Commentary: January 6, 2017
A collection of today’s economic, market, political, geo-political, and human-interest news, thoughts, and analysis.
In This Month’s edition:
- Saving America
- 2017: A Year of Change
- 20,000 Is Only a Number
- Random Thoughts
HAPPY NEW YEAR!!
As we enter a new year, it’s time to reflect on the top news stories of 2016. My top 3 are:
- Trump’s election.
- DOW 20,000…almost.
- Cubs win World Series.
Your top 3 are probably different, but I’m willing to bet that almost all will have at least one of mine on their list. Like most recent years, notable deaths, scandals, politics, weather, protests, and terror dominated the headlines. However, I haven’t been this optimistic about our economic future since before 9/11/2001.
As a country, we have a new sheriff in town along with new hope from an economic point of view. Contrary to what most believed would have happened, including yours truly, the market has strongly rallied following Trump’s convincing yet contentious victory. So far the market has put its stamp of approval on the nation’s decision. The question we all face is whether this is the beginning of the next sustained leg up in an arguably aging bull market, or has the market only become a little further ahead of itself given all the fundamental weakness at many levels?
Many will listen, with peaked interest, to Trump’s inaugural message. As we await, I thought the following excerpt from Ronald Reagan’s first inaugural speech was appropriate and oddly fitting today’s political divide.
“We are a nation that has a government – not the other way around. And this makes us special among the nations of the Earth. Our government has no power except that granted to it by the people. It is time to check and reverse the growth of government, which shows signs of having grown beyond the consent of the governed.
It’s my intention to curb the size and influence of the Federal establishment and to demand recognition of the distinction between the powers granted to the Federal Government and those reserved to the States or to the people. All of us need to be reminded that the Federal Government did not create the States; the States created the Federal Government.
Now, so there is no misunderstanding, it’s not my intention to do away with government. Its rather to make it work – work with us, not over us; to stand by our side, not ride on our back. Government can and must provide opportunity, not smother it; foster productivity, not stifle it.
If we look to the answer as to why for so many years we achieved so much, prospered as no other people on Earth, it is because here in this land we unleashed the energy and individual genius of man to a greater extent than has ever been done before. Freedom and the dignity of the individual have been more available and assured here than in any other place on Earth. The price for this freedom has at times been high, but we have never been unwilling to pay that price.
It is no coincidence that our present troubles parallel and are proportionate to the intervention and intrusion in our lives that result from unnecessary and excessive growth of government. It is time for us to realize that we’re too great a nation to limit ourselves to small dreams. We’re not, as some would have us believe, doomed to inevitable decline. I do not believe in a fate that will fall on us if we do nothing. So, with all the creative energy at our command, let us begin an era of national renewal. Let us renew our determination, our courage, and our strength. And let us renew our faith and our hope.”
In this month’s edition, I attempt to take a look at the bull versus bear market views as well as the fiscal policy decisions we will likely see coming out of the Trump Administration and the new Congress as Republicans attempt to take advantage their fleeting political advantage. The first 100 days will set the stage as Trump pushes to make good on his campaign promises in whatever form they eventually manifest themselves.
Barron’s recently devoted five weekend editions following Trump’s election entitled “Saving America” authored by Randall W. Forsyth and Gene Epstein.
Barron’s attempted to equate the challenges facing Trump to those confronting Washington, Jefferson, and Hamilton as they attempted to “put the young nation’s finances in order” following a costly and fiscally disruptive Revolutionary War. Today, an older nation’s finances urgently need to be reordered in order to avoid eventual collapse. Let’s hope that over 200 years from now, Americans will be looking back at policies put forth by our new leaders in the same way we admire the foresight of our founding fathers.
In this series, Barron’s examines potential solutions as we look ahead:
- Taming the Federal Debt: The Case for 100-Year Bonds
- Why Trump should channel Alexander Hamilton and take advantage of ultralow interest rates.
- Cut the Top U.S. Corporate Tax Rate to 22%
- Cutting the corporate tax rate will boost the U.S. Economy.
- The Great Rebuilding
- Trump should champion 10-year, $1 trillion program…using Build America Bonds.
- Trade Barriers
- The ghosts of recessions past in the form of the Smoot-Hawley Tariff Act of 1930 should haunt Trump’s thought of introducing expensive tariffs on imports from countries allegedly employing unfair trade practices.
- Barron’s Prescription to U.S. Economic Growth
- How to eliminate $8.6 trillion of spending without raising taxes.
In Part 1, Barron’s looks at potential solutions to the ominous debt burden facing this nation along with the need for considerably faster economic growth.
Under Obama, the Federal debt doubled to $20 trillion as he oversaw the adding of more to the federal debt than all 43 presidents before him combined. This was a man who called George W. Bush unpatriotic due to the debt added during his presidency. Even scarier is the actual burden facing the nation by including the future unfunded liability making up Medicare and Social Security. Experts peg this number at about $200 trillion. That’s Trillion with a big, fat, capital T. The Congressional Budget Office estimates if the Trump administration added no new spending programs and left taxes unchanged that the current programs in place would add another $25 trillion to the debt over the next 20 years…a conservative estimate for a $45 trillion debt level.
Well, we know that Trump wants to also implement a massive $1 trillion infrastructure spending initiative over the next decade and plans to push through major tax and regulatory cuts. The thesis is that the economic growth resulting will create incremental tax revenues in dollar terms that will offset what would otherwise be large increases to the federal debt. While I firmly believe in the theory, I have little faith in the political disciplines necessary to allow the plan to work. We’ll see, but the approach we’ve witnessed over the last 50 years has failed miserably and set the stage for a future economic failure of gargantuan proportions.
I do believe that if Trump can accomplish the above coupled with reforms to the major spending programs, he could not only balance the budget but possibly reduce our debt footprint or at least set the stage for future administrations to begin chipping away at it. However, if he is successful at restoring 3%-4% GDP growth rates, interest rates will quickly rise making the cost of our massive debt more expensive than we can realistically afford as a nation…a real life Catch-22.
Using the CBO’s $45 trillion debt projection, the carry cost at today’s historically low interest rates would be about $750 billion per year. This could easily double to an unimaginable $1.5 trillion per year if interest rates do nothing more than normalize. That represents almost half of the federal government’s current annual spending. In 1981, Treasury debt cost about 14%. Today, a 14% rate would create an annual interest charge of $2.8 trillion or close to total current annual government spending budget including the military, Social Security, Medicare, Welfare, etc, etc.
Barron’s introduces an interesting, but not necessarily new, idea with interest rates at historic lows. The federal government can lock in low rates on the current debt and stretch repayment requirements far out into the future if they were to issue 50 or even 100 year bonds. The debt is the debt, but interest rate risk is enormous. Doing this would eliminate interest rate risk for generations. The current longest maturity for Treasury debt is 30 years, but there are many countries that have already issued 100-year debt.
Interestingly enough, the current 10, 20 and 30 year Treasury maturities are primarily designed to provide Wall Street and the banking world a convenient benchmark against which to price corporate and mortgage debt. With interest rates at current levels, it is estimated that longer term Treasury debt (50-100 years) could be set at about half of what its median long-term borrowing rate has been through history.
Apparently Barron’s concept caught some willing ears. Two weeks after the article was printed, Trump’s nominee for Treasury Secretary, Steven Mnuchin suggested that he would be open to the concept of issuing 50 or 100-year paper. They better act fast as average Treasury rates could top 6% in a robust growth environment. This may save trillions of dollars in interest costs over the next few decades.
The key to reversing the tidal wave debt spiral in the face of lower taxes and increased spending will be policies that truly stimulate economic growth. It is widely believed and historically proven that tax cuts result in increased economic growth. Part 2 of “Save America” focuses on Trump’s stated corporate tax policy. Trump wants to reduce the current 35% rate to 15% while Barron’s is more comfortable with a 22% rate which they believe will be tax neutral.
It’s pointless to debate the nuances between 15% and 22%. Both are built on the reality that lower tax rates will result in more economic growth that in turn will bring more net revenues into the Treasury over the long run. It’s important to understand the benefits that will be derived from significantly lowering the corporate tax rate. At 35%, U.S. corporations face the highest corporate tax rate in the world. As such they spend hundreds of millions of dollars each year trying to figure out how not to pay those taxes. Those are potential profits for business owners and shareholders much of which will be reinvested in growth initiatives…OR…go towards lower prices for goods and services produced.
Remember, taxes are nothing more than another expense item on the income statement which drops right into the cost of goods calculation. Higher taxes mean that the consumers pay more. The American consumer would benefit greatly from tax cuts by way of lower prices, more jobs, and higher wages. What’s not to like?
Trillions of dollars remain in overseas accounts so they won’t be taxed at U.S. rates. Money always flows to where it is treated best. Many of those dollars are invested in growth endeavors overseas where profits are treated better. Wouldn’t it be nice if those dollars were instead invested in U.S. growth initiatives?
Why would tax cuts lead to more growth? It’s simple economics. I love simple economics. If companies can keep more of their hard earned profits, those profits will allow companies to invest in activities that will grow their business which generally leads to more hiring and then more growth. As growth occurs, more taxes are paid, and even at reduced rates, more dollars find their way into the Federal Treasury. More people are working and paying their fair share of taxes, and more importantly, spending their income thus creating even more economic growth. Thus, lower taxes beget:
- Less need to make costly expenditures attempting to avoid taxes in the first place leading to more profits.
- More investment in growth and productivity leading to even more net profits and capital to invest in growth.
- More jobs as growth begins to multiply and expand.
- The reduced tax burden will also allow businesses to charge less for their goods and services so consumers benefit from lower prices which especially helps the lower and middle class wage earners.
- More businesses are started because one of the biggest burdens (taxes) to opening a business is reduced.
- More net dollars are collected by the IRS to support spending programs.
- Of course, business owners and shareholders also make more money…ahhh the beauty of capitalism.
- Win, Win, Win, Win.
What will happen to the estimated $2 trillion in cash sitting in corporate accounts overseas? If the tax burden is reduced or better yet eliminated, those funds will be repatriated. Some will go to taxes that would otherwise never be realized. However, most will be invested in plant and equipment, new jobs, higher salaries, dividends, share buy backs, etc. So the benefits will be…re-read the bullet points above.
Another benefit would be the elimination of much of the economic need for companies to move operations overseas, so the future dilution of U.S. economic and job growth is reduced.
Moving on, everyone paying attention knows that America’s infrastructure is in serious need of updating. Many roads, highways, and bridges are in dire need of repair. Public buildings, water treatment systems, public transportation systems, railways, airports, schools, and ports all need to be brought up to current global standards. Because of poor fiscal and economic policy over the previous 5 decades coupled with paying for two wars and suffering through the Great Recession, we are faced with the daunting question of how do we pay for this urgent need.
Of course, the worry of how to pay for something has never stopped the government from spending before. In this case, not spending the money now would be more expensive on many levels in the long run. This can be measured in higher costs as well as lost productivity and lives. For example, tens of billions of hours are wasted each year stuck in traffic or waiting for trains and planes.
Trump campaigned on a $1 trillion infrastructure spending plan over the next 10 years. The skeptic that lives within me wonders how government, following tradition, will maximize waste and inefficient spending. If done well, this effort will create hundreds of thousands of high paying jobs and our nation will enjoy the efficiencies that accompany state of the art facilities. One-sixth of working age adult males are not employed and their skills are diminishing. They need to get back to work while they still can. Many will under a well-orchestrated infrastructure spending plan.
Goldman Sachs economist Daan Struyven estimates that the short term multiplier effect from infrastructure spending is 1.4. In other words, for every dollar spent, $1.40 of economic growth is created. Conceptually, this makes sense if the spending is efficient and well placed. Done poorly, our debt problem will only worsen, and the infrastructure needs will remain unmet. Obama’s stimulus is the most recent bad example. Now we sit with the ability to fund debt with historically low interest rates using creative financing options that partner with the private sector. Good stewardship and creative financing will optimize the multiplier impact.
Efficient planning and approval processes for these major expenditures is critical. The painful and expensive memory of the $800 billion Obama Administration stimulus program that was supposed to go towards ‘shovel ready’ jobs looms large. “Only a tiny fraction of the $800 billion in the program actually went towards infrastructure improvement.”
So, how do we pay for it? In Part 3 of “Save America”, Forsyth explores the concept of Build America Bonds. These are taxable Municipal Bond offerings where issuers may receive a 35% government subsidy against the dividends/interest paid to the bondholder. In another version, a refundable tax credit is issued to the bond holder. In essence, these structures offer very safe fixed income investments for those looking for income and reduces the cost for states and local communities to finance infrastructure spending. Better yet, it doesn’t serve to increase federal debt. These bonds would be repaid by revenues (e.g. tolls, fees, etc.) or by taxes as approved locally and not by Washington. The tax burden is then proportionately assigned to those most benefiting from the spending. Local oversight reduces the risk of waste and fraud at the federal level.
In Part 4, Barron’s discusses the risks of punitive tariffs and trade barriers being threatened by Trump. This is one of the few areas where I disagree with Trump economic policy. As 1000 petitioning economists at the time correctly believed, the infamous Smoot-Hawley Tariff Act of 1930 would “injure the great majority of our citizens.” It did…contributing to the Great Depression, and Trump’s threatened policy risks the similar side effects. This is one campaign promise that Trump should let die a quiet death.
Fewer, more expensive imports invariably lead to fewer U.S. exports. Both history and economic theory would argue that tariffs would accomplish little other than make affordable goods less affordable and less available for the average citizen at best. The world is a much smaller place today and nations are interdependent on fair trade.
The Cato Institute’s trade expert Dan Ikenson reacted to Trump’s across the board threats of 35%-45% tariffs saying they, “would be devastating to the U.S. and global economies and would destroy the international trading system” resulting in a global recession and drawdowns in global stock markets.
Trump should attempt to renegotiate elements of trade agreements that seriously disadvantage U.S. manufacturing profits short of triggering trade wars and unnecessary inflationary forces. Adam Smith wrote, “In every country it always is and must be the interest of the great body of the people to buy whatever they want of those who sell it the cheapest.” Smith’s economic theories are reflected in the evolution of U.S. balance of trade where imbalances began as cheap labor around the world began to compete with our increasingly expensive labor markets.
Statistically, most job loss occurs in America due to technological advances and automation. Cheap labor abroad is only a very small factor in job loss in the U.S. This creative destruction coupled with free trade unleashes future economic development and new job growth barring bad economic policy getting in the way.
We don’t levy tariffs when manufacturing is moved from one state to another in order to take advantage of economic efficiencies. The same theory should apply to movement internationally. Interestingly enough, data shows that countries with greater openness to trade experience substantially higher per-capita incomes and more rapid economic growth.
There are positive effects on many levels from the evolution resulting from the U.S. creating and developing industries. As those industries mature, cheap global labor is introduced helping reduce manufacturing. Global competition causes U.S. manufacturers to introduce productivity efficiencies in order to compete. Necessity continues to be the mother of invention and resulting advancing technologies benefit all. Tariffs and trade wars are only another form of governmental attempts to engineer outcome which far too often leads to destructive unintended consequences.
Epstein follows in Part 5 with a plan to radically cut spending in a way that the budget could be balanced without raising taxes. Using CBO’s 10 year estimates of revenues (based on current tax rates) and expenditures, trillion dollar deficits are the projected norm for the next decade. The CBO model calls for modest but steady continued economic growth. Debt service uses an average of 3.1% over the next 10 years.
Barron’s examines an aggressive plan to cut fraud, waste, and abuse in line with Trump’s campaign pledges. Barron’s plan generates surpluses by 2026…WITHOUT raising taxes. In fact, their plan uses lower growth estimates to achieve this goal. The vast majority of the $8.6 reduction comes on the spending side of the ledger. To be more accurate, the what appears on the surface to be aggressive spending cuts is actually a reduction in the estimated rate of spending increase. This finally challenges the concept of baseline budgeting which assumes that current budget initiatives will increase by a prescribed amount each year into infinity. Don’t you wish you could do that with your budget…personal or business?
Epstein writes, “Our cost-cutting proposals, scored in consultation with Cato Institute scholars Chris Edwards and Benjamin Friedman, attempt to root out the waste, fraud, and abuse that largely accrues to entrenched interests such as the garden-variety congressmen who logroll to bring pork-barrel projects to their districts. But we assume our incoming president will pursue aggressive reform, entrenched interests be damned. Our suggestions go after low-hanging fruit from a wide range of programs, departments, and agencies.”
The non-politicized details behind Barron’s plan are as compelling as they are plausible and we may finally have a leader willing to take on the status quo in Washington. We’ll see, but economic revolutions must start somewhere if there is any hope of avoiding the economic Armageddon looming over future generations. Let’s see if Washington has the appetite and courage to do so.
2017 A Year of Change
As we bid farewell to a tumultuous 2016 where the equity markets have exceeded the expectations of most experts on the back of economic optimism stemming from Donald Trump’s stunning victory, everyone now turns to 2017. The worst market start for any year in history has become a distant memory, but shouldn’t be so easily forgotten. What should we expect going forward? Opinions vary greatly…no surprise.
In the following section, I attempt to make both the bull as well as the bear market case looking ahead. The expectation is for tremendous fiscal policy changes, so it makes sense to think in terms of the potential Trump effect as it relates to the economy in the coming year.
Setting the economic stage:
- We face sluggish global and domestic economic growth. We are in the eighth year of economic expansion representing the fourth longest expansion since 1900. Unfortunately, with an average growth rate of 2.1% per year, it also represents the slowest of all post-World War II expansions.
- Japan is stagnant, China is slowing, the EU is brittle, and uncertainty reigns supreme.
- Interest rates remain historically low and in some parts of the world are negative, and now at home they are finally appear poised to begin their ascent towards normalcy.
- Domestic equity markets are at record highs as fixed income markets are ebbing following a strong decade.
- Global debt is at historic levels.
- We enjoy statistically full employment in the U.S. while the number of working age adults without jobs is at four decade highs. Some is basic aging demographics, but much is very troubling.
- Wage growth remains stagnant and far too many jobs including most job growth is part-time.
- Consumer optimism is high.
- Manufacturing numbers are rising.
- Home prices have recovered most of their Great Recession losses.
- Millennials are feeling left out as they are saddled with strangling college debt and low wages. They are living with their parents in record numbers and for longer periods than previous generations which delays starting families, buying homes, and moving up and out.
- The cost of Obamacare has overwhelmed the benefits from lower oil prices and low inflation overall.
- Corporations around the world have been on an easy credit feeding frenzy following the global financial crisis, yet they are having trouble finding buyers as economic mediocrity remains in charge. Slow growth leads to defensive tactics at the corporate level as well as politically as countries invoke trade restrictions to protect their people but further hampering growth.
- Yet, as we approach 2017, the “Plow Horse Economy” (Wesbury) has cleansed many wounds. There are signs that the expansion will pick up pace potentially supported by economically friendly fiscal policy emanating from Washington. Faster economic growth begets inflation which begets higher interest rates which in turn slows economic growth.
- The economic cycle suggests that we may be overdue for a recession which in this case may not be a bad thing…only a temporary reset.
Confusing? You bet! And the stock market marches boldly on. In recent years, investors have been piling into the markets in search of yield within a zero interest rate environment. Investors are beginning to feel left out and are starting to chase a market that appears to be moving away from them. Careful!
The Trump Effect
A couple of months ago Harvard professor, former chief economist with the International Monetary Fund (IMF), and past McCain campaign advisor Kenneth Rogoff was nervous about the extreme uncertainty surrounding a then potential Trump presidency. He now talks about the possibility of a coming economic boom as a result of Trump’s proposed policies including tax cuts, regulatory reform, and fiscal stimulus through infrastructure spending.
Rogoff believes these policies may disproportionately benefit the rich, but isn’t that the historical outcome as capitalism has proven to be the optimal way to improve the lifestyles of the masses. A rising tide lifts all boats, if you will. Take away the political misuse of the topic, success is the great by-product of risk taking and ingenuity. Without the titans of industry, there would be no industry, middle class, or a path for the entrepreneurially inclined to rise up and out. In my view, a robust middle class is dependent upon the ability for a few visionary individuals who are willing to blaze trails and reap the rewards for doing so.
Larry Jeddeloh of UBS and founder of The International Strategist newsletter predicted a Trump win early on and believes a Trump presidency brings great potential for the country, our economy, and the markets. “This is one of the best opportunities I’ve seen for a long time. The stock market is underpriced relative to the growth rates we will see in the economy.” He sees a 2400 on the S&P 500 next year and 3000 within three years.
Goldman Sachs predicts that a “Trump presidency will benefit stocks in almost every sector.” Even as uncertainty looms, JPMorgan also sees Trump policies flush with pro-growth leanings. Both are mindful that the President-elect’s populist positions could be economically disruptive.
Much of the economic optimism surrounding a government with Trump at the helm is centered on advertised policies that will reduce taxes and regulation as well as replace Obamacare with a practical solution that preserves many of the features ACA currently has but with far less government intrusion. Trade will continue unmolested for the most part. The threat of punitive tariffs are probably a negotiating ploy. Current and future trade agreements may take on a different, more pro-American bias. These policy positions will be aggressively prosecuted in the first 100 days. Vice-President-elect Mike Pence tells us to buckle up.
On other fronts, Trump will immediately begin to deport criminals in this country illegally and take on sanctuary cities. The “Wall” will come later, but much stronger boarder control policies will be implemented immediately. Expect a quick Supreme Court nomination to replace Scalia. The courts will retain a business friendly bias for a generation to come. It’s very likely the first 100 days will see some significant foreign policy excursions including the kick off of renegotiating the Iran nuclear agreement. Dodd-Frank will go under the microscope with potential sweeping changes to the restrictive inefficiencies in that law.
Barron’s Greg Valliere offered “12 Political Rules That Will Guide 2017.”
- Do not underestimate Donald Trump: Ever.
- The great economic pendulum shifts: spending, tax-reform, and rate hikes are in. Fiscal restraint, regulations, QE are out.
- Washington’s cozy relationship with corporate America is over: this is a populist era; don’t send jobs overseas.
- The industry that wins the most is defense: sequester will end and the Pentagon gets whatever it wants.
- Health care…the hot potato: ACA will die as we know it only to be reincarnated in a vastly more efficient form.
- Regulatory reform is coming: executive orders reversed, many regulations overturned, huge psychological win for business.
- Immigration – the big fizzle: tougher border enforcement, some criminal deportations, no wall for now.
- Infrastructure comes later not sooner: Republicans will resist the spending impact.
- The Democrats don’t have a clue: a party that re-elects Nancy Pelosi as their leader does not have a vision for the future.
- China will saber rattle: much posturing. Both need each other in the end.
- Trump’s real challenge will be Iran: both sides itching for a fight, watch the Strait of Hormuz.
- When in doubt, remember Rule 1!
In 1999, Jim Glassman famously released his book DOW 36,000 as the DOW poked 12,000…Ooops…next stop 7,500. Seventeen years later, Barron’s is now telling us to get ready for DOW 20,000.
Have we gone too far too fast? Is that the makings of a classic head and shoulders in the above DOW chart? Does DOW 7500 seem to be a major resistance level? Have we seen 10,000 for the last time as the right shoulder takes shape? OR, is this only the beginning of the next bull market run towards DOW 36,000? There are certainly no shortages of predictions for 2017. Let’s take a look at some…
First, it’s important to understand that 20,000 is just another number no more or no less important than 19,500, 20,500, or any other number for that matter. Investing America is obsessed with numeric milestones. A recent article in the Wall Street Journal even projected a DOW 1 Million by 2094…I’ll be at ripe ol’ age of 143 by then. History has told us that these major milestones often find the going pretty tough when attempting the last summit push and almost always are better the second third, or fourth time around.
The first time the DOW broke through 100 in 1906 found huge optimism for a roaring bull market. It didn’t hold, and investors had to wait another two decades before seeing it break the 100 mark for good. It wasn’t until 1966 that the index touched 1,000 intraday. Eighteen years later it crossed 1,000 for the final time. Over the next 32 years the rollercoaster witnessed 18 more 1000 point milestones be eclipsed at faster and faster rates with a couple of notable 21st century interruptions…the tech bubble bursting (2000-2002) and the credit market collapse (2008-2009).
It took a mere 33 years from the first time the DOW hit 1,000 for it to achieve rarified space closing above 10,000 first in March of 1999 supported by a roaring economy. We would then see the market move through the 10,000 mark five more times before finally making its historic run towards 20,000.
From 1984, when 1,000 points was forever surpassed, we saw 18 more 1,000 point milestones broken averaging about 1.7 years between each. Most saw that next level broken more than once before moving on. The last six-1,000 point moves from 14,000 to 19,000 have averaged 5.5 months each to achieve with the last leg represent the fastest 1,000-point jump in market history taking about a month to achieve. When markets make major moves in short periods of time, they become very vulnerable. Is that where we are? How much more vulnerable can we become before the inevitable happens?
The journey from 10,000 to 20,000 has been treacherous with a couple of episodes that wiped out trillions in market valuation. Most believe it’s only a matter of days before the index surpasses 20,000 for the first time, but if it doesn’t happen soon, it may take a while. When it does, it’s hard to believe that we won’t see it cross that point again perhaps many times and even harder to predict from what level it may make the final push through 20,000.
In 2008, we were only 7,000 points away. A year later the gap was 13,000. As we sit on the precipice of 20,000, it’s still historically reasonable to question whether or not we’ve seen 10,000 for the last time. The chart on the previous page shows support at 7500 and Harry Dent can see 5,000 or lower in his crystal ball. If the chart completes the head and shoulders, the DOW will probably see 10,000 again in the next few years.
Another fairly consistent indication of the market having achieved significant resistance levels is Robert Schiller’s cyclically adjusted P/E ratio for the S&P 500. It now sits at 28 based on S&P 500 inflation-adjusted earnings for the last decade which makes it one of the most expensive of those observations in the last 135 years. Typically, milestones are not maintained when the S&P 500 achieves them with this ratio at 24 or above. This ratio is generally a little less than 13 when milestones are surpassed for the final time.
Economic growth is relatively weak and earnings are unproven. The wobbly economic foundation doesn’t create a lot of reasons for celebration as the DOW teases 20,000.
So where are we headed. I have never seen the so called experts issuing such wide ranges of potential outcome as they make their case for 2017. The consensus opinion sees a modest 5.5% increase for the S&P 500 and a 2017 close of 2363. The best case worst case scenarios create a range of +20% to -30% for the year.
For example, Bank of America Merrill Lynch has a base case for the S&P 500 gaining 3% in 2017 based on the Trump Administration achieving their economic policy goals. If that does not occur, the bear case sees the S&P 500 plummeting 30%. The bull case scenario combines policy success, stimulation, and no surprises seeing the S&P 500 closing the year at 2700 up 21%.
The BULL Case:
The year came to an end with the DOW and S&P 500 up 14% and 10% for the year respectively. Even though the market may very well be ahead of itself for now, it is definitely in melt-up mode. A USA Today article presented 5 theories as to why stocks are in rallying:
- Money managers playing catch up: most fund managers are trailing in 2016.
- Bond sell-off eases: reducing fears of spiking borrowing costs that could stall the market.
- Cash flooding back to stocks: sidelined cash now being put to work.
- Trump effect: must have been hard for them to print this item.
- A trend signal says “buy”: transportation stocks hit new highs for first time in two years. Stocks for companies that make stuff and stocks for companies that ship stuff all at new highs = buy.
Barron’s interviews 10 top investment strategists twice a year. Collectively they view Trump’s win as a market catalyst and expect the melt-up to continue well into 2017. The election results caused a major reversal in their thinking from September opinions where this group was bearish for the first time in years. They now see optimism in the form of tax cuts, regulatory reform, infrastructure spending, and accelerating job growth.
With Washington’s propensity to underwhelm and disappoint, this blind optimism sits on shaky ground.
Collectively they see the S&P 500 at 2380 by the end of 2017 or 6% higher than 2016’s close. This may suggest that the post-election run-up borrowed a little from 2017. From here, this group believes dips should be bought. A 10% correction translates to a 16% gain to 2380 if their vision is accurate.
PNC believes markets are going higher. Jeffrey Saut of Raymond James believes “Equity markets are transitioning from an interest rate-driven to an earnings-driven bull market” and should continue to grind higher until late January or early February. Ditto Tom McClellan of the McClellan Report. T. Rowe price predicts a strong rebound for 2017 but warns that there will still be winning sectors and losing sectors.
Brian Wesbury, First Trust’s chief economist, sees a boom market for stocks in the “years ahead.” He has been largely right on the economy and markets since the Great Recession of 2008-2009 when he correctly applied the metaphor of the “Plow Horse Economy” to describe what was has gone on. According to Wesbury, “QE never had much impact on the economy because one hand of government was shoveling money in to the economy, but the other hand was hammering banks with regulations, higher capital requirements, and fines. The result was that, in spite of QE, the growth rate…never accelerated.”
He went on to say, “we expect fiscal policy to move towards growth…a reduction in corporate tax rates, and a rollback of regulatory burdens…moving toward an even more expansionary phase, the stock market is set to soar.” He predicts unemployment at 4.4%, 2.5%-3.0% inflation, and a 10-year Treasury rate of 3.25%. With that in mind, Wesbury makes a bold prediction seeing the Dow and S&P 500 finishing 2017 up about 20% (including dividends) at 23,750 and 2700 respectively. WOW! Sign me up. How might ol’ Dr. Greenspan label this level of exuberance?
What kind of return could be realized if the markets achieve those levels following a likely correction? Remember, your starting point matters. If we are on the receiving end of a 20% correction ahead of Wesbury’s 2700 S&P 500 prediction, the post-correction recovery would represent a 50% increase.
The Lightning Round:
- Goldman Sachs:
- Sees the S&P 500 rising to 2400 by spring on the back of the Trump enthusiasm before pulling back to 2300 by year end as economic reality sets in.
- Merrill Lynch:
- Expects a stronger economy with higher inflation with the potential of big market swings.
- Credit Suisse
- Expects a pullback to 2300 following a first-half rally.
- Predicts 2325 a year from now.
- Trend toward stronger economic growth and inflation may be accelerated with new administration’s policies.
- Should be a positive for global equities and a negative for fixed income.
- Growing global debt, the rise of political populism, and geopolitical threats highlight need to diversify risks.
- Interest rates should rise calling for a focus on credit and short durations.
- Equities should perform well with 2017 S&P 500 closing at 2400 (+7%).
- Rising interest rates will define winners and losers.
- Based on valuation, Emerging Markets will play an important role in long-term portfolio growth.
- Guarded on global equities with 5%-7% growth for 2017, 2% inflation, and a 1% Fed Funds rate.
- 50% chance global equities will produce a 5% average real (inflation adjusted) return for the next decade versus 6.8% for the last 90 years.
- Remain positive in a muted way towards fixed income with 10-year Treasury remaining near 2.5%.
- Bullish on stocks based on where they are on the earnings cycle.
- Opportunities appear good for 2017, but you can’t ignore the uncertainties that loom.
- We simply don’t know what we don’t know…this is not a close your eyes and buy type of market.
- This is a very challenging, tactical environment that not only has some upside potential, but more downside risk.
- Potential for better economic growth and earnings offset by rising interest rates and elevated valuations.
- See another year of modestly positive equity prices with S&P 500 ending the year at 2360 (+5%).
- See developed market equities moving higher.
- Likes Japan and Emerging Markets but see potential trade tensions as risks.
- Global bonds have bottomed, but prefer equities over fixed income and credit over government bonds.
- Expect higher yields and steeper curves favoring short over long durations, high quality credit and inflation-linked securities.
- State Street:
- See upside to their forecasted 3% gain in U.S. large cap equities is 2017 as earnings growth turns positive.
- W. Baird:
- Predicts that the earnings recession has ended.
- S&P 500 could see 2400 (+7%) in first half of the year. More risk in the second half.
- Franklin Templeton:
- Global equities are well positioned for rising inflation and low interest environment expected for 2017.
- Remain cautious on fixed income due to vulnerability to negative surprises, longer-term risks (high debt levels, diminishing returns to monetary easing and populism), the three P’s (productivity, policy, and politics.)
The Bear Case
One may best take the optimistic talk with a grain of salt. On average, Wall Street strategists as a whole have not failed to predict gains in any year since 2000. Unfortunately, the market fell one out of every three of those years. As you may recall, a couple of those declines were breathtaking.
Jan Loeys of JPMorgan believes these forecasts have no value saying, “We do forecasts only because our client base asks for forecasts, not because we have any great advantage in forecasting levels.” He looks a probabilities of outcome as his primary guidepost. This hits home for us as we are a probability based investor.
Maybe the biggest reason to be bearish right now is that everyone else is so optimistic. Investec’s Philip Saunders warns, “An overwhelming consensus is extremely dangerous.”
The world was and is full of uncertainty leading to BREXIT and Trump, and yet there seems to be a very tight consensus regarding 2017 market expectations which brings into effect Bob Farrell’s rule # 9: “when all forecasters and experts agree, something else is going to happen.”
Famed economist Harry Dent, known for his bold predictions, believes we are facing a “once in a lifetime” market crash that could take the DOW down 17,000 points. “I think this is going to be a stock market peak of a lifetime followed by a crash very similar to the early 1930s. This happens once in a lifetime.” However, before the crash, he says the Trump rally could add another 10 or 20 percent in the coming months. “You can’t have stocks going up at this rate when earnings are going nowhere. I think it’s going to all to between 3,000 to 5,000 a couple years from now.” Hmmmm.
What would have to happen to see that type of catastrophic outcome? It would most certainly the result of a barrage of unknown unknowns surprising the best and the brightest minds. However, imagine the recovery from those levels if you didn’t participate in the drawdown.
Respected economist David Rosenberg believes the current focus should be on capital preservation rather than future returns. He advises “Having cash on hand and reducing beta…with a view towards allocating dry powder at better price levels.”
One of the cornerstones to our investment philosophy is that your starting point matters. Valuations matter. For each of us, every new day, in theory, brings a new starting point. While many wish to suggest that we are in the middle of a secular bull market, history may disagree.
Dr. Robert Shiller’s cyclically adjusted PE (CAPE) data is pretty clear as it shows that secular bull markets tend to begin when valuations are below 10x and end somewhere around 23x-25x earnings. We’re now at 28. It has only been higher on 3 occasions: pre-crash 1929, the peak of 2000 tech mania, and in 2007 prior to the credit market collapse…not getting a lot of warm and fuzzies from this comparison.
Research has shown that when CASE is above 27.6, future 10-year stock returns, on average, are lower than those of 10-year Treasury Bonds or a couple of percent per year. All things considered, the end of the current expansion run may be near. Shiller won the Nobel Prize in Economics in 2013 for his work on stock market inefficiency and valuations. A more common measure of price-earnings shows the S&P 500 P/E for the last 12 months is 18.9…the highest in more than 12 years according to FactSet research. No comfort there.
A real argument exists that we may be approaching the end of a secular bear market as opposed to being in a later stage secular bull market. Secular bears tend to last on average 17 years and have three major drawdowns. Using 2000 as your starting point, we have had 2 major drawdowns in the last 16 years and now are perched with the markets at record highs supported by what at best would be considered a feeble economy and enormous uncertainties coupled with a whole lot of optimism. The market always tends to disappoint the most people possible when the Bear begins to roar.
Either way, probabilities supporting a significant correction are too high to ignore. The equity markets either grow because earnings are advancing or because the multiple that investors are willing to pay for those earnings is increasing based on optimistic views of the future. Earnings are not growing and multiple expansion may be nearing its limits.
When viewing previous secular bull markets, one finds an inverse relationship between valuations and interest rates, inflation, and dividend yields. The beginning of a secular bull market finds valuations low and the other stuff high. Secular bears find the opposite relationship. Today, valuations are high. At the same time, we have record low interest rates and inflation along with less than optimal dividend yields coupled with historically low real wages and savings rates. What would your conclusion be?
Jeremy Grantham’s firm GMO recently issued their 7-year average annual real (inflation adjusted) rate of return forecast for various major asset classes using 2.2% assumed annual inflation as summarized below:
Asset Class Real ROI Gross ROI
U.S. Large Cap Stocks -3.0% -0.8%
U.S. Small Cap Stocks -2.3% -0.1%
International Large Cap Stocks 0.8% 3.0%
International Small Cap Stocks 0.4% 2.6%
Emerging Market Stocks 4.4% 6.6%
U.S. Bonds -0.8% 1.4%
International Bonds (hedged) -3.0% -0.8%
Emerging Debt 1.8% 4.0%
U.S. Cash -0.1% 2.1%
The above forecast will lead to a lot of very disappointed investors 7 years from now if this scenario plays out.
Following a strong 10-year performance, bonds now face a tough decade from a total return perspective. Perceived risk may be low but real risk suggests potential fixed income ROI may be very low for the next decade. For fixed income, the math is pretty simple. The predictor of future 10-year total returns are the current yield of any fixed income index. Given that yields on most are flirting with all-time lows, the total return for the foreseeable future is fairly thin.
With both bonds and stocks looking pricey at current levels, it’s hard to be real optimistic for now.
Does anyone else out there see the irony in main stream media collectively jumping on the “Fake News” bandwagon even suggesting that the election result was largely determined by “Fake News” influence? Network news, cable news, and the print media for years have been the biggest purveyor of “Fake News” out there. Social media is king of the mountain with regard to the extreme levels of “Fake News”, but there it is easy to detect and discount. Mainstream media on the other hand craftily injects difficult to discern, agenda driven nuances that twist or distort the truth in ways the average consumer of the news cannot detect. Add to that their propensity to ignore news that does not further their cause and you end up with the corruption of a once highly respected profession. I like Denzel Washington’s recent quote, “If you don’t read the newspaper you’re uninformed. If you do read it, you’re misinformed.”
There were several protests in cities around the country following the election of Donald J. Trump as our next president. Remember all the riots and looting when McCain and Romney lost? Me either. As silly as I find the civil disobedience in this case, I defend the rights of those misguided individuals to throw this temper tantrum. Unfortunately for them, the outcome of their efforts is likely to be the opposite of what they hoped for. Republicans will come together and rational Democrats will shrink from embarrassment.
Many schools around the country allowed students to skip class following the election because they were just too emotionally distraught about the election results. Not sure how that’s preparing them for the real world. I can’t imagine a lot of bosses being too sympathetic to the emotional stress brought on by not getting your way and needing time off to cope.
If the protests in the streets following the election as well as the emotional vitriol vomited in social media are any indication of the temperament and mentality of progressive thought, the nation just dodged a big bullet. If they don’t wake up and realize that it is exactly this type of unhinged behavior and extreme rhetoric that led to their party losing significant ground over the last four election cycles, they will continue to become less relevant.
No matter what you think of the president elect, he pulled off a tremendous feat. He won with the Democratic party against him, the Republican party against him, and the media against him. He goes to Washington beholding to no one. This next journey for our nation should be very interesting.
The news continues to give voice to a few individuals who keep trying to perpetuate the concept of the popular vote determining presidential election outcome. It’s a silly argument in that the popular vote was never intended to elect the president. It never has, and in all likelihood never will. So, get over it. Our constitution was designed to protect the rights of two broad constituencies: the individual citizen as well as each state. As it applies to the presidential election, the one person one vote concept is preserved at the state level, and the rights of each state are protected with the electoral college…pretty ingenious and effective through history. As it is, Clinton won the popular vote in California by about 4 million votes. Without California, Trump won the popular vote by 1.7 million votes. This is exactly why our founders established the Electoral College. See last month’s edition for a deeper dive into the Electoral College design. Since it is rare that one candidate wins the electoral college contest without also winning the popular vote, the idea of changing a time tested institution due to a few divergent outcomes is akin to the tail wagging the dog. All the noise about changing it to a popular vote contest is a total waste of time and energy.
Bill Murray: “It’s hard to win an argument with a smart person, but it’s damn near impossible to win an argument with a stupid person.”
I guess we now know for sure which side of the political spectrum The Atlantic magazine lies. In a recent issue, The Atlantic asked contributors and readers to select who they thought was the worst leader of all time. Unbelievably, two of those names on their top 12 list were Ronald Reagan and George W. Bush joining the Devil, Roman emperor Romulus Augustus, Hitler, Russian emperor Nicholas II, France’s Napoleon Bonaparte, German emperor Kaiser Wilhelm II, Jefferson Davis, Idi Amin, Pol Pot, and British Prime Minister Neville Chamberlain. Incredible, but I guess I shouldn’t be surprised.
I sent the cartoon below to Sue. If she could outfit me with one of these things before parties, it would lead to a much more peaceful after party experience.
HAPPY NEW YEAR,
May your year be complete with personal as well as economic happiness and success.
Bruce Anderson, Managing Partner: South Georgia Capital, LLC, 2135 City Gate Lane, SUITE 460, Naperville, IL 60563
630-447-2760 email@example.com www.sgcim.com
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