigers. China’s 7.1% Q1 GDP growth may be inflated by government spending, but that doesn’t mean US companies don’t stand to benefit from it (Fig. 10). The strength in Asia has been accompanied by a 26% rebound in the CRB raw industrials spot price index from a low on November 23, 2015 through Tuesday’s close, which undoubtedly has helped US industrials as well (Fig. 11).

Sales in Asia were a bright spot in Caterpillar’s surprisingly strong Q1 results. Asia/Pacific Q1 sales in Caterpillar’s construction division jumped 23% y/y to $1.1 billion, while sales in Latin America rose 8%; in North America and in Europe/Africa/Middle East, sales fell 7% and 4%, respectively, according to the company’s press release. Likewise, Asia/Pacific sales in Caterpillar’s resource industries division grew 23%, but they slumped 13% in the energy & transportation division.

All in all, Caterpillar reported revenue of $9.8 billion, up from $9.5 billion a year ago, and profits excluding restructuring expenses came in at $1.28 a share, up from 64 cents and well above analysts’ estimate of 63 cents a share. Like Dover, Caterpillar increased its full-year 2017 earnings outlook to $3.75 a share excluding restructuring costs. Its previous outlook, given in January, was for $2.90 a share of earnings. Caterpillar’s Q1 tax rate: 31.1%.

Caterpillar resides in the S&P 500 Construction Machinery & Heavy Trucks stock index, which has jumped 71.2% since January 25, 2016 (Fig. 12). The industry is the fourth-best performer in April among the industries we follow in the S&P 500. Despite its mighty climb, the Construction Machinery & Heavy Trucks index has failed to make a new high for the past seven years and isn’t much higher than where it stood in 2007. The industry’s forward P/E is a lofty 20.7 because forward earnings estimates have fallen for much of the past five years and only began to hook up at the end of last year (Fig. 13). If industry revenues revive, there’s much room for improvement, as forward profit margins are 6.8%—well off the peak margin level topping 9.5% in 2012 (Fig. 14).

(3) Beating estimates. On their face, Q1 results at Honeywell weren’t fabulous, with reported sales flat y/y. However, excluding the impact of foreign exchange, acquisitions, and divestitures, sales rose 2% y/y. Add in margin expansion and a slightly reduced share count, and adjusted EPS rose 11% to $1.66.

The results beat Honeywell’s January guidance by two cents, and the company increased the low end of its 2017 guidance by five cents to $6.90 to $7.10 a share. The upshot: Honeywell shares hit a record high on Monday.

Strong results came from Honeywell’s performance materials and technologies division, where sales rose 5% and margins expanded by 260bps. The materials division was helped by increasing sales of Solstice, which Honeywell developed to replace hydrofluorocarbons, a gas that is believed to contribute to global warming.

The 3% jump in adjusted sales in the safety and productivity solutions group was aided by a 20% jump at Intelligrated, which Honeywell purchased for $1.5 billion last August. The company provides software, equipment, and services to fulfillment centers used by retailers, manufacturers, and logistics providers. Its sales were predominately in the US, and Honeywell aims to help the company expand sales internationally. Honeywell’s Q1 tax rate: 22.7%.

Honeywell is a member of the S&P 500 Aerospace & Defense index, which has outpaced the broader market and risen 3.5% in April (Fig. 15). The industry is expected to see a revenue jump of 2.7% over the next 12 months and an earnings gain of 7.4% (Fig. 16). Investors are optimistic that President Trump will successfully push through a $54 billion increase in defense spending. Like many industries, however, Aerospace & Defense’s forward P/E, at 18.6, has risen to close to the top of its 20-year range (Fig. 17).

Millennials: Adultish. Many Millennials, particularly men, have been unfairly belittled. According to the popular stereotype, they are living in the finished basements of their parents’ homes playing video games while snacking on Cheetos. But is this an accurate depiction of the typical Millennial? Today’s young adults might be delaying many of the milestones that previously defined adulthood. However, many of them are also redefining what it means to be a responsible adult, as Melissa discussed on Monday. Today, she reviews highlights of the Census Bureau’s April report titled The Changing Economics and Demographics of Young Adulthood: 1975-2016. Defending her maligned cohort, she concludes that most Millennials are not as sorry a bunch as some might think. Consider the following:

(1) Living at home. Census reports that “1 in 3 young people, or about 24 million 18- to 34-year-olds, lived in their parents’ home in 2015,” according to Current Population Survey (CPS) data. Buried in the footnotes, however, there is an important disclaimer: “The CPS counts college students living in dormitories as if they were living in their parents’ home. As a result, the number of young adults residing in their parents’ home is higher than it would be otherwise, especially for 18- to 24-year-olds, who are more likely to be living in college housing.” Of the 18- to 24-year-olds living at home, more than half, or 53.6%, of them is enrolled in school. Further, nearly two-thirds, or 67.3% of them, is employed or actively seeking a job. In other words, most younger Millennials living with their parents are not really living at home at all!

Neither are older Millennials. Nearly three-quarters of the 25- to 34-year-olds supposedly living at home is enrolled in school or working. It’s the remaining one-quarter of older Millennials living at home whose economic contribution and motivation are questionable. However, the data show that 21.4% of this smaller cohort has at least one child and nearly 30.0% has a disability. Comparatively, of the three-quarters enrolled in school or working, just 17.5% has a child and only 5.0% has a disability. So it could be that a sizable portion of the older Millennials living at home is doing so because they are legitimately struggling. Nevertheless, those who are living at home and also not in school or working make up just a small subset of the Millennials population at large and are hardly representative of the generation.

(2) Working women. The image of the idle male Millennial wasting the day away might be a suburban legend. Young women indeed have surpassed young men in terms of educational attainment today. “There are now more young women than young men with a college degree, whereas in 1975 educational attainment among young men outpaced that of women,” according to the report.

On the other hand, “more young people are working today and have a full-time job that employs them year-round” than in 1975. That’s largely because lots more young women stayed home to take care of the kids during previous generations than do now. The share of employed young women has risen from under one-half to over two-thirds over the same time period. Meanwhile, the share of employed men aged 25- to 34- is “about the same today as it was in 1975.” So women have done better in terms of employment over the generations, but men aren’t worse off.

(3) Adult milestones. Many Baby Boomers were eager to leave the nest, buy homes, and start their families. Today’s young adults are more eager to achieve their own personal goals before committing to a relationship or children. Today, 62.0% of adults surveyed says that finishing school is extremely important to becoming an adult, according to the report. “Over half of Americans believe that marrying and having children are not very important in order to become an adult.” Back in the 1970s, 8 in 10 people were married by age 30. Today, that statistic doesn’t occur until age 45. According to research cited in the report, less than 10% of young adults thinks that having kids is necessary to being happy in life. Further, most of those living at home are happy with that arrangement and their family life in general.

Brain Drain

April 26, 2017 (Wednesday)

See the pdf and the collection of the individual charts linked below.

(1) Turing Test. (2) Tech’s latest Great Disruption: From brawn to brain. (3) Robots are easy-going, but will AI make them cranky? (4) AI at YRI. (5) Head in the Cloud. (6) The sinister goal of knowledge workers. (7) IT+R&D spending up from 26% to 44% of capital spending since 1981. (8) Consumers are spending more than business on computers, really. (9) Swamp vs Valley people. (10) The Great Disruptors want to read your mind with a quantum computer, while you are cruising in an electric flying car. (11) When taxing robots, beware of the one called “Spartacus.”


Technology I: From Brawn to Brain. The movie “Ex Machina” (2014) is in some ways the sequel to “The Imitation Game” (2014), which was about British mathematician Alan Turing, who cracked the Nazi code with a computer he designed. He posited the “Turing Test” of a machine’s ability to exhibit intelligent behavior equivalent to, or indistinguishable from, that of a human. In “Ex Machina,” a programmer is selected by his boss—a Google-type of entrepreneur—to judge whether a beautiful female robot he created with artificial intelligence can pass the test.

In the past, technology disrupted animal and manual labor. It speeded up activities that were too slow when done by horses, like pulling a plow or a stagecoach. It automated activities that required lots of workers. Assembly lines required fewer workers, and increased their productivity. The focus was on brawn. Today, the “Great Disruption” is increasingly about technology doing what the brain can do.

Robots with artificial intelligence are coming. Should we laugh out loud—happy that they will do lots of our dirty work? Or should we cry out loud—fearing that they will take away all of our jobs? Perhaps the most significant disruptive force at the forefront of technological innovation is the meeting of machines and hyper-connected systems. “Smart machines,” such as robots and self-driving cars, are computing systems that can make autonomous decisions. Several industries are on the verge of reaching, or have already reached, the point where it’s cheaper to employ robots than humans.

Robots ultimately may make better employees than humans in a lot of ways. They don’t need to take bio breaks, eat lunch, go home to see their families, or sleep. And you won’t find them making trips to the water cooler, getting involved in office politics, or otherwise losing focus from assigned tasks. They can work anywhere and won’t hesitate to relocate. They can operate in dangerous environments without requiring employers to worry about government regulations and lawsuits. They won’t care, complain, or get frustrated unless they’re programmed to do so—or learn to on their own.

At YRI, our experience with technology suggests that the government may be underestimating the productivity of technology. Many years ago, we started to maintain our huge library of chart publications on an off-site server that we owned and was maintained by an outsourced vendor. The system was buggy and often needed to be “rebooted” by the local operator, causing us frequent downtime and lots of agita. We used only a small fraction of the capacity of the servers during the day and not much at night.

In March 2006, Amazon officially launched Amazon Web Services (AWS). We signed up in 2008 for this fantastic Cloud service, which has been remarkably reliable and very cost effective for us. When we need more computing and storage power, we turn up the dial for more resources. AWS is running its servers much more efficiently and productively than we and everyone else had done at the “server farms.” No more downtime and no more agita!

We don’t have any plans to buy robots. However, our current system has incorporated crude Artificial Intelligence for many years. Anytime that our data vendors update any series we use, the system automatically updates all the charts that include that series and refreshes the publications on our website with those updated charts.

Technology II: By the Numbers. Will an increase in knowledge-based employment offset the job losses attributable to the Great Disruption? Many knowledge workers are tasked with the job of eliminating the jobs of other workers, including well educated ones! They are constantly looking for ways to use technology to increase productivity. Many of them have their heads in the Internet Cloud and other technologies, and are using them to produce more goods and services with less labor. They are doing so in manufacturing, services, and even in information technology. Consider the following:

(1) Employment. Payroll employment in all information industries peaked at a record 3.7 million during March 2001. It dropped to 2.7 million during mid-2010, and has remained around that level since then (Fig. 1).

(2) Real knowledge capital. The real GDP report for Q4-2016 showed that spending on “knowledge” capital is in record-high territory for information processing equipment ($352.3bn, saar), software ($352.4bn), and R&D ($288.3bn) (Fig. 2). The total of these three was a record $993.0 billion, up 3.4% y/y, 96% since Q4-1999, and 52% since Q4-2005. Pre-Y2K, from Q1-1995 through Q4-1999, this total rose 93%.

(3) Current-dollar IT capital. In current dollars, the three categories listed above summed to $1.01 trillion (saar) during Q4, the highest on record (Fig. 3). Aggregate knowledge-based capital spending accounted for 43.5% of nominal nonresidential investment during Q4 (Fig. 4). That’s up from 25.6% during Q3-1981, when the first IBM PC was introduced.

(4) More bang-per-buck. I reckon that there is more bang per buck in knowledge-based capital spending today than in the past, as evidenced by the deflationary trend in the prices of high-tech hardware and software (Fig. 5). Since Q1-1980, the price deflators for information processing equipment and software are down 78% and 31%.

(5) Business vs consumer spending. As I was sifting through the GDP data on high-tech spending, I was surprised to see that on an inflation-adjusted basis consumers have been spending more than business on hardware since Q4-2014 (Fig. 6). Prior to Y2K, real capital spending on IT equipment rose 506% from Q1-1995 through Q4-1999. During the next five years through Q4-2005, it rose 87%. The slowdown was undoubtedly attributable to all the purchases in anticipation of Y2K. Since Q4-2005 through Q4-2016, it is up only 52%. Might this reflect the impact of AWS and other Cloud vendors allowing IT users to rent rather than to own hardware? I think so. Meanwhile, real spending by consumers on computers and peripheral equipment remains on a relatively steep ascending slope.

On the other hand, real capital spending on software continues to significantly exceed real consumer spending on software, which isn’t a surprise (Fig. 7).

In current dollars, during Q4-2016, business still spent more than consumers on hardware, i.e., $74 billion vs $64 billion, both saar (Fig. 8). However, the former has been on a slight downward trend since Y2K passed without incident, while the latter remains on an upward trend. In current dollars (as in real ones), software spending by businesses well exceeded consumer spending during Q4-2016, i.e., $344 billion vs $53 billion, both saar.

Technology III: The Great Disruptors. While the headlines are giving lots of attention to all the swamp people in Washington, DC, there’s lots of important things happening that the rest of us are doing every day. Much of the drama coming out of our nation’s capital was hardwired by the Founders, who designed an exceptional political system of checks and balances. It often leads to gridlock with lots of screaming on both sides of the aisle, as the Founders intended. That means that despite all the noise, not much gets done in Washington, and change tends to be relatively slow.

The same cannot be said about the Silicon Valley people. They live and breathe creative destruction. Change is what they do for a living. They were born to disrupt our lives, most often in good ways. However, their innovations can also have adverse consequences including the use of the Internet by terrorists and social media bullies to bully other kids. Brick-and-mortar retailing is getting clobbered by online vendors that now account for a record $526 billion in GAFO sales, or a whopping 29.5% of all GAFO sales (Fig. 9 and Fig. 10).

On the other hand, thanks to the Valley people, Yardeni Research is thriving. The fracking revolution in the oil patch owes much to the IT revolution. The greatest disruptions are yet to come. Amazon continues to clobber traditional retailing by offering the same prices as at the malls, but with free delivery subsidized by all the cash flowing from AWS. Uber may be hurting car sales as more young and elderly people opt to use the remarkably efficient service rather than own a car. Tesla will soon sell a mid-priced electric car. Such vehicles could put dealers out of business if more electric cars are sold online. Service departments could also go out of business if the mechanic can come to your house to replace a defective electric motor or battery. So what have the Great Disruptors been up to recently?

(1) Amazon. On March 31, 2015, Amazon introduced its Dash Buttons. The small, thumb-sized devices let customers reorder paper towels, laundry detergent, and toilet paper by merely clicking a button. Two years later, Dash is among Amazon’s fastest-growing services. Orders using Dash Buttons are placed more than four times a minute compared to once a minute a year ago, according to Amazon. Amazon told Fortune that many brands—such as Folgers Coffee, Peet’s Coffee, Pepperidge Farm, and Ziploc—are seeing more than half of their orders placed via Dash Button devices. Household items are particularly popular. To date, customers have placed millions of orders with Dash Buttons, according to Amazon. Overall, Amazon now has more than 300 Dash Buttons for products.

(2) Apple. Apple is hiring former NASA and Tesla employees as part of a self-driving car initiative, per several reports. Although Apple has declined to comment about its plans for self-driving cars, news reports over the last few years have suggested that the company is working on such technology. Unknown is whether Apple is developing its own car. More likely is that Apple is focused on technology that it could sell to automakers to put into their self-driving cars.

(3) Facebook. At last week’s Facebook F8 conference in San Jose, California, CEO Mark Zuckerberg updated his ambitious 10-year plan for the company, first revealed in April 2016. Business Insider reported: “On Facebook’s planet of 2026, the entire world has internet access, with many people likely getting it through, Facebook’s connectivity arm. Zuckerberg reiterated last week that the company was working on smart glasses that would look like your everyday Warby Parkers. And underpinning all of this is artificial intelligence that Facebook says will be good enough that we can talk to computers as easily as chatting with humans. …

“In fact, Michael Abrash, the chief scientist of Facebook-owned Oculus, said last week that we could be just five years away from a point where augmented-reality glasses become good enough to go mainstream. And Facebook is now developing technology that would let you ‘type’ with your brain, meaning you’d type, point, and click by thinking at your smart glasses. Facebook is giving us a glimpse of this with the Camera Effects platform, making your phone into an AR device.”

Elon Musk, the SpaceX and Tesla CEO, gave more details about NeuraLink Corp, his venture to merge the brain with artificial intelligence, in a Wait But Why explainer. In four years, Musk hopes to have a brain-machine interface. Cool, then anyone can hack into your brain and download it … the ultimate brain drain!

(4) Google. According to a 4/21 article in MIT Technology Review, a research group at Google is working on building amazingly powerful computer chips that manipulate data using the quirks of quantum physics. By the end of this year, the team will build a device that achieves “quantum supremacy,” meaning it can perform a particular calculation that’s beyond the reach of any conventional computer. Proof will come from a kind of drag race between Google’s chip and one of the world’s largest supercomputers.

(5) Tesla. Later this year, Tesla will start selling its Model 3, which the company says achieves 215 miles of range per charge while starting at only $35,000 before incentives. These cars will be powered by batteries from the Gigafactory, a huge factory Tesla has constructed in the Nevada desert. If the car is a hit, the Gigafactory will ensure Tesla has plenty of batteries to meet demand for this relatively affordable mass-market vehicle. Other car companies would have to scramble—not only to design a similar vehicle but also to find suppliers for yet more batteries.

(6) Uber. Yesterday, Uber started hosting its first “Elevate Summit,” a three-day conference in Dallas on vertical take-off and landing (VTOL) aircraft, i.e., “flying cars.” Its focus is on the possibilities and pitfalls in developing an on-demand airborne ride-hailing service. Last October, the company released a white paper that envisioned a flying taxi service as a network of lightweight, electric aircraft that take off and land vertically from preexisting urban heliports and skyscraper rooftops. A few months later, Uber hired Mark Moore, the former chief technologist for on-demand mobility at NASA’s Langley Research Center and one of the leading thinkers on VTOL aviation.

Technology IV: Taxing Robots. The robots are coming, that’s for sure. Less certain is whether they will make lots of humans unemployable or lead to the creation of better jobs, as technological innovation has done in the past. Pessimistic futurists are already chattering about ways to support all the human economic zombies. Consider the following:

(1) Fewer jobs? A recent tweet from self-made billionaire Mark Cuban received a lot of press: “Automation is going to cause unemployment and we need to prepare for it.” Attached to his tweet was a 2/18 article titled “A warning from Bill Gates, Elon Musk, and Stephen Hawking.” Melissa and I explored various studies on just how many human jobs could be lost to machines by 2025 in our 12/21/15 Morning Briefing. The bottom line is that no one knows, but automation is likely to hurt employment on balance.

(2) Tax robots? “Taxing robots is Bill Gates’s dumbest idea yet” was the title of a 2/22 MarketWatch article. Gates said that there will need to be taxes related to robot automation in a 2/17 interview with Quartz. Because “you can’t just give up that income tax” on a human worker that’s been replaced by a robot. Especially given that more people might need support from social programs once the robots take over. Gates isn’t alone.

A 5/31/16 draft report from the European Parliament’s committee on legal affairs reads like science fiction. It stated that “consideration should be given to the possible need to introduce corporate reporting requirements on the extent and proportion of the contribution of robotics and AI to the economic results of a company for the purpose of taxation.”

But really, “why pick on robots?” as Lawrence Summers asked in a 3/5 opinion piece for the FT. We only have more questions to add to the mix: How would a robot tax even work? How much should the tax be? Should there be a flat tax on owners of robot capital? Or should the tax be graduated based on how much labor-saving technology is implemented? Further, should there be a separate tax on robots versus labor-saving automation? How would companies even begin to separate the two?

(3) Define “robot.” The word “robots,” or “bots” for short, has become synonymous with many automated labor-saving technologies run on software programs rather than hardwired machinery. In a 2/24 Wired article, Andy Rubin, the creator of Android (which was purchased by Google), observed that a robot must meet three qualifications: It must sense, it must compute, and it must actuate. The definition of a robot will continue to evolve as robots do. That may make it harder to tax them.

(4) Speed bumps. Gates thinks some sort of robot tax would be helpful to “slow down the speed” of robotic adoption, thereby allowing for policy adjustments as human workers are displaced. In response to Gates, a 2/25 article in The Economist observed that a robot is a form of capital investment. Taxing capital investments is not typically a good idea. It would discourage companies from innovating! Besides, how would Gates feel about an additional robotics tax on software?

(5) Subsidize humans? If robots are taxed, should the revenues fund a Universal Basic Income (UBI), where everyone would receive a small stipend to cover basic needs? The European Parliament report cited above added that the Committee “takes the view that in the light of the possible effects on the labour market of robotics and AI a general basic income should be seriously considered.” Cuban told Business Insider in late February that UBI was a “slippery slope” that raises hard-to-resolve questions, like: “Should I get UBI? Who doesn’t get it? How much? Who pays for it? How?” These questions will be pondered by lots of brains in the years to come, no doubt including artificial ones.

Minimalist Millennials

April 25, 2017 (Tuesday)

See the pdf and the collection of the individual charts linked below.

(1) Millennials are different than Baby Boomers. (2) Not rushing to get married. (3) Baby dearth. (4) Turn-ons and turn-offs. (5) Still renting. (6) Our in-house Millennial. (7) Cool experiences. (8) Lifestyles-of-the-rich-and-famous is so yesterday. (9) Cars are just cars. (10) Habitats for Hobbits. (11) An alternative way to be an adult.


US Demography I: By the Numbers. During most of my career, my demographic work focused on the impact of the Baby Boom cohort on the economy. However, in recent years, the Millennials have become just as important. They are the generation that is replacing the Baby Boomers as they retire. I reckon that the Millennials were born between 1981 and 1996, making them 20 to 35 years old during 2016 (Fig. 1). I figure they are mostly out of college and have entered the labor force, and are mostly working.

What they aren’t doing is rushing to get married and have kids. In the US, the median age at first marriage during 2015 was 29.2 years old for males, up from 23.5 years old during 1975. For women, this matrimonial age rose from 21.1 years old to 27.1 years old over this period (Fig. 2). Data compiled by the National Center for Health Statistics show that the average age of first-time mothers rose from 24.9 years old in 2000 to 26.3 years old in 2014. No wonder that the general fertility rate has been flat-lining at a record low since the mid-1970s (Fig. 3).

These demographic trends are likely to weigh on economic growth, though much depends on whether and when more Millennials might decide to marry, have kids, and buy houses. My hunch is that more will once they turn 30 years old. The oldest of them started to do so in 2011 (at the same time as the oldest Baby Boomers turned 65 years old), and will continue to do so until 2026 when the youngest Millennials will turn 30.

I can understand why the Millennials might be less inclined to be rearing a family. When I was growing up as a Baby Boomer, we tended to marry our high-school or college sweethearts. That was likely to be as good as it gets. Now thanks to the Internet and social media tools such as Tinder and Cupid, young adults can hook up until they get bored and move on to another “friend with benefits.” So couples have to fall truly in love and want to have kids to get married these days. Raising kids is certainly much more expensive than in the past given record-high home prices and soaring college tuition costs.

To monitor the Millennials’ demographic impact on the economy, Melissa and I track the quarterly household formations report compiled by the Census Bureau. It also shows whether the new households are renters or homeowners. Needless to say, the decision to rent or to buy a home is also affected by current and expected economic conditions. When people are doing well and are optimistic about the future, home buying is likely to be more appealing than during bad times, when confidence is depressed and renting seems like a safer option. The level of mortgage interest rates and the prices of homes, as well as the expected appreciation of those prices, are further considerations in the rent-versus-own decision.

The data, which is available since the end of 1956, show that household formation was brisk during the mid-2000s (Fig. 4). Most of the new households bought homes rather than rented them (Fig. 5). When the housing bubble burst starting in 2007, and as mortgages became much harder to obtain, household formation slowed dramatically through mid-2014, with the number of homeowners declining, while renting became increasingly popular. By the second half of 2014, household formation rebounded, though renting continued significantly to outpace owning. The percentage of households renting rather than owning a housing unit remained high at 36.3% during 2016, up from a record low of 30.8% during 2004 (Fig. 6).

Anecdotal evidence suggests that many Millennials prefer to rent in urban areas rather than to own a home in the suburbs. In addition, the Millennials don’t view homes as a safe asset after seeing the housing bubble burst. Those who would like to buy a home are facing much tougher lending standards following the financial crisis of 2008. So it’s no wonder that many of the Millennials, along with other potential first-time homebuyers, aren’t buying homes but are renting instead.

The percentage of homeownership among all households dropped from a record high of 69.2% during Q4-2004 to 62.9% during Q2-2016, the lowest since the start of the data in Q1-1965 (Fig. 7). Ownership rates have dropped for all age groups, but the biggest declines since their 2004 peaks have been for those under 35 years old (down from 43.6% to 34.1%) and those between 35-44 years old (down from 70.0% to 58.3%) (Fig. 8).

Contributing to the renter boom is the growing number of people who are single rather than married. Since the start of 2014, for the first time ever in the US, the number of singles in the working-age population—which includes everyone 16 years of age or older—equaled the number of married people (Fig. 9). That’s up from 42% 30 years ago to 50% now (Fig. 10). At the end of 2016, 30.5% of the working-age population was never married (up from 22.1% in 1976) and 19.5% was divorced, separated, or widowed (up from 15.3% in 1976) (Fig. 11 and Fig. 12). The former includes lots of Millennials, while the latter includes lots of Baby Boomers. There are more singles because Millennials are getting married later in life, while the Baby Boomers are living longer and losing their spouses along the way for one reason or another.

US Demography II: Alternative Adulthood. Melissa happens to be our in-house Millennial. She is a senior member of this cohort, and has been staying current on her peers. She reports that while many Millennials still desire the American dream of a family in their own house, lots of them also have embraced a minimalist mindset. It’s not that they don’t want to own anything, but rather want only stuff that they actually need—no frills and trophies for them! Many of them would rather enjoy a cool experience that they can brag about on Instagram than buy the newest hot sneakers or handbag.

Many Millennials were children during the 1980s and 1990s, growing up with materialistic parents who indulged in flashy lifestyles. When they were in their teens and early twenties, many watched their parents struggle financially following the Great Recession. They don’t want to make the same mistakes that their parents did. Besides, many Millennials are saddled with student loans and have struggled to find good-paying entry-level jobs after graduating from school.

Living a modest lifestyle takes less effort and is more appealing to lots of Millennials than the lavish lifestyles of the rich and famous. The widespread view is that the Millennials have delayed adulthood. That’s probably wrong. Instead, many of them simply are embracing their own version of what it takes to be a financially responsible adult. Consider the following:

(1) Prius over Porsche. “Millennials have produced plenty of anxiety for automakers. As the stereotype goes, entitled young adults would prefer to hail an Uber, take public transportation or even hitch a ride from Mom instead of driving; an unusually large number of young millennials haven’t even bothered to get a driver’s license,” according to the caricature laid out by a 12/23/16 LA Times article.

Recent data, however, present a more nuanced view of Millennials’ attitudes toward cars. Many of them aren’t rejecting car ownership, but rather delaying it. In a study last year, JD Power’s Power information network reported that the share of Millennials in the new car market jumped to 28% from just 17% in 2010. Likewise, a 2015 study found that 35% of Millennials plan to purchase a vehicle in the next 12 months compared to 25% of total US adults.

One theory for why Millennials put off car buying is that cars don’t represent an “aspirational” purchase as for many of their parents. The key to Millennials’ purchase satisfaction is value for money, observed the press release for the JD Power’s study. Instead of viewing a fancy luxury car as a status symbol as generations before them had, many Millennials have more basic aspirations.

“Millennials tend to view cars as more of a practical need than an emotional want,” noted Many millennials will buy a good value car just when it becomes necessary to own one. According to a 32-year-old San Diego real estate agent quoted in the LA Times article: “I see a lot of people my age have affordable, reliable cars. I bought my Prius because I wanted to get great gas mileage.”

Another nationwide study, commissioned by the personal finance blog NerdWallet last year, showed that young adults think that the costs of owning a car, including maintenance and insurance, are a drag. But they don’t regret buying a car after the fact. However, they are taking on less auto debt as their student loan debt has risen over the years.

(2) Cottage over mansion. The tiny house movement is particularly popular among those under the age of 35 and Baby Boomers, observed a 2016 USA Today article, which highlighted an informal social media survey that showed nearly 40% of respondents had lived in dwellings less than 500 square feet in size at some point. While there were just an estimated 10,000 tiny houses in the US last year, the mini-movement itself speaks to the Millennials’ preference toward minimalism.

“Those taking part in the budding movement often embrace the lifestyle because it allows them to leave a smaller environmental footprint, live mortgage free, and because the houses are often on wheels, to pick up and pursue a new career or passion without worrying about having to sell or find a new home,” explained the article, which was titled “Recession-scarred Millennials fuel growing interest in tiny homes.”

(3) Experiences over stuff. This month, the US Census Bureau released a report titled The Changing Economics and Demographics of Young Adulthood: 1975-2016. Most of the statistics included within the report aren’t new news. Nevertheless, the report’s conclusion supports the case that many young adults are making responsible adult-like decisions; they just aren’t embracing the traditional notions of adulthood held by previous generations.

The report concludes: “That young people wait to settle down and start families tells us about their behavior, but not how they feel about their experiences. More than half of all Americans June 18, 2018 believe that getting married and having children are not important to becoming an adult. In contrast, more than 9 in 10 Americans believe that finishing school and being gainfully employed are important milestones of adulthood.” Most Americans today believe that financial security should come well before marriage.

The report continued: “The complexity of the pathways to adulthood extends to economic conditions, as well. Today, more young people work full-time and have a college degree than their peers did in 1975, but fewer own their home. Whereas young women have made economic gains, some young men are falling behind … Taken together, the changing demographic and economic experiences of young adults reveal a period of adulthood that has grown more complex since 1975, a period of changing roles and new transitions as young people redefine what it means to become adults.”

In our view, as notions of what it means to be an adult have expanded to include more variations, many young adults have chosen to live more simply, owning less stuff and shoring up their finances by focusing on value.

Now, Voyager

April 24, 2017 (Monday)

See the pdf and the collection of the individual charts linked below.

(1) Team tours abroad. (2) Voyager now on Google Earth. (3) France: The more things change, the more they stay the same. (4) Commodity prices still trending higher. (5) High PMIs. (6) French and German shoppers are shopping. (7) Inflation disinflating again? (8) Overseas revenues and earnings growth rates rising. (9) Asian exports data showing widespread strength. (10) IMF raising rather than lowering growth outlook, for a change. (11) Bette Davis assesses the global economy.


Global Economy: More Postcards. To avoid getting cabin fever and becoming too US-centric, our team at YRI goes on regular “team tours” around the world to see the sights. These are virtual tours focusing mostly on two-dimensional charts of global economic indicators. Only one of our colleagues, Mali, actually lives overseas for a stretch every year, spending a few months with her family and friends in Spain. Also, I go abroad on a regular basis to see our accounts. My family and I are looking forward to a 10-day vacation at the end of this year in Vietnam, Cambodia, and Thailand. Since we are a virtual company, operating solely over the Internet, we all work from home. That could be in Timbuktu if we wanted, assuming there is a good Wi-Fi connection there.

Soon with the aid of VR goggles, we all will be able to roam around the globe virtually while in reality walking around our air-conditioned living rooms. Google just released a new version of Google Earth, which includes a link to Voyager, a collection of interactive guided tours. Forbes explains:

“The Voyages are organized under the headings Travel, Nature, Culture, History and Editor’s Picks. Each one takes you to different places and tells you about what’s going on there using slideshows, videos and brief text panels Google calls Knowledge Cards. You can go to Gombe National Park in Tanzania and hear from Jane Goodall about her work with chimpanzees, tour natural habitats with the BBC or visit locations that figure in the life and works of Charles Dickens or Ernest Hemingway. There are more than 50 Voyages to choose from with Google promising more in the future.” How cool is that? It could be even cooler with VR goggles once they figure out how to stop the nausea reaction.

Since late last year, we’ve liked what we’ve been seeing abroad, especially in emerging economies. The latest batch of data out of China was certainly surprisingly strong, though that isn’t surprising given that the country’s central planners still command the economy over there as they see fit. The EU’s economy also has impressed us. Like everyone else, we’ve been concerned about the region’s political drift toward anti-EU populism that could lead to the destabilizing disintegration of the EU and/or the Eurozone. However, that risk seems to have dissipated somewhat given the recent successes of the establishment parties that remain in power in Spain and the Netherlands. Italy continues to be ungovernable—so what else is new?—but still committed to the EU.

What about France? Following the weekend’s first-round presidential election, we expect that pro-EU centrist Emmanuel Macron, who was a member of the Socialist Party from 2006-2009, will beat National Front leader Marine Le Pen during the second-round contest scheduled for May 7. As they say in French, “Plus les choses changent, plus elles restent les mêmes.

Let’s take a tour of the latest developments around the world, shall we?

(1) Commodity prices. The CRB raw industrials spot price index dropped last week to the lowest level since January 9 (Fig. 1). However, it’s down only 2.4% from its recent high on March 17. It is still up 26.2% from its most recent low near the end of 2015. In the big picture, this index remains on a solid uptrend (Fig. 2). However, it is a bit odd to see this recent weakness coinciding with all the better-than-expected data coming out of China last week.

(2) PMIs & production. There shouldn’t be much more downside in commodity prices given the strength in April’s flash M-PMIs for Germany and France, as Debbie discusses below (Fig. 3 and Fig. 4). The composite PMI (C-PMI) for Germany edged down to 56.3 from 57.1 last month. That’s still a relatively high level, with Germany’s M-PMI remaining very elevated at 58.2 versus 58.3 during March. France’s C-PMI jumped to 57.4 from 56.8, with lots of strength in the M-PMI (55.1) and NM-PMI (57.7). Japan’s M-PMI also remained solid at 52.8 this month (Fig. 5).

On the other hand, the flash M-PMI for the US continued to edge down from a recent high of 55.0 during January to 52.8 this month (Fig. 6). The NM-PMI has also come down from a recent high of 55.6 during January to 52.5 this month. Nevertheless, these are all solid readings for the US. The average of the business conditions indexes from the NY and Philly Fed district surveys declined to 13.6 this month from a recent high of 31.0 during February, as Debbie discusses below. Looks like some of the “animal spirits” unleashed by Trump’s election may be going back into their cages!

On yet another hand, industrial production indexes remain on uptrends in the US, Canada, the Eurozone, and Japan (Fig. 7). Even Brazil’s output seems to have bottomed, while Mexico’s remains stalled at a record high despite Trumps tough talk on US trade with our southern neighbor. Most impressive is that industrial production among the 34 members of the OECD rose 1.2% y/y during January after having stalled during 2015 and the first half of 2016 (Fig. 8). It is now almost at the previous record high during January 2008.

(3) Retail and auto sales. In the Eurozone, the volume of retail sales (excluding motor vehicles) rose 0.7% m/m and 1.8% y/y during February to a new record high (Fig. 9). Both French and German shoppers are doing lots of shopping, with their volume indexes up 2.8% and 1.6% y/y, respectively, at record highs. The Italians and Spaniards are lagging far behind. New passenger car registrations in the EU jumped 1.2% m/m and 6.0% y/y during March, using the 12-month sum (Fig. 10).

(4) Inflation. Both actual and expected inflation rates have edged down recently, suggesting that the global economy isn’t overheating. Expected inflation implied by the yield spread between the US Treasury 10-year bond and TIPS fell from a recent high of 2.08% on January 27 to 1.84% at the end of last week (Fig. 11).

The headline CPI inflation rates, on a y/y basis, moved down in March in the US (from 2.7% to 2.4%) and the Eurozone (from 2.0% to 1.5%), and was little changed in China (from 0.8% to 0.9%). The core CPI inflation rates also have ticked down in the US (from 2.2% to 2.0%) and the Eurozone (from 0.9% to 0.7%), and edged up in China (from 1.8% to 2.0%).

(5) Forward revenues and earnings growth. Interestingly, there has been a significant increase since early last year in analysts’ consensus expectations for short-term revenues growth over the year ahead, from 2.3% to 6.3% in mid-April (Fig. 12). Even more impressive is the rebound in year-ahead short-term earnings growth from the most recent low of 6.2% early last year to 13.7% now. Long-term earnings growth, over the next five years at an annual rate, is up to 12.5%, the highest since September 2011.

(6) Global trade. Global trade indicators are looking more buoyant. The Baltic Dry Index is up 86% y/y through mid-April (Fig. 13). Over the past 12 months through March, US West Coast ports’ outbound container traffic is up 6.0% y/y to the highest level of activity since January 2015 (Fig. 14). Actual exports data coming out of Asia are especially strong. March data are available in dollars for India (up 28.3% y/y), Indonesia (23.2), China (17.4), Singapore (15.8), Taiwan (14.0) South Korea (13.5), and Japan (10.3). Altogether, they are up 16.4% y/y, and 15.4% excluding China (Fig. 15).

No wonder that the Emerging Markets Asia MSCI stock price index (in local currency) is up 29.0% from its low early last year (Fig. 16). The index’s forward earnings (in local currency) is up 8.6% over this period. Analysts’ consensus expected short-term earnings growth over the year ahead for this index was back up to 16.0% in early April compared to the most recent low of 4.5% early last year (Fig. 17). The index remains relatively cheap with a forward P/E of 12.2 (Fig. 18).

(7) IMF forecast. The only fly in this hearty soup is that the IMF’s economists are raising their expectations for global economic growth. Since nearly the start of the latest global economic expansion, they were too optimistic and have had to lower their forecasts. Last week, they nudged up the IMF’s forecast for world growth this year a tenth of a percentage point to 3.5%, which will be the fastest rate in five years if they are right. Next year’s growth rate is expected to be 3.6%, according to the IMF’s latest World Economic Outlook. Global growth was 3.1% last year.

The so-called advanced economies, which grew 1.7% last year, are expected to expand by 2.0% during both 2017 and 2018. The emerging and developing economies, which grew 4.1% last year, are predicted to grow by 4.5% this year and 4.8% next year. The top concern among the IMF’s economists is trade protectionism: “An inward shift in policies, including toward protectionism, with lower global growth caused by reduced trade and cross-border investment flows.”

By the way, the 1942 film classic “Now, Voyager,” starring Bette Davis, is a complicated love story that doesn’t end quite as happily as most do, with a few notable unhappy exceptions like “Romeo and Juliet.” But the ending of this movie isn’t that tragic, as Bette Davis famously says, “Oh, Jerry, don't let's ask for the moon. We have the stars.” I think that’s a fitting assessment of the current US and global economic situations too.

Financials: Out of Favor Again?

April 20, 2017 (Thursday)

See the pdf and the collection of the individual charts linked below.

(1) Bronx cheer. (2) C&I loans and flatter yield curve are turn-offs. (3) Net interest margins expanding. (4) Capital markets issuance boom may explain weakness in business loan demand. (5) No alarms about credit quality, even in auto loans, on bank conference calls. (6) Goldman was an outlier with a miss for a change. (7) S&P 500/400/600 forward revenues and earnings continue to rise in record territory.


Industry Focus: Financials Mostly Shine. Investors gave financial companies’ Q1 earnings the Bronx cheer as the lack of growth in commercial and industrial (C&I) loans and poor performance in fixed-income trading at Goldman Sachs amplified concerns that the industry’s outperformance over the past year could unwind. C&I loans rose just $58.1 billion y/y through the week of April 5, the weakest pace since July 2011 (Fig. 1 and Fig. 2). Confidence in the sector was already faltering, as the yield curve has flattened in recent weeks (Fig. 3).

Despite the gloomy developments, there are a number of reasons for continued optimism. Banks were able to charge more for their loans in Q1, and they should be able to do so again in the current quarter thanks to the Federal Reserve’s March interest-rate increase. Capital markets are alive and well, and loan credit quality appears to be stable despite analysts’ worries about auto loans and retailers. In addition, the sector’s valuation looks more reasonable in the wake of its recent selloff, and strong capitalization levels mean banks should be able to continue returning capital to shareholders via stock repurchases and dividends.

The S&P 500 Financials stock price index fell 1.4% over the week through Tuesday’s close, and it has fallen 8.3% since peaking on March 1 (Fig. 4). However, it remains the top-performing S&P 500 sector on a y/y basis: Financials (23.2%), Tech (21.1), Industrials (13.6), S&P 500 (11.8), Materials (11.4), Consumer Discretionary (9.3), Utilities (5.9), Energy (4.8), Consumer Staples (4.7), Health Care (3.9), Real Estate (1.6), and Telecom Services (-1.3) (see Tables). Here’s a look at what may drive the sector for the rest of this year:

(1) Fatter NIMs. The brightest part of banks’ earnings was the increase in revenue from loan portfolios due to the quarter-point increase in the federal funds rate in December and again in March. The increase in revenue was even more impressive because it doesn’t look like banks had to pass their windfalls on to depositors. So the overall difference between what banks earned on their loans and what they paid on deposits—their net interest margin (NIM)—widened nicely and should do so again in Q2 (Fig. 5).

At JPMorgan, the NIM improved to 2.33% in Q1, up 0.11ppt from Q4 and up 0.3ppt y/y. M&T Bank’s NIM was 3.34% in Q1, up 0.26ppt from Q4, and PNC’s NIM was 2.77%, up 0.08ppt from Q4. Bank of America’s net interest income improved $730 million from Q4, primarily due to higher interest rates, according to CFO Paul Donofrio’s comments in the Q1 conference call transcript. “The net interest yield increased 16 basis points to 2.39% from Q4 as loan yields improved 17%, while the rate we paid on deposits was flat at 9 basis points.” The improvement is expected to continue, but to a lesser extent, in Q2—closer to $150 million.

PNC’s CEO Bill Demchak noted that corporate CFOs looking to park their cash have limited options. Institutional prime money-market funds, which invest in commercial paper and other short-term debt, are required to market-to-market their assets because of new regulations that went into effect last year, explained a 9/14/16 WSJ article. Because of the rule change, institutional investors pulled their money out of prime funds and put it into government money market funds, which aren’t subject to the new rules. Government money market funds offer extremely low yields, providing little competition to banks looking to raise deposits.

(2) Deals cut into loans. Banks’ largest problem during Q1 was the lack of growth in C&I loans. At JPMorgan, C&I loans remained relatively flat versus the Q4 level, even though they were up 8% y/y. CEO Jamie Dimon remained sanguine about lending activity. He noted that companies have a choice between funding with bank loans or selling debt in the capital markets. And Q1 activity was brisk in the debt capital markets. Investment-grade bond issuance is up 5% ytd, and high-yield bond issuance is up 84%, according to Dealogic.

There’s some concern that President Trump’s inability to pass health care legislation and the related delay in tax reform and infrastructure spending have led to delayed decision-making in the C-suite. Dimon referred to the new President’s first 100 days as a “sausage-making period,” when there will be wins and losses. However, the President’s pro-growth agenda—with proposed tax reduction, increased infrastructure spending, and regulatory reform—should be a good thing for Americans, he said in the Q1 conference call transcript. It has already led to clients hiring and spending more, and that should ultimately translate into loan growth, JPMorgan’s CFO Marianne Lake said.

PNC’s CFO Rob Reilly said the bank continues to expect mid-single-digit loan growth, helped by its expansion into new markets including Dallas, Kansas City, and Minneapolis. “Given the March rate hike, we now expect revenue to grow in the upper end of the mid-single digit range. And we continue to expect a low single-digit increase in expenses, which will allow us to post positive operating leverage for the year,” he said according to the Q1 conference call transcript.

(3) Watching autos and retailers. Bank loan credit quality may have peaked last year but seems to have stabilized at high levels. That said, during the various bank conference calls, analysts asked a number of questions about the performance of auto loans and loans to retailers. The message they received: So far … so good.

Bank of America’s CFO said auto loans were up 12% y/y and the bank is focused on prime and super-prime borrowers. As a result, its net charge-offs were 0.38ppt. The Fed’s data show that auto loans rose 7.0% y/y during Q4 (Fig. 6).

(4) Mostly friendly markets. With the IPO market reviving and debt issuance surging, it’s no wonder that capital markets provided a tailwind for most commercial and investment banks. At Bank of America, Q1 total investment banking fees were up 37% y/y, fixed-income trading revenue jumped 29% y/y, and equity sales and trading was up 7%. Morgan Stanley beat Wall Street Q1 earnings estimates, helped by a 30% y/y jump in sales and trading revenue and a 43% surge in investment banking revenue. Fixed-income trading nearly doubled to $1.7 billion y/y, while equity trading fell 1.9% to $2.0 billion. “Triple-digit gains in underwriting more than offset a 16% decline in M&A fees” noted a 4/19 WSJ article. It added that Morgan’s CFO Jonathan Pruzan said the firm’s merger pipeline is higher today than it was at this point in 2016.

Goldman Sachs was the outlier. The firm’s fixed-income, currencies, and commodities trading revenue rose only 1% y/y. Also, revenue from the M&A business fell 2% y/y, and the firm said its backlog of M&A and underwriting business decreased from the end of 2016. “This suggests that political uncertainty may be holding back activity to some degree,” noted a 4/18 WSJ article. According to the Q1 conference call transcript, Goldman Deputy CFO Martin Chavez said: “However, during the first quarter, the market began to reconsider both the pace and strength of economic growth, particularly in light of uncertainty regarding upcoming European elections and legislative challenges in the United States. This confluence of events resulted in tempered expectations, a modest retreat in equity prices from intra-quarter highs, and a more benign market environment.”

(5) Analysts’ outlook. It’s still too soon to tell whether Q1 results will send analysts scampering to slash their estimates. But it’s very possible they may not, since most earnings—with the notable exception of Goldman Sachs’—came in above expectations.

Currently, analysts estimate that S&P 500 Diversified Banks will grow revenues over the next 12 months by 4.1% and earnings by 10.6% (Fig. 7). Likewise, S&P 500 Regional Banks is expected to grow forward revenues by 6.6% and earnings by 12.4% (Fig. 8). Net earnings revisions for both industries have been positive, yet their forward P/Es have come down slightly.

Diversified Banks has a 12.2 forward P/E, down from 13.6 in early March, and it trades at 1.08 times forward book value (Fig. 9). Regional Banks is growing faster and is slightly more expensive, with a forward P/E of 13.8 and a forward price-to-book ratio of 1.16 (Fig. 10).

The S&P 500 Investment Banking & Brokerage industry is more expensive than its banking counterparts, but it’s expected to grow more quickly. Analysts see Investment Banks and Brokers growing revenues over the next 12 months by 7.2% and earnings by 16.7% (Fig. 11). The industry sports a 13.1 forward P/E and trades at 1.31 times its forward book value (Fig. 12).

(6) Returning capital. After years of bolstering their capital bases, many banks continued to share the wealth with shareholders via stock repurchases and dividends last quarter. With a little luck, the amount of capital returned should increase going forward.

For example, at Citigroup about $2.2 billion was returned to common shareholders in Q1 through dividends and the repurchase of roughly 30 million shares. The repurchases reduced the bank’s average diluted shares outstanding by 6%. “Even still, our common Equity Tier 1 Capital ratio has increased to 12.8%, well above the 11.5% upper range of what we believe we need to operate the firm prudently. So, we clearly have excess capital and couldn’t be more committed to returning that capital to our shareholders,” said CFO John Gerspach, according to the Q1 earnings conference call transcript.

(7) Most interesting factoid. At Bank of America, mobile devices now account for one out of every five deposit transactions, approximating the deposit volume of nearly 1,000 financial centers.

Earnings: Looking Up. It’s still a bit early in the Q1 earnings season, but it seems to be going about as expected, with the exception of a couple of outliers like Goldman Sachs and IBM. At the beginning of this month, the forward revenues estimates of industry analysts were still rising in record-high territory for the S&P 500/600 and moving closer to last year’s record high for the S&P 400 (Fig. 13).

Forward earnings is on the up-and-up for the S&P 500/400/600 as well (Fig. 14). It has been rising at a nice steady pace since early last year for the S&P 500. It seems to be increasing at a faster pace for the S&P 400 over the same period. It has stalled in recent weeks for the S&P 600, though at a record-high level.

Go With the Flows

April 19, 2017 (Wednesday)

See the pdf and the collection of the individual charts linked below.

(1) Fed provides lots of data about capital market flows. (2) Looking at US-based equity mutual funds and ETFs that invest in the US or around the world, we see big inflows to domestic ETFs since election. (3) World equity mutual funds and ETFs (based in US) were less popular last year. (4) Production is yet another weak indicator in auto industry’s soft patch. (5) Truck freight and sales stalled. (6) Economic Surprise Index is down. (7) Washington may have to respond sooner with fiscal stimulus, while the Fed can wait on next rate hike. (8) Chinese economy remains too dependent on government and debt.


Strategy: Homeward-Bound ETFs. The Fed publishes the Financial Accounts of the United States on a quarterly basis. This excellent compilation was updated through Q4-2016 on March 9. It is an overwhelming amount of data about the flows and levels of assets and liabilities in the US capital markets. Debbie and I are always coming across something either new or that we had overlooked before. We recently sorted out the data available for US-based equity mutual funds and ETFs. We were especially pleased to find that data are available for both by “investment objective” under the following categories: domestic equity funds, world equity funds, hybrid funds, taxable bond funds, and municipal bond funds. They appear in Table F.122 in the Fed’s publication for mutual funds and F.124 for ETFs.

As is our nature, we posted them all in a new chart publication titled Mutual Funds & ETFs By Investment Objective. Let’s focus on equity funds that invest in US stocks only and those that invest around the world, using four-quarter sums to smooth out the quarterly volatility:

(1) Domestic funds. On a combined basis, domestic equity mutual funds and ETFs contributed to the previous bull market with sizable net inflows, particularly during late 2003 through 2005 (Fig. 1). Net inflows dried up from 2008 through early 2011. Then there was some significant selling during the second half of 2011 and in 2012 before buyers came back in 2013 and 2014. Despite some selling at the beginning of last year, there was a tiny inflow of $8 billion into domestic funds last year.

Focusing on domestic equity mutual funds, we see that the bear market of 2000 slowed net inflows, but they remained mostly positive right through the next bull market that started in 2003, with a brief period of minor net outflows during late 2002 and early 2003 when corporate accounting scandals might have scared off some retail investors. They turned into consistent sellers during the bear market that started in late 2007 and never really came back: Outflows continued unabated; in fact, only seven of the past 38 quarters have had net inflows based on four-quarter sums for US mutual funds investing at home.

On the other hand, domestic equity ETFs never experienced any net outflows on this basis since the start of the data during Q4-2002. The trend has been mostly upward for these net inflows, with a record high of $167.5 billion last year. The actual Q4-2016 net inflow was a whopping $413.0 billion (saar). This may very well have reflected the animal spirits unleashed by Trump’s election, though it certainly didn’t show up in domestic mutual funds, which had record net outflows totaling $159.5 billion last year, with the actual Q4-2016 outflow at $174.1 billion (saar).

(2) World funds. Since the start of the four-quarter-sum data during Q4-2002, net inflows into US mutual funds and ETFs that invest globally have been negative during only five quarters (Fig. 2). During the bull market from Q4-2002 through Q3-2007, they attracted $607 billion in net inflows, while domestic funds (mutual and exchange-traded) had net inflows of $476 billion. So far, during the current bull market since Q1-2009 through Q4-2016, world equity funds had net inflows of $1.0 trillion, while domestic ones had $227 billion.

Both equity mutual funds and ETFs contributed to the popularity of global investing during the latest two bull markets, presumably mostly by American investors. Interestingly, they both became much less less popular last year. Among the domestic and world funds, the category that stands out as attracting a record net inflow is domestic ETFs. It’s arguable that investors responded to Trump’s “America First” presidential theme by jumping into US ETFs that invest only in American companies.

That could change if Trump continues to soften this theme and adopts a more centrist foreign policy. Already, the new administration’s policies are looking less and less protectionist, as most recently evidenced by giving the Chinese government a pass on getting labeled as currency manipulator, while offering to ease off on trade issues if the Chinese do something about North Korea’s Li’l Kim.

(3) Monthly data. The Fed’s quarterly funds data are mostly based on the monthly series compiled by the Investment Company Institute (ICI). Because that data are also volatile, we track the 12-month sum of the net inflows, which are available for domestic versus world mutual funds based in the US (Fig. 3). They show that over the past year through February, all mutual funds had a total net outflow of $161.3 billion, led by domestic mutual fund outflows of $159.8 billion, while international ones lost just $1.5 billion.

What about ETFs? Understanding the monthly flows into domestic versus world ETFs is a bit more complicated because ICI only provides net issuance of shares by all US-based ETFs, combining those that invest in equities and bonds. The former continue to attract most of the inflows. The share issuance data show US ETFs raising a record $368.0 billion over the past 12 months through February, led by $227.5 billion going into domestic ETFs, followed by $53.1 billion into international ETFs (Fig. 4).

US Economy: Driving in the Slow Lane. Following the latest reports on housing starts (down 6.8% m/m during March) and manufacturing output (down 0.4% last month), the Atlanta Fed’s GDPNow model showed an increase of just 0.5% (saar) in Q1’s real GDP. As we noted yesterday, the auto industry is a major soft patch in the economy. Sure enough, auto output fell 3.6% during March (Fig. 5). Auto assemblies are down 7.3% over the past five months to 11.1 million units (saar) from last year’s peak of 12.0mu. The weather can be blamed for the drop in housing starts, but not for the weakness in auto sales and production.

There are other soft patches in the economy. For example, the ATA Truck Tonnage Index dipped 1.0% m/m in March, and is up by only 0.7% y/y. In other words, it has stalled at a record high over the past year (Fig. 6). Sales of medium-weight and heavy trucks dropped 8.0% m/m in March and 19.0% y/y (Fig. 7).

So it comes as no surprise that the Citigroup Economic Surprise Index (CESI) has plunged from a recent high of 57.9 on March 15 to 6.6 on Tuesday (Fig. 8). These developments are likely to put pressure on the Fed to hold off on another rate hike for now, and on the Trump administration to move forward with its fiscal stimulus agenda. Treasury Security Steve Mnuchin said on Monday that tax reform might not happen until after the summer. We think the weakness in the economy will prompt a faster response by Washington.

By the way, there is a reasonably good fit between the CESI and the 13-week change in the US Treasury 10-year bond yield (Fig. 9 and Fig. 10). The actual yield has dropped from a recent peak of 2.62% on March 13 to 2.17% yesterday. It seems to be heading toward the bottom end of our predicted trading range of 2.00%-2.50% for the first half of this year.

China: Command Economy. China’s recently released output figures suggest that China’s economy is back operating with full steam ahead. However, the Chinese government is using the same old growth engine that seems to require increasing injections of high-octane debt to keep cruising along. China’s leaders have said that they are aiming to downshift the government’s role in the economy. They’ve said they would like to see consumer spending driving their economy more than government infrastructure projects and state-owned enterprises (SOEs) that export manufactured goods.

They just can’t figure out how to make this transition. So the government continues to do more of the same. That means more infrastructure spending to keep workers busy and more debt to prop up the SOEs. Consider the following:

(1) Growth chugging along. China’s preliminary GDP increased at a healthy clip of 6.9% y/y during Q1, according to a recent press release from China’s National Bureau of Statistics (NBS) (Fig. 11). It was China’s strongest economic performance since Q3-2015. The government has set a target of around 6.5% for growth this year, an NBS spokesperson told reporters on Monday according to the 4/17 WSJ.

(2) Speeding down the rails. The Chinese government claims that the sharp rebound in the y/y PPI inflation rate from a recent low of -5.9% to 7.6% during March proves that efforts to reduce excess capacity among SOEs have succeeded. More likely is that renewed stimulus measures have done the trick. There is a reasonably good correlation between the PPI inflation rate and the growth in railway freight traffic. The latter soared 19.4% y/y during February (Fig. 12).

(3) Three categories of growth. In the GDP press release, the NBS breaks out China’s output into three categories: primary (includes farming, forestry, fishing), secondary (includes manufacturing), and tertiary (includes services). China’s tertiary industry (i.e., the “new” economy) grew the fastest at 7.7% y/y and contributed to more than half of China’s GDP for Q1. However, the primary and secondary industries (i.e., the “old” economy) continue to make up the balance of China’s GDP, with the secondary (including manufacturing) industry rising 6.4% y/y.

(4) Manufacturing going strong. China’s Q1 figures show that “industry” (which includes manufacturing) continues to compose 34.3% of China’s GDP, the largest of the industry sub-group breakdown. It grew at a rate of 6.5% y/y during Q1. Wholesale and retail trades rose 7.4% y/y, contributing to 9.8% of China’s overall GDP. Growth rates for technology, business services, and real estate were especially high compared to the overall growth rate, but those sectors individually contributed to less than 7.0% of GDP. However, “other” services grew 6.9% and did contribute to 16.8% of GDP.

(5) SOEs leading investment. China’s private-sector investment increased 7.7% y/y during Q1. For the same time period, investment from SOEs grew at nearly double that rate, reported the WSJ based on NBS data. China’s government-led growth might be even larger than reported. Public-policy think-tank American Enterprise Institute explained in a note last year that China’s NBS definition of private may include some firms that are neither wholly state- or private-funded, but a mix of both.

(6) Debt-fueled growth. China’s debt-fueled boom is a big concern for China’s officials, as discussed in a 3/22 FT article. The aforementioned WSJ article adds some detail: “Total debt is now at an estimated 277% of the economy, up from 125% at the end of 2008. Credit continues to expand significantly faster than economic growth despite Beijing’s bid to address growing economic risk.” Evidence of China’s further inflating credit bubble is China social financing, a broad credit and liquidity measure. It is up $2.7 trillion over the past 12 months through March, led by a $1.8 trillion increase in bank loans (Fig. 13 and Fig. 14).

(7) Twice the size of NYC. According to the WSJ article cited above, China’s property industry contributes to around one-quarter of GDP when related industries like construction are taken into account. Apparently, government officials have no shortage of long-term projects to help avoid slower growth or a meltdown. For example, on April 1, the Chinese government announced its plans to build a new city that would be more than double the square mileage of New York City. Since the announcement, real estate investors have rushed in to purchase local properties there, pushing up prices.

The Trump Doctrine

April 18, 2017 (Tuesday)

See the pdf and the collection of the individual charts linked below.

(1) Eye on the prize. (2) Alternative leadership styles. (3) Obama vs. Trump Doctrines. (4) Geopolitics hasn’t shocked this bull market so far. (5) Might stocks stall if Trump puts Foreign Policy First, ahead of America First? (6) Mixing it up in Yemen, Syria, Afghanistan, and North Korea. (7) Running out of strategic patience. (8) Trump has a few kind words for Yellen. (9) Auto industry is main soft patch in US economy. (10) China’s economy is doing a wheely, really.


Geopolitics: Mother of All Bombs. On October 9, 2009, the Norwegian Nobel Committee announced that President Barack Obama would receive the Nobel Peace Prize for promoting nuclear nonproliferation after being in the White House for less than 10 months. How has that worked out? Given North Korea’s declared ambition to build nuclear ballistic missiles that can strike the US, it seems that the award was premature. The Obama administration may have delayed Iran from doing the same, though the Mullahs could probably purchase a nuclear arsenal from North Korea at any time after the previous administration handed them a multi-billion-dollar check for assets that were frozen in foreign bank accounts after sanctions were lifted.

The Obama Doctrine was based on leading from behind—backing away from red lines, while giving diplomacy and peace a chance. As a result, the Russians had no second thoughts about annexing Crimea and infiltrating eastern Ukraine. The Chinese built more islands to claim sovereignty over the South China Sea. Syria’s murderous Assad regime continued to murder Syrian civilians, triggering the massive migration of refugees to Europe. ISIS remains a powerful force for terrorism in the Middle East and around the world.

Yet, the bull market in stocks that began on March 9, 2009 rose 131.9% to a record high first on March 28, 2013, and has continued to climb in record territory since then, by another 48.4% through Thursday’s close. Altogether, it is up 244.2%. The bull has mostly ignored all the geopolitical turmoil over the past eight years. I don’t recall that any of the geopolitical disturbances along the way provided enough of a selloff to describe it as a good buying opportunity. There have been times in the past when such disturbances did so, while they have rarely triggered bear markets.

However, could geopolitical concerns at least stall the bull run that resumed following Election Day? The S&P 500 rose 12.0% from November 8 of last year to peak at a record high of 2395.96 on March 1 (Fig. 1). It is down 2.0% since then through yesterday’s close. The Trump Doctrine has already been defined as a more pro-active approach to addressing geopolitical issues:

(1) Yemen. It started with a Special Forces raid on an al Qaeda camp in Yemen on January 29. It had been planned under the Obama administration, but given the go-ahead by Trump. In any event, it was badly executed.

(2) Syria. On April 6, a total of 59 US cruise missiles blasted a Syrian air base that had been used in a lethal chemical attack on civilians by the Assad regime. Coincidentally, President Trump was dining with Chinese President Xi Jinping at Mar-a-Lago, asking him to do something to stop North Korea’s nuclear missile program as a US naval task force was cruising on its way toward the Korean Peninsula.

(3) ISIS. Then on April 13, Trump dropped the “Mother of All Bombs” on an underground ISIS stronghold in Afghanistan. Reportedly, it killed 92 ISIS militants. It also sent a powerful military message following so soon after the cruise missile attack and the deployment of warships near Korea.

(4) North Korea. On April 15, North Korea’s sixth nuclear test was a dud, leading some to speculate that Trump had ordered a cyber-attack that might have caused the spectacular nonevent.

When Secretary of State Rex Tillerson traveled to Asia in March, he warned that the US would consider a preemptive strike on North Korea if its nuclear program continued unabated. “The policy of strategic patience,” Tillerson announced, “has ended.” The Chinese seem to be getting the message that they must stop Little Kim. On April 5, speaking through an editorial in the Global Times—which is owned by People’s Daily, the official mouthpiece of the Chinese Communist Party—Beijing put Pyongyang on notice, saying that it must rein in its nuclear ambitions or else China’s oil shipments to North Korea could be “severely limited.” It is extraordinary for China to make this kind of threat. The editorial continued that no North Korean nuclear fallout can be allowed to “contaminate” the region. Nor can North Korea be allowed to “descend into the kind of turbulence that generates a huge outpouring of refugees,” the editorial said, adding that China will also not allow “a hostile government” in Pyongyang.

In mid-February, China suspended all imports of coal from North Korea as part of its effort to enact United Nations Security Council sanctions aimed at stopping the country’s nuclear weapons and ballistic-missile program. The ban will last until the end of the year. Coal has accounted for 34%-40% of North Korean exports in the past several years, and almost all of it was shipped to China, according to South Korean government estimates.

By the way, in his first meeting with President Barack Obama before taking office, Trump noted that the outgoing president advised him to focus on North Korea. Last October, Obama appeared in a skit with Stephen Colbert for the Late Late Show, where he practiced his interview skills in light of his impending search for a new job. When asked by Colbert to list any other relevant awards or qualifications, Obama replied: “I have almost 30 honorary degrees and I did get the Nobel Peace Prize.” Colbert then asked, “Really, what was that for?” Obama joked, “To be honest, I still don’t know.”

Strategy: Stocks Stall. Trump’s critics charge that he is inciting global tensions to deflect attention from his domestic policy failures, though he has been in office for less than 100 days. Whether this charge is right or wrong, might heightened geopolitical conflicts force the administration to postpone the domestic policy agenda? It’s possible, and that might explain why the stock rally has stalled. It’s also possible that the market is simply experiencing some profit-taking among the rally’s recent sector leaders, including Financials and Industrials.

Here is the S&P 500’s sector derby since November 8 through the March 1 record high: Financials (26.0%), Industrials (14.0), Materials (12.8), Information Technology (12.2), S&P 500 (12.0), Consumer Discretionary (10.9), Health Care (10.7), Telecommunication Services (8.9), Real Estate (5.3), Consumer Staples (5.0), Utilities (3.9), Energy (3.9) (Fig. 2).

Here is the derby since the March 1 top through Thursday of last week: Utilities (1.2), Real Estate (0.2), Consumer Discretionary (-0.7), Consumer Staples (-0.7), Information Technology (-0.9), Health Care (-2.1), S&P 500 (-2.8), Telecommunication Services (-3.1), Materials (-3.7), Industrials (-3.9), Energy (-4.0), Financials (-9.0).

Of course, another reason for the stall-out is that the hard economic data continue to be weak, on balance, despite the strength of all the soft, mostly survey data. So while most of the employment indicators confirm that the labor market is very tight, retail sales, particularly auto sales, have been weak. The Atlanta Fed’s GDPNow is tracking Q1 real growth of only 0.5% (saar).

The good news is that this increases the likelihood of a very gradual normalization of monetary policy. Trump has even said that he might be inclined to reappoint Fed Chair Janet Yellen, who is the leader of the gradualists at the Fed. The 10-year bond yield has responded favorably, having recently peaked at 2.62% on March 13 and falling down to 2.26% yesterday (Fig. 3). Debbie and I are still predicting that it will range between 2.00% and 2.50% through mid-year. Then we see it trading between 2.50% and 3.00% during the second half of the year. That’s because we expect some pickup in economic growth, especially if Trump pushes ahead with his domestic stimulus agenda, as we still expect. In this case, one or two more Fed rate hikes are still likely this year.

US Economy: Soft Patch for Autos. One of the softest patches in the US economy right now is the auto industry. Jackie and I have been monitoring the mounting subprime auto loan problem in recent months, arguing that it could weigh on auto sales. That may have started to happen. Consider the following recent developments:

(1) Auto retail sales. During March, US motor vehicle sales dropped 5.1% below the 12-month moving average of 17.5 million units to 16.6 million units (saar). It was the worst month for auto sales since February 2015, and down 9.8% from the cyclical high of 18.4mu at the end of last year. Included in the figure are domestic cars, light trucks, and imports. In the monthly retail sales report, auto sales fell 4.3% over the past three months through March (Fig. 4). This obviously weighed on retail sales, which declined 0.5% over the past two months, but was fractionally higher excluding autos over this same period.

(2) Auto credit. Auto credit conditions are tightening according to the January 2017 quarterly Senior Loan Officer Opinion Survey compiled by the Federal Reserve. The banks responded that they expect to tighten auto loan standards and to see a deterioration in the quality of auto loans during 2017. The net percentage of domestic banks tightening standards for auto loans increased to 11.7% during January, up from -6.3% a year ago (Fig. 5).

(3) Used car prices. Manheim Inc., an auto auction company, compiles a measure of used vehicle prices based on more than 5 million transactions annually. It is available since 1995. In March, the Manheim Used Vehicle Value Index increased only 1.3% y/y and declined 0.5% m/m based on wholesale used vehicle prices adjusted for mix, mileage, and seasonality. The index has declined during five of the past six months. The CPI measure of used car and truck prices has dropped 1.9% over the three months through March and 4.7% y/y (Fig. 6). According to Manheim, dealer incentives to move a high inventory of new cars off their lots has pressured used vehicle values. Recently, Morgan Stanley analysts forecasted that used car prices could fall another 20% from here.

(4) Auto carloads. Railcar loadings of motor vehicles tend to track motor vehicle sales. Both measures had risen steadily from mid-2009 to mid-2015, which appears to have been the peak for both. Since then, loadings (which are available through the week of April 8) and sales have stalled (Fig. 7).

China: Fast & Furious. While auto sales seem to have hit the skids in the US, the Chinese economy seems to have patched out of its doldrums at a fast and furious speed. Consider the following:

(1) Trade. Chinese merchandise exports (in yuan) surged 23.2% y/y during March to a record high (Fig. 8). Imports also increased sharply, by 27.2% y/y. The sum of the two jumped 24.9% to a new record high (Fig. 9). A spokesman for China’s top economic-planning agency said in a news conference that the global economy is showing signs of “warming up,” according to a 4/13 Reuters article. President Trump’s softened stance on China trade will only serve to help the outlook for Chinese exports. In volume terms, imports of copper, crude oil, iron ore, and coal all surged during March, reported a 4/13 Business Insider article citing data from China’s National Bureau of Statistics (NBS).

(2) Production. China’s economy is off to a strong start overall this year. During the first quarter, real GDP increased 7.0% q/q (saar) and 6.9% y/y (Fig. 10). There’s a strong relationship between China’s industrial production and GDP growth rates. During March, industrial production rose 7.6% y/y, the best pace since December 2014 (Fig. 11).

(3) Retail sales. China’s industrial production is also highly correlated with China’s inflation-adjusted retail sales, which rose 10.0% y/y during March, the best pace since January 2015 (Fig. 12). Online sales contributed to strong growth, noted a 4/13 report from the English-language website of the state news agency China News Service. “The country has vowed to promote a steady increase in consumer spending this year,” observed the report.

Creative Destruction

April 13, 2017 (Thursday)

See the pdf and the collection of the individual charts linked below.

(1) The headline stories that aren’t on front pages are important too. (2) Now that Fed is tightening, bull market in stocks feeds on earnings. (3) Thursdays are when we contemplate creative destruction throughout the US economy. (4) US economy continues to create more jobs than it destroys. (5) JOLTS and NFIB survey showing lots of unfilled job openings. (6) Apple is disrupting chip industry as it turns to making its own hardware. (7) Google’s TPU is another example of a software company making its own hardware. (8) Will Tesla clobber auto dealers the way Amazon is clobbering malls? (9) Spring is in the air for home prices as demand exceeds supply.


US Economy: Exceptional. The headline financial news tends to be dominated by front-page stories about monetary and fiscal policies. The Fed and other central banks have certainly gotten lots of press since the financial crisis of 2008 as they have pledged to do “whatever it takes” to avert another financial meltdown and to revive economic growth. Since Election Day, there have been more stories about the outlook for fiscal policy. In recent days, geopolitics has made a big comeback following the Trump administration’s cruise missile attack on a Syrian airfield and rising tensions in US relations with North Korea.

The bull market in stocks certainly has been charged up by the ultra-easy monetary policies of the Fed. Indeed, some naysayers have argued that were it not for the Fed’s QE bond-purchasing program, stocks wouldn’t have performed so well. Their Exhibit A was the apparently close correlation between the Fed’s holdings of securities and both the S&P 500 stock price index and its total market capitalization (Fig. 1 and Fig. 2).

However, the Fed terminated its QE program at the end of October 2014, yet the S&P 500 is up 16.6% since then into record-high territory. That’s because earnings, which stalled from the second half of 2014 through the first half of 2016, have resumed climbing to new record highs as well. As Joe and I observed yesterday, S&P 500 forward earnings suggests that actual earnings will continue to rise solidly over the next 12 months to around $135 per share from $119 last year (Fig. 3). That’s assuming there won’t be a recession over this period. The forward estimate may also be too low since Trump’s MAGA program of deregulation and tax cuts could boost earnings by at least $10 per share if it is implemented sooner rather than later.

The bottom line is that the headlines that get all the attention tend to overshadow the dynamic changes occurring in the US economy. On a daily basis, I try to provide a balance in the “What I Am Reading” email we send you at 6:15 am every day except Sunday. (See also the WIAR archive.) On Thursdays, Jackie and I like to focus on some of the most interesting aspects of the ongoing process of creative destruction in so many industries, which makes our economy truly exceptional. In our opinion, no one does creative destruction better than Americans, because we accept and welcome the consequences more than most other major industrial economies.

Before we update some of the more interesting recent developments in a few industries, let’s review how well the US labor market has recovered. There certainly has been a lot of destruction of jobs in recent years on a secular basis. There was also a great deal of unemployment on a cyclical basis. But the economy is now creating plenty of jobs, with the major problem being finding people to fill them. Consider the following:

(1) JOLTS. The number of quits totaled 3.1 million during February, according to the latest JOLTS report released by the Bureau of Labor Statistics (Fig. 4). It remains at a cyclical high. Hires have been fairly steady just north of 5.0 million per month since September 2014. Job openings have been a bit higher, exceeding the hiring pace 24 of the past 26 months.

(2) NFIB. According to the National Federation of Independent Business, 31% of small business owners had positions they were not able to fill during March (based on a three-month average of the data) (Fig. 5 and Fig. 6). That’s the highest reading since February 2001. Not surprisingly, it is highly correlated with the percentage of consumers confirming the “jobs plentiful” characterization of the labor market in the Conference Board’s monthly survey of consumer confidence. It is also inversely correlated with the “jobs hard to get” percentage. In March, 31.7% said jobs are plentiful (the highest since August 2001), while 19.5% said jobs are hard to get (the lowest since July 2007).

Industry Focus I: Chip Wars. Is a turf war brewing in the chip industry? More hardware and software companies seem to be designing and manufacturing their own semiconductor chips. Leading the trend: none other than Apple. That might explain why the S&P 500 Semiconductor Equipment index is up 19.5% ytd while the Semiconductors index is up only 2.7%. Here’s a look at some of the recent developments:

(1) Dialog left speechless. On Tuesday, Dialog Semiconductor shares tumbled 20% after an analyst warned that Apple may develop its own power management chips. That’s a huge threat to Dialog, which generates about 74% of sales from Apple. A Bloomberg article on 4/11 cited a research report from Karsten Iltgen, an analyst at Bankhaus Lampe: “‘We believe that Apple is setting up power-management design centers in Munich and California,’ said Iltgen. ‘We hear from the industry that about 80 engineers at Apple are already working on a PMIC with specific plans to employ it in the iPhone by as early as 2019.’” The Bankhaus Lampe analyst downgraded Dialog to a sell rating from hold.

(2) Hard to imagine. Imagination Technologies Group had a similar experience last week when its shares plunged almost 7% on news that Apple would stop using its graphics technology in new products within two years, according to a 4/3 Bloomberg article. Apple kicks in just over half of Imagination Technologies’ revenue. The news is an interesting twist given that Apple is Imagination’s fourth-largest shareholder, with an 8.1% stake as of early February.

(3) Beware Mr. Chips. Apple is also designing a new chip for its Mac laptops to power the keyboard’s Touch Bar feature, Bloomberg reported on 2/1, citing people familiar with the situation. Apple is using ARM Holdings technology to build the chip, which is expected to use less energy. “Building its own chips allows Apple to more tightly integrate its hardware and software functions. It also, crucially, allows it more of a say in the cost of components for its devices,” the article stated. Apple already designs its own smartphone processors, instead of using Qualcomm’s chips.

(4) Searching for speed. Not to be left behind, Google has been developing its own chips to run machine-learning applications faster than the competition’s chips. Google published a study on the chips, called “Tensor Processing Units” (TPU), which it has been using since 2015.

A Google 4/5 blog explains what the company has achieved by designing the chip: “TPUs allow us to make predictions very quickly, and enable products that respond in fractions of a second. TPUs are behind every search query; they power accurate vision models that underlie products like Google Image Search, Google Photos and the Google Cloud Vision API; they underpin the groundbreaking quality improvements that Google Translate rolled out last year; and they were instrumental in Google DeepMind’s victory over Lee Sedol, the first instance of a computer defeating a world champion in the ancient game of Go.”

TPUs also allowed the company to use existing servers instead of having to build out additional server farms to handle computing traffic. The company claims its chip is faster and uses less energy than competing chips from Intel and Nvidia. “A TPU was on average 15 to 30 times faster at the machine learning inference tasks tested than a comparable server-class Intel Haswell CPU or Nvidia K80 GPU. Importantly, the performance per watt of the TPU was 25 to 80 times better than what Google found with the CPU and GPU,” explained a 4/6 article on the study in TechWorld.

However, Nvidia countered that Google’s TPUs from 2015 might top Nvidia’s older chips, but not its new ones, like the Tesla P40. “According to Nvidia, all of these improvements allow the P40 to be highly competitive to an application-specific integrated circuit (ASIC) such as Google’s TPU. In the Nvidia-provided chart below, the Tesla P40 even seems to be twice as fast as Google’s TPU for inferencing,” according to a 4/10 article on Tom’s Hardware. “What we’re seeing from both Google’s TPU, as well as Nvidia’s latest GPUs is that machine learning needs as much performance as you can throw at it. That means we should see chip makers strive to optimize their chips for machine learning as much as possible over the next few years, as well as narrowing their focus (for training or inferencing) to squeeze even more performance out of each transistor.”

(5) Carbon: The new silicon? One more recent development to watch is the push to use carbon instead of silicon on chips. IBM researchers claim to have found a way to use carbon on chips to make them six to 10 times faster than modern silicon chips within a decade. They’d also use “far less” electricity, according to an 11/14/16 article in Wired.

The development is important because there’s wide expectation that Moore’s Law, which says the number of transistors that can fit on a silicon chip will double every two years, is coming to an end because transistors are getting too small to manufacture efficiently.

(6) Adding the digits. After climbing 24.7% in 2016, the S&P 500 Semiconductor index is up only 2.7% ytd through Tuesday’s close (Fig. 7). The Semiconductor industry is expected to see a nice pop in revenue and earnings this year, but projected growth slows sharply in 2018. Analysts expect the industry to produce revenue growth of 10.8% this year and 5.0% in 2018. Likewise, earnings are expected to jump 23.9% this year and only 8.6% in 2018. The market isn’t pricing in much, with a forward P/E of 14.6 (Fig. 8).

Meanwhile, the S&P 500 Semiconductor Equipment index continues to soar, gaining 19.5% ytd on top of a 47.1% jump in 2016 (Fig. 9). This year’s rally comes despite expectations that the stellar earnings growth this year will moderate sharply in 2018. Analysts expect revenues to jump 24.3% this year and 2.6% in 2018, and they see earnings jumping 44.5% this year and 3.5% next year. The industry’s forward P/E ratio is modest, sitting at 14.5 (Fig. 10).

Pioneering computer scientist Alan Kay famously said: “People who are really serious about software should make their own hardware.” Looks like people are starting to listen.

Industry Focus II: Broken Chains. There was more dour retail news in the headlines this week. Rue21, a teen retailer with about 1,000 stores, is reportedly preparing to file for bankruptcy as soon as this month, according to 4/7 Bloomberg article. In addition, Gymboree, a children’s clothing retailer controlled by Bain Capital, is preparing a bankruptcy filing, Bloomberg reported on 4/11. It operates roughly 1,300 stores.

Troubles in retailing made headlines last week when the March employment report showed that jobs at general merchandise stores were disappearing at an accelerating pace. These retail jobs dropped by 34,700 in March, following drops of 23,400 in February and 12,800 in January (Fig. 11).

Nine retailers filed for bankruptcy protection in Q1, equal to the entire number of filings in all of 2016, according to a 3/31 CNBC article. The uptick in filings may mean there will be more filings this year than in 2008, when 20 retailers filed, or in 2009, when there were 18 filings.

The CNBC article also pointed out that retailers filing for Chapter 11 are now more likely to end up liquidating, instead of restructuring, to live another day. The article blames a 2005 change in the bankruptcy code, “[which] trimmed the timeline retailers have to gain approval for sale or reorganization. While they used to be able to spend more than a year in bankruptcy, they now have 210 days to decide whether to keep a store’s lease. Because going-out-of-business sales can take 90 days to run, senior lenders often try to make that decision in as little as 120 days.”

Banks have noticed the problems plaguing retailers, and the 4/12 WSJ reported that lending terms to mall landlords are tightening. “Loan terms have become more conservative. The average size of a retail real-estate loan was $8.3 million in 2016, down from $12.2 million in 2015, according to data from Real Capital Analytics. The average loan-to-value ratio fell to 66% in 2016 from 70% in 2015, while the average occupancy rate of the underlying properties rose to 98% in 2016 from 92% in 2015,” the article states.

While strong malls have been able to replace closed stores and will be just fine, weak malls that are unable to find replacements may begin to decline, with their property values dropping sharply. One example cited in the article: “JC Penney and Macy’s closed stores at Hudson Valley Mall in Kingston, N.Y., in 2015 and 2016, respectively, and the value of the mall plummeted 90%. The mall was valued at $87 million in 2010. Last December, Kroll Bond Rating Agency said it was worth $8.1 million.”

Industry Focus III: Tesla Charges Ahead. Auto retailers would be wise to watch the evolution in the retail industry closely. For just as Amazon has changed how we buy clothes, Tesla aims to change how we purchase cars. And except for folks who enjoy haggling, few find going to buy a car to be the most pleasant experience. We’d guess that consumers would be open to a different way of purchasing a car if one were offered. Tesla aims to sell cars directly to consumers, bypassing the dealership network that traditional auto manufacturers have established.

So far, the dealerships have fought the advent of Tesla outposts by leaning heavily on state laws protecting dealerships; they have had some success, but if history is any guide, their efforts will ultimately be fruitless. “In the 1920s, the American Horse Association mobilized to block the spread of internal combustion technologies by lobbying for laws against heavy trucks on public roads and granting horses special legal status in urban areas,” according to an article published last year in the University of Michigan Law School Scholarship Repository. We all know how well that situation played out for the horses.

Tesla has 108 stores and galleries scattered across 26 states and Washington DC, according to its website. The stakes are undoubtedly high, as 2.0 million employees worked in auto retail in March compared to 944,400 in auto manufacturing (Fig. 12). With Tesla’s market capitalization now in the same ballpark as General Motors’, auto retailers certainly are watching.

Industry Focus IV: Scarce Homes. After a cold and rainy start to spring, New York’s daffodils are in bloom, and that means the spring home-selling season is underway. Our guess: Sellers will be in the driver’s seat because new and existing home inventories remain extremely lean. Investors are anticipating a good season, with the S&P 500 Homebuilding index up 23.9% ytd, making it the fourth-best-performing industry we track.

There were 1.75 million existing homes available for sale in February, about the same as January’s level, which was the lowest in just over 17 years (Fig. 13). The ratio of existing single-family homes for sale to existing single-family homes sold edged up from January’s record low for the series going back to 1999 (Fig. 14). In addition, financing remains inexpensive, with the 30-year mortgage yield at 4.08%.

One area of concern is the sharp run-up in both new and existing home prices. Median single-family existing home sales prices, using the 12-month average, jumped 5.6% y/y in February to $236,160, an all-time high. Likewise, new home prices jumped 4.0% y/y in February to $310,500, which is finally above where new homes were selling just before the bubble burst in 2007 (Fig. 15).

For new-home builders, another area that might constrain their ability to break new ground is the tight labor market. JOLTS shows that 169,000 construction industry jobs are unfilled, five times the amount at the end of 2010. The problem is laid out in a 2/1 article in The CEO of Vantage Homes, which operates in Colorado Springs, told the website that it could have built 20 more homes last year if it had more labor available. The company builds on average 120-150 homes a year.

As long as unemployment remains low and the Fed raises interest rates gradually, real estate agents should remain busy.

Back to the Future?

April 12, 2017 (Wednesday)

See the pdf and the collection of the individual charts linked below.

(1) Chauncey Gardner’s favorite season. (2) S&P 500 revenues and earnings are growing again. (3) Green shoots. (4) Forward revenues and earnings at record highs for S&P 500/400/600. (5) Industry analysts may be boosting 2018 estimates to reflect impact of Trumponomics. (6) A few downbeat hard-data indicators. (7) Back to slower, but longer growth? (8) Demography and technology did not change on Election Day. (9) The CBO’s estimate for potential real GDP growth at odds with Trump’s MAGA ambitions for economy. (10) Hard to Make America Young Again. (11) Both labor force and productivity growth weighing on economic growth. (12) Earnings remain on growth track for stock market.


Strategy: Spring-Like Earnings Season. In the satirical movie “Being There,” the presumed-to-be-great-economist Chauncey Gardner assures the President of the United States “there will be growth in the spring.” His simple reasoning strikes the President as profoundly wise: “As long as the roots are not severed, all is well and all will be well in the garden,” explains Gardner. “In a garden, growth has its season. There is spring and summer, but there is also fall and winter. And then spring and summer again.” The irony: Chauncey actually is a gardener, talking about gardening.

In a 6/7/16 National Review editorial, conservative columnist Jonah Goldberg compared Donald Trump to Chauncey Gardner. Specifically, he questioned the presidential candidate’s conservative credentials: “It’s more like Trump is a kind of angry Chauncey Gardner who benefits from intellectuals’ reading deeply—too deeply—into his outbursts.”

Happily for stock investors, Joe and I anticipate that there will be lots of growth in this spring’s earnings season as companies report their Q1-2017 results. On a y/y basis, S&P 500 operating earnings per share (using Thomson Reuters data) declined during the five quarters from Q2-2015 through Q2-2016 (Fig. 1). We attributed the earnings recession over this period mostly to the plunge in the S&P 500 Energy sector’s earnings. Last summer, we predicted that there would be growth in the second half of 2016 after the price of oil rebounded during the first half of the year. So far, so good:

(1) Quarterly earnings. Sure enough, green shoots began to sprout during Q3-2016 when earnings rose 4.1% y/y. That was followed by a gain of 6.0% during Q4-2016. Now we are predicting that Q1-2017 will be up 10.3%.

(2) Quarterly revenues. S&P 500 revenues per share actually started to recover (ever so slightly) during the first quarter of 2016 after declining during all four quarters of 2015 (Fig. 2). Revenues per share rose 4.2% during the last quarter of 2016. We estimate it rose 7.1% last quarter, the best growth since Q4-2011.

(3) Forward ho! S&P 500 forward revenues, the time-weighted average of industry analysts’ consensus expectations for the current year and the next year, is a great coincident indicator of four-quarter-trailing revenues. The former is available weekly, while the latter is available only quarterly and with a lag of about six weeks (Fig. 3). The weekly forward revenues series peaked at a record high during the week of October 9, 2014, and then slumped along with oil prices. Last year, it began to rebound during the week of February 25, and rose to a new record high during the week of September 1. It has continued to rise to record highs right through the end of March of this year.

A similar pattern was traced by S&P 500 forward earnings per share, which serves as a leading (not coincident) indicator of four-quarter-trailing S&P 500 earnings per share (Fig. 4). The former is also at a record high.

By the way, S&P 400 forward revenues is rebounding back to its 2016 high, while S&P 600 forward revenues continues to make new highs, after holding up very nicely during the energy recession (Fig. 5). Forward earnings for the S&P 500/400/600 are all rising in record-high territory (Fig. 6).

(4) This year & next year. Currently, industry analysts are predicting that S&P 500 earnings will rise 10.9% this year to $130.86 and 12.2% next year to $146.77 (Fig. 7). Joe and I are using $142 for this year and $150 for next year. (See YRI S&P 500 Earnings Forecast.) We expect that deregulation and a retroactive cut in the corporate tax rate will boost earnings in 2017. If the tax cut isn’t retroactive, then it should boost 2018 instead of 2017 earnings, and the market should be happy either way, in our opinion.

We are impressed by the stability in analysts’ high expectations for 2018’s S&P 500 earnings per share. They can’t incorporate the impact of Trump’s policies on earnings until company managements provide some guidance, which would be premature currently. However, analysts’ high hopes for next year suggest that they may be adding a positive fudge factor for the impact of Trumponomics on earnings.

The same story can be told for S&P 400 earnings, which are expected to increase 10.1% this year and 13.3% next year. Ditto for S&P 600, with growth estimated at 9.1% this year and 20.3% next year.

US Economy: Back to Slower, Longer? In my meetings in London last week, many of our accounts were skeptical that the strength in the soft data in the US will trickle down to the hard data until the Trump administration actually succeeds in cutting taxes and in boosting infrastructure spending. The soft data consist mostly of surveys of consumers, CEOs, purchasing managers, small business owners, industry analysts, and investors. They all turned remarkably upbeat after Election Day, as Debbie and I have been monitoring in our new Animal Spirits chart publication.

On the other hand, a few hard-data indicators are downright downbeat. Auto sales totaled 16.6 million units (saar) during March, down from a recent high of 18.4 million units at the end of last year. Payrolls in general merchandise stores have dropped 89,300 over the past five months through March as a result of widespread store closings due to competition from Amazon (Fig. 8). Then again, employment in construction, manufacturing, and natural resources rose 175,000 during the first three months of this year (Fig. 9). The sum of commercial and industrial bank loans and nonfinancial commercial paper has been flat since the start of the year.

A bigger question is whether there has been a structural decline in the potential growth of the economy that may defy both the animal spirits that seem to have been unleashed by Trump’s election as well as his “Make America Great Again” (MAGA) fiscal policies, assuming they get fully implemented. If so, then the long-term trend of growth for both the real economy and corporate earnings may be lower than in the past. The good news in this scenario is that it might mean that a boom is less likely, which obviously would reduce the risk of a bust.

While much has changed since Election Day, some things have not. Demography hasn’t changed. Neither has technology. Globalization might change, but for now the world remains very competitive as a result of relatively free (though not necessarily fair) trade. Productivity growth remains abysmal, and might improve as a result of MAGA policies, or might not. Consider the following:

(1) Potential output. The Congressional Budget Office (CBO) calculates a quarterly series for potential real GDP growth that starts in 1952 and is available through 2027 (Fig. 10). The outlook for this year and beyond is based on demographic projections used to estimate labor force growth and assumptions about productivity.

From 1952 through 2001, potential real GDP grew in a range mostly between 2.5% and 4.0%, averaging 3.5%. Since then, growth has consistently been below 3.0%, and actually below 2.0% since Q1-2007.

(2) Real GDP. Debbie and I constructed a series for the underlying growth in real GDP simply as the 40-quarter percent change in real GDP annualized (Fig. 11). It tells more or less the same story as the CBO’s estimate for potential output. From 1960 through 1975, growth averaged 4.7%. From 1975 through 2007, it averaged 3.7%. It plunged during the Great Recession, and has remained consistently below 2.0% since Q3-2009.

(3) Labor force. Trump may or may not succeed with his MAGA plans. However, he certainly can’t Make America Young Again (MAYA). He can’t bring back the Baby Boom. There has been a dramatic slowing in the growth of the working-age population and the labor force, particularly of the 16- to 64-year-olds (Fig. 12 and Fig. 13). The actual growth rates of this age segment of the working-age population and the labor force are down to 0.5% and 0.3% over the past 10 years at annual rates (Fig. 14).

(4) Productivity. The big unknown is whether Trump’s MAGA policies can revive productivity growth. That’s the only way that real GDP growth might finally exceed 2.0%. Getting it up to Trump’s 4.0% goal seems very unlikely. Nonfarm productivity growth has been below 1.0% since Q4-2014, based on the five-year percent change at an annual rate (Fig. 15). Surprisingly, manufacturing has contributed greatly to this weakness, also rising less than 1.0% since Q4-2015.

(5) S&P 500 earnings. The potential growth of the economy matters a great deal for the stock market since it determines the potential growth of corporate earnings. Surprisingly, so far, the S&P 500 forward earnings since 1979, which is when the data start, remains on a 6%-7% annualized growth trajectory (Fig. 16). Over this same period, the S&P 500 has been tracking growth of 8%-9%, with more upside and downside volatility than in forward earnings (Fig. 17).

DIY Fed Policy

April 11, 2017 (Tuesday)

See the pdf and the collection of the individual charts linked below.

(1) The old normal vs. the new abnormal for Fed policymaking. (2) Monetarism’s brief day in the sun. (3) Normalization now involves reducing an abnormally large balance sheet. (4) Learning-by-doing at the Fed. (5) Dudley and Yellen gang up on Taylor. (6) Taylor worked for Greenspan, then devised a linear equation to replace him. (7) Inflation and output gaps. (8) Atlanta Fed has an app for running monetary policy.


The Fed I: Abnormalization. Prior to the financial crisis of 2008, the Fed responded to such events by slashing interest rates (Fig. 1). Those crises typically triggered recessions (Fig. 2). Once the crises abated and the economy started to recover, the Fed would start a process of normalizing monetary policy. Again, prior to the financial crisis of 2008, that simply meant that the Fed would start raising the federal funds rate back to some normal level (Fig. 3).

It has usually been up to the FOMC to set the course for normalization and to assess what is the normal level for the federal funds rate. In other words, monetary policy has usually been based on the collective judgment of the monetary policy committee. So running monetary policy has usually been based on the discretion of the FOMC.

During the 1960s and 1970s, Milton Friedman strongly criticized this approach and championed a rule-based monetary regime. He favored setting a growth rate for the money supply and sticking to it. Fed Chairman Paul Volcker gave it a try starting during October 1979, but abandoned “monetarism” in 1982. Discretionary policymaking has remained in fashion at the Fed since then.

In response to the latest financial crisis, the Fed lowered the federal funds rate down to zero on December 16, 2008. To provide more monetary stimulus, the FOMC implemented a series of QE bond-purchasing programs, which swelled the Fed’s securities held outright on its balance sheet from $489 billion when QE1 started on November 25, 2008 to $4.25 trillion currently, as Melissa and I discussed yesterday (Fig. 4).

Now the process of normalization is much more complicated because it involves reducing the size of this gigantic balance sheet at the same time as hiking the federal funds rate. As we noted yesterday, the Fed has hiked the federal funds rate three times since late 2015, but the balance sheet has remained at its record level since the Fed terminated QE purchases at the end of October 2014. That was accomplished by reinvesting the proceeds from maturing securities back in Treasury and mortgage-backed securities (MBS) (Fig. 5).

The 3/15 FOMC minutes indicated that the Committee soon will proceed to include a reduction in the Fed’s balance sheet as part of the process of normalization. That’s easy to do in theory since the Fed currently has $261.5 billion in Treasuries maturing in one year or less and another $1,194.5 billion maturing in one to five years (Fig. 6). Its $1,757.8 billion of MBS generates lots of income that includes principal payments.

The problem is that FOMC officials have no experience with normalizing both the Fed’s balance sheet and the federal funds rate. This suggests that even had they adhered to some rule for conducting monetary policy in the past, it would be hard to implement under the current circumstances. So it will be learning-by-doing for a while at the Fed. The Fed may have to raise interest rates at a more gradual pace as it reduces the size of its balance sheet.

The other major central banks will face similar challenges when they begin to normalize their policies (Fig. 7). In dollars, the assets of the BOJ have increased from $1.00 trillion in late summer 2008 to $4.34 trillion during March. The ECB’s balance sheet has swelled from $2.17 trillion to $4.38 trillion over this same period.

The Fed II: Rule vs. Discretion. Top Fed officials have gone out of their way recently to dis rule-based monetary policy. That’s because a few congressional critics of the Fed have been promoting such an approach. Again, under the current circumstances of normalizing both the balance sheet and the level of the federal funds rate, discretionary policymaking makes more sense to us. Here is how FRB-NY President Bill Dudley and Fed Chair Janet Yellen made a similar case in recent speeches:

(1) Dudley. In a 3/30 speech titled “The Importance of Financial Conditions in the Conduct of Monetary Policy,” Dudley stated, “The importance and complexity of financial conditions also underscore the need for caution in following any mechanical monetary policy rule.” He bluntly said that “such rules often perform poorly at times when the economic environment and outlook are rapidly changing. This is one important reason why I do not support proposals that would require the Federal Reserve to explain to Congress whenever its federal funds rate target deviates from a particular prescriptive monetary policy rule.”

(2) Yellen. In his speech, Dudley referenced a 1/19 speech by Yellen in which she also explained why she is against rule-based monetary policy. In short, her opinion is that the members of the FOMC should consider the “advice” of monetary rules, but need to judge on their own how to conduct monetary policy. Here is what she said about this matter:

“As I noted, the Committee routinely reviews policy recommendations from a variety of benchmark rules, and I believe that their prescriptions can be helpful in providing broad guidance about how the federal funds rate should be adjusted over time in response to movements in real activity and inflation. That said, I will emphasize that the use and interpretation of such prescriptions require careful judgments about both the measurement of the inputs to these rules and the implications of the many considerations the rules do not take into account.”

In addition, “simple rules ignore such important factors as fiscal policy, trends affecting global growth, structural developments influencing the supply of credit, and overall financial conditions.” Then she mentioned the current complication in normalizing monetary policy:

“One special factor at the moment pertains to the Federal Reserve’s balance sheet. The downward pressure on longer-term interest rates that the Fed’s asset holdings exert is expected to diminish over time—a development that amounts to a ‘passive’ removal of monetary policy accommodation. Other things being equal, this factor argues for a more gradual approach to raising short-term rates.”

The Fed III: Taylor’s Rule. Both Dudley and Yellen seemed to relish beating up on the Taylor Rule in their recent speeches. John Taylor is an economics professor at Stanford University. He once worked for Alan Greenspan’s consulting firm. Of course, Greenspan championed discretionary monetary policy, which to some of his critics seemed more like a personality cult.

Taylor turned into one of those critics and devised a rule to replace Greenspan and everyone else at the Fed with one linear equation: r = p + 0.5y + 0.5(p-2.0) + r* where r is the federal funds rate, p is the inflation rate, y is the output gap, and r* is the neutral rate of interest. The constant variable “2.0” is the Fed’s target for the inflation rate. So, the inflation gap is p minus 2.0. The “0.5” multiplier coefficients are applied to the output gap and the inflation gap. In other words, for every percentage point that inflation increases above the Fed’s target and that output increases relative to its potential, the federal funds rate should be increased by half a percentage point.

Our good friend Jim Solloway at SEI explained all of the above in English to his investors as follows: “[T]he rule provides some insight into where the federal funds rate ‘should’ be versus where it is. It is based on three factors: actual versus targeted inflation levels; actual employment or output versus an estimate of full-employment levels; and the level of short-term interest rates thought to be consistent with full employment and a steady (non-accelerating) inflation rate. A year ago, this measure suggested that the federal funds rate should have been in the 1.50%-to-1.75% range instead of the 0.25%-to-0.50% range targeted at the time by the FOMC. Since then, inflation has rebounded and the output gap has narrowed further, indicating (based on the Taylor Rule) that the federal funds rate should be near 2.75% compared to the current 0.75%-to-1.00% range that was approved in mid-March. Note that the federal funds rate target suggested by the Taylor Rule is close to the FOMC’s forecast of 3% for the long-run equilibrium federal funds rate” (Fig. 8, Fig. 9, and Fig. 10).

The Fed IV: Do It Yourself. The Atlanta Fed has a Taylor Rule Utility on its website where you can pick and choose variables to generate a personalized Taylor Rule chart. It’s based on the model outlined on the site, which is a little more complex than the formula outlined above. The following are the default selections for the assumptions: “Inflation Target Measure” of “Two Percent,” a “Natural Real Interest Rate Measure” of “Two Percent,” a “Resource Gap Measure” of “Real GDP gap, CBO” (based on the Congressional Budget Office’s estimates), and an “Inflation Measure” of “Core PCE inflation, 4-quarter” along with a “0.5” coefficient and “Interest Rate Smoothing” of 0.

Hitting “Draw chart” reveals that the Taylor Rule prescription has fallen above the actual federal funds rate since Q1-2010. The Q1-2017 Taylor Rule result is a federal funds rate target of 3.15%. Even if we changed the assumption for the “Natural Real Interest Rate Measure” to be closer to zero (i.e., by selecting the “Laubach-Williams model 2-sided estimate”), the program yields a rate prescription that is higher than where the federal funds rate is now at 0.75%-1.00%. In her speech, Yellen’s Figure 9 showed two additional rules besides the Taylor Rule (i.e., the Balanced-approach and the Change rules). Two of the three showed the federal funds rate to be below where the rules would have it, while the Change rule approximates it.

Over There & Over Here

April 10, 2017 (Monday)

See the pdf and the collection of the individual charts linked below.

(1) Getting around London town. (2) Fairly relaxed about both Brexit and Trump. (3) Not so relaxed about US stock valuation multiples. (4) Frexit would face a bigger constitutional challenge than did Brexit. (5) EMU looks cheaper than US MSCI now that forward earnings are improving in Eurozone. (6) A sector perspective shows that EMU may not be as cheap as it looks relative to US. (7) Employment still among strongest hard data, except for big job losses among retail stores. (8) Is Trump bringing back factory jobs already? (9) Fed getting ready to unwind balance sheet as securities purchased under QE mature. (10) Another reason to expect gradual rate hikes. (11) Movie Review: “Cézanne et Moi” (+).


Europe: Postcards from London. Last week, I had lots of good meetings with our accounts in Europe. Most of them are in London. As I noted, they are mostly suffering from an overload of research reports about the economic and investment implications of Brexit. Most of the folks I met with are fairly relaxed about it and figure that it will take a few years for the consequences to unfold, and that there will be plenty of time to soften the impact of adverse ones.

For the past 10 years, I’ve employed Steve Nunn to drive me to my meetings around London in his cab. Unlike limo and Uber drivers, Steve knows all the highways and byways around town and can wait for me on the street without getting chased away by bobbies. His talents were especially useful this time because traffic in London was the worst I’ve ever seen it, and Steve confirmed my observation. New bicycle paths have reduced the lanes available for cars. In addition, I observed more construction of commercial and office high-rises than ever before all around the city. They must have all been started before Brexit created lots of uncertainty about whether London will lose jobs to the remaining members of the EU.

In my meetings on the other side of the pond, I found that investors also were remarkably relaxed about President Donald Trump. They didn’t express any strong opinions about him other than that his election was an “interesting development.” Perhaps they recognize that in a world of controversial leaders, Trump doesn’t stand out as any more than all the rest.

The main concern over in Europe is that valuations are too high in the US stock market. Most global investors I met with over there are finding better values in Europe and emerging markets. I agree with them about emerging markets. The fundamentals are also looking better in Europe, despite all the Brexit commotion, as Melissa and I wrote last Tuesday. However, we still have some concerns about the outcome of the election in France scheduled for April 23. Should no candidate win a majority, a run-off election between the top two candidates will be held on May 7.

One of our accounts in London observed that even if “Madame Frexit” wins, separating France from the EU would be tougher than separating Britain. France’s far-right National Front leader Marine Le Pen, who wants to be the next president, celebrated Britain’s vote to leave the EU. But unlike Britain, France has a written constitution, which states that “the Republic is part of the European Union.” So a Frexit would require a constitutional change that may be more difficult than Brexit, but not impossible.

If LePen loses, as is widely expected among the accounts I met, then the EMU MSCI stock price index may continue to outperform the comparable US index, as it has since July 6, 2016, with the former up 26.6% in euros and the latter up 12.3% in dollars (Fig. 1). Helping this relative outperformance have been March 15 Dutch elections that saw the establishment party fend off the challenge by an anti-EU populist party. At the end of March, Chancellor Angela Merkel’s party won the governor’s seat in Saarland state, auguring well for her reelection on September 24. In Spain, the establishment party remains in power, while populists are wracked by infighting. The wild card is Italy—quindi cosa c'è di nuovo (so what else is new)?

On the other hand, in dollars, the EMU MSCI has matched, rather than beaten, the comparable US index since early 2016. Let’s have a closer look at the relative performance, fundamentals, and valuations in the US vs the EMU MSCI stock price indexes:

(1) Relative performance. Since the start of the year, the EMU MSCI stock price index is up 6.8% in euros, slightly outpacing the US MSCI’s gain of 5.4% in dollars (Fig. 2). Leading the way in the EMU is Spain with a gain of 13.4%, followed by France (6.0%), Germany (5.8), and Italy (3.4) (Fig. 3). In dollars, the ytd performance derby is as follows: Spain (14.2), EMU (7.5), France (6.7), Germany (6.5), US (5.4), and Italy (4.1) (Fig. 4).

(2) Fundamentals. Since the start of the current bull market on March 9, 2009, the US MSCI is up 244% versus the EMU MSCI’s 121% and 84% gains in euros and in dollars. This has certainly helped our Stay Home investment strategy to beat the Go Global alternative. The underlying fundamentals also outperformed in the US, as the ratio of the forward earnings of the US MSCI to the EMU MSCI (in euros) doubled from a low of 4.4 in late 2008 to high of 8.8 in late 2014 (Fig. 5). Since then, the ratio has been relatively stable. (See our US MSCI Stock Price Index vs Rest of the World.)

(3) Valuations. At the end of March, the US MSCI had a forward P/E of 18.0, while the EMU’s was at 14.6 (Fig. 6). While it seems that the EMU is cheaper, it has been consistently so since the start of the data during October 2001. Joe reports that the former has been trading at an average 21% premium to the latter over this period. The current premium is 24%.

Let’s take a dive into the major sectors of the MSCI to see where the valuation divergences between the US and EMU are occurring (Fig. 7). We have weekly data for forward P/Es for the MSCI sectors starting in January 2006. What we see is that Consumer Discretionary, Energy, Financials, and Utilities tend to be consistently more expensive in the US than in the Eurozone. Undoubtedly, companies such as Amazon and Netflix account for much of the divergence in the Consumer Discretionary sector. The US also seems to have more relatively highly valued oil services companies in the Energy sector. US banks have recovered better from the financial crisis of 2008 than European ones, which accounts for the divergence in the Financials sectors’ valuations.

Consumer Staples, Health Care, and Materials tend to have very similar valuations in both the US and the EMU. The same is usually so for Industrials, though the US sector has been more expensive than the EMU sector since early 2016, perhaps on expectations of more infrastructure spending in the US following the latest presidential election, no matter who won.

The bottom line is that on closer inspection, the EMU doesn’t stand out as particularly cheaper than the US.

US Economy: Soft vs Hard Data. Back in the US, there isn’t much evidence that the strength in the so-called soft data is showing up in the hard data so far. The former are based on surveys of consumers, purchasing managers, CEOs, and small business owners. The Atlanta Fed’s GDPNow model currently shows real GDP rising by only 0.6% (saar) during Q1. The New York Fed’s Nowcast reports a 2.8% increase currently. However, the former seems to give more weight to hard than soft data compared to the latter.

Among the strongest of the hard data have been various employment indicators. However, they gave a mixed message for March. The ADP private-sector payrolls rose 263,000 last month, while the official Bureau of Labor Statistics (BLS) figure was just 89,000, as Debbie reviews below. The latter was weighed down by a loss of 29,700 retail jobs following a drop of 30,900 during February. Jackie and I have been warning about layoffs in retailing as brick-and-mortar stores are shuttered due to intense competition from online vendors like Amazon. Sure enough, general merchandise employment has dropped by an increasing amount during each of the past five months for a total loss of 89,300 (Fig. 8).

The good news is that despite the weakness in retail payrolls, manufacturing employment has picked up by 95,000 during the past four months through March according to ADP and 49,000 over the first three months of this year according to BLS. A case can certainly be made that President Trump already has succeeded in bringing back some factory jobs to the US. Construction employment is up 177,000 and 139,000 over the past five months as reported by ADP and BLS, respectively. That may have more to do with the relatively mild winter and the ongoing improvement in housing demand.

In any event, during March, the household measure of employment—which counts employed people whether they have one or more jobs rather than the number of part-time and full-time jobs, which is captured in the payroll measure—jumped 472,000 following a gain of 447,000 in February. So the unemployment rate dropped to 4.5%, the lowest since May 2007. The number of full-time employees rose to a record 125.5 million last month (Fig. 9). Meanwhile, our Earned Income Proxy for private-sector wages and salaries rose 0.3% during March to yet another record high, auguring for continued growth in retail sales (Fig. 10 and Fig. 11).

Fed: The Great Unwinding. We need to start paying more attention to the often-overlooked SOMA section at the bottom of the FOMC statements from now on. That was probably the most important message of the latest FOMC meeting minutes. “SOMA” stands for “System Open Market Account.” It contains the Fed’s holdings of US Treasury and mortgage-backed securities (MBS) and a few other scant categories of assets. Since the start of the Great Recession, when the Federal Reserve greatly expanded its balance sheet to avert a total financial meltdown and jumpstart the recovery, the proceeds from maturing securities have been reinvested by the Fed even after the QE purchase program was terminated at the end of October 2014 (Fig. 12).

Recently, several Fed officials have hinted that the great unwinding is forthcoming. When that day comes, the Fed will stop reinvesting some of the proceeds from maturing securities to shrink its balance sheet back to pre-recession norms. The 3/15 FOMC statement read: “The Committee is maintaining its existing policy of reinvesting principal payments from its [holdings in the SOMA] and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. This policy, by keeping the Committee’s holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.”

However, the 3/15 FOMC meeting minutes (released on 4/5) paves the way for a change, possibly in the next meeting’s statement (on 5/3), to wording stating that the Committee will begin allowing holdings in the SOMA to mature off of the Fed’s balance sheet. Such a change would signal the Fed’s increased confidence in the strength of the US economy and desire to continue to remove financial accommodation.

When the great unwinding begins, bond yields could be pushed higher. Were it not for the SOMA reinvestments cushioning the impact, bond yields might have moved higher than they did in response to the Fed’s three 25bps interest-rate hikes since December 2015. So yields could face some upward pressure once the SOMA starts to contract. Consider the following:

(1) Shrinking SOMA. In a September 2014 press release, the Federal Reserve issued a statement on “policy normalization principles and plans.” The note stated that the Committee agreed that it was an appropriate time “to provide additional information regarding its normalization plans.” Among the key elements of the approach, first would be to raise the target range for the federal funds rate “when economic conditions and the outlook warrant a less accommodative monetary policy.” That would be done “primarily by adjusting the interest rate it pays on excess reserve balances.” Next, the Committee would “cease or commence phasing out reinvestments” on assets held in the SOMA “after” increasing the federal funds rate with no otherwise specific timing. Currently, the Federal Reserve holds about $4.25 trillion in securities outright in the SOMA. These securities totaled just $489 billion before the Fed began to purchase assets under its QE programs on November 25, 2008 (Fig. 13).

The Committee signaled that the intentions laid out in 2014 soon will become a reality in a section at the top of the 3/15 FOMC minutes. During the meeting, the Committee discussed several staff briefings related to potential changes to the Committee’s SOMA reinvestment policy: “These briefings discussed the macroeconomic implications of alternative strategies the Committee could employ with respect to reinvestments, including making the timing of an end to reinvestments either date dependent or dependent on economic conditions. The briefings also considered the advantages and disadvantages of phasing out reinvestments or ending them all at once as well as whether using the same approach would be appropriate for both Treasury securities and agency mortgage-backed securities (MBS).”

(2) Later this year. The specific details on timing and approach were not decided at this meeting. Nevertheless, all participants seemingly “agreed” that reductions in these securities holdings should be “gradual and predictable.” And “most” participants agreed that there should be a phase-out rather than stopping reinvestment “all at once.” Most participants also agreed that the federal funds rate should be “the primary means for adjusting the stance of monetary policy” rather than balance-sheet adjustments. Finally, most participants anticipated that a “change to the Committee’s reinvestment policy would likely be appropriate later this year.”

Nevertheless, there was still disagreement on the issues that “most” participants agreed on. For example, one participant “preferred” that a monthly “minimum pace for reductions in MBS holdings” be set and to allow for MBS sales to meet that pace if required. That happens to run counter to what the 2014 policy statement indicated, that MBS securities would not be sold as part of the wind-down but rather later on and only if necessary.

(3) Apples and oranges. Maturity obviously is important here. It indicates how fast the wind-down could occur if the Fed does not reinvest the funds received once securities reach the predetermined duration. Of course, US Treasuries and MBS are not apples-to-apples comparable when it comes to funds that are made available for reinvestment over the maturity period: As FINRA explains, the US Treasury bond pays only interest until the bond’s maturity, when the lump-sum principal is paid, whereas MBS pay out interest plus some principal during the credit term.

Some insights as to maturity can be gleaned from the Federal Reserve Statistical Release H.4.1, titled “Factors Affecting Reserve Balances.” As of 4/5, the breakdown of securities held outright in the SOMA was as follows: $2.46 trillion in US Treasuries, $1.77 trillion in MBS, and $13.3 billion in other securities. The breakdown of US Treasury securities maturities is: 10.5% maturing in less than 1 year, 48.5% in 1-5 years, 15.5% in 5-10 years, and 25.5% in over 10 years (Fig. 14).

For MBS, nearly 100% of the securities are set to mature after 10 years (Fig. 15). That makes sense, as most mortgages are provided over 15- or 30-year terms. And the Fed purchased most of its MBS holdings less than 10 years ago, following the financial crisis. In any event, we don’t know whether the Fed will treat the wind-down differently for US Treasuries and MBS, or how it might do so.

(4) Lots of maturing bonds. We do know that a big bunch of US Treasuries will mature within 1 to 5 years. If the Fed ceases to reinvest those funds, or phases them out, that will surely impact the Treasury market within that timeframe. Bloomberg ran a helpful article on 1/18 of last year, which included a great chart showing the SOMA maturity distribution for US Treasuries by year. It observed: “The $216 billion of Treasuries the Fed has maturing in 2016 amounts to almost half the net new government-debt issuance that JPMorgan Chase & Co. forecasts for this year. And there’s no letup in sight.”

Here’s another helpful excerpt: “If the Fed had opted not to reinvest this year, the Treasury would have had to make up for the lost funding with additional debt sales that might have boosted 10-year yields by 0.08-0.12 percentage point, according to Priya Misra at TD Securities LLC, one of the 22 primary dealers that trade with the central bank. Misra, head of global rates strategy in New York, based the estimate on a 2010 study by the Fed on the link between its bond purchases and yield changes.”

(5) Market-neutral? Indeed, changes in the Federal Reserve’s portfolio can significantly impact bond yields, a point emphasized in a 2016 Fed study. However, the Fed theoretically has the ability to control how much they do so. Our take is that the Fed does not wish its great unwinding of the balance sheet to have a great impact on the market.

So they will attempt to do it in a market-neutral way. In their own words from the minutes, the “primary” tool for removing accommodation will continue to be the federal funds rate. Even so, there is a chance that the Fed might not have a choice but to readjust their interest-rate strategy if they cannot figure out how to keep the SOMA wind-down market-neutral.

The Shark & the Octopus

April 06, 2017 (Thursday)

See the pdf and the collection of the individual charts linked below.

(1) Tesla worth more than Ford? (2) Elon’s stormy-weather tweet. (3) Tesla cruising along. (4) The auto mechanic will make house calls for electric cars. (5) Low P/Es for clunkers. (6) Amazon recruiting consumer staples companies to sell door to door. (7) Online sales almost 30% of GAFO. (8) Can Amazon improve on home-improvement retailers?


Autos Focus: Speeding & Stalling. Doesn’t Elon know it’s not nice to gloat? Earlier this week, as Tesla’s market cap drove past Ford’s, Elon Musk tweeted, “Stormy weather in Shortville … ” Tesla and Amazon have been taunting short-sellers and the traditional players in their respective industries all year. Tesla may have losses and negative cash flow, but its shares closed above $300 on Tuesday before retreating yesterday. Meanwhile, Amazon, with a market cap that long ago surpassed Macy’s, is charging ahead with its expansion while traditional retailers retrench. This week, it was Ralph Lauren’s turn: It’s shuttering its flagship Fifth Avenue store.

Both Amazon and Tesla are using the Internet to radically change the way business is done in the retailing and auto industries, displacing many traditional businesses—and their employees—along the way. Amazon’s most recent moves imply that it has Walmart, Target, Kmart, and grocers directly in its sights. Tesla, meanwhile, aims to use the Internet to sell cars with engines that are so much simpler than the combustion engine that the company will send a technician to your home or office to do repairs. Tesla’s operation is certainly at a much younger stage than Amazon is, but if Tesla is successful and copied by others, this new model for selling and servicing cars could provide a sharp challenge to the thousands of car dealerships and auto mechanics, to say nothing of the auto manufacturers.

We took a look at the retail and auto industries last week in the 3/30 Morning Briefing. But the ensuing week has been so chock-full of news in the two areas that Jackie and I decided to dive in again and look at the industries’ financial metrics as well. Here’s the latest:

(1) Electrifying performance. Last week, the traditional auto industry hit a big pothole while Tesla got a green light. On Sunday, Tesla reported that global sales rose 69% in Q1 to 25,148 cars, which puts the company on a path to meet its goal of delivering 50,000 cars in the first half. That followed another dose of good news: Tencent Holdings, China’s most valuable company, bought a 5% stake in Tesla.

“The $1.8 billion investment marks a vote of confidence in Tesla Chief Executive Elon Musk, who is facing questions about whether he can meet his ambitious goals of delivering the $35,000 Model 3 sedan on time later this year and at the scale he has projected,” the 3/29 WSJ reported. Tesla is expected to begin production of the Model 3 sedan in July and produce 5,000 vehicles a week in Q4. Next year, Tesla expects sales of its three models will total 500,000 vehicles.

Tesla’s shares have soared 42.1% from the start of this year through Tuesday’s close, even though the company recently sold $250 million of common stock and $750 million of convertible notes. Compare that to Ford stock’s 6.3% decline, GM’s 1.6% decline, and the 5.4% gain in the S&P 500 over the same period.

(2) Shifting into lower gear. As Debbie reviewed yesterday, motor vehicle sales in March dropped to 16.6mu (saar), the lowest since February 2015 and down from 18.4mu in December. Most of the drop occurred in the sale of cars, which at a 4.6mu (saar) rate in March has been in decline since the August 2014 peak of 6.1mu. Light truck sales remain at very high levels, easing to 8.7mu last month, not far from December’s cyclical high of 9.3mu.

There are a number of reasons to be concerned about the industry beyond the drop in used car prices and the subprime lending spree in recent years that we discussed yesterday. The drop in March auto sales occurred even though “the average sales incentive topped $3,750 in March, or 10.3% of the sticker price, according to research firm J.D. Power. Incentive levels haven’t been this high since 2009 when the auto industry was navigating the financial crisis,” a 4/3 WSJ article reported. The article continued, “Meanwhile, J.D. Power said the number of days a vehicle sat on a dealer lot before being sold hit 70 days in March, the highest level since July 2009.”

(3) The numbers. The market is starting to discount the dour news from the traditional auto industry. The S&P 500 Automobile Manufacturers index, which represents Ford and GM, peaked in May 1999 and has fallen 75.3% since then through Tuesday’s close (Fig. 1). The index’s forward P/E has fallen to 6.5 (Fig. 2). Forward P/Es of cyclical industries often get that low when the market anticipates that an industry is experiencing peak earnings. Indeed, analysts are calling for earnings to fall 3.2% over the next 12 months (Fig. 3). If that estimate is accurate, it will mean the industry generated peak earnings in 1998.

Analysts expect the Auto Parts & Equipment industry (BWA and DLPH) to grow earnings 5.4% over the next 12 months, down sharply from expectations for y/y forward earnings growth that topped 10% in the past three years (Fig. 4). The industry has an 11.2 forward P/E, which is roughly in the middle of the range it has held for the past 20 years, and the index has climbed 8.4% ytd.

The S&P 500 Automotive Retail stock price index (AAP, AN, AZO, KMX, and ORLY) started this year near its peak and since has fallen 11.6% ytd (Fig. 5). Its forward P/E has fallen from almost 20 at the start of the year to 17.4 (Fig. 6). This industry is still expected to grow earnings 10.8% over the next 12 months, handsome growth but down from the 14.4% forward earnings growth expected in late 2015 (Fig. 7). We’ll be keeping an eye on Tesla to see if it manages to change not just how automobiles are powered but also how they are sold and serviced. More pressure could be applied in upcoming years, as the industry is sure to face increasing competition from Amazon, which is selling parts for cars with combustion engines, and from Tesla, which services its own electric cars.

Amazon Focus: More Tentacles. In addition to selling books and auto parts, Amazon sells groceries and appears to be making a concerted effort this year to go toe to toe with giants like Walmart, Target, and your local grocery store. Last week, we discussed two formats it’s testing: Amazon Go, where consumers can purchase groceries by using their phone and never waiting on a checkout line, and AmazonFresh Pickup, where consumers can get curb-side pickup.

Were that not enough, a 3/30 Bloomberg article reported that Amazon’s hosting a meeting with consumer products companies to discuss how they can start shipping goods directly to consumers. It’s every kid’s dream: the ability to ask Alexa for a box of Oreos and have it appear at the front door in an hour. “Manufacturers would have to re-imagine everything from the way products are made to how they’re packaged. Laundry detergent could come in sturdier, leak-proof containers. Instead of flimsy packages designed to pop on store shelves, cookies, crackers and cereal could be packed in durable, unadorned boxes. Plants could spit out products for individuals rather than trucks-full of inventory.” The company declined to comment in the story.

The move is similar to what Costco and the club stores did 20 years ago, Bloomberg explains. Those stores asked merchants to “create bulk sizes sold at a discount” and in return they enjoyed a surge in sales. Now Amazon has the leverage, with 300 million shoppers, and the ability to make its own products to sell to consumers if companies are unwilling to join with it.

Amazon also made news by shelling out about $50 million for the rights to stream 10 Thursday night football games over one year to members of Amazon Prime. That price is a fivefold increase over the NFL’s deal with Twitter for the same number of games last season, noted a 4/4 WSJ article. The move makes Amazon’s Prime the only streaming service offering sports and can’t be welcome news for ESPN or the broadcast networks.

The bounty of good news of late has helped propel Amazon’s shares 20.9% ytd and 52.9% over the past year through Tuesday’s close. The recent surge has made Jeff Bezos the second wealthiest person in the world, behind only Microsoft’s Bill Gates, the 3/29 Bloomberg reported. Meanwhile, the Department store industry is the worst performer ytd, down 18.4%. Here’s a look at some of the financial metrics driving those diverging stock performances.

(1) Online sales on fire. The shift to online continues unabated. Online shopping now accounts for almost a third of in-store and online sales included in GAFO, which stands for general merchandise, apparel and accessories, furniture and other sales (Fig. 8). And while sales at department stores, warehouse clubs, and supercenters plateaued last year, online sales climbed 13.2% (Fig. 9).

The continued growth in online sales has helped Amazon’s stock price and the S&P 500 Internet & Direct Marketing Retail stock price index, which has gained 19.8% ytd through Tuesday’s close (Fig. 10). The industry index is the seventh-best-performing ytd, and in addition to Amazon counts Netflix, Expedia, Priceline, and TripAdivsor as members. The industry’s forward revenues—i.e., those analysts anticipate over the next 12 months—are expected to grow 20.6%, and earnings are thought to improve by 32.6% over the same timeframe (Fig. 11). This index isn’t cheap, with a forward P/E of 60.2 (Fig. 12). But analysts are anticipating extremely strong earnings growth going forward, which would drop the index’s P/E on 2018 earnings to 46.8.

(2) Falling bricks. Compare that to the S&P 500 Department Stores index, for which revenues over the next 12 months are forecasted to fall 1.2%, while earnings are expected to rise 1.5% (Fig. 13). The meager growth has depressed the industry’s forward P/E to 10.6, down sharply from roughly 15 in 2015 (Fig. 14). The situation is slightly better at Costco and Walmart, which make up the S&P 500 Hypermarkets & Super Centers industry. That industry is expected to produce forward revenue growth of 3.4% and forward earnings growth of 3.4%, and has a forward P/E of 19.5 (Fig. 15 and Fig. 16). Given Amazon’s recent initiatives in the grocery aisle, that above-market P/E might be in peril.

(3) Home improvement next? The Home Improvement retailers, Home Depot and Lowe’s, so far have proved resistant to online competition, but vigilance is warranted. Over the next 12 months, the industry is expected to post revenue growth of 4.7% and earnings growth of 13.0% (Fig. 17). Investors have rewarded the S&P 500 Home Improvement Retail industry with a 19.2 forward P/E ratio (Fig. 18).

The Home Improvement industry undoubtedly has been helped by the housing recovery, the woes at Sears, and consumers’ desire to see items like refrigerators and kitchen cabinets in person before making a purchase. Weekend gardeners still need to make a trip to the stores to buy tulips, and contractors still head to the store for a part instead of holding up a job. Could that change if Amazon figures out how to make last-mile delivery quicker? Absolutely. You can be sure they’re working on it.

Across the Pond

April 05, 2017 (Wednesday)

See the pdf and the collection of the individual charts linked below.

(1) Worrying about US C&I loans in London. (2) Two significant soft patches in US economy. (3) Toxic fumes from subprime auto loans. (4) Used car prices falling, and so are new car sales. (5) M-PMI is soft data, but it’s upbeat. (6) Fed officials mostly predict two more rate hikes this year, with a couple seeing three. (7) One-and-done may be back on the table for 2017. (8) Fixed-income markets aren’t buying Fed’s hawkish talk.


US Economy: Back to New Normal Already? Greetings from London again. During my meetings over here on Monday and Tuesday, I was surprised by how many times I was asked to explain why commercial and industrial (C&I) loans held by US banks have stopped growing. In addition, there were some questions about the weakness in March auto sales, which were reported on Monday.

Investors on this side of the pond are troubled that there is almost no evidence that the so-called hard economic data are confirming the remarkable strength since Election Day in the soft data that are based on surveys of consumers, purchasing managers, CEOs, small business owners, and regional business surveys, which we continue to track in our Animal Spirits chart publication. Actually, the hard data remain surprisingly soft. The FRB-Atlanta’s GDPNow is tracking at only 1.2% (saar) for Q1-2017.

At the end of last year, on December 12, Debbie and I raised our real GDP growth estimate for 2017 from 2.5% to 3.0%. We are sticking with that forecast, for now, but note that the economy has a couple of significant soft patches currently. Consider the following:

(1) Autos spewing toxic fumes. Last Thursday, Jackie and I reiterated our concerns about the stress in auto financing, especially in the subprime segment, since used car prices have declined 5.1% over the past 21 months through February (Fig. 1). We noted that auto loans outstanding increased 6.9% y/y through Q4-2016 to a record $1.1 trillion (Fig. 2).

A combination of rising delinquencies and falling used car prices is a toxic mix for auto sales. All this has been widely recognized for a while. However, investors were jarred to see auto sales drop from 17.6 million units (saar) during February to 16.6 million last month, down from a cyclical peak of 18.4 million units during December and the lowest since February 2015 (Fig. 3). The domestic auto inventories-to-sales ratio rose to 3.2 months’ supply during February, the highest since June 2009 (Fig. 4).

The S&P 500 Automobile Manufacturing stock price index (F, GM) lost 2.7% on Monday and Tuesday, with its 200-day moving average remaining on a modest downward trend since 2014 (Fig. 5).

Auto manufacturing employed 941,600 workers during February, up from a cyclical low of 623,300 during June 2009. Auto dealers employed 1.3 million workers during February, up from a cyclical low of 998,800 during November 2009. Both could suffer losses if auto sales continue to weaken.

The good news is that the national M-PMI remained high at 57.2 last month, with the employment component at 58.9, the highest since June 2011 (Fig. 6). Also remaining elevated were the new orders (64.5) and production (57.6) components. We reckon that the auto industry isn’t rushing to reduce employment and will provide financing incentives to reduce bloated inventories. We also believe that energy-related capital spending should rebound from the oil industry’s recession that lasted from the summer of 2014 through the winter of 2016.

(2) Department stores liquidating inventories and employees. Also, last Thursday, Jackie and I discussed how Amazon is seriously disrupting (if not outright destroying) in-store retailers who are struggling to compete with the online juggernaut. As we noted, during February, 15.9 million people worked in retailing, while 12.4 million worked in manufacturing. Trump might succeed in bringing back some jobs to robots in American factories.

Meanwhile, lots of humans working in retailing might lose their jobs. Payroll employment in retail stores rose 27,000 over the past 12 months through February (Fig. 7). The seasonally adjusted data are volatile, but February payrolls did drop 33,800 during February following a 26,400 gain during January.

Meanwhile, inventories at general merchandise stores are down 3.1% over the past 16 months through January (Fig. 8). This might partly explain why short-term business credit—which is the sum of C&I loans at commercial banks plus nonfinancial commercial paper—has stalled in recent weeks (Fig. 9). It tends to fluctuate around the trend in total business inventories. On a y/y basis, it is up just $55 billion, the weakest since April 2011 (Fig. 10).

Stores that are being closed are liquidating their inventories and generating cash to pay down outstanding short-term business credit. They certainly aren’t ordering more merchandise. Apparently, the Census Bureau doesn’t publish data on the inventories of online retailers, though Debbie is still working on tracking it down. It stands to reason that Amazon must be increasing its merchandise inventories. The company may be financing those stocks with the cash flow it generates from its enormously profitable cloud services. Are we worried about all these developments? No, but they have our undivided attention.

The Fed: One-&-Done Again? Melissa and I have noted that the majority of FOMC participants agree that barring any unexpected developments, they intend to raise the federal funds rate by 25bps two more times this year. It was one-and-done in 2015, when the Fed raised the rate from 0%-0.25% to 0.25%-0.50% on December 16. At that same meeting, the FOMC signaled in their dot plot that they expected four rate hikes in 2016. It turned out to be one-and-done again at the end of last year on December 14, when the rate was raised to 0.50%-0.75% and the dot plot projected three rate hikes this year.

Sure enough, the FOMC hiked the rate to 0.75%-1.00% on March 15. Most Fed officials have reiterated that two more rate hikes are coming this year, though a couple said that perhaps there might be four rather than three hikes all told in 2017. These hawks seem to be concerned about the post-election melt-up in stock prices.

Melissa and I still expect two more rate hikes this year, but we are losing our conviction based on our concerns, mentioned above, about auto sales and store closings. In other words, we are putting one-and-done back on the table as a possible scenario. The federal funds future market is also relatively dovish, with the fed funds rate projected to be 1.31% within 12 months (Fig. 11). Meanwhile, the 10-year US Treasury bond yield has dropped from a recent high of 2.62% on March 13 to 2.36% yesterday. Over this same period, the yield curve spread between 10-year and 2-year Treasuries has narrowed from 122bps to 111bps (Fig. 12).

Europe: Good Fundamentals, Bad Politics

April 04, 2017 (Tuesday)

See the pdf and the collection of the individual charts linked below.

(1) Brexit overdose in London. (2) UK is between the Rock and a hard place. (3) Brexit negotiations will be nasty. (4) Fundamentally, Europe is looking upbeat, according to PMI and ESI. (5) Forward revenues and earnings are also improving. (6) Investors seem to believe that populism is a passing fad in Europe. (7) Dutch treat. (8) French fried. (9) Will there be a Frexit referendum after presidential election? (10) Germans preferring the status quo voted for Mini-Merkel. (11) Italy is still Italy politically, but Italian banking crisis may be getting worse.


Europe I: War Talk. Greetings from London! I am visiting our accounts in Europe this week. During my meetings yesterday, I found that London’s institutional investors are sick and tired of talking and reading about Brexit. They reckon no one knows for sure how it will all play out. In any event, they were happy to discuss the investment implications of the Trump administration for a change. Of course, in the US we have all had enough of all the cacophony from Washington since Election Day, though we can’t complain about the stock market rally since then, with the S&P 500 up 10.2% through yesterday’s close. Meanwhile, American investors in general aren’t particularly concerned about Brexit.

According to my informed sources in London, I am reasonably confident that a war between the United Kingdom and Spain over Gibraltar is very unlikely. On Sunday, the former Tory leader Michael Howard, citing Margaret Thatcher’s war with Argentina over the Falkland Islands, said he was “absolutely certain that our current prime minister will show the same resolve in standing by the people of Gibraltar.” The rocky 2.6-square-mile (or 6.7-square-kilometer) enclave at the tip of the Iberian peninsula has been a British territory—and cause of friction between the UK and Spain—since 1713. The latest spat was sparked by draft Brexit negotiating guidelines drawn up by the European Union (EU), which said no future agreement between Britain and the bloc would apply to Gibraltar unless both the UK and Spain agreed.

Fabian Picardo, the chief minister of Gibraltar, accused the EU of behaving like a “cuckolded husband who is taking it out on the children” by appearing to hand Spain a veto over the Rock’s future in Brexit negotiations. He said: “Gibraltar is not a bargaining chip in these negotiations. Gibraltar belongs to the Gibraltarians, and we want to stay British.” He made the comments after Spain accused Britain of “losing its temper” over Gibraltar. Downing Street dismissed suggestions that Britain could send a task force to Gibraltar. “It isn’t going to happen,” a spokesman said. Brexit negotiations are likely to be rancorous.

Europe II: Good Fundamentals. Political uncertainty in Europe has weighed on European equity valuations, especially with the Netherlands, France, and Germany all holding critical elections this year. Lately, the cheapness of Eurozone relative to US equities has attracted the attention of investors and gotten lots of financial press. Eurozone stocks have been performing well so far this year, yet valuations remain relatively attractive. In addition, the latest economic data out of the region show upward momentum. In other words, the fundamentals are looking better for the Eurozone, while politics remain unsettled if not unsettling. Let’s start with the former before moving on to the latter:

(1) Performance & valuation. During Q1, the performance derby among the MSCI stock price indexes for the major developed countries is as follows (in dollars, and local currencies): EMU (8.3%, 6.8%), US (5.7, 5.7), UK (3.9, 2.7), Japan (3.7, -1.0) (Fig. 1 and Fig. 2). The forward P/E of the EMU MSCI index is 14.5, which is well below the US at 17.9 (Fig. 3).

(2) Factory activity & prices. The Eurozone’s M-PMI (56.2) and NM-PMI (55.5) jumped to cyclical highs during March and February, respectively, according to Markit (Fig. 4). Chris Williamson, chief business economist at IHS Markit, observed that the six-year highs were evident across all key business activity gauges—output, new order inflows, exports, backlogs of work, and employment. The upturn was broad-based, with Greece being the exception to the strength. Business is so good elsewhere in Europe that suppliers are having trouble keeping up with demand.

Europe’s M-PMI performance derby shows Germany leading the way: Germany (58.3), Italy (55.7), UK (54.2), Spain (53.9), France (53.3). March data for the NM-PMI will be available on Wednesday. February’s performance derby for the NM-PMI showed Spain leading the way: Spain (57.7), France (56.4), Germany (54.4), Italy (54.1), and UK (53.3) (Fig. 5 and Fig. 6).

(3) Economic sentiment. Europe’s economic sentiment indicator (ESI) is also upbeat. During March, the European Union and Eurozone ESIs were at cyclical highs (Fig. 7). The latter is highly correlated with the y/y growth rate of real GDP in the Eurozone, which was 1.7% during Q4 (Fig. 8).

(4) Forward revenues and earnings. Industry analysts have turned more optimistic on the outlook for both revenues and earnings of the EMU MSCI stock index (Fig. 9 and Fig. 10). Both have turned up on a 52-week forward basis. Revenues are expected to increase 4.9% this year and 3.5% next year, while earnings are expected to rise 13.3% this year and 10.5% next year.

Europe III: Bad Politics. Since the Brexit decision last summer, populist movements have been gaining strength in Europe, threatening the viability of both the European Union and the Eurozone. Investors received a momentary reprieve when the populist party was defeated in the latest Dutch election on March 15. In France’s upcoming presidential election, the populist candidate has a decent shot at winning. Germany’s national election will be held this fall, with the likely result skewed toward the establishment given the outcome of recent regional elections. In Spain also, the establishment has managed to outmaneuver the populists. The most unstable political situation of all might be in Italy. That’s hardly a new development. Neither is the Italian banking crisis, which has fueled the political unease.

To buy into Europe, investors must buy into the this-too-shall-pass belief. Melissa and I aren’t believers, so we aren’t ready to overweight European equities. Even if the election outcome in France, for example, turns toward the establishment, anti-EU sentiment probably won’t just disappear. Neither will Italy’s debt woes, although officials are trying to force Italian banks to clean up the mess before it gets messier. The bottom line is that Europe has good fundamentals right now, but the political situation isn’t pretty. Neither are Italy’s zombie banks. See our 3/1 and 2/14 Morning Briefings for prior coverage of the European drama. Below, we recap the latest episodes:

(1) Wilders loses and wins. On 3/15, Geert Wilders, the Dutch platinum-blonde version of Donald Trump, lost the presidential election in the Netherlands. Some say it was a small victory for the anti-EU Party for Freedom, which gained five seats in Parliament while the People's Party for Freedom and Democracy lost 8 seats. However, Wilders’ party failed to get a majority. It won 20 seats to the 33 seats that Dutch Prime Minister Mark Rutte’s establishment party held onto. (See Bloomberg’s helpful chart on “How the Dutch Voted” from a 3/16 article.) Even if Wilders had won, his party was unlikely to have been able to form a government, according to a British analyst quoted in Barron’s. Rutte’s party has a better chance of forming a majority coalition, although that’s still not guaranteed, and could take months to finalize, according to The Guardian.

(2) Mudslinging in France. The French presidential election begins on April 23 (the first round) and ends on May 7 (the second round). French presidential candidate Marine Le Pen, who staunchly opposes the EU and wants to take France out of the euro, leads the opinion polls, reported Barron’s. However, Le Pen is expected ultimately to be defeated in the second-round vote. But it’s all up in the air, especially with the mudslinging increasing as the days of reckoning approach. Center-right Francois Fillion is knee-deep in the mud after a formal investigation was opened on him in mid-March for a case involving nepotism. However, centrist Emmanuel Macron and far-right-winger Marine Le Pen have not been immune to accusations of wrongdoing themselves.

But what would a Le Pen win look like? France wouldn’t just up and leave the EU immediately if Le Pen takes office. First, she would need the support of a parliamentary majority to push her program forward, according to a 3/23 WSJ article. Also, a “Frexit” referendum vote would need to be held.

Europe’s already sensitive recovery could take a turn for the worse if Le Pen were to get that far and further succeed with her agenda of dismantling France’s involvement with the euro. Research house Autonomous recently suggested that France leaving the euro could trigger a Lehman-style event for European banks and markets, according to the 3/20 FT. On the other hand, the bearish analysts attached a 27% probability to a Le Pen victory and only a 12% probability to her “securing a ‘leave-the-euro’ referendum vote later this year.”

(3) Merkel’s mini-win. At the end of March, Germany’s establishment scored when German Chancellor Angela Merkel’s Christian Democratic Union (CDU) party won the governor’s seat in Saarland state, reported The Washington Post. Incumbent Minister-President Annegret Kramp-Karrenbauer, dubbed “Mini-Merkel,” overcame her center-left opponent. In May, two more state elections will be held, followed by Merkel’s run for chancellor in the 9/24 national parliamentary election. Merkel is campaigning against Martin Schulz, the candidate of the center-left Social Democratic Party (SPD), who remains confident that his party still has a chance on a national level.

As for the populists, the title of a 3/27 local German news article says it all: “How Saarland could show that the far-right AfD are finished.” An “equally intriguing story” as the Merkel-vs-Schulz contest has been “the miserable result scored by the AfD.” The populist party won just 6.2% of the Saarland vote, which is just a touch above the 5% “threshold for making it into German parliaments.” The article noted that the “drab score is in sharp contrast to a string of double-digit results in five state elections throughout 2016.” Several political analysts were quoted in the article as saying that the Saarland vote could signal that the Afd will “disappear.” But the AfD party’s co-leader said of the result that not too much should be read into it given special conditions in the small state.

(4) In-fighting in Spain. During a radio interview in January, Spain’s Prime Minister Mariano Rajoy was asked about the possibility of populists coming into power in European countries like France and Germany. According to Breitbart, Rajoy responded: “I don’t even want to think about it, that would be a disaster. It would simply mean the destruction of Europe.” Rajoy was reelected as Spain’s prime minister during February, and Spain’s anti-austerity party suffered some major setbacks.

A 2/12 Politico article reported that Rajoy’s reelection was the “surprise development of Spanish politics.” It noted: “Just a year ago, pundits were writing Rajoy’s political obit. But the conservative leader, who took over the party in 2004 and survived two electoral defeats before winning government, has defied his doubters once again.” Now “back from the dead” politically speaking, the Prime Minister and his party are expected to remain “unchallenged for some time.” That’s especially true given the “disarray” of the other political parties.

For example, Podemos, the anti-austerity party, has been plagued by in-fighting. According to a 2/10 Politico article: “On January 31, journalists and politicians in Spain’s Congress watched as the party’s leader, Pablo Iglesias, became locked in what seemed to be a bitter argument with his deputy, Íñigo Errejón, seated next to him. In photos subsequently published in the media, the ponytailed Iglesias looks haggard and tired, sometimes fiercely making a point to his colleague, at others frowning as he listens. The usually fresh-faced Errejón appears much older than his 33 years, at one point wearily removing his glasses to remonstrate with the party leader.”

Comparing the outward display of the party’s internal power struggle to a train wreck, an important member of the party’s governing committee resigned the next day. Others in the party were not shy to chime in with distaste for the episode. Spain’s populist party might very well “self-destruct” given all of this. So the establishment can safely celebrate their victory, and investors can take solace in the apparent stability, at least for now.

(5) Italy in purgatory. Italy’s banks are in crisis, while the country’s government is unstable. These are the two major reasons why investors are betting against Italy, as discussed a 3/9 Forbes article. Not much is new on either situation since we last discussed them in our 3/1 and 7/6/16 Morning Briefings.

On 3/10, MarketWatch observed that some are still clinging to the hope that Prime Minister Renzi could make a comeback in a new election. Renzi had stepped down after failing to reform the Italian Senate by a referendum vote held on December 5, 2016. While not impossible, the latest developments might have made that more difficult.

Upon Renzi’s defeat, rebels within Renzi’s party broke off to form a new party, the Democratic and Progressive Movement (MDP), which is further to the left. “They took enough lawmakers with them that they could now potentially bring down the government,” according to MarketWatch. The “current disarray” means that elections now are more likely to be held earlier than next year. Meanwhile, the anti-EU, anti-austerity Five Star Movement party led by Beppe Grillo has “emerged as the most popular party at about 30% and continues to build support,” according to Forbes.

(6) Running on empty. The 3/30 Economist explored the deep roots of Italy’s bad-debt problems. It wrote: “Bad loans have quadrupled in value since 2008 ... But no bank has quadrupled their staff to manage them. Lenders have been [reluctant] to sell their loans. Many have them in their books at around 40% of their face value, whereas investors are prepared to pay around half that. Banks’ capital ratios are already thin; disposals would stretch them further. Government efforts to boost the market have flopped.” On the other hand, last year was “the first since 2008 in which Italy’s total NPL exposure fell.” Additionally, the ECB has been pressuring banks to clean up their balance sheets. That development has forced the banks to come up with detailed plans, which some investors are optimistic about.

The Third Mandate

April 03, 2017 (Monday)

See the pdf and the collection of the individual charts linked below.

(1) More fuel for the melt-up. (2) Financial stability is the third mandate. (3) Putting odds on Nirvana, melt-up, or meltdown. (4) The S&P 500’s Price/Sales (a weekly version of Buffett Ratio) is in outer space. (5) Nose-bleed valuations unless Trump can boost earnings. (6) The melt-up mechanism may be in gear. (7) Stock buybacks plus equity ETF inflows are boosting stock prices. (8) Passive is the new active. (9) Valuation-dependent: Fed officials saying market is “a little rich” and “a little frothy.” (10) Dudley wants to add more fruit juice to the punch bowl. (11) Keep drinking for now; even fruit punch can cause a sugar high. (12) Movie Review: “The Zookeeper’s Wife” (+ +).


Strategy: Fueling the Melt-Up. Fed officials have more or less been declaring “mission accomplished” since early March. They mostly are convinced that they have achieved their dual congressional mandate of full employment with low and stable inflation. The unemployment rate has been below 5.0% for the past 10 months through February (Fig. 1). The “jobs-hard-to-get” series compiled by the Conference Board (with data collected from a monthly survey of consumer confidence) fell in March to 19.5%, the lowest reading since July 2007. It is highly correlated with the jobless rate and suggests this rate might be heading closer to 4.0%. So does the initial unemployment claims series, which is hovering around its lowest since 1973 (Fig. 2).

The headline and core PCED inflation rates, on a y/y basis, were 2.1% and 1.8% during February, close enough to the Fed’s 2.0% target for the Fed’s preferred measure of core consumer price inflation (Fig. 3). The headline and core CPI inflation rates were 2.8% and 2.2% in February (Fig. 4).

Now, as Melissa and I discuss below, Fed officials seem to be moving surprisingly quickly toward their third, though unofficial, mandate—i.e., financial stability. This is a subject many of them have discussed from time to time since the Great Recession, but it has always taken a back seat to the official dual mandate.

Until recently, Fed officials had been stressing that monetary policy was “data-dependent.” In other words, it would remain very accommodative, even ultra-easy, until the economic data confirmed that the labor market was at full employment with inflation rising closer to the 2.0% target. Believing that they were nearing the Promised Land, the members of the FOMC voted to raise the federal funds rate by 25bps at the end of 2015, 2016, and again this year on March 15. They also signaled that they would stick with a gradual normalization of monetary policy with two more rate hikes this year and three next year. But some of the natives are getting restless, recently saying that a faster pace of normalization might be appropriate.

What has changed? The “hard data” still look relatively soft. The Atlanta Fed’s GDPNow is tracking a growth rate of only 0.9% currently. On the other hand, as we’ve been monitoring in our new Animal Spirits publication, the “soft data” have been remarkably strong. Leading the way has been investor confidence, as evidenced by the surge in stock prices since Election Day. In our opinion, Fed officials may be starting to turn from being data-dependent (focusing on the economy) to being valuation-dependent (focusing on the stock market). A few already may be worrying about a melt-up scenario in the stock market.

On March 7, Joe and I lowered our subjective probability of a Nirvana scenario for the stock market from 60% to 40%. At the same time, we raised the odds of a melt-up scenario from 30% to 40%. Consequently, we raised the odds of the meltdown scenario from 10% to 20%. We figured that if the odds of a melt-up have increased, so have the odds of a subsequent meltdown.

Valuation measures are elevated across the board, for sure. The forward P/E of the S&P 500 is currently 17.7 (Fig. 5). It is highly correlated with the forward price-to-sales ratio (P/S) of the same stock market index. This valuation metric closely tracks the Buffett Ratio, which is equal to the market capitalization of the entire US equity market (excluding foreign issues) divided by nominal GNP (Fig. 6). During Q4-2016, the Buffett Ratio was 1.67, not far below the record high of 1.80 during Q3-2000. The forward P/S rose from 1.58 in early 2016 to a record high of 1.93 in March.

These all are nose-bleed levels. However, they may be justified if Trump proceeds with deregulation and succeeds in implementing tax cuts. His policies may or may not do much to boost GDP growth and S&P 500 sales (a.k.a. revenues). Nevertheless, they could certainly boost earnings.

The risk is that Trump’s victory activated a melt-up mechanism that has nothing to do with sensible assessments of the fundamentals or valuation. Instead, structural market flows may be driving the market’s animal spirits. Consider the following:

(1) Lots of corporate cash is still buying equites. At the end of last week, Joe updated our chart publications with Q4-2016 data for S&P 500 buybacks. They remained very high at a $541 billion annualized rate (Fig. 7). For all of last year, buybacks totaled $536 billion, a slight decline from the previous year’s cyclical high of $572 billion. S&P 500 dividends rose to a record high of $396 billion last year. Since the start of the bull market during Q1-2009 through the end of last year, buybacks totaled $3.4 trillion, while dividends added up to $2.4 trillion. Combined, they pumped $5.7 trillion into the bull market, driving stock prices higher without much, if any, help from households, mutual funds, institutional investors, or foreign investors (Fig. 8).

(2) Passive is the new active. On the other hand, equity ETFs have been increasingly consistent net buyers of equities during the current bull market (Fig. 9). Their net inflows totaled a record $281 billion over the past 12 months through February. Since the start of the bull market during March 2009, their cumulative net inflows equaled $1,167 billion, well exceeding the $179 billion trickle into equity mutual funds (Fig. 10).

So there you have it: The bull may be chasing its own tail. We know that image doesn’t quite jibe with the bull charging ahead, but work with us here. The bull has been on steroids from share buybacks by corporate managers, who have been motivated by somewhat different and more bullish valuation parameters than those that motivate institutional investors, as we have discussed many times before. Most individual investors seemingly swore that they would never return to the stock market after it crashed in 2008 and early 2009. But time heals all wounds, and suddenly some of them may have turned belatedly bullish on stocks after Election Day. Add a buying panic of equity ETFs by individual investors to corporations’ consistent buying of their own shares, and the result may very well be a melt-up.

The Fed: Valuation-Dependent. Fed officials may be starting to get it. If so, then monetary policy may pivot from being data-dependent to being valuation-dependent. This would imply that the pace of raising interest rates might be stepped up. A couple of Fed officials seem to be signaling that now. Consider the following:

(1) Rosengren & Williams. Last Wednesday, both FRB-Boston President Eric Rosengren and FRB-SF President John Williams seemed to be turning more hawkish. In an interview with Bloomberg, Rosengren said some asset markets are “a little rich.” He called for a rate hike at every other FOMC meeting through yearend, which would add up to four, rather than three, rate hikes this year.

Then Williams warned that stock market valuations “may be a little frothy” and might “come down” on fiscal policy disappointment. He told reporters during a Q&A in New York that “I do think that the market’s perceptions of what’s going to happen ... kind of got ahead of reality” on fiscal policy. Williams also echoed Rosengren in saying that he “would not rule out more than three increases total for this year.” Interestingly, he also said that the “growing wealth-to-income ratio is another reason to keep raising rates.” Indeed, this ratio rose to 6.5 during Q4-2016, the highest on record (Fig. 11)!

(2) Evans. Also last Wednesday, FRB-Chicago President Charles Evans said that “for the first time in quite a while, I see more notable upside risks to growth.” Speaking at a conference in Frankfurt, he said the environment “reflects both strong economic fundamentals and, possibly, stronger fiscal support over the medium term.” He told reporters after his speech the Fed could lift rates four times this year “if things proceed even better” than currently expected. Apparently, he did not specifically mention asset prices as a concern.

(3) Fischer, Powell, and Kaplan. Rosengren, Williams, and Evans are quite influential members of the FOMC. Until not too long ago, they all were deemed to be doves. Now they seem hawkish. However, of the three, only Evans gets to vote on the FOMC this year. Recently, three other voting members were a bit more dovish than their non-voting colleagues at the end of March. In an interview with CNBC on Tuesday, Fed Vice Chairman Stanley Fischer said that his forecast mirrors that of the FOMC’s median estimate of about two more hikes in 2017. He prefers to watch and wait to see how fiscal policies develop, reported Bloomberg on 3/28. Fed Governor Jerome Powell and FRB-Dallas President Robert Kaplan also seemed to suggest a more gradual approach in comments at the end of March.

(4) Dudley. Last Thursday, FRB-NY President William Dudley, who gets to vote, also weighed in on the outlook for monetary policy. In a 3/30 speech, he said: “Even after the latest increase, the federal funds rate target range at three quarters of a percent to 1 percent is still unusually low in both nominal and inflation-adjusted terms. While most FOMC participants judge the equilibrium short-term real interest rate that is consistent with a neutral monetary policy to be low—perhaps in a range of 0 to 1 percent—this is still above the current inflation-adjusted federal funds rate. In such circumstances, it seems appropriate to scale back monetary policy accommodation gradually in order to reduce the risk of the economy overheating, and to avoid a significant inflation overshoot in the medium term.”

So he is still in the “gradual” camp, along with Fed Chair Janet Yellen, who used this word (or “gradually”) to describe the course of monetary policy 21 times in her 3/15 press conference. However, Dudley also said that “there is still considerable uncertainty about fiscal policy and its potential contribution to economic activity.” He added that “it seems likely that it will shift over time to a more stimulative setting.” He concluded that “the risks for both economic growth and inflation over the medium to longer term may be shifting gradually to the upside.”

Dudley indirectly might have alluded to the stock market with the following punch line about the Fed’s punch bowl: “William McChesney Martin, the ninth chair of the FOMC, once famously opined that the Federal Reserve is ‘in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.’ I don’t think we are removing the punch bowl, yet. We’re just adding a bit more fruit juice.” Here is the full excerpt from Martin’s speech given on October 19, 1955:

“In the field of monetary and credit policy, precautionary action to prevent inflationary excesses is bound to have some onerous effects—if it did not it would be ineffective and futile. Those who have the task of making such policy don’t expect you to applaud. The Federal Reserve, as one writer put it, after the recent increase in the discount rate, is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.”

Martin was focusing on price inflation in the economy rather than in the stock market. Dudley’s comments arguably seem more relevant to the current inflation in the stock market than in the economy. Our advice is keep drinking until they take away the punch bowl! Even fruit juice can provide a sugar high.

Movie. “The Zookeeper’s Wife” (+ +) (link) is a big-screen adaptation of the book of the same name about the remarkable story of an incredibly heroic married Polish couple, Antonina and Jan Żabiński, who owned and operated the Warsaw Zoo before World War II. They lost all their animals when the Nazi’s invaded Poland, but kept the zoo as a pig farm during the war. At the same time, the Christian couple secretly saved about 300 Jews from certain death at great risk to their family. Jan was also a leader of the Polish resistance. The Żabińskis reopened the zoo after the war. The world certainly needs more decent people like them.

Jeff Bezos, The Terminator

March 30, 2017 (Thursday)

See the pdf and the collection of the individual charts linked below.

(1) Jeff Bezos and Sigourney Weaver both have powerful exoskeletons. (2) Amazon is killing its competitors and inflation. (3) A short history of the plot to murder inflation. (4) From the Walmart price to the China price to the Amazon price. (5) Killing more and more categories. (6) Nearly one-third of GAFO online now. (7) More jobs at risk in retailing than manufacturing. (8) The hole in the mall. (9) Will theaters die along with anchor stores? (10) Autos getting weighed down by debt. (11) Used car prices falling.


Amazon: Piranha Tank. At a conference last week, CEO Jeff Bezos climbed into the control cockpit of a giant, 14-foot-tall robot and moved its arms menacingly, waving them back and forth. According to a 3/20 CNN article, he quipped: “Why do I feel so much like Sigourney Weaver?,” referring to the epic scene in “Alien” when she wore an exoskeleton to battle and beat the alien.

In the business world, Bezos has no need for such armor, but his competitors must identify with the alien and feel the creature’s pain. Started in 1994 as a book retailer, Amazon now sells just about everything you can imagine at prices that make it a fierce competitor. It offers furniture for the living room, cookware for the kitchen, and tools for the garage. It hawks arts and crafts, food, electronics, toys, sporting equipment, and towels. Amazon created the Kindle, has us talking to Alexa, and became a web-hosting powerhouse. Bezos even attended the Academy Awards because Amazon Studios distributed “Manchester by the Sea,” which won two Oscars.

Amazon is killing lots of businesses. In the process, it may also be killing inflation. In the early 1980s, Paul Volcker seriously wounded inflation with killer interest rates (Fig. 1 and Fig. 2). This monster has struggled to raise its ugly head only to be subsequently whacked back down by deregulation that started under President Jimmy Carter and continued under President Ronald Reagan. Then came the end of the Cold War in 1989, unleashing globalization, which increased global competition. Walmart’s “everyday low prices” reflected the disinflationary impact of the retailer—which became a publicly traded company in 1970—distributing cheap imported goods in the US. Then the “China price” continued to put downward pressure on inflation after the country joined the World Trade Organization in 2001. Now Amazon has turned into the price killer in retailing and increasingly in other businesses.

As the world’s largest retailer and the sixth-largest publicly traded company, Amazon has single-handedly disrupted the retailing industry, the tech industry, and the entertainment industry. It employs 341,400 people, but it has caused competitors to close their stores and lay off countless employees. The company arguably has done as much as the Chinese to kill jobs and keep a lid on inflation by enabling fast and easy price discovery for anyone with a cell phone. I’ve asked Jackie to look at the impact Bezos and Amazon have had on us mere mortals so far. Here is what she found:

(1) Retail’s category killer. Last year, Amazon sold $94.7 billion worth of products around the world, and it continues to expand its offerings. One area of growth is private-label brands for men’s, women’s and children’s clothing, according to a 3/27 Business Insider article. It cites a Cowen & Co. research report that estimates Amazon will become the biggest apparel seller this year. “The company’s clothing and accessory sales are expected to grow nearly 30%, to $28 billion. Macy’s apparel sales, by comparison, are expected to drop 4%, to $22 billion, in the period,” the article states.

Amazon is also experimenting with a small-format, bricks-and-mortar grocery store, Amazon Go. Consumers would use their phones to pay, eliminating cashiers and checkout lines. The rollout of Amazon Go has been pushed back due to technological hitches the company is addressing, but it envisions opening roughly 2,000 stores if the format is ultimately successful. The company also announced earlier this week that it’s launching a grocery store that offers curb-side pickup, dubbed “AmazonFresh Pickup,” according to a 3/28 WSJ article. Watch out, Walmart!

The online retailer’s impact on the bricks-and-mortar set is hard to overstate. A 3/15 MarketWatch article looked at retailers that fell into the GAFO category, General Merchandise Apparel and Accessories, Furniture, and other stores. Sales at GAFO retailers have “stalled, falling $1.8 billion (or 0.6%) in the past year. … Meanwhile, online sales jumped by $13.7 billion through the third quarter of 2016, with Amazon accounting for most of that,” the article reported.

The US Census Bureau reports that online shopping rose to a record $521 billion (saar) during January (Fig. 3). Debbie calculates that it now accounts for a record 29.1% of total online and in-store GAFO sales (Fig. 4). Sales at general merchandise stores were relatively flat as a percentage of GAFO from 1992 through 2008 at around 43%, while the percentage at warehouse clubs and super stores (which are included in general merchandise stores) rose from about 7% to 27% over that same period (Fig. 5). Since 2009, the percentages of the former and the latter are down to 37.8% and 25.2%, respectively.

Some retailers have been laying off workers, but overall headcount has grown. “While sales fell 0.6% in 2016, employment at GAFO stores increased by 1.6%, or about 95,000,” according to the MarketWatch article cited above. That implies more layoffs are needed, the article states.

Amazon may absorb some of those laid-off employees. Earlier this year, it announced plans to hire more than 100,000 people in the US over the next 18 months. But the MarketWatch article contends that Amazon needs about half as many workers to sell $100 worth of merchandise as Macy’s does. Amazon has automated much of the work done in its warehouses, it hopes to eliminate grocery store cashiers at Amazon Go, and it’s working on using drones to deliver packages, endangering the local delivery guy.

The monthly employment report shows that 15.9 million workers are employed in retail trade (Fig. 6). There are 6.2 million people working in GAFO stores, 3.4 million workers in grocery stores, and another 700,000 or so working at pharmacies and drug stores. That might still be less than the 12 million folks employed by manufacturers, but the numbers are large enough that President Trump might want to start paying attention. If nothing else, he should think long and hard about introducing a border adjustment tax at a time when the industry is already under intense financial pressure due to the competition from Amazon.

(2) Dearly departed and walking dead. All manner of retailers have gone bust during Amazon’s expansion over the last two decades. Granted, some retailers accelerated their demise by taking on too much debt, and others were felled by the drop in demand during the Great Recession. But the competition from Amazon shouldn’t be underestimated. The list of deceased over the past 13 years includes Tower Records, CompUSA, Circuit City, KB Toys, Linens ‘n Things, Blockbuster, Borders, and RadioShack.

What’s notable today is that retailers are going bust or shuttering stores at a pace that would normally indicate an economic recession. Current moderate economic growth and strong consumer confidence haven’t helped some retailers improve their fortunes. Bebe Stores, a women’s apparel chain, recently announced plans to shutter its physical stores and sell exclusively online, while shoe retailer Payless is expected to file for bankruptcy protection and close 500 stores. Many department stores have been shuttering stores as they face competition from Amazon as well as discount and fast-fashion retailers like T.J. Maxx, H&M, and Zara.

Sears, which has been closing stores for years, warned investors in its annual report that “‘substantial doubt exists related to the company’s ability to continue as a going concern,’” reported a 3/22 WSJ article. “Sears quickly added that it is ‘probable’ that cost cuts, asset sales and other actions would mitigate its problems.” Sears is shutting 108 Kmart stores and 42 Sears early this year, in addition to closures in previous years. “[T]he retailer will have fewer than 1,500 stores left by early 2017. That’s down nearly 60% from 2011, when Sears had more than 3,500 stores,” calculated a 1/4 Business Insider article.

Sears may face the most dire situation, but it’s not the only department store shutting stores. Earlier this year, J.C. Penney announced plans to close 130 to 140 stores and two distribution centers. And after Macy’s reported that same-store sales fell 2.1% over the November-December holiday period, it warned that it could lay off as many as 10,000 workers, noted a 1/4 FT article. The retailer is in the midst of closing 100 stores.

(3) Hole in the mall. Investors in real estate also have begun to fear the Amazon threat. Shares of the FTSE NAREIT Equity Regional Malls Index are down 15.8% over the past year as of Tuesday’s close, compared to the 17.6% gain in the S&P 500.

Store closures affected 97.8 million square feet of retail space in 2016, more than double the 41.4 million affected in 2015. So far, strong malls have managed to replace closing stores with other tenants. The net absorption rate in 2016 was 105.7 million square feet, more than the 97.8 million square feet of closed stores, according to a JLL research report. Strong malls have replaced closing stores with new, expanding retailers or with new types of tenants, like grocery stores or bowling alleys. Weak malls, however, have had a tougher time.

“For malls in strong locations, these vacancies may actually be a boon, allowing them to trade up to a more productive anchor (like Nordstrom or Saks) or shift to a strong non-traditional anchor, like Bass Pro Shops. However weak malls will likely struggle to replace these tenants, resulting in a domino effect of decreasing performance and increasing vacancy.” The market may be anticipating tougher times ahead, even for strong malls: Shares of Simon Property Group, known for its high-end properties, are down 17.25% over the past year.

(4) Hollywood’s horror show. Were its domination of the retailing industry not enough, Amazon has expanded into and is disrupting new areas, including the entertainment and technology industries. It’s producing award-winning TV shows and movies, and throwing around big bucks to attract talent and distribution rights. Amazon purchased the distribution rights to “Manchester by the Sea” at last year’s Sundance Film Festival for $10 million, the second-largest sum paid to acquire a film at the festival in 2016. “The e-tailer has also made the biggest acquisition so far of this year’s Sundance: $12 million for comedy ‘The Big Sick,’ according to a person close to the deal,” the 1/24 WSJ reported.

As is industry custom, Amazon has released its movies in traditional theaters and waited before allowing access to the videos online. To watch a streamed movie over the Internet, Amazon customers must have a Prime membership, at the cost of $99 a year, which also gives them free two-day shipping. Netflix, another recent comer to the Hollywood game, streams its films the same day they are available in the theater.

The competition is pushing Hollywood studios to change the way they release films. Today, movies are available for at-home on-demand viewing 90 days after opening in theaters. Releasing the films with a lag time insulates theater ticket sales from competition. By yearend, however, studios may make films available on demand just a few weeks after they’ve appeared in theaters for between $30 and $50, the 3/26 WSJ reported. The Journal article explained: “To compensate theaters for lost box office, studios may share 10% to 20% of premium VOD revenue with them if the window is less than 30 days after the cinema debut, people with knowledge of the talks said. A key sticking point is for how many years theaters would be guaranteed to receive their share and that prices for early home release won’t fall too low.” Of course, empty movie theaters would be yet another blow to malls.

(5) Shoot-out in Westworld. It became clear that Amazon could do tech devices well when its Kindle e-reader outsold Barnes & Noble’s Nook. And now we’re all talking to Alexa, not to Siri, at home. But Amazon’s most impressive tech offering is certainly Amazon Web Services (AWS), its cloud-computing business that’s growing 50% annually and is expected to generate $13 billion in revenue this year, according to a 1/19 Information Week article. The business goes toe-to-toe with Microsoft and has a lead on both Google and IBM. And perhaps most importantly, AWS’s juicy operating profit margin of more than 25% gives Amazon a way to fund its new ventures and a retail business that has notoriously skinny margins. The cash and financial flexibility AWS provides ensures that Amazon will be a lethal competitor in the retailing industry for many years to come.

Auto Industry: Stalling Out? Auto sales may be running out of gas. Moody’s Investors Service believes auto sales have peaked at an annual high of 17.55 million units in 2016 and will decline ever so slightly to 17.40 million this year (Fig. 7). And, it warns, fewer car loans presumably will mean greater competition among lenders to make loans. Heightened competition could prompt lenders to extend credit on even riskier terms than they have in recent years. Let’s take a look at what might drive the industry down a slippery slope:

(1) Higher loan-to-value. Car loans already have grown riskier in recent years because they represent a larger percentage of the automobile’s value. “In the first nine months of 2016, around 32 percent of US vehicle trade-ins carried outstanding loans larger than the worth of the cars, a record high,” according to a 3/27 article in Reuters, citing Moody’s and Edmunds, an auto website. ”Typically, car dealers tack on an amount equal to the negative equity to a loan for the consumers’ next vehicle. To keep the monthly payments stable, the new credit is for a greater length of time. Over the course of multiple trade-ins, negative equity accumulates. Moody’s calls this the ‘trade-in treadmill,’ the result of which is ‘increasing lender risk, with larger and larger loss-severity exposure.’”

Loan amounts also increased because the average price of a new vehicle jumped by 30% from 2009 to an all-time high of $35,309 in December, a 3/23 Bloomberg article reports. “Car buyers tend to make buying decisions based on monthly payments instead of sticker price,” a 3/23 WSJ article. “ estimates the average monthly car payment for a vehicle purchased in February was $515, up only 6% from the $487 buyers paid in February 2007. Over the same period, the amount financed by new car buyers has skyrocketed 23%, from $25,003 to $30,753, the firm said.”

(2) Lower used car prices. The treadmill is also under pressure because the price of used cars is falling. The National Automobile Dealers Association’s seasonally adjusted used vehicle price index fell 8% in February y/y, marking its eighth straight month of declines (Fig. 8). The drop was the biggest for any month since November 2008, and news of the decline sent the stock price of car rental company Hertz Global Holdings tumbling, a 3/27 Bloomberg article reported. Used car prices have come under pressure as a surge of cars have come off their leases. The number of cars coming off lease jumped by 33% last year and is expected to increase another 9% this year, a 1/23 Bloomberg article estimated.

The first potential signs of a problem are showing up in subprime loans that are more than 60 days past due. A 3/22 Business Insider article noted that the 60-day-plus delinquency rate for subprime auto loans has gradually risen over the past seven years to almost 6% in Q4-2016, as measured by the Fitch Auto ABS index. Delinquencies among prime loans have risen much less dramatically and remain below 3%. “Subprime credit losses are accelerating faster than the prime segment, and this trend is likely to continue as a result of looser underwriting standards by lenders in recent years,” said Michael Taiano, a director at Fitch.

The decline in used car prices is aggravating loan losses. Lenders are losing more money on delinquent loans because the cars securing those loans have fallen in value. Annualized losses for subprime loans bundled into bonds were 9.1% in January, up from 8.5% in December and 7.9% in January 2016, S&P Global Ratings reported. A 3/10 Bloomberg article reported that S&P noted the losses were the highest since January 2010 and were “largely driven by worsening recoveries after borrowers default.”

(3) Trimmed earnings estimates. Auto manufacturers could offset this problem by subsidizing the auto lenders or by increasing incentives to reduce the purchase price, but that would hurt the bottom line. Ford Motor recently warned that Q1 results would miss targets, in part because it expects sales to slow as auto affordability declines due to higher interest rates and a decline in used-car values, the 3/23 WSJ article stated. The company, which expects auto sales to decline in the US and China in 2017 and 2018, also blamed higher engineering costs, the strong dollar, commodity price increases, and rising warranty costs. It expects FY2017 operating profits of $9 billion, a 14% decline y/y.

Ford isn’t alone. Ally Financial, the former auto-financing arm of General Motors, warned investors to expect 2017 earnings growth of 5% to 15%, a touch more subdued than the company’s January estimate for earnings growth of up to 15%. It too blamed the decline in used car prices and an increase in auto loan defaults among lower credit tiers. About a third of its retail auto loans in Q4 were made to subprime or near-subprime borrowers, noted a 3/21 WSJ article. That said, its stock is still up roughly 10% over the past year.

Is this a problem the size of the 2007 housing crisis? No. Consumers have $1.1­­ trillion of auto loans in Q4, which is 7.4% of all household debt (Fig. 9 and Fig. 10). That’s the highest percentage in more than a decade, but it still pales in comparison to the $9.75 trillion of home mortgage debt outstanding. Also, with the unemployment rate down to 4.7%, a major crisis is unlikely. Furthermore, as explained in our 5/3/16 Morning Briefing, cars aren’t houses. Cars are much easier to repossess and liquidate to cover outstanding loans. Our 2016 note concluded: “[I]f what’s driving auto sales is easier credit, then auto sales could slow if credit tightens.”

Could the consumer auto debt problem put a damper on new car sales, dampen economic growth, and hurt the stocks of auto manufacturers and lenders? We continue to think that it certainly could do so. It may be hard to make America much greater if the auto industry shifts into a lower gear.

Many Happy Revenues

March 29, 2017 (Wednesday)

See the pdf and the collection of the individual charts linked below.

(1) The recession is over. (2) Low oil prices are now stimulative on balance for the global economy. (3) Revenues are recovering with manufacturing & trade sales. (4) M-PMI is bullish for revenues, and so are regional business surveys. (5) Lots of sectors showing record-high forward revenues. (6) Belushi & Trump: “Toga! Toga! Toga! Toga!” (7) Giddy measure of consumer optimism. (8) Older consumers turned especially upbeat after Election Day. (9) Jobs are plentiful.


Strategy I: S&P 500 Revenues. The global economy fell into a growth recession from mid-2014 through early 2016. It was caused by a severe recession in the global commodities sector, led by a collapse in oil prices. It was widely expected that the negative consequences of lower oil prices for producers would be more than offset by the positive ones for consumers. That was not the case. The former outweighed the latter because the commodity-related cuts in capital spending overshadowed the boost to consumer spending from lower oil prices. In addition, there was a brief credit crunch in the high-yield market on fears that commodity producers would default on their bonds and trigger a widespread financial contagion.

Now the worst is over for commodity producers, as their prices have rebounded. That’s because they scrambled to reduce output and restructure their operations to be more profitable at lower prices. More importantly, global demand for commodities remained solid. Now with commodity prices, especially oil prices, well below their 2014 highs, consumers are benefitting more than producers are suffering.

Voila! The global economy is showing more signs of improving in recent months. That’s already boosting revenues growth for the S&P 500, and should be increasingly obvious as corporations report their top-line growth rates during the Q1 earnings season during April. Let’s have a closer look:

(1) Commodity prices. The CRB raw industrials spot price index fell 27% from April 24, 2014 through November 23, 2015 (Fig. 1). The index is up 28% from the low. The price of a barrel of Brent crude oil plunged 76% from its 2014 high of $115.06 on June 19 to its 2016 low of $27.88 on January 20 (Fig. 2). It is up 84% from its low to $51.28 yesterday.

(2) Business sales. US manufacturers’ shipments of petroleum products plunged 58% from the end of 2013 through February 2016 (Fig. 3). That drop weighed heavily on US manufacturing and trade sales, which declined on a y/y basis each month from January 2015 through July 2016 (Fig. 4). Excluding petroleum shipments, this broad measure of business sales of goods barely grew during this energy recession.

(3) S&P 500 revenues. Joe and I aren’t surprised to see S&P 500 revenues tracing out the same pattern as business sales since we have been tracking the close relationship of the two for some time (Fig. 5). The y/y growth rates of business sales and S&P 500 revenues (either on an aggregate or per-share basis) continue to be very close (Fig. 6). The same goes for the relationship excluding Energy revenues from the S&P 500 aggregate and business sales excluding petroleum shipments (Fig. 7).

Joe continues to monitor analysts’ expectations for the short-term (year-ahead) growth rates of S&P 500 revenues and earnings (STRG and STEG), as well as long-term (five-year-ahead) earnings growth (LTEG) on a weekly basis (Fig. 8). He reports that STRG has rebounded from close to zero in early 2015 to about 5.5% currently. Since the start of last year, STEG has jumped from about 5% to over 10%. LTEG is around 12.3%, near the best reading of the current economic expansion.

We doubt that any of these improvements have much to do with Trump’s election victory. We have no doubts that the end of the global Energy sector’s recession accounts for much of the improvement.

(4) Business surveys. Another upbeat indictor for S&P 500 revenues is the M-PMI, which has a good correlation with the y/y growth rate in S&P 500 revenues (both in aggregate and per-share) (Fig. 9). The former jumped from a recent low of 49.4 during August 2016 to 57.7 during February, the best level since August 2014. That too is consistent with a manufacturing recovery following the end of the energy recession, and augurs well for revenues growth.

By the way, there is a similarly good correlation between revenues growth and the composite business indicators from the regional surveys conducted by five Fed districts. All five are available through March, with their average index jumping from last year’s low of -12.8 to 21.6 this month (Fig. 10).

Strategy II: S&P 500 Sectors Revenues. For the upcoming Q1 earnings season, Joe reports that industry analysts are currently forecasting a revenue gain of 7.1% y/y for the S&P 500, and 5.0% excluding Energy. Here are the expectations for the 11 sectors of the S&P 500: Energy (35.9%), Utilities (8.7), Financials (8.1), Tech (7.9), Health Care (6.1), Materials (6.0), Consumer Discretionary (4.7), Real Estate (2.8), Industrials (2.5), Consumer Staples (1.7), and Telecom (-0.4).

Forward earnings are in record-high territory for all but the following sectors: Energy, Financials, Materials, Real Estate, Telecom Services, and Utilities (Fig. 11).

US Economy: More Animals. The US economy is turning into Animal House. I say that with great admiration. After all, the 1978 movie “National Lampoon's Animal House” cost only $2.8 million to make, and is one of the most profitable movies in history, with an estimated gross of more than $141 million in ticket sales. When it was released, it got mixed reviews, but Roger Ebert judged that it was one of the year's best. In 2001, the United States Library of Congress proclaimed that the comedy film is “culturally, historically, or aesthetically significant” and selected it for preservation in the National Film Registry. It starred John Belushi.

The question is whether “Trump World” starring Donald Trump will eventually win similar accolades. It hasn’t cost much so far. Yet it has arguably increased the market capitalization of the Wilshire 5000 by $2.2 trillion, to $24.4 trillion, since Election Day. It did so by reviving Animal Spirits. They’ve been boosted by Trump’s moving rapidly on his promise to reduce regulations on business and bring back manufacturing jobs. The elevated spirits haven’t been dashed by his failure last week to R&R Obamacare. Apparently, there are still high hopes for lower tax rates.

Our measure of consumer optimism has turned giddy, though half the country reportedly thinks that Trump is a joke. His poll ratings are terrible, though the pollsters have been wrong about him before. Indeed, the vote of confidence implied by the current and expected outlook for the economy in recent surveys of consumers is overwhelmingly upbeat. The Conference Board’s Consumer Confidence Index (CCI) is particularly euphoric, rising from 100.8 last October to 125.6 during March, the highest since December 2000 (Fig. 12).

The Consumer Sentiment Index compiled by the Survey Research Center at the University of Michigan is more subdued. Maybe its respondents represent more Democrats and fewer Republicans than the CCI’s. When Debbie and I average the two, our Consumer Optimism Index still shows lots of optimism (Fig. 13).

The CCI jump has been especially large among people who are 55 years and over (Fig. 14). The CCI seems to give more weight to labor market conditions. The survey used to compile the CCI shows that 31.7% of respondents agree that jobs are plentiful (Fig. 15). That’s the highest reading since August 2001.

Previously, I’ve suggested that Olivia Newton-John’s 1981 hit song “Physical” might provide a clue to the economy and the stock market in Trump World. The lyrics at the end are “Let’s get animal, animal / I wanna get animal.” You can monitor it all in our new Animal Spirits chart publication.

Bumps & Slumps

March 28, 2017 (Tuesday)

See the pdf and the collection of the individual charts linked below.

(1) Will failed ACA-R&R be followed by delayed and diminished (D&D) tax reform? (2) Plenty of time left for Trump to get it right, or wrong. (3) No harm, no foul for Trump on ACA. (4) Dollar remains strong despite recent slump. (5) End of energy recession early last year more bullish than Trump’s election, so far. (6) Low oil prices might finally be stimulating rather than depressing global economy. (7) Bond yields and stock prices may be slumping on lower oil prices. (8) Financials and Industrials clearly enjoyed Trump bumps, and now paying with slumps. (9) US stocks could slump for a short while relative to foreign ones.


Strategy: From R&R to B&S? This week may be dominated by the fallout from the failure of the Republicans to repeal and replace (R&R) Obamacare (a.k.a. the Affordable Care Act, or ACA) at the end of last week. The good news is that it didn’t take very long to cripple this flawed legislative initiative, which means that the Trump administration can move forward with tax reform much sooner than had been widely expected. The bad news is that the perception, right or wrong, is that the new administration has been greatly weakened by the implosion of their ACA-R&R initiative. It’s too soon to be sure of that. It’s also too soon to be sure that Obamacare won’t implode, as Trump has often claimed it would. If it does so, then he will be in a better position to repeal and replace it at that point.

For now, the so-called “Trump bump” in the financial markets may be turning into a “Trump slump.” Putting it all together: The Trump slump is replacing the Trump bump because Trump is having trouble draining the swamp. Joe and I are sticking with our assumption that a combination of deregulation and tax cuts will significantly boost S&P 500 earnings this year and next year. We still expect that tax cuts will happen this year, on a retroactive basis. If they don’t take effect until next year, however, we won’t know that until this summer, at which point the effective date won’t matter much to stocks: Either way would be just as bullish since investors by then will be focusing increasingly on 2018 anyway.

Debbie and I believe that the surge in animal spirits, as evidenced by all the soft-data economic surveys, is driven mostly by the perception that the new administration is very pro-business and anti-regulators. That hasn’t changed notwithstanding the failure of ACA-R&R. High hopes for significant tax reform might suffer a slump, but that’s not inevitable. If Obamacare remains the law of the land and succeeds, then Trump can say “no harm, no foul.” If it fails, he can say “I told you so.” Of course, Trump is still in a position to tweak the ACA with executive and regulatory actions that could either save it from a death spiral or speed up its demise.

Animal spirits could trickle down to boost the hard data on consumer spending, durable goods orders, and housing starts. Debbie and I are still forecasting that the US Treasury 10-year yield should continue to trade between 2.0%-2.5% during the first half of this year and rise to 2.5%-3.0% during the second half of the year. The Fed is likely to proceed with two more rate hikes later this year.

In any event, the economy is at full employment, so it doesn’t need a lot of fiscal stimulus. Too much could boost expected and actual inflation, though we continue to see very powerful structural forces keeping a lid on inflation, including competitive, demographic, and technological ones. Now, let’s review how the financial markets are interpreting all the developments since Election Day:

(1) Currencies. The JP Morgan trade-weighted dollar jumped 5.4% from 119.78 on November 8 to a recent peak of 126.21 on January 11 (Fig. 1). It then fell 4.2% through Monday to the lowest level since Election Day. It is widely assumed that mounting uncertainty about Trump’s agenda may cause the Fed to slow the pace of rate hikes. This might explain why the dollar’s Trump bump has been followed by the recent slump.

In any event, the dollar is still up 21% since July 1, 2014, the start of its latest significant ascent. So the recent weakness in the dollar may reflect long-overdue rebounds in the euro, the yen, and the pound. In other words, it may also have something to do with developments in Europe and in Japan rather than just in the US.

The euro is up from a recent low of 1.04 to 1.09 on Monday (Fig. 2). That might have something to do with the remarkable strength in the latest batch of Eurozone economic indicators. As Debbie and I reviewed yesterday, the composite PMI for the region rose to 56.7 during March, led by France (57.6) and Germany (57.0) (Fig. 3). Germany’s Ifo business confidence index rose to 112.3 this month, the highest since July 2011 (Fig. 4). The current situation component of the index has been especially strong for the past seven months.

(2) Commodities. On March 17, the CRB raw industrials spot price index rose to the highest level since September 23, 2014 (Fig. 5). There’s no slump in this index, which is confirming—along with Germany’s Ifo business survey—that the global economy has recovered nicely from the global energy-sector recession that ended in early 2016. Joe and I have been arguing that the end of the energy-led earnings recession last summer has been at least as important as political developments in Washington since November 8.

The CRB index cited above does not include any petroleum products. The price of a barrel of West Texas crude oil rebounded 108% from a low of $26.21 on February 11, 2016 to a high of $54.45 this year on February 23 (Fig. 6). Yesterday, it was back down to $47.85. This slump might be partly attributable to Trump, who has moved forward aggressively with deregulating the energy industry in the US.

On Thursday, Jackie reviewed Trump’s latest actions on this front: “In his first month on the job, he signed executive memos that make it easier for TransCanada to construct the Keystone XL pipeline and for Energy Transfer Partners to build the remainder of the Dakota Access pipeline. He also signed House Joint Resolution 41, eliminating a federal rule that requires energy companies to disclose royalties and government payments. …. The EPA under Scott Pruitt has repealed a rule enacted under Obama that required oil and natural gas companies to provide the EPA with information about methane emissions. …. The administration has said it plans to roll back an Obama rule requiring companies that drill for oil and natural gas on federal lands to disclose chemicals used in fracking [and] …. also pledged to revive the coal industry using clean coal technology.”

A more likely explanation for the recent slump in the price of oil is that the US oil rig count has rebounded 106% from a low of 316 units during the final week of May 2016 to 652 in mid-March (Fig. 7). US oil field production, which fell only 12.3% during the energy recession, has rebounded to 9.1 million barrels in mid-March, only 5.0% below its peak during the week of June 5, 2015. There’s no slump in US crude oil inventories, which hit another record high in mid-March (Fig. 8).

Oil prices and fuel prices remain well below their 2014 highs. Now that the energy recession is over, the benefit of low energy prices may be stimulating world economic growth. That’s bullish for the stock market. It’s not bad for the bond market since low oil prices help to keep a lid on inflation. Trump may simply have lucked out with all these global economic forces going his way just in time and providing lots of support for the stock market’s Trump bump, which owes a lot to Trump, but not everything to him.

(3) Bonds. The 10-year US Treasury bond yield was 1.88% on Election Day (Fig. 9). It rose to a high this month of 2.62% on March 13. Yesterday, it was back down to 2.38%, presumably because Trump’s fiscal stimulus agenda may be delayed and diminished (D&D) by the failure to R&R Obamacare. That may be part of the story. Another is that on Wednesday, March 15, Fed Chair Janet Yellen came across as more dovish than was expected at her press conference.

The recent drop in the price of oil may also be reducing inflationary expectations. There certainly was a Trump bump in expected inflation in the 10-year Treasury bond market. The spread between the nominal and TIPS yields widened from 173bps on Election Day to a high of 208bps on January 27 (Fig. 10). Yesterday, it had edged down to 197bps.

(4) S&P 500. What has been more bullish so far: The end of the energy recession or the election of Donald Trump? This isn’t a trick question, and the answer is obvious. The price of a barrel of WTI crude oil bottomed last year on February 11 at $26.21. It is up 83% since then. The S&P 500 is up 28.0% through yesterday’s close since the price of oil troughed. It is up 9.4% since Election Day.

Renewed fears of a slump in oil prices might have more to do with the 2.3% slump in the S&P 500 through Friday’s close since it hit a record high of 2395.96 on March 1 than with anything happening in DC. In any event, Joe and I are still forecasting that the S&P 500 will rise to 2400-2500 by the end of the year. Of course, the index would have to rise just 2.5% to hit the bottom of that range, while the top would require a 6.8% advance. A spring slump in stock prices would be the pause that refreshes, in our opinion, giving earnings a chance to reduce highly elevated valuation multiples.

(5) S&P 500 sectors. Not surprisingly, the S&P 500 Energy sector led the stock index higher last year once the price of WTI crude oil bottomed on February 11. From then until last year’s peak for Energy on December 13, the sector rose 40.3%, outpacing the S&P 500’s 24.2% gain over the same period (Fig. 11). Since then, the Energy sector has weighed on the S&P 500, with a decline of 12.1%.

However, S&P 500 Financials and Industrials are two sectors that clearly enjoyed a remarkable Trump bump and now are slumping. The former soared 26.0% since Election Day through March 1, while the latter jumped 14.0% over the same period. Since then, both are down by 6.8% and 3.6%, respectively.

(6) Foreign stock markets. Joe and I are still recommending a “Stay Home” investment strategy. However, we are getting cabin fever and seeing cheaper stocks abroad. Here are the forward P/Es for some of the major MSCI stock market indexes: US (18.2), Japan (14.5), EMU (14.4), UK (14.3), and Emerging Markets (12.0) (Fig. 12).

The relative performance of the US index may be starting to slump because of mounting uncertainty about Trump’s economic agenda (Fig. 13). There’s no shortage of uncertainties overseas, of course. While Europe may be cheaper than the US, populist movements have been gaining political power in the region, and threaten to disintegrate both the Eurozone and the European Union. However, this may be a relatively low risk for now, which might allow Europe to outperform the US, especially in dollar terms.

Trump Swamped?

March 27, 2017 (Monday)

See the pdf and the collection of the individual charts linked below.

(1) Dead in the swamp already? (2) Trump is learning on the job. (3) Melissa’s good call. (4) Pelosi still takes ownership of Obamacare. (5) Trump’s Plan B is to let Obamacare implode and move forward on tax reform. (6) Markey Maypo, Uncle Ralph, and the stock market. (7) On to tax reform. (8) No cuts in ACA taxes on tap. (9) Tax reform might be tougher to reconcile than Mnuchin says. (10) US and regional business surveys available for March looking strong. (11) Eurozone PMIs very robust in March. (12) Q1 earnings season starting with forward earnings in high spirits.


Fiscal Policy I: Trump 0, Swamp 1? President Donald Trump has been in the White House for only 67 days. Yet some pundits are saying that his agenda is already dead on arrival because GOP House Majority Leader Paul Ryan (R-WI) couldn’t muster enough votes among his own rank and file to pass the bill repealing and replacing the Affordable Care Act (ACA-R&R) last week.

Trump doesn’t have any experience in government, so he is learning by doing. What he is learning quickly is that his goal of “draining the swamp” will be much harder than he ever imagined. In some ways, Friday’s retreat is reminiscent of President John Kennedy’s Bay of Pigs debacle. Kennedy was also inexperienced and signed on for an action that had been in the works for a while, but was very badly executed.

As for Trump, Melissa and I believe that this isn’t the beginning of the end for his administration, but rather the end of the beginning. On March 15, we wrote:

“Melissa is our resident Washington watcher. Her theory is that Trump doesn’t care if the GOP’s healthcare bill doesn’t pass through Congress. If ACA-R&R fails to happen soon, he won’t press the issue. He’ll let it go and move on to tax reform under a 2018 budget resolution, which is being worked on behind the scenes as ACA-R&R takes center stage and flounders. Trump will be happy to let Obamacare implode on its own. Politically, Trump still can say he made ACA-R&R his first priority to protect healthcare for Americans, as he promised during the campaign. He can later also say ‘I told you so’ to Congress once Obamacare totally implodes. ‘It could self-repeal in this scenario,’ says Melissa. ‘Then Congress will have no choice but to replace it.’”

We concluded:

“Trump must know—because the stock market has been telling him so—that his big win would be tax reform. Market commentators have been baffled as to why the administration has put ACA-R&R ahead of tax reform. The answer is to get ACA-R&R out of the way whether it passes or not. Either way, we expect tax reform to remain on the timeline that officials have been signaling, which is to finalize writing it over the summer.”

Melissa and I haven’t spent much time focusing on the three branches of government over the past eight years. Rather, our focus has been on the Fed, i.e., the monetary branch of government. Our rallying cry for the stock market rally since March 2009 has been “Don’t Fight the Fed!” Now, despite last week’s turn of events, our advice remains “Don’t Bet Against Trump!”—not yet anyway.

Trump has already moved aggressively forward on deregulation, as Jackie and I reviewed last Thursday. The Democrats still own Obamacare, as Nancy Pelosi and her colleagues immediately gloated over the failure of ACA-R&R. Given the exorbitant increases in health insurance premiums, deductibles, and copays under Obamacare, Democrats running for reelection in the 2018 congressional races are likely to face much angrier constituents than are Republicans, thanks to what could turn out to be a smart tactical retreat by Trump.

Trump can still take credit for having tried to fix the healthcare system. On Friday, he said, “It’s imploding and soon will explode and it’s not going to be pretty. The Democrats don’t want to see that. So, they’re going to reach out when they’re ready.” In other words, he might have lost round one, but the fight is long from over. The Trump administration is likely to move forward with various regulatory actions that will increase the odds that Obamacare will implode.

The IRS is likely to ease up on enforcing the health law’s individual mandate that requires people to sign up for health insurance or pay a fine. The administration certainly isn’t likely to promote the program with ads encouraging people to sign up. Insurers undoubtedly will face less political pressure to stay in the program. Insurers might be allowed to reduce their coverage of such services as contraception. Subsidies that insurers get could be terminated, which could quickly cause the individual markets to implode for sure. Adding insult to injury for some, Medicaid recipients might be required to work.

Trump might be able to fashion a coalition with Democrats, who are most vulnerable to losing in 2018, while threatening to support Republican populist challengers to defeat the incumbent Tea Partiers in his party if they embarrass him again and don’t tow the line. Trump will have to get dirty if he seriously intends to clean up the swamp. Melissa and I are fans of House of Cards and Homeland, which seem especially useful these days in understanding all the intrigue in Swamp Land.

Fiscal Policy II: Maypo. “I Want My Maypo” was a famous advertising slogan used by Maltex Company of Burlington, Vermont to sell Maypo, a brand of maple-flavored oatmeal starting in the 1950s. A black-and-white animated TV commercial featured Uncle Ralph trying to feed his cowboy-hat-wearing little nephew, Marky, the oatmeal without any success, until he accidently eats it himself after telling the kid that cowboys like it. The uncle obviously likes the taste and eats more. The kid then screams: “I want my Maypo!”

The stock market didn’t tank on Friday, as was widely predicted by some of the usual panic promotors. That’s because what stock investors really want is tax cuts. That’s their Maypo. Now they won’t have to wait long to see whether they get it, since the ACA-R&R kabuki play is over for now—already. The failure to replace and reform Obamacare does complicate moving ahead on tax reform because the GOP bill would have helped to make the (alternative but similar) tax packages proposed by Trump and the GOP easier to be “revenue-neutral.” Consider the following:

(1) Cost of losing the first round. The failed healthcare bill had tax cuts of its own, about $1 trillion worth over 10 years that would have been paid for by spending cuts—most of them in the federal Medicaid program that provides health care to the poor. “Republicans said the resulting lower revenue baseline would have made a revenue-neutral tax overhaul that much easier,” according to a 3/25 Bloomberg article. Meanwhile, the decision to pull the health bill means upper-income investors won’t get a repeal of the 3.8% Medicare tax on dividends, capital gains, and interest for individuals making over $200,000 and couples earning more than $250,000.

(2) Reconciliation and revenue neutrality. Balancing revenue and cuts in the tax bill is essential to allow it to bypass rules requiring 60 votes in the Senate, where Republicans hold only 52 seats. The so-called reconciliation process would allow the bill to pass with a simple majority. On Friday, Treasury Secretary Steve Mnuchin said, “Health care and tax reform are two different issues. Health care is complicated; tax reform is a lot simpler in some ways.” Like Trump, Mnuchin hasn’t had much experience dealing with swamp people, so he may be too optimistic.

(3) Going south on the border tax? On Friday, House of Representatives Ways and Means Committee Chairman Kevin Brady (R-TX) conceded that the demise of ACA-R&R could make the path to tax reform harder: “This made a big challenge more challenging. But it’s not insurmountable.” One of the obstacles is the border adjustment tax that Brady strongly champions. The plan has divided businesses, prompting import-dependent industries to warn of higher prices for consumer goods from clothing and electronics to gasoline. Brady has been adamant that border adjustment will be part of the House tax reform, saying earlier this week that the provision was “a given” for final legislation, but would include a transition period for import-heavy industries.

Strategy: Spirited Earnings. The Q1 earnings season is fast approaching as March is fast coming to an end. Since Election Day, Debbie and I have been commenting on the remarkable jump in “animal spirits” visible in surveys of consumers, CEOs, small business owners, purchasing managers, regional businesses, and homebuilders. Last week’s setback for the Trump administration might quash some of the animal spirits, but we expect they will remain strong overall on expectations that deregulation and tax cuts will happen and be good for consumers, workers, and businesses. We are tracking the happy-go-lucky surveys in our new chart publication, Animal Spirits.

The first hint we have that animal spirits are cooling off a bit was Markit’s report last Friday that the US M-PMI declined from 54.2 during February to 53.4 during March (Fig. 1). By the way, while there’s no reason whatsoever to believe that Trump’s election unleashed animal spirits in the Eurozone, they are showing up in the region’s March M-PMIs and NM-PMIs (Fig. 2, Fig. 3, and Fig. 4). The standouts are Germany’s M-PMI (58.3) and France’s NM-PMI (58.5). Europe continues to show signs of economic improvement.

Back at home, as Debbie discusses below, the “soft data” available from three regional surveys conducted by the FRBs of NY, Philly, and KC confirm the overall dip in March activity shown in the Markit M-PMI. However, they remain very strong, with notable strength in new orders and employment (Fig. 5). Nondefense capital goods orders and shipments excluding aircraft over the past three months are also showing better growth rates of 8.8% and 8.6% (saar) over the three months through February, based on the three-month average (Fig. 6 and Fig. 7).

The upturn in these orders and shipments over the past few months, following declines during the second half of 2015 and first half of 2016, confirms that the energy-led recession is over and no longer weighing on capital spending. That’s also been confirmed by S&P 500 revenues and earnings, as Joe and I have observed since late last summer. Let’s review the latest developments:

(1) Forward and annual earnings estimates. Forward earnings for the S&P 500/400/600 continue rising into record-high territory (Fig. 8). Just as impressive is that 2018 estimates for all three aggregates are holding firm and showing growth rates of 12.2%, 13.3%, and 19.0% y/y. Joe and I surmise that industry analysts may be factoring in expectations that corporate tax cuts will boost next year’s earnings, so they are in no rush to lower their estimates for the coming year, as they have often done in the past as it approaches.

(2) Forward and annual revenues estimates. Forward revenues for the S&P 500 remained at a record high during mid-March (Fig. 9). The same can be said of the forward revenues for the S&P 600. However, revenues for the S&P 400 have been sloppier of late, dipping during the second half of 2016, but showing a bit of a recovery in recent weeks.

(3) Let the season begin. Joe and I are estimating that S&P 500 earnings rose 10.3% y/y during Q1. Industry analysts are currently forecasting a 9.5% increase, with the following expectations for the 11 sectors of the S&P 500: Energy (returning to a profit in Q1 from a year-ago loss), Financials (15.9%), Tech (14.3), Materials (11.5), Industrials (4.8), Health Care (2.6), Telecom (2.6), Consumer Staples (2.4), Real Estate (1.4), Utilities (1.3), and Consumer Discretionary (1.3).


March 23, 2017 (Thursday)

See the pdf and the collection of the individual charts linked below.

(1) If Trump lifts regs as promised, many companies will benefit big time. (2) Jackie recaps which industries stand to gain the most. (3) Financials, freed from Dodd-Frank shackles, would be a huge winner. (4) Other potential jackpot-hitters include autos, energy, homebuilders, and maybe even pharma. (5) Analysts project big earnings growth in 2017. (6) Joe gives us the lowdown on projected growth by sector.


Strategy: Regulatory Relief. This week, markets got the first evidence that even President Donald Trump and his Cabinet of deal-makers might have a tough time negotiating deals in Washington, DC’s political swamp. His proposed repeal and replacement of Obamacare is running into resistance in Congress even within his own party. This is raising some doubts about whether Trump can push other parts of his agenda through Congress. As of Tuesday’s close, the S&P 500 is down 2.2% from its record high of 2395.96 on March 1, but it’s up 9.6% since Election Day.

A pullback after the strong rally in recent months should be the pause that refreshes if investors conclude that Trump will have an easier time and move even more aggressively on reducing regulations, as he has promised. If he’s even partially successful, corporations stand to save billions on lower costs to adhere to regulations, and revenues may rise if CEOs are emboldened to expand their businesses once the shackles are off.

In other words, Jackie, Joe, and I aren’t convinced that the Trump rally has been just about tax reform. It’s also been about one of the most pro-business administrations in history. A cut in the corporate tax rate is still likely, and it is likely to boost earnings significantly when it happens. Meanwhile, deregulation may have a more immediate positive effect on earnings as well as animal spirits.

During the election campaign, Candidate Trump touted his intention to cut regs by 70%. Now President Donald Trump is following through on that promise, though 70% is certainly a stretch. Within 10 days of moving into the White House, Trump signed an executive order requiring federal agencies to slash two old regulations for every new regulation they write. In addition, any costs generated by the new rule must be offset by the costs eliminated by the two revoked regulations. There will be new task forces at every federal agency to identify regulations for elimination or modification. And starting next year, the director of the White House Office of Management and Budget will give each federal agency a target for how much the agency should aim to increase or cut costs resulting from regulations. How’s that for setting the tone from the top? Let’s take a look at what regulations Trump has in his sights and how much companies may benefit:

(1) Financials. Perhaps no other sector has been saddled with more regulations in recent years than the S&P 500 Financials. After the Great Recession, Congress aggressively wrote laws and established new institutions aimed at insuring against a repeat of the devastating crisis. The legislation mostly gave President Barack Obama’s financial regulators a carte blanche to chain the financial institutions with a myriad of regulations. But they might have taken a well-intentioned idea too far with, for example, the Dodd-Frank law spanning 2,300 pages and spawning many more pages of regs.

Hopes are high that less regulation under a Trump administration will mean lower compliance costs and more earnings for financial institutions. Medy Agami, co-founder of Opimas, a management consultancy firm focused on capital markets, estimated that the reduction in regs could “redirect” $25 billion of capital in financial services over the next 18-24 months, according to a 1/21 Business Insider article.

Trump has already taken a number of steps toward reducing regulations in the Financials sector. He signed in February an executive order directing the Treasury and regulatory agencies to report to Trump about what can be done to scale back the “overreaching” aspects of the Dodd-Frank law, UPI reported on 2/3. Revising the law supposedly would increase liquidity at the banks and generate new areas of revenue and profitability.

Trump also delayed the implementation of a fiduciary rule, which was going to require financial advisers to act in the “best interests” of clients with retirement accounts. Scheduled to go into effect in April, the rule is now under review by the Labor Department. It was set to affect about $3 trillion of retirement assets and could have forced companies to offer products with the lowest fees even if they weren’t the best products for clients. The rule would also open up money managers to greater legal liabilities if sued by disgruntled clients.

Also in Trump’s sight: changing the Financial Stability Oversight Council, an overhaul of Fannie Mae and Freddie Mac, and changing the mission of the Consumer Financial Protection Bureau by installing a new person at its helm.

“Americans are going to have better choices and Americans are going to have better products because we’re not going to burden the banks with literally hundreds of billions of dollars of regulatory costs every year,” White House National Economic Council Director Gary Cohn said in a 2/3 WSJ interview. “The banks are going to be able to price product more efficiently and more effectively to consumers.”

(2) Autos. Flash back to 2012. Near the start of the year, the price of oil was $126 per barrel. President Obama announced new vehicle fuel-efficiency standards that required US auto fleets to have an average 54.5 miles per gallon by 2025, which translates into 36.0 mpg on the road. The deal also set an emissions standard of 144 grams of carbon dioxide per mile for passenger cars and 203 grams for trucks.

At the time, the press described the deal as “uncontroversial” and “endorsed by industry and environmentalists alike,” as it was a grand compromise among government, auto makers, and California, which was pushing for even tougher standards. “By 2025, the EPA said, the standards would cut U.S. oil consumption by 2.2 million barrels per day compared with 2010 levels, save $1.7 trillion in fuel costs and result in an average fuel savings of more than $8,000 per vehicle,” noted a 8/28/12 Washington Post article.

One constituency did complain: auto dealers. They warned that the changes required to meet the efficiency standards would increase the average price of a vehicle by $3,000 by the time the rules are fully implemented. The article quoted the chair of the National Automobile Dealers Association asserting that the increase “shuts almost 7 million people out of the new-car market entirely and prevents many millions more from being able to afford new vehicles that meet their needs.”

Flash forward five years. The price of oil is now down to $51 per barrel, SUVs and light trucks are hot sellers, and there’s a new resident in the White House. The Obama vehicle standards from 2022 through 2025 are in the midst of a midterm evaluation. The EPA under Obama concluded that the rules should stand, but the Department of Transportation hasn’t signed on yet, according to a 3/15 article on And that has opened the door to a major revision of the rules.

Last fall, the Alliance of Automobile Manufacturers sent President Trump a letter asking him to ease the requirements, arguing that they cost too much. According to the organization’s 9/22 statement to the House Subcommittee on Commerce, Manufacturing, and Trade: “The Federal government estimates the total cost of the current [One National Program] to be about $200 billion from 2012-2025. This is a significant regulatory burden on the auto industry and an accurate and thorough evaluation of potential employment impacts is critical for both the success of One National Program and the continued health of the manufacturing sector and the overall U.S. economy.” Read between the lines, and they’re saying the rule could hurt sales and cost American jobs.

But changing the rules for the whole country may not be easy. Remember, the original rule involved California. The state was pulled into the compromise because it has a waiver under the Clean Air Act that allows it to have its own stricter car emission regulations than the federal government, the Vox article explains. It’s a good assumption that if the Trump administration rolls back the mileage and emission rules, California could institute its own set of tighter rules. That’s something the auto industry certainly wouldn’t want. The EPA could try to rescind the waivers. The state could sue to block. The upshot: Things could get messy.

(3) Energy. President Trump didn’t come up with the phrase “Drill, baby, drill,” but his actions certainly support it. In his first month on the job, he signed executive memos that make it easier for TransCanada to construct the Keystone XL pipeline and for Energy Transfer Partners to build the remainder of the Dakota Access pipeline. He also signed House Joint Resolution 41, eliminating a federal rule that requires energy companies to disclose royalties and government payments. The rule was imposed by the Obama administration last year to improve transparency. The Trump administration said it puts US energy companies at a disadvantage, reported a 3/6 UPI article.

The Trump administration is expected to loosen environmental regulations that often hamstring energy companies. The proposed federal budget would cut the Environmental Protection Agency’s (EPA) budget by 31%, from $8.1 billion to $5.7 billion. It would reduce the agency’s headcount by 3,200 positions, or more than 20% of the current 15,000 person workforce, reported a 3/16 Washington Post article. The proposed budget would also end funding for the Clean Power Plan, Obama’s effort to regulate carbon dioxide emissions from power plants.

Already, the EPA under Scott Pruitt has repealed a rule enacted under Obama that required oil and natural gas companies to provide the EPA with information about methane emissions. Opponents of the rule said the rule’s costs hurt smaller oil companies. “The EPA’s rules when combined with other recently imposed federal methane regulations were expected to cost as much as $155 million in 2020 rising to $290 to $400 million by 2025. That’s roughly three times more than EPA’s projected cost, according to a study by the National Economic Research Associates,” the Daily Caller reported on 3/3.

The administration has said it plans to roll back an Obama rule requiring companies that drill for oil and natural gas on federal lands to disclose chemicals used in fracking, according to a 3/16 article by the Associated Press. It has also pledged to revive the coal industry using clean coal technology, and the President signed House Joint Resolution 38 to end an Obama administration rule that protected waterways from coal-mining waste. Trump’s administration said the rule puts mining companies at a competitive disadvantage, a 3/6 UPI article reports.

Trump laid out his overarching intentions in his “An America First Energy Plan.” It states: “For too long, we’ve been held back by burdensome regulations on our energy industry. President Trump is committed to eliminating harmful and unnecessary policies such as the Climate Action Plan and the Waters of the U.S. rule. Lifting these restrictions will greatly help American workers, increasing wages by more than $30 billion over the next 7 years.”

The plan also says the administration will care for the environment: “Lastly, our need for energy must go hand-in-hand with responsible stewardship of the environment. Protecting clean air and clean water, conserving our natural habitats, and preserving our natural reserves and resources will remain a high priority. President Trump will refocus the EPA on its essential mission of protecting our air and water.” Good luck with that: Achieving both goals will be tough, to say the least.

(4) Homebuilders. While not much has been done for homebuilders so far, speeches by Candidate Trump indicate that help may be forthcoming. When speaking to the National Association of Home Builders Board of Directors in August, Trump said, “No one other than the energy industry is regulated more than the home building industry,” according to a NAHB 8/11 article. “Twenty-five percent of the cost of a home is due to regulation. I think we should get that down to about 2 percent.”

The housing industry is hopeful that Trump will revise the Waters of the US Rule, published last year by the EPA and the Army Corps of Engineers. As we mentioned above, Trump has targeted the rule, which is disliked by those in the energy and housing industries. The Clean Water Act historically applied to navigable and interstate bodies of water. The Waters of the US rule expanded the reach of the Clean Water Act to “all tributaries, adjacent waters, wetlands and other waters.”

“NAHB and others have objected to those terms as broad and vague, and have said the new definition could subject ponds, creeks, and ditches on private property to federal oversight and their owners to additional regulatory red tape,” explains a 4/15/15 article in

The industry would also like to be rid of the overtime rule, written last year by the Department of Labor (DOL) but hung up by numerous lawsuits in the courts. Before the rule, employees making $23,660 a year would receive overtime if they were classified as “executive,” “administrative,” “professional,” or “computer professional.” The overtime rule lifted the cap to $47,476 and instituted a plan to raise the minimum salary every three years based on an index.

The rule was estimated to impact more than 4.2 million workers, and critics said it didn’t take into consideration regional differences in pay and it could force employers to convert some salaried workers into hourly positions. NAHB Chairman Ed Brady called the DOL’s rule an action of “sheer arrogance.”

(5) Pharmaceuticals. Drug industry CEOs met with President Trump in January, and his message was: Bring your companies and production back to America and lower drug prices, and he’ll work on reducing regulations. “So you have to get your companies back here. We have to make products ... We have to get rid of a tremendous number of regulations,” Trump said according to a 1/31 CNN article. “I know you have some problems where you cannot even think about opening up new plants. You can’t get approval for the plant and then you can’t get approval to make the drugs.” He aims to resolve those problems.

Sector Focus: Earnings. As the market gets bumpier, investors can take solace in analysts’ call for solid 2017 earnings growth. Overall, the S&P 500’s earnings are expected to increase 9.9% in 2017 to $128.57 a share, up from miserly growth of 1.6% last year, when the energy recession and the strong dollar weighed on results in the first half of the year.

Indeed, growth this year is being bolstered by easy comparisons to Q1-2016, when S&P 500 earnings fell 5.7% y/y (Fig. 1). Sectors that had weak starts to last year include Tech, where Q1-2016 earnings fell 12.2% and Q2-2016 earnings dropped 6.6%, and Industrials, where Q1-2016 earnings dropped 5.3% (Fig. 2 and Fig. 3). Telecom services saw earnings drop in each quarter of 2016, and Financials posted declines in earnings in the first half: 11.5% in Q1 and 6.2% in Q2 (Fig. 4 and Fig. 5).

Here are the earnings growth rates analysts are targeting for all of 2017: Energy (422.2%), Materials (12.3), Financials (12.2), S&P 500 (9.9), Tech (9.8), Consumer Discretionary (7.0), Consumer Staples (5.6), Health Care (4.7), Industrials (3.2), Telecom (0.4), Utilities (-0.1), and Real Estate (-33.5).

As is the norm this long into an economic recovery, 2017 earnings estimates are being trimmed as the year progresses. But the decline in expectations has been comparatively modest (Fig. 6). At the start of the year, analysts were calling for an 11.6% increase in S&P 500 earnings, so the estimate has fallen by 1.7ppts. From 2011 to 2016, the annual growth rate forecast fell an average of 2.3ppts over the same time period from the start of those years.

Here’s how much the 2017 earnings-per-share estimates have changed for each of the S&P 500 sectors since the start of the year: Financials (+0.4%), Industrials (0.1), Utilities (-0.1), Energy (-1.0), Information Technology (-1.0), Consumer Staples (-1.2), S&P 500 (-1.4), Consumer Discretionary (-1.9), Telecommunication Services (-2.8), Materials (-3.3), Real Estate (-3.5), and Health Care (-4.2).

Nothing Happened

March 22, 2017 (Wednesday)

See the pdf and the collection of the individual charts linked below.

(1) Another age-old adage. (2) Baron Rothschild’s secret. (3) The Bull/Bear Ratio may be too high. (4) Streets covered in blood vs. paved with gold. (5) Seinfeld market. (6) From tapering to tightening tantrums. (7) Emerging Markets growing faster despite Fed headwinds. (8) Bond funds still seeing net inflows. (9) Corporate bond liquidity crisis still a no-show. (10) Timeout for Trump rally? (11) Nothing to fear but profit-taking.


Strategy: Action & Reaction. Yesterday, we discussed some oft-quoted adages in the stock market. Today, let’s add another one: “Buy on the rumor, sell on the news.” Stock prices often go up on good news, unless it was widely anticipated, in which case they might go down on profit-taking. Stock prices often go down on bad news even if it was widely expected. However, if the news was worse than expected, gutsy traders and investors will step in and buy what others are dumping at distressed prices.

Investopedia notes: “Baron Rothschild, an 18th century British nobleman and member of the Rothschild banking family, is credited with saying that: ‘The time to buy is when there’s blood in the streets.’ He should know. Rothschild made a fortune buying in the panic that followed the Battle of Waterloo against Napoleon. But that’s not the whole story. The original quote is believed to be: ‘Buy when there’s blood in the streets, even if the blood is your own.’”

With the benefit of hindsight, Rothschild’s adage for the ages worked like a charm during late 2008 and early 2009 when the Bull/Bear Ratio (BBR) compiled by Investors Intelligence was below 1.0, stocks sold at bargain-basement prices (Fig. 1). Of course, if you bought before the S&P 500 fell to an intra-day low of 666 on March 6, 2009, you had to spill some of your own blood for a short but painful time.

As I’ve observed before, the BBR works better as a contrary buy signal when it is at 1.0 or less than as a contrary sell signal when it is at 3.0 or higher (Fig. 2 and Fig. 3). That might be because blood is flowing in the streets in the former scenario, while the streets are paved with gold in the latter one. It is easier to panic investors out of stocks when they are losing their own money than when they are giving back some of their profits.

Early in the current bull market, there were two wicked corrections (Fig. 4). The S&P 500 dropped 16.0% from April 23 to July 2, 2010. It plunged 19.4% during from April 29 to October 3, 2011. The BBR fell to a 2010 low of 0.78 during the week of August 31, and to a 2011 low of 0.74 during the week of October 11. Both were great buying opportunities.

On the other hand, the BBR mostly exceeded 3.0 during 2014; the S&P 500 rose 11.4% that year, but then stalled with a decline of 0.7% in 2015. The BBR fell below 1.0 again in early 2016, setting the stage for a 9.5% gain in the S&P 500 last year. Now the BBR has exceeded 3.0 again every week since the week of December 13. Meanwhile, the stock market remains in record-high territory. It seems to have been buoyed by concerns about bad things that didn’t play out. I’ve described it as the “Seinfeld market”—as long as nothing happens, it tends to go up. Consider the following:

(1) Another memorable year. There was a 13.3% correction at the end of 2015 through early 2016 (Fig. 5 and Fig. 6). Most of it occurred at the beginning of last year after two Fed officials reiterated that the FOMC’s December 16, 2015 dot plot predicted four rate hikes. The selloff was somewhat reminiscent of the emerging markets’ mini-crisis at the start of 2014 and the 5.8% decline during May and June 2013, which was widely described as a “taper tantrum” (Fig. 7 and Fig. 8). On May 21, Fed Chairman Ben Bernanke suggested that the Fed might soon start tapering its QE program. It didn’t do so until the end of October 2014, when the program was terminated.

The “tightening tantrum” at the beginning of last year turned out to be a great buying opportunity, as Joe and I predicted it would be on January 25. The actual low in the S&P 500 was made on February 11, when JP Morgan CEO Jamie Dimon announced that he was buying a slug of his company’s shares. The price of oil also happened to bottom that day. The Fed did raise the federal funds rate again last year, but only once, at the end of the year. The S&P 500 is up 28.2% since last year’s low through yesterday’s close.

There was another buying opportunity last year following the unexpected Brexit vote. However, the selloff lasted just two days, through June 28. Since then, the S&P 500 is up 15.1%. Stocks sold off before Election Day in the US. It was widely believed (not by us) that if Trump won, the market would tumble. The S&P 500 is up 9.6% since Election Day.

(2) EMs stopped submerging. Emerging markets (EM) stocks and currencies fared relatively poorly from the spring of 2013 through early 2016 (Fig. 9 and Fig. 10). Investors feared that Fed tapering, then tightening would cause financial capital to pour out of EMs, and to trigger stress among EM borrowers who would have to pay higher rates, assuming they even could borrow the funds they needed.

Well, the Emerging Markets MSCI stock price index bottomed on January 21, 2016 rising 30.2% and 41.2% since then in local currencies and in US dollars through Monday. The Emerging Markets MSCI currency index bottomed on January 20, 2016 and is up 12.0% since then. In other words, the EMs didn’t submerge into oblivion following the termination of the Fed’s QE in late 2014, the rate hikes in 2015 and 2016, and again last week. Nothing terrible happened, as was widely feared.

Joe reports that industry analysts covering EM companies have been raising their 12-month forward consensus expected growth rates for both revenues and earnings, currently up to 9.4% and 16.6%, respectively (Fig. 11). Joe and I have been warming up to EMs since last fall, figuring their growth rates remain high and their forward P/Es are relatively cheap.

(3) Corporate bond market didn’t implode. The plunge in oil prices during the second half of 2014 through early 2016 heightened fears of a financial contagion triggered by defaults in the corporate bond market, particularly by energy companies that had issued junk bonds. The yield spread between high-yield corporate and US Treasury 10-year bonds rose from a 2014 low of 253bps on June 23 to a high of 844bps during February 11, 2016. However, there was no crisis and certainly no contagion, we know now that the spread is back down to 352 bps.

So far, there has been no panic selling in the investment-grade corporate bond market. It had been widely feared that once the Fed started to tighten monetary policy, the corporate bond market would become very illiquid as a result of Wall Street’s reduced market-making role. Interestingly, since the May 2013 taper tantrum through January of this year, bond mutual funds and ETFs have continued to enjoy net inflows (Fig. 12 and Fig. 13).

(4) Timeout for Trump rally. Yesterday’s 1.2% drop in the S&P 500 stood out because it was the biggest one-day drop since October 11, 2016. However, it was no big deal. Nothing really happened to trigger it other than investors decided to take some profits before Thursday’s vote in Congress on the GOP’s healthcare reform bill, which they reckon could make or break the rest of Trump’s agenda. Or maybe it was a delayed reaction to the Fed’s widely expected rate hike last week. It was the third one since 2015, so maybe yesterday was the obligatory stumble following such an event. This past weekend, the G20 finance ministers dropped their pledge to avoid protectionism, at the insistence of the Trump administration.

Then again, if the market’s rally since early last year was driven by lots of bad things not happening, maybe yesterday’s selloff is about nothing more than profit-taking. Maybe the Bull/Bear Ratio is just too high. Let’s all turn bearish so that the bull market can continue.

What Is Normal?

March 21, 2017 (Tuesday)

See the pdf and the collection of the individual charts linked below.

(1) Old timers. (2) The DJIA is up 20-fold since my first day on the Street. (3) Lots of adages. (4) Let the trend be your friend. Don’t fight the Fed. Taking away the punch bowl. Three strikes. (5) Bull markets start when Fed starts to ease, and continue when it starts to tighten. (6) Fed’s tightening usually ends badly. (7) If the real neutral federal funds rate is zero, the nominal rate should equal the inflation rate (2% currently). (8) Yellen’s swan song: Leave on a neutral note.


Strategy I: Secular Bull. There are lots of old timers in the stock market. In a few more years, I could be one of them. I’m not sure how much time qualifies one to be an old timer. I’ve been watching and writing about the stock market since the late 1970s. I haven’t aspired to be a market timer so much as to be an investment strategist, getting the trends right rather than calling every turn. Fortunately for me, my career so far has spanned an amazing secular bull market.

When I started on Wall Street at EF Hutton during January 1978, the Dow Jones Industrials Average was around 1000 (Fig. 1). It had been trading around this level since 1971. On October 11, 1982, it finally rose above that level, and hasn’t revisited it again since. By November 21, 1995, it had increased five-fold to 5000, and then ten-fold to 10,000 by May 29, 1999. By January 25, 2017, it had increased 20-fold to 20,000 since I started on Wall Street.

Of course, along the way, there were a few wicked bear markets (defined as 20.0% or greater declines in the S&P 500) and plenty of nasty corrections (defined as 10.0%-19.9% declines) (Fig. 2). On balance, I was mostly bullish most of the time. I remained bullish during almost all the corrections. I wasn’t sufficiently bearish when the tech and housing bubbles burst. However, I correctly saw the selloffs as buying opportunities. Since January 1978, the S&P 500 has risen during 30 years and declined during nine years (Fig. 3). So the odds clearly favored the bulls, as did the total returns.

All of the above confirms the age-old adage often recited by old timers: “Let the trend be your friend.” The trend has been bullish because the economy has mostly expanded from 1978 through 2016. Over this period, there were 139 up quarters for real GDP, and 17 down quarters (Fig. 4). S&P 500 forward earnings, which starts in 1979, has been tracking an annual trend growth rate of 6%-7% (Fig. 5). Over the same period, the S&P 500 index price has been tracking at an 8%-9% pace of appreciation, with lots of volatility attributable to fluctuations in the P/E (Fig. 6).

Strategy II: The Fed & the S&P 500. There are plenty of other adages that are more short-term-oriented and focus on the Fed’s impact on the stock market. They tend to be more cautionary and are recited by old timers who’ve lived through some wicked bear markets and fearsome corrections. The basic message is that the Fed is your friend until it isn’t. Consider the following:

(1) Zweig. Martin Zweig was a highly respected analyst and investor who passed away in 2013. He famously often said “Don’t fight the Fed.” He started his newsletter in 1971 and his hedge fund in 1984. On Friday, October 16, 1987, in a memorable appearance on Wall Street Week with Louis Rukeyser, he warned of an imminent stock market crash. It happened the following Monday, and Zweig became an investment rock star. His newsletter, The Zweig Forecast, had a stellar track record, according to Mark Hulbert, who tracks such things.

In his 1986 book Winning on Wall Street, Zweig elaborated on his famous saying: “Monetary conditions exert an enormous influence on stock prices. Indeed, the monetary climate—primarily the trend in interest rates and Federal Reserve policy—is the dominant factor in determining the stock market’s major direction. … Generally, a rising trend in rates is bearish for stocks; a falling trend is bullish.” There are two reasons for this, he wrote: “First, falling interest rates reduce the competition on stocks from other investments, especially short-term instruments such as Treasury bills, certificates of deposit, or money market funds. … Second, when interest rates fall, it costs corporations less to borrow. … As expenses fall, profits rise. … So, as interest rates drop, investors tend to bid prices higher, partly on the expectation of better earnings. The opposite effect occurs when interest rates rise.”

(2) Martin. In 1949, President Harry Truman appointed Scott Paper CEO Thomas McCabe to run the Fed. McCabe pushed to regain the Fed’s power over monetary policy and did so with the Fed-Treasury Accord of 1951. He negotiated the deal with Assistant Treasury Secretary William McChesney Martin. McCabe returned to Scott Paper and Martin took over as chairman of a re-empowered Federal Reserve on April 2, 1951, serving in that position until January 31, 1970 under five presidents. The March 1951 Accord freed the Fed and marked the start of the modern Federal Reserve System. Under Martin, the Fed’s overriding goals became price and macroeconomic stability. He believed that the Fed’s job was to be a party pooper. His famous “punch bowl” metaphor seems to trace back to a speech given on October 19, 1955 in which he said:

“In the field of monetary and credit policy, precautionary action to prevent inflationary excesses is bound to have some onerous effects—if it did not it would be ineffective and futile. Those who have the task of making such policy don’t expect you to applaud. The Federal Reserve, as one writer put it, after the recent increase in the discount rate, is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.”

(3) Gould. According to the Market Technicians Association, the late technical analysis pioneer Edson Gould, who was active from the 1930s through the 1970s, observed that “whenever the Federal Reserve raises either the federal funds target rate, margin requirements, or reserve requirements three times without a decline, the stock market is likely to suffer a substantial, perhaps serious, setback.” This adage is widely known as “three steps and a stumble.” So far, investors are betting against it since stocks actually rose sharply last Wednesday after the Fed hiked the federal funds rate for the third time since the Great Recession.

What do the data show about the relationship between the Fed’s monetary policy cycle and the S&P 500? Monthly data for the index show that it tends to bottom during the beginning of easing phases of monetary policy, when the Fed is lowering the federal funds rate (Fig. 7). It tends to continue rising through the end of the easing phases and even when the Fed starts raising interest rates. Three rate hikes may cause occasional stumbles, but it’s hard to see them in the data (Fig. 8).

What does stand out is that the tightening phase of monetary policy often ends in tears because it tends to trigger financials crises (Fig. 9). Forward P/Es have a tendency to peak before the crises hit as investors begin to fret that higher interest rates may be starting to stress the economy (Fig. 10). A lagging indicator of doom is the credit quality yield spread between Baa corporate bonds and US Treasury 10-year bonds (Fig. 11). It tends to rise after panic crises hit.

The Fed: Aiming for Real Neutrality. In the prepared remarks for her 3/15 press conference, Fed Chair Yellen said: “We continue to expect that the ongoing strength of the economy will warrant gradual increases in the federal funds rate to achieve and maintain our objectives. That’s based on our view that the neutral nominal federal funds rate—that is, the interest rate that is neither expansionary nor contractionary and keeps the economy operating on an even keel—is currently quite low by historical standards. That means that the federal funds rate does not have to rise all that much to get to a neutral policy stance. We also expect the neutral level of the federal funds rate to rise somewhat over time, meaning that additional gradual rate hikes are likely to be appropriate over the next few years to sustain the economic expansion.”

On numerous recent occasions, Yellen made the point that policy remains “modestly accommodative.” That seems to be true despite the Fed’s third 25bps increase in the federal funds rate during the current rate-hiking cycle, which started with similar hikes at yearend 2015 and yearend 2016. Even so, the FOMC won’t need to raise rates much further to achieve a neutral stance, rather than an accommodative one, according to Yellen. To understand why, it’s first necessary to understand the concept of the real neutral federal funds rate, which Fed officials call “r-star.” Consider the following:

(1) Wishing upon star. Yellen delved deep into r-star in a 3/3 speech titled: “From Adding Accommodation to Scaling It Back.” In it, she succinctly defined “r-star” as “the level of the federal funds rate that, when adjusted for inflation, is neither expansionary nor contractionary when the economy is operating near its potential. In effect, a ‘neutral’ policy stance is one where monetary policy neither has its foot on the brake nor is pressing down on the accelerator.” The economy is on cruise control in this happy state.

The problem is that the Fed is driving blind because there is no way to actually measure r-star. The difference between the actual inflation-adjusted federal funds rate and the educated guestimate of r-star is what might qualify monetary policy as accommodative, neutral, or tight.

The real federal funds rate is simple to calculate. First, take the nominal federal funds rate currently set at a range of 0.75%-1.00%. From it, subtract some measure of inflation. Using the yearly percent change in the core PCED of 1.7%, which is the Fed’s preferred measure of inflation, the actual real federal funds rate is somewhere near minus 1.0%.

Recent guesstimates of r-star by Fed officials peg it close to zero. Obviously, r-star by those estimates is above the actual real federal funds rate around minus 1.0%. So now you see why monetary policy can be called “modestly accommodative.” By these measures, it would take about four 25bps rate hikes to get policy back to neutral. However, it’s not quite that simple because r-star is difficult to measure and its trajectory is uncertain.

(2) Observer effect. “Although the concept of the neutral real federal funds rate is exceptionally useful in assessing policy, it is difficult in practical terms to know with precision where that rate stands,” Yellen stated in her speech. Back in 2005, the Federal Reserve Bank of San Francisco published an explainer on r-star that is still applicable today. It stated: “The neutral federal funds rate has no explicit value—it is an estimate.” Economists “famously disagree on … the range in which the neutral rate falls, and how it might change over time.”

In physics, the “observer effect” is the concept that nothing can be observed in its natural state. That’s because the observer naturally will have an influence over the subject being observed. In a 6/26/16 blog post from Mises Institute, a research arm of the Austrian school of economics, academician Joseph Salerno wrote: “It is precisely the Fed’s attempt ‘to set the short-term interest rate somewhere’ that causes it to be unobservable anywhere.”

Salerno noted: “If the Fed were to completely halt its manipulation of the money supply, the loanable funds market would not disappear nor would interest rates become indeterminate. The supply of loanable funds would simply shift to the left and the interest rate would rise to a new equilibrium that aligns the loan rate with the long-run rate of return on investment in the real production structure.” Maybe so. In any event, monetary policy is complicated because r-star isn’t observable. Further complicating matters is that the observing Fed is influencing what is a moving target.

(3) Shooting star. Naturally, if the real neutral rate rises faster than expected (as surmised by clairvoyant Fed officials), the FOMC will also have to raise rates faster just to achieve a neutral stance. The FRB-SF’s explainer included a quote from a magazine interview with Yellen in which she stated: “The neutral real rate itself depends on a variety of factors—the stance of fiscal policy, the trend of the global economy which shows up in our net exports, the level of housing prices, the equity markets, the slope of the yield curve, or the term premium built into the yield curve. So it changes over time.” (For more, see our chronology of how the Fed’s thinking about r-star has evolved over recent years in our 10/12/16 Morning Briefing.)

For some time, estimates of r-star have been historically low. Have a look at some estimates plotted in Figure 1 of the FRB-SF’s 2/21 Economic Letter by the bank’s President John Williams. Individual estimates differ, but the range of estimates has moved lower over the past decade. Each estimate is below 1% by Q3-2016. The average of the estimates shown “fluctuated between 2 and 2½% in the 1990s through the mid-2000s, and then plummeted to about ½% around 2009, where it has remained through 2016.” Structural factors like the aging population, global savings glut, and declining productivity and innovation might be causing r-star to remain low. Nevertheless, it seems possible to us that forthcoming fiscal stimulus could light a fire under r-star, sending it higher—though there won’t be any hard evidence of any of that happening.

(4) Swan song. As we discussed yesterday, the median forecast of the FOMC is projecting two more 25bps rate hikes this year to get to a federal funds rate of 1.4% by the end of 2017. Three more hikes are also expected in 2018 to get to 2.1%. Yellen’s term as Fed chair expires January 2018. By then, she would like to leave her post with the real federal funds rate closer to neutral, which will end the long period of accommodative monetary policy. Perhaps then she and the markets can get back to normal, whatever that might be.

Lots of Strong Soft Data

March 20, 2017 (Monday)

See the pdf and the collection of the individual charts linked below.

(1) Yellen waiting to see if strong soft data turn into hard data. (2) Fed officials say business people more optimistic, but have a wait-and-see attitude. (3) “Gradual” remains in fashion at the Fed. (4) Less focus on “fiscal.” (5) Markets loved Yellen’s latest dovish cooing. She remains the Fairy Godmother of the Bull Market! (6) CEOs are bullish, which is good for capital spending. (7) Republicans are happy, while Democrats are sad. A net negative for spending? (8) Homebuilders seeing more traffic. (9) Lots of quitters. (10) NY & Philly business surveys remained exuberant in March. (11) The Fed plays with words and dots. (12) From one-and-done to three-a-piece.


US Economy: Wait & See? The economy’s soft data are hard, while the hard data remain relatively soft. That might explain the Janus-like posture Fed Chair Janet Yellen took during her press conference last Wednesday. She said more rate hikes are coming this year and probably over the next two years, but they will occur gradually. Yet she also said that the FOMC’s projections for the economic outlook remain unchanged since December. Last Wednesday, when she was asked about the remarkable strength of soft data—such as surveys of CEOs, consumers, homebuilders, small business owners, regional businesses, and purchasing managers—she responded as follows:

“So, we recognize, our statement actually last time noted that there had been an improvement, a marked improvement in business and household sentiment. It's uncertain just how much sentiment actually impacts spending decisions. And I wouldn't say, at this point, that I have seen hard evidence of any change in spending decisions based on expectations about the future. We exchange around the table what we learned from our many business contacts, and I think it's fair to say that many of my colleagues and I note a much more optimistic frame of mind among many, many businesses in recent months. But I'd say most of the business people that we've talked to also have a wait and see attitude, and are very hopeful that they will be able to expand investment and are looking forward to doing that, but are waiting to see what will happen. So, we will watch that. And, of course, if we were to see a major shift in spending reflecting those expectations, that could very well affect the outlook. I'm not seeing it—I'm not seeing that at this point. But the shift in sentiment is obvious and notable.”

That might explain why Yellen used the word “gradual” (or “gradually”) 21 times during her press conference in reference to the pace of future rate hikes. Melissa and I were mildly shocked when we did a similar word count on the transcript of her previous presser on December 14, 2016: There were only two mentions of “gradual” in her prepared remarks and none at all during the Q&A session by either her or the reporters in the room.

That might be because the word “fiscal” appeared 20 times during the December press conference, with her mentioning the word eight times and reporters doing so 12 times. Obviously, since that was the first Yellen presser since Trump’s election, there was much focus on Trump’s plans to stimulate the economy with tax cuts and infrastructure spending. During last week’s presser, there were 12 mentions of “fiscal,” split 50/50 between Yellen and her inquisitors. This suggests that everyone in the room was a bit less confident about the likelihood that Trump’s plans will be fully implemented than at the previous press conference.

So, the FOMC will maintain a gradual approach to monetary policy tightening while waiting to see if all the strong soft data show up as harder hard data. Yellen seemed a wee bit skeptical that this will happen. No wonder that the markets interpreted Yellen’s comments as more dovish than was widely expected, sending stock and bond prices higher and the dollar lower. Yellen remains the Fairy Godmother of the Bull Market! While we are all waiting to see if the hard data improves, let’s update the deluge of strong survey data:

(1) CEOs. Not surprisingly, chief executive officers are exuberant about the pro-business leanings of the new administration in Washington. The Business Roundtable’s CEO Economic Outlook Index—a measure of expectations for revenue, capital spending, and employment—jumped 19.1 points to 93.3 during Q1, according to the group’s survey released last Tuesday (Fig. 1). The increase, the biggest since Q4-2009, left the gauge above its long-run average of 79.8 for the first time in seven quarters. Readings above 50 indicate economic expansion.

This index, which is available since Q4-2002, is highly correlated with the y/y growth rate in capital spending in real GDP, in general, as well as in spending on business equipment, structures, and intellectual property, in particular (Fig. 2, Fig. 3, and Fig. 4).

The survey, with responses from 141 member CEOs, was conducted from February 8 to March 1. In response to a special question, 52% of the participants said tax reform would be the single best policy change to create the most pro-growth environment for businesses. The CEOs project the economy will expand 2.2% in 2017, up from their December estimate of 2.0%. That’s still a fairly soft projection for the hard data. So is the latest estimate by the Atlanta Fed’s GDPNow for Q1-2017 real GDP growth at only 0.9% (saar)! On the other hand, the NY Fed’s Nowcast estimate is 2.8%—go figure.

(2) Consumers. The Survey Research Center at the University of Michigan said Friday that its preliminary Consumer Sentiment Index (CSI) increased to 97.6 in mid-March from 96.3 in February. The index of current conditions jumped three points to 114.5, the highest reading since November 2000 (Fig. 5).

The gauge of expectations was little changed at 86.7 from a three-month low of 86.5 in February. Among Republicans, the expectations index was at 122.4, while it was 55.3 for Democrats. A whopping 87% of Republicans expect continued gains in the economy over the next five years, compared with 22% of Democrats, according to the survey.

Respondents expected the inflation rate in the next year will be 2.4%, compared with 2.7% in the February survey. Over the next five years, they project a 2.2% rate of price growth, the lowest reading on record, after 2.5% in the prior month.

Interestingly, the Conference Board’s Consumer Confidence Index (CCI) rose 14.0 points from 100.8 during October of last year (before the election) to 114.8 last month, the highest reading since July 2001, while the somewhat less volatile CSI rose 9.1 points over this same period. The CCI is available by age cohorts (Fig. 6). The biggest jump has been for people 55 years and older, by 25.4 points from October through February.

Despite all the hoopla, retail sales growth has been slowing. On an inflation-adjusted basis (and excluding building materials, which is a component of residential investment in real GDP), it was up only 2.1% (saar) over the three months through February, based on the three-month average, the weakest since August 2015 (Fig. 7). Any way we slice and dice the data, we find a significant slowing in the growth of real consumer spending on goods since mid-2016 (Fig. 8).

Could it be that Republicans don’t spend as much as Democrats? Or maybe happier Republicans don’t spend enough more to more than offset the cutbacks by depressed Democrats. Maybe happier, mostly older Donald Trump supporters don’t spend enough more to more than to offset the cutbacks of Bernie Sanders’ unhappy, mostly younger supporters.

(3) Homebuilders. The National Association of Home Builders’ confidence index surged 6 points to 71 this month, the highest level since June 2005. It was 63 during October, before the election (Fig. 9). The subcomponent tracking current sales conditions rose 7 points to 78, and the one tracking sales over the coming six months was up 5 points to 78.

The measure of prospective buyer traffic jumped 8 points to 54, also the highest since mid-2005. Any reading over 50 signals improvement, and the traffic component is only rarely higher than that. It broke above the 50 line in December after the election for the first time since the bubble era.

Housing starts increased 3.0% m/m to 1.29 million units (saar) last month. Unseasonably warm weather helped to boost the construction of single-family houses to near a nine-and-a-half-year high, but it remains closer to previous cyclical troughs than peaks (Fig. 10). A positive harbinger of still stronger starts is the recent jump in lumber prices (Fig. 11). All these developments are bullish for the S&P 500 Homebuilding stock price index, which is up 24.5% ytd, the third-best industry performance among the 100+ S&P 500 industries we track (Fig. 12).

(4) JOLTS & SBOs. Last Thursday’s JOLTS report for January showed that total hires jumped to 5.4 million, remaining near the cyclical high during December 2015 (Fig. 13). Separations also rose, but to a new cyclical high of 5.3 million, led by a record high of 3.2 million quits (Fig. 14). Not surprisingly, quits are highly correlated with consumer confidence (Fig. 15). When the labor market is strong, workers will tend to feel more confident about searching for a better job and higher pay. If they succeed, then that will boost confidence some more. It’s a virtuous cycle.

Last Wednesday, Debbie and I reviewed February’s very strong survey of small business owners conducted by the National Federation of Independent Business. The survey’s series on the percentage of firms with one or more job openings is highly correlated with the JOLTS job openings rate, both on a 12-month average basis. The former rose to a cyclical high of 28.4%, the highest since September 2001.

(5) Regional business. Incredibly, the March average of the new orders indexes available from the NY and Philly Fed regional business surveys rose from 7.1 during October to 30.0 this month, the highest since July 2004 (Fig. 16). The average of the two regional employment indexes jumped from -4.4 to 13.2 over the same period to the highest since July 2014. The average of the two regional composite indexes edged down from 31.0 last month to a still highly elevated 24.6 this month.

(6) Purchasing managers. Debbie and I reviewed February’s strong M-PMI and NM-PMI reports at the beginning of March. The two available regional surveys suggest that both could come in as strong or stronger in March. The good news on the hard data is that manufacturing industrial production has been making new cyclical highs during the first two months of this year (Fig. 17).

(7) LEI. Finally, as Debbie reports below, the Index of Leading Economic Indicators—which is a mix of 10 soft and hard components—rose to a record high in February (Fig. 18). That augurs well for the Index of Coincident Economic Indicators, which consists of four hard data series on employment, personal income, business sales, and production.

The Fed: Word Play & Dot Plots. Fed officials spend a great deal of time fine-tuning how they communicate with the financial markets. All too often, they aren’t fully in sync among themselves and add to the markets’ confusion about the direction of monetary policy. However, they did a great job of communicating the latest rate hike, which was widely expected even though Fed officials only teed it up a couple of weeks before last week’s FOMC meeting. Above, Melissa and I reviewed the frequency of a couple of key words in Yellen’s press conference. Now let’s turn to the actual FOMC statement, as well as the Fed’s latest forecasts:

(1) Symmetric semantics. The word “symmetric” was added as an adjective to describe the FOMC’s “inflation goal” in the latest statement. Presumably, it was to ease concerns that the FOMC might raise rates more quickly if inflation rises above 2%. During her 3/15 press conference, Yellen explained that “symmetric” means that 2% isn’t a ceiling or a floor. It’s a target that the FOMC has an equal degree of tolerance for “undershooting” or “overshooting.” Further, however, she said that if an “overshoot” were to be “persistent,” then the FOMC would “try to bring inflation back” down to 2%.

This isn’t the first time that the word has been used in this context. As part of its annual organizational meeting actions on 1/26/16, the FOMC amended its “Statement on Longer-Run Goals and Monetary Policy Strategy,” to clarify “that it views its inflation objective as symmetric.” The statement was amended as follows (with our emphasis): “[The] Committee would be concerned if inflation were running persistently above or below" its 2% objective.

(2) Delete “only. The word “only” was removed as a qualifier for “gradual increases in the federal funds rate.” The FOMC thus conveyed that there could be moves other than “gradual” ones. In her 3/3 speech titled “From Adding Accommodation to Scaling It Back,” Yellen said: “[G]iven how close we are to meeting our statutory goals, and in the absence of new developments that might materially worsen the economic outlook, the process of scaling back accommodation likely will not be as slow as it was in 2015 and 2016.” Those were one-and-done years, as we had predicted. This year and next year could be three-a-piece.

When asked about the removal of the word “only” from the statement during her press conference, Yellen responded: “I think this is something that shouldn't be over-interpreted.” She said it should be considered in the context that the economic projections were “unchanged” from December. Nevertheless, the wording change suggests that the FOMC is making room for upside surprises. “Our economic forecast can change,” Yellen said.

(3) Connecting the dots. Along with the statement, the FOMC provided an update of the quarterly Summary of Economic Projections (SEP). The median forecast of the 17 participants of the FOMC for the federal funds rate hasn’t changed from about two more hikes this year to reach 1.4%, with a longer-term target of 3.0%. However, for the 2017, 2018, and longer-run projections, there are notably fewer dots below the median forecast in the Fed’s latest dot plot, which charts each participant’s assumptions for the federal funds rate. For 2019, although one extra dot fell below it, the median drifted higher a touch. Overall, the upward drift in the dots indicates that more participants are more optimistic.

While we don’t know which dot corresponds to which Fed participant, Fed Governor Lael Brainard exemplified a newfound optimism during a 3/1 speech titled “Transitions in the Outlook and Monetary Policy.” She focused mostly on positive developments, concluding that there was a “favorable shift in the balance of risks at home and abroad.”

(4) Fiscal fudge. Even though Fed officials seem to be increasingly optimistic, the median forecast for the longer-run change in real GDP included in the Fed’s March SEP was just 1.8%. According to Yellen, only some participants even “penciled in” fiscal policy changes to their projections. So it seems to us that participants may be underestimating the potential Trump fiscal boost.

Yellen conceded: “So, we have not discussed, in detail, potential policy changes that could be put into place, and we have not tried to map out what our response would be to particular policy measures. We recognize that there is great uncertainty about the timing, the size, the character of policy changes that may be put in place. And don't think that that's a decision, or a set of decisions, that we need to make until we know more about what policy changes will go into effect.” It seems safe to speculate that if Trump’s agenda is accomplished sooner rather than later, then the Fed may have to consider dropping the word “gradual.”


March 16, 2017 (Thursday)

See the pdf and the collection of the individual charts linked below.

(1) Tech leads ytd performance derby among S&P 500 sectors. (2) Kudos to Health Care for coming in second despite Obamacare R&R commotion. (3) Homebuilders help to put Consumer Discretionary in third place despite retailers’ troubles. (4) The race to tech out cars pits Detroit against Silicon Valley. (5) But don’t expect Detroit’s economics to shift into higher margin & growth gears enjoyed by tech titans. (6) As tech firms make inroads into auto markets, Big Brother will be watching and driving.


Sector Focus I: What’s Hot & What’s Not. Never doubt that an apple a day is good for you. Investors betting that an iPhone upgrade cycle will boost Apple’s bottom line have sent its stock climbing 20.0% ytd through Tuesday’s close. Its strong start to the year has helped the Tech sector gain 10.9% ytd, making it the top-performing sector of the 11 S&P 500 sectors. The Tech sector is trouncing the 5.7% return of the S&P 500, while the worst-performing sector of the index is Energy, with a 9.0% decline ytd.

Apple accounts for about a third of the Tech sector’s ytd gain, Joe calculates. Without Apple, the Tech sector’s ytd return would be 7.5%, still besting the S&P 500. The company has also helped the Technology Hardware, Storage & Peripherals industry increase 18.3% ytd. Other industries boosting the Tech sector include Home Entertainment Software, which is the top-performing S&P 500 industry ytd with a 25.9% gain, Semiconductor Equipment (17.7%), and Application Software (16.8), which are in sixth and eighth places among the 100-plus industries we monitor (Fig. 1 and Table).

Here’s the performance derby for the S&P 500 sectors ytd through Tuesday: Tech (10.9%), Health Care (9.4), Consumer Discretionary (6.7), Financials (6.2), Consumer Staples (5.9), S&P 500 (5.7), Utilities (4.3), Materials (4.0), Industrials (3.7), Real Estate (-0.6), Telecom Services (-4.0), and Energy (-9.0) (Fig. 2). Let’s take a look at what’s driving performance in some of the other sectors before returning to Tech:

(1) Drugs on a high. The market-beating performance of Health Care (9.4%) is admirable given the uncertainty about the potential repeal and replacement (R&R) of Obamacare and the hostile tweets about drug pricing from President Trump. Indeed, Pharma, Biotech, and Managed Care are up 7.6%, 9.1%, 8.5% ytd, respectively (Fig. 3).

(2) Houses beating malls. Likewise, the Consumer Discretionary sector has overcome the terrible performance of Department Stores (-14.5%), General Merchandise Stores (-14.0), and Apparel, Accessories & Luxury goods (-6.3). The sector’s above-average performance ytd is thanks to Homebuilding (21.7), Casinos & Gaming (21.0), Tires & Rubber (17.9), and Auto Parts & Equipment (16.9), which were the second, third, fifth, and seventh best-performing of the industries we track in the S&P 500 (Fig. 4 and Fig. 5).

(3) Rising rates bifurcating returns. The specter of higher interest rates may be broadening to affect industries beyond the obvious Financials industries, which benefit from a steeping yield curve. For example, the Materials sector is underperforming despite the recent string of solid economic reports. Among its worst-performing industries are Copper (-7.0%), Construction Materials (-5.2), and Gold (-4.9). The price of gold is inversely correlated with the 10-year TIPS yield, which has been moving higher recently (Fig. 6). In addition, commodity-related industries may be pricing in a strengthening US dollar in anticipation of further interest-rate increases by the Fed (Fig. 7). Conversely, the potential for higher rates has helped Financials, as we’ve expected, with Diversified Banks (7.6) and Investment Banking & Brokerage (6.2) leading the way (Fig. 8).

Higher interest rates undoubtedly are weighing on returns in the Real Estate and Telecom Services sectors. However, rates have had less of an impact on the Consumer Staples sector, which includes many stocks that pay a nice dividend and were being used by investors as bond alternatives. The sector has performed well thanks to M&A activity. Kraft Heinz announced and withdrew a $143 billion offer for Unilever PLC in February, leaving investors in other companies in the sector hoping that Kraft would satiate its hunger for acquisitions by buying a US consumer goods company. It was also revealed that shareholder activist Trian Fund Management had invested more than $3 billion in Procter & Gamble. The news lit a fire under Household Products (10.4%) and Personal Products (8.3) (Fig. 9).

(4) Transports heading in different directions. One area to keep an eye on: Transports. It’s odd that they’re trailing the market, having risen only 1.7% ytd, even though lower oil prices should be acting as a tailwind. Declining have been Airlines (-3.4% ytd), Air Freight & Logistics (-1.9), and Trucking (-1.8). Only Railroads continues to chug along, having climbed 9.3% ytd (Fig. 10).

Sector Focus II: Technology’s Amazing Race. President Donald Trump met with the automakers in Detroit yesterday, the same day the EPA reopened a review of tougher emissions targets and fuel mileage requirements established at the end of the Obama administration. One industry estimate put the cost of meeting those standards at $200 billion. So lowering the bar would be a nice carrot to throw the auto industry while the administration continues to consider taxing Mexican imports, including low-priced vehicles made over there by American automakers.

Meanwhile, auto manufacturers and suppliers are investing in developing autonomous cars. They know the competition is heating up as the titans of Silicon Valley are throwing tons of money at the area. Earlier this week, Intel was the latest to put the pedal to the metal with its $15.3 billion acquisition of Mobileye NV, the Israeli company that makes cameras used to guide autonomous cars, and warn you when you are about to change lanes into another vehicle. The deal follows Qualcomm’s $39 billion deal to buy NXP Semiconductors, which makes chips to handle functions like braking and fuel injection, and Samsung Electronics’ $8 billion acquisition of Harman International Industries, which makes sound systems for cars.

At the same time, auto manufacturers are making their own acquisitions to stay in the race. GM paid $1 billion for Cruise Automation, Uber bought Ottomotto for $680 billion, and Ford spent $1 billion for a majority stake in Argo AI. That’s in addition to the money being spent by new industry upstarts like Tesla and Waymo (the Google unit) on developing the technology.

The raft of deals did get us thinking, however, about the economics of car-making. Auto manufacturing is a highly competitive, cyclical business. Although it’s enjoying good times today, history is littered with the bankruptcies of automakers that have not successfully navigated downturns. It was only eight years ago that General Motors filed for Chapter 11 bankruptcy protection.

Analysts estimate that Auto Manufacturers will have relatively low forward profit margins of 5.1%, and a decline over the next 12 months in both revenues (-0.4%) and earnings (-2.2) (Fig. 11). The Auto Parts and Equipment industry is slightly more attractive. Analysts forecast a forward profit margin of 9.8%, with revenue and earnings growth rates of 1.5% and 5.4%, respectively. Investors have bestowed below-market multiples on both industries: a 6.8 forward P/E on the Auto Manufacturers and an 11.6 multiple on the Auto Parts industry.

Compare that to the Semiconductors industry, which is also cyclical. Analysts expect the Semiconductor industry to produce 6.2% revenue growth, 10.9% earnings growth, and a forward profit margin of 24.8%. Those more attractive economics have earned the industry a forward P/E of 14.9. The economics at companies like Google and Apple are even more attractive.

Will adding self-driving capabilities make the auto industry’s economics more attractive and tech-like? Our guess is no. The pricing for autonomous capability is coming down rapidly, and the feature will become expected by drivers over time, just as navigation is today and a sunroof was 20 years ago.

Alphabet’s Waymo division has reduced the cost of lidar (the lasers that help cars “see”) by 90% to roughly $7,500 from $75,000 a few years ago. Tesla Motors plans to charge buyers $8,000 to activate the autonomous driving technology in its newest cars. That price tag does not include the equipment needed for an autonomous car, which is put into all Tesla cars today, before the buyer indicates an intention to activate the software or not. The equipment consists of eight cameras, radar, ultrasonic sensors, and a supercomputer, according to a 10/20 article on

The price of autonomous driving systems must continue to come down if mass adoption is the goal. The $8,000 price tag might not be a stretch for consumers who can afford Tesla’s high-end models starting at $66,000. However, the $8,000 may be a tougher swallow for the customer buying Tesla’s low-end $35,000 model, especially since the company doesn’t yet have regulatory approval to let its cars drive autonomously. Tesla suggests owners can pay for the cost of the software by having their cars join the Tesla Network, a fleet of ride-sharing cars that will compete with Uber and Lyft. More details on the project are expected this year.

The US consumer already seems to be stretching to buy a car. Motor vehicle loans have risen 59% since the recent low during Q3-2010 to an all-time high of $1.1 trillion at the end of last year (Fig. 12). The average maturity of new car loans has increased from 59.5 months in March 2009 to 66.5 months in December 2016, according to data from the St. Louis Federal Reserve. And car loans delinquent by 30 days or more grew to $23.3 billion, the most since $23.5 billion in Q3-2008, during the recession, according to data from the New York Fed.

It’s clear why Intel would want to expand into the auto industry. Its core PC business is in decline. “Intel, which faces a raft of challenges in its core business of powering the personal-computer industry, estimates the market for autonomous-driving systems, services and data will reach $70 billion by 2030. That includes navigation, in-car communications and advertising—and keeping a car’s perception and decision-making capabilities finely tuned to avoid mishaps as road conditions change,” noted a 3/13 WSJ article.

No doubt the revenues involved will be large if these systems achieve mass adoption. The tougher question is whether profit margins on these new products will look like tech industry margins or auto industry margins? The answer may determine whether shareholders will be happy about tech companies’ diversification efforts.

Certainly, the CIA should be pleased about the advancements in car technology. Stephen Soukup and Mark Melcher, our friends at The Political Forum, recently noted that documents disclosed by WikiLeaks revealed that the CIA can use most web-connected devices to further its spying ambitions. It can tap into TVs, computers … and cars. The CIA supposedly has the ability to know where your car is headed, and it may be able to control the vehicle and cause it to crash. Driving with a roadmap and listening to a push-button AM/FM radio might be a safer way to travel.

Animal Spirits Showing Up in Earnings

March 15, 2017 (Wednesday)

See the pdf and the collection of the individual charts linked below.

(1) Happy eighth birthday. Now take a nap. (2) Trump wins whether ACA-R&R passes or fails. (3) The swamp thickens. (4) Breitbart wants to sink Ryan. (5) Small business owners think now is a good time to expand. (6) Old problems for SBOs were regulations and taxes. New one is shortage of workers. (7) Boom-Bust Barometer still boomingly bullish for earnings and stocks. (8) Forward revenues and earnings at record highs. (9) It’s not all about Trump: Global economy seems to be improving.


Strategy: Draining the Swamp. Joe and I are hoping that the stock market bull will celebrate his eighth anniversary by taking a rest. As you get older, it’s not healthy to be sprinting. It makes more sense to jog at a leisurely pace. Taking regular naps is also widely recommended by health professionals for older folks. Presumably that advice applies to all aging animals.

The bull obviously got recharged by the animal spirits unleashed following Election Day. Undoubtedly, investors got into the spirit as well on expectations that Trump’s Electoral College win along with the Republican majorities in both houses of Congress would allow the new administration to charge ahead with its program, particularly deregulation and tax reform. So far so good on the former, but the latter is on hold while Washington focuses on Affordable Care Act repeal and replace (ACA-R&R). Trump has declared that he intends to drain the swamp. Doing so is already proving to be hard and tedious work. The bull may also find it hard to charge ahead in the swamp water.

Melissa is our resident Washington watcher. Her theory is that Trump doesn’t care if the GOP’s healthcare bill doesn’t pass through Congress. If R&R fails to happen soon, he won’t press the issue. He’ll let it go and move on to tax reform under a 2018 budget resolution, which is being worked on behind the scenes as ACA-R&R takes center stage and flounders. Trump will be happy to let Obamacare implode on its own. Politically, Trump still can say he made ACA-R&R his first priority to protect healthcare for Americans, as he promised during the campaign. He can later also say “I told you so” to Congress once Obamacare totally implodes. “It could self-repeal in this scenario,” says Melissa. “Then Congress will have no choice but to replace it.”

Melissa’s theory is backed up by a 3/9 CNN report: “In an Oval Office meeting featuring leaders of conservative groups that already lining up against House Republicans’ plan to repeal and replace Obamacare, President Donald Trump revealed his plan in the event the GOP effort doesn’t succeed: Allow Obamacare to fail and let Democrats take the blame, sources at the gathering told CNN.” Sources said that Trump strongly expressed that now is the chance for repeal and replace.

Trump’s secret ploy has been hidden in plain sight. In his 2/24 Conservative Political Action Committee speech, he stated: “[F]rom a purely political standpoint, the single best thing we can do is nothing. Let it implode completely, it's already imploding. You see the carriers are all leaving. I mean, it's a disaster. But two years, don't do anything. The Democrats will come to us and beg for help, they'll beg and it's their problem. But it's not the right thing to do for the American people, it's not the right thing to do.” So either Trump will get a plan that might work, or he’ll get zippo and let the Dems take the fall if Obamacare continues to implode.

Trump must know—because the stock market has been telling him so—that his big win would be tax reform. Market commentators have been baffled as to why the administration has put ACA-R&R ahead of tax reform. The answer is to get ACA-R&R out of the way whether it passes or not. Either way, we expect tax reform to remain on the timeline that officials have been signaling, which is to finalize writing it over the summer.

CNN also reported that on Monday, Breitbart News escalated its battle against House Speaker Paul Ryan by publishing audio of Ryan saying in October that he is “not going to defend Donald Trump—not now, not in the future.” The website, which was previously run by current White House strategist Steve Bannon, has blasted the House GOP’s plan as “House Speaker Paul Ryan’s Obamacare 2.0 plan.” Bannon certainly won’t shed a tear if Ryan sinks in the swamp along with the current ACA-R&R bill.

The good news is that while the bull may be forced to nap on high ground surrounded by the swamp as Trump tries to drain it, the economy and earnings may continue to thrive on animal spirits. In the next section, let’s examine the latest survey of small business owners. Then let’s see if animal spirits are having any impact on earnings.

US Economy: Small Business Owners Remain Upbeat. Of all the so-called “soft data” showing the surge in animal spirits following Election Day, the survey of small business owners (SBOs) conducted by the National Federation of Independent Business (NFIB) certainly stands out. That matters a great deal for the economy, since SBOs account for lots of employment and business spending, as we have previously shown on numerous occasions. If they are happy, that augurs well for the economy.

As Debbie discusses below, the NFIB survey’s optimism index jumped from 94.9 during October to 105.9 during January, and edged down to 105.3 last month (Fig. 1). The past two months are the best readings since December 2004. There was a dip in the percentage of SBOs saying that the number one problem they face is government regulation to 18.2%, the lowest since November 2011 (Fig. 2). Taxes remain their number-one problem, with 21.0% saying so last month, but that could change for the better if Trump succeeds in cutting the corporate tax rate. This rate is probably effectively higher for SBOs than large corporations, which have more resources for gaming the tax system to their advantage. Let’s take a deeper dive into the survey, which is much more fun than doing the same into Washington’s swamp:

(1) Future looking up. When I was an undergraduate at Cornell, I read a novel by a former Cornelian, Richard Fariña, titled Been Down So Long It Looks Up to Me. Sadly, he died in a motorcycle accident two days after his book was published by Random House. But I digress. SBOs have been mostly depressed during the current economic expansion, but now are looking up again. The percentage expecting better rather than worse business conditions six months ahead was mostly negative since 2009 (Fig. 3). This diffusion index shot up from -7.0% during October to 47.0% in February. The net percentage expecting higher real sales in six months jumped from 1.0% during October to 26.0% during February (Fig. 4).

(2) Expansion plans. That’s influencing SBOs’ decisions to expand over the next three months, with this diffusion index jumping from 9.0% during October to 22.0% last month (Fig. 5). That’s great news. However, their new number-one problem may be finding workers. During February, 32.0% of SBOs said that they have one or more job openings, the highest since February 2001 (Fig. 6).

(3) Full employment. Last month, the percentage of SBOs with positions that they were unable to fill, based on the three-month average of this volatile series, rose to 30.7%, also the highest since February 2001 (Fig. 7). This series happens to be highly inversely correlated with the official unemployment rate, which has been below 5.0% for the past 10 months. In other words, it is confirming that the economy is probably at full employment.

Earnings: Industry Analysts More Bullish. There are plenty of other soft data showing animal spirits, including surveys of consumer confidence, purchasing managers, and regional businesses. February’s better-than-expected increase in employment measures was widely attributed to mild weather boosting construction payrolls.

Meanwhile, our Boom-Bust Barometer (BBB), which is the ratio of the CRB raw industrials spot price index to initial unemployment claims, continues to boom (Fig. 8). Debbie and I consider it to be one of the most reliable, high-frequency, hard-data business-cycle indicators. It has gone almost rocket-ship vertical since bottoming during the week of January 16, 2016. It is up 50% through early March.

Our BBB is based on hard rather than soft data. The S&P 500 stock price index has been highly correlated with it since 2000 (Fig. 9). That’s because our BBB has been highly correlated with S&P 500 forward earnings (Fig. 10). Needless to say, it is wildly bullish for earnings and for stocks, though it does tend to be more volatile than both. For now, S&P 500 forward earnings continues to climb into record-high territory. Let’s review the latest data:

(1) Looking at forward earnings. S&P 500 forward earnings remained at a record high of $133.99 last week (Fig. 11). This metric is a good year-ahead leading indicator of four-quarter trailing earnings, as measured by Thomson Reuters, with just one important proviso: It doesn’t anticipate recessions. As the year progresses, it will converge toward the analysts’ consensus expected earnings for 2018 (Fig. 12). Their 2018 estimate has been remarkably stable since Election Day around $146 per share, while the 2017 estimate has continued to decline, as is typical for annual estimates.

Industry analysts may be assuming that Trump’s tax reform will boost earnings in 2018. Joe and I are still estimating $143 per share for this year’s earnings and $150 for next year. If the corporate tax cut doesn’t hit until next year, then this year’s figure will be around $130 and next year’s will still be $150, in our opinion. As we’ve previously written, the timing shouldn’t matter much, since by the time we know whether tax reform is or is not retroactive to 2017, the market will be focusing increasingly on 2018. (See YRI S&P 500 Earnings Forecast.)

(2) Looking at forward revenues. S&P 500 forward earnings is rising in record-high territory because forward revenues is doing the same (Fig. 13). Analysts are expecting revenues per share to rise 5.7% in 2017 and 4.8% in 2018. The estimates for both years have been holding up quite well in recent weeks. While a cut in the corporate tax rate directly boosts earnings, it can have only an indirect impact on revenues. In other words, some of the animal spirits in next year’s consensus earnings estimate may reflect a more constructive outlook for the global economy, which drives revenues.

(3) Looking at 2017 earnings. The one downer in the weekly data that Joe and I track is the 3.5% drop in the consensus estimate for Q1-2017 since the beginning of the year (Fig. 14). This is a typical occurrence, and typically sets the upcoming earnings season for an upside “hook” once the actual results are reported. In any event, industry analysts currently predict that 2017 earnings will be up 10.7% over 2016, with the following quarterly profile: Q1 (9.5%), Q2 (8.5), Q3 (9.0), and Q4 (13.0). Of course, if the price of oil continues to drop, that could weigh on earnings, though not as much as during 2015.

Go With the Flows

March 14, 2017 (Tuesday)

See the pdf and the collection of the individual charts linked below.

(1) The Fed’s world of credit. (2) Supply of equities continues to shrink, while debt continues to expand. (3) Lots of cash flow for nonfinancial corporations. (4) Move from active to passive clear in record purchases by equity ETFs. (5) Big buyers of equities not as valuation-oriented as traditional investors. (6) Treasury borrowing exceeds official deficit numbers. (7) Foreigners are biggest buyers of US corporate bonds. (8) China’s social financing blows away credit expansion in US. (9) Draghi’s policies have yet to boost Eurozone credit expansion.


US Flow of Funds: Equities & Debt. The Fed released its Financial Accounts of the United States with data for Q4-2016 last week. It provides amazingly comprehensive insights into the flow of funds, balance sheets, and integrated macroeconomic accounts of the US financial system. It’s really almost too much information to wrap one’s head around.

To help process it all, Debbie and I have created a bunch of chart publications over the years that visualize quite a bit of it on our website. The saying that a picture is “worth a thousand words” is attributed to newspaper editor Tess Flanders discussing journalism and publicity in 1911. Debbie and I have always believed that a chart is worth a thousand data points in a time series. Given our chosen profession, we tend to focus on the data for the equity and debt markets in the Fed’s quarterly statistical extravaganza. Let’s start with the latest supply side of these markets, and move on from there to the demand side:

(1) Supply-side totals. Net issuance of equities last year totaled minus $229.7 billion, with nonfinancial corporate (NFC) issues at -$565.7 billion and financial issues at $269.7 billion (Fig. 1). The increase in financials was led by a $283.9 billion increase in equity ETFs, the biggest annual increase on record. The decline in NFC issues reflected the impact of stock buybacks and M&A activity more than offsetting IPOs and secondary issues.

The net issuance of debt securities totaled $1,555.3 billion last year, with the major components all increasing, as follows: Treasurie