As we discussed yesterday, stocks have fully recovered the decline that people were attributing to Trump’s trade barrier announcement last week.
With that, the tariff hysteria seems to have subsided a bit, as they struggle for evidence to support their hyperbole. Perhaps people may start acknowledging that we are now in a higher volatility environment, and that we will be slowly working out of this recent price correction until corporate earnings and economic growth data start confirming the benefits of tax cuts.
Interestingly, they seem to hate the trade threat, far more than the love the tax incentives and the pro-growth initiatives. And while trade is a complicated issue, everyone seems to suddenly have an expert opinion on it. And everyone is an expert on the Smoot-Hawley Act (which, by the way was a tariff on over 20,000 goods) and depression-era economics.
If they indeed were reflective about the economy, I think they would agree that we (and the world) desperately need growth initiatives to save us from terminal central bank life support (which wouldn’t be so terminal given they have fired all of their bullets to keep us afloat as long as they did). And they would know that we are in for a perpetual cycle of booms and busts (repeat of the credit bubble and burst) if the trade imbalances (mainly between China overproducing and the U.S. overconsuming) ultimately are not corrected.
Now, as more of the conversation on trade turns more toward China, I want to revisit an excerpt from my note in December of 2016 (when Trump was President-elect):
MONDAY, DECEMBER 19, 2016 — “While many think Trump will provoke a military conflict, that’s far from a certainty. With the credibility to act, however, Trump’s tough talk on China creates leverage. And from that leverage, there may be a path to a mutually beneficial agreement, where the U.S. can win in trade with China, and China can win. But it may get uglier before it gets better. In the end, growth solves a lot of problems. A hotter growing U.S. economy (driven by reform and fiscal stimulus), will ultimately drive much better growth in the global economy. And China has a lot to gain from both. Though in a fair-trade environment, they won’t get as much of the pie as they’ve gotten over the past two decades. But it has the chance of leading to a more balanced and sustainable economy in China, which would also be a win for everyone.”
Now, why not just focus on China now? Because they will continue to abuse other countries. And those open trade channels will still allow that product to enter the U.S. As we discussed yesterday, the global economy has been damaged by China’s currency/trade policy, yet the rest of the world has been relying on the U.S. to lead the fight. They need to join the fight to create the leverage to make it ultimately work – so that the global economy can find a sustainable path of recovery and robust growth.
As we discussed yesterday, the minutes from the most recent Fed meeting (which was still under Yellen) gave us some clues about the tone of a Powell-led Fed. They acknowledged the lift they expected from fiscal policy, which we didn’t hear all of last year, despite the clear telegraphing of it from the Trump administration. Powell was Trump appointed. And it looks like the Fed messaging will now reflect that.
This is from his prepared remarks today:
“The economic outlook remains strong. The robust job market should continue to support growth in household incomes and consumer spending, solid economic growth among our trading partners should lead to further gains in U.S. exports, and upbeat business sentiment and strong sales growth will likely continue to boost business investment. Moreover, fiscal policy is becoming more stimulative. In this environment, we anticipate that inflation on a 12-month basis will move up this year and stabilize around the FOMC’s 2 percent objective over the medium term. Wages should increase at a faster pace as well.”
So he’s bullish on economic output, wage growth and therefore, inflation. That’s bullish for rates. And, for the moment, what’s bullish for rates is bearish for stocks.
Oddly, on the same day Powell had his first testimony to Congress, the two former Fed chairs (Bernanke and Yellen) thought it was acceptable to host a chat about monetary policy this afternoon at the Brookings Institute.
It looked a bit like a partisan counter-punch. The same two former Fed Chairs that were, not long ago, begging Congress for fiscal stimulus to take some of the burden off of monetary policy, continue to (now) criticize the move. In fact, in Powell’s statement, he called the lack of fiscal response from Congress in past years, a headwind: “some of the headwinds the U.S. economy faced in previous years have turned into tailwinds: In particular, fiscal policy has become more stimulative.”
The takeaway from our first look at Powell: He doesn’t sound like a guy that will risk choking off the benefits of fiscal stimulus with overly aggressive “normalization” of monetary policy. That’s good.
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With the big decline and wild swings in the stock market, earnings season has gotten little attention.
We’ve now heard from 80% of the companies in the S&P 500 on Q4. According to FactSet, 75% of the companies have beat on earnings. And 78% have had positive revenue surprises.
Now, earnings estimates are made to be broken. And they tend to be beaten at a rate of about 70% of the time. But the same cannot be said for revenues. This has been a key missing piece in the economic recovery. Companies have been cutting costs, refinancing and trimming headcount, all in an effort to manufacture margins and profitability. But revenues, the true gauge of business activity and demand, had been dead for the better part of the past decade.
It was just last year that we finally saw some decent revenue growth coming in from the earnings reports. And this most recent quarter, revenue growth is running at the hottest rate since FactSet has been keeping records. That’s a very good sign for the economic outlook.
And corporate earnings are running 15.2% higher than the same period the year prior. That’s the hottest earnings growth we’ve seen since 2011. More importantly, that’s four percentage points higher than analysts were projecting at the end of the year–with knowledge of the tax cut legislation.
With that said, remember, just last Friday, we had a moment during the day when the forward P/E on the S&P 500 hit 16.2. But if the fourth quarter is any indication, those forward earnings (estimates) will likely get ratcheted UP over the coming quarters, but will still undershoot. That will keep downward pressure on the P/E. Stocks are cheap.
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On Friday, stocks bottomed into two big technical levels: 1) the two-year rising trendline that represented the recovery from the lows of 2016, which were induced by the oil price crash, and 2) the 200-day moving average.
We’ve since seen a 5.5% bounce off of the bottom.
Interestingly, the market that has had so many people concerned over the past two weeks–interest rates–were tame and lower on the day. But only after printing a new high (at 2.90%, which is the highest since January of 2014).
That climb in rates, of course, has had everyone uptight about the inflation outlook. But the market you would expect to reflect inflation fears hasn’t been telling the inflation story at all. I’m talking about the price of gold. And gold has been lower, not higher, since stocks have fallen.
Here’s a look at that chart …
With this in mind, the psychology always changes when stocks go down. People search for stories to fit the price–for trouble to fit the price. Even some of the more rational market practitioners were succumbing to this over the weekend, trying to conjure up a negative scenario unfolding for markets.
Having been involved in markets for 20 years, I’ve seen, within both short- and long-term cycles, thousands of turning points, trend changes, phases of a cycles, trends and corrections of trends. Markets can and do have technical corrections. And they can and do correct for no reason, other than price.
So, for perspective, things are good. We will have the hottest economy this year that we’ve seen in a decade. The benchmark 10-year yield, at 2.90%, remains very low relative to history. That means, although borrowing costs are ticking higher, money is still cheap. Gas is cheap. Consumer and corporate balance sheets are as good as they’ve been in a long time. And we’ve just gotten a blue light special on stocks–marking down prices from 18 times to something closer to 16 times earnings. And with the prospects for earnings to come in better than expected, given influence of tax cuts, we are probably looking at a P/E on the S&P 500 forward earnings closer to 15.
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Two weeks ago there were signals that a correction was underway. First we had a swing back into positive yield territory for the German 5-year government bond. That was a significant marker for the end of the negative interest rate era and the end of global QE.
And with the outlook for rate normalization formalizing in the market, we should expect stock market growth to be driven from that point by earnings and dividends, and therefore economic growth. And then we had a perfect trigger lining up to set off the correction: earnings from the big tech giants. On script, Google missed. Apple disappointed on guidance, and the broad market sell-off began.
With that, when stocks broke down on February 2nd, we remembered that the stock market has had about a 10% decline on average, about once a year, over the past 70 years.
Then on Monday, the sell-off accelerated, and for a target in the S&P 500 we looked at this chart, which projected a reasonable spot to think we might find a bottom–around 2,560. We hit that on Friday and traded through to the 200-day moving average (2,539)–and we got an aggressive bounce.
Now, I’ve said a decline like this would make stocks cheap–“maybe something closer to 15 times forward earnings.” That sounded crazy two weeks ago. But guess what? We’re pretty darn close. At the lows on Friday, the P/E on earnings forecasted over the next four quarters was 16.2!
But as we know, Wall Street has a long history of underestimating earnings. That’s why about 70% of companies beat on earnings every quarter. And in this case, we’re talking about a huge earnings bump coming in the first quarter from the tax cuts. And Wall Street has barely bumped earnings expectations to incorporate that.
As said earlier this week, when the tax cut was in proposal stages, Citigroup estimated it would add $2 to S&P 500 earnings for every 1 percentage point cut in the tax rate. We’ve gone from 35% to 21%. With that, the forward four-quarter estimate for S&P 500 earnings, before the tax bill (in late November) was around $142.
If we add $28 in tax savings, we get $170. At the lows today in the S&P 500 that puts the P/E on a $170 in S&P 500 forward earnings at 14.8! That’s cheap relative to the long run historical P/E on stocks. And it’s extremely cheap in a world of low rates. And rates are still very low relative to history. And the low-rate environment will continue to motivate investors to seek higher returns in stocks–and pay higher valuations as stocks rebound. With hotter earnings and multiple expansion from here, we could reasonably see a 20%-30% rebound in stocks by year end.
Remember, the psychology always changes when stocks go down. People search for stories to fit the price–for trouble to fit the price. Rather than one of these stories leading to another major fallout, it’s a much higher probability that we are in the early innings of an economic boom, and stocks will be much higher than here in a year’s time. It’s time to be greedy while others are getting fearful.
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We talked last week about the correction underway in stocks. As I said, since 1946, the S&P 500 has had a 10% decline about once a year. And we haven’t had one in a while. Since the November 2016 election, the worst decline in stocks from peak to trough had been only 3.4%.
So we were due. And we’ve gotten it.
Today we’ve seen it accelerate. With the steep slide in stocks today, for a brief moment, the Dow futures were down 11% from the peak of just 7 days ago.
Now, let’s add a little perspective on this …
First, as I’ve said, when you are a hedge fund or trader and you’re leveraged 10, 20, 50, 100 times, then avoiding corrections or trend changes is critical to your survival. Getting it wrong, can mean your portfolio blows up and maybe goes to zero. That’s the mentality the media is speaking to, and frankly much of Wall Street is speaking to, when addressing any market decline.
The bottom line is that 99.9% of investors aren’t leveraged and should have no concern about U.S. stock market declines, other than saying to themselves: “What a gift! Do I have cash I can put to work at these cheaper prices? And, where should I put that cash to work?” As the great Warren Buffett has said, “be greedy when others are fearful.”
So, for the average investor, dips are an opportunity to buy stocks at a discount. Don’t let the noise distract you.
Remember, we’ve talked about the transition that is underway, with a global economy that now has the potential to officially exit the economic slog of the past decade, driven by pro-growth policies in the U.S. And those economic tailwinds have introduced the likelihood that the world will finally be able to exit central bank life support (i.e. QE). That’s all very positive.
But it has also been the trigger of the correction in stocks–this transition. QE has promoted higher stock prices. Now we get a correction, and a new catalyst (earnings and the growth picture) to justify the next leg of the global economic recovery (and stock bull market).
With that in mind, the fundamentals for stocks are very strong. As stocks tick down, the better valuation on stocks will only be amplified, when we get hot first quarter earnings hitting in a few months (thanks to the big corporate tax cut). For the S&P 500 P/E: We have the “P” going down, and the “E” going up.
How long could this correction last?
Remember when we were discussing the probability of a correction back in November, we looked at this chart …
In September 2014, with no significant one event or catalyst prompting it, the S&P 500 went on a slide. Stocks closed on a record high on Friday, September 19 (2014). On Monday, stocks gapped lower and over the next 18 days fell 10%. But over the following 12 days it all came back–a sharp V-shaped recovery. It was a textbook technical correction–right at 10%, right into the prevailing trend. You can see it in the chart above: the v-shaped move in stocks, and the bounce right off of the big trendline.
What’s happened in the markets the last few days reminds me of that correction. The moves can be fast, and the recovery can be fast, in this (post-crisis) environment. Big institutions have been trading stocks through computer programs for a long time, but the speed at which these algorithms can access markets and information have changed dramatically over the past decade–so has the massive amount of assets deployed through high frequency trading programs. They can remove liquidity very quickly. Combine that with the reduced liquidity in markets that has resulted from the global financial crisis (i.e. the shrinkage of the marketing making community and of hedge fund speculators, and the banning of bank prop trading) and you get markets that can go down very fast. And you get markets that can go up very fast too.
The proliferation of ETFs exacerbates this dynamic. ETFs give average investors access to immediate execution, which turns investors into reactive traders. Selling begets selling. And buying begets buying.
With the above dynamic, we’ve seen a fair share of quick declines and quick recoveries in the post-financial crisis era.
How do things look now?
In the chart above, this big trend line represents the move off of the oil crash lows of 2016. This 2560 area would give us a 10.8% correction in the S&P 500. I wouldn’t be surprised if we got there over a few days, and a recovery began. And I expect to stocks to end the year up double digits (still).
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We talked this past week about the prospects that a correction was underway in stocks. Stocks in China, Japan, Germany and the UK were already leading the way. And with earnings from the big tech giants, I thought any cracks in the armor might give people reason to accelerate the profit taking.
That was the case. Google (NASDAQ:GOOG) missed on earnings. And Apple (NASDAQ:AAPL) disappointed on guidance. And the global stock markets were a sea of red on Friday.
Now, markets don’t go in a straight line, there are corrections along the way. Remember, since 1946, the S&P 500 has had a 10% decline about once a year. And we haven’t had one in a while. Since the election (in November of 2016), the worst decline in stocks from peak to trough has been only 3.4%. We’ve matched that now.
Now, it should be noted that this decline isn’t driven by a negative turn in fundamentals, rather it’s driven by profit taking, and (more importantly) the increasing likelihood that a higher growth environment will ultimately allow the central banks in Europe and Japan to exit QE — the remaining instruments of life support for a global economy that has been brought back to life by fiscal stimulus.
With that, as I’ve said, it’s fair to expect a correction until the data begins to prove out the benefits of fiscal stimulus (i.e. when we see first quarter corporate earnings and GDP growth – both of which should be very strong).
Now, as they do, the media wrings their hands over a slide in stocks and tries to find a story of trouble to fit the price. The reality is, most investors should see a decline in the U.S. stock market as an exciting opportunity. The best investors in the world do. If you are not leveraged, dips in stocks (particularly U.S. stocks – the largest economy in the world, with the deepest financial markets) should be bought, because in the simplest terms, over time, the broad stock market has an upward sloping trajectory.
And when better earnings from tax cuts start coming in for Q1, a lower stock market would amplify the impact of a higher denominator in the P/E ratio — that means stocks could become cheap (er) – maybe something closer to 15 times forward earnings, in a world of (still) low rates.
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Rates continue to run higher. As we’ve discussed, the move higher in rates is likely to stifle the runup in stocks, until we start seeing the fiscal stimulus benefits reflected in the data. That will be a couple of months away.
Globally, there are already some technical signals indicating a lower path for stocks (NYSE:SPY).
Here’s a look at China …
Chinese stocks (NYSE:FXI) ran up over 8% and have already given back 4% in just four days (marked by an outside day at the top).
Japanese stocks (NYSE:DJX) have soared 25% just in the past four months. And this big trend broke down just a few days ago.
German stocks are 4.5% off of record highs just over the past nine days.
And stocks in the UK were the first to top out in the middle of January, now off almost 4% from the record highs. Canadian stocks are down 3.3% in the past week, from record highs. Both the Bank of England and the Bank of Canada are already on the move on normalizing interest rates.
This all continues to look like a world that is pricing in the end of QE, as we’ve discussed. And it’s happening because fiscal stimulus in the U.S. is expected to lift all boats, leading ultimately to major central banks and governments following the path of the U.S. — exiting emergency monetary policy, and stoking the recovery by adding fiscal stimulus.
Ultimately, that gives the global economy the best chance to sustainably recover from the economic slog of the past decade. But again, expect the “prove it to me period” to be coming (if not underway) for stocks, waiting to see the better growth justify the “end of QE” theme.
With this in mind, we had some spotty earnings from the stock market giants after the bell: Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG). The FAANG trade is up 15% this year alone, and up huge since the election (about 75%). But remember, the administration’s regulatory outlook isn’t so favorable to the tech giants. We may some cracks in the armor starting to show.
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Remember, this time last year, the biggest Wall Street investment banks told us stocks would do just 3% in 2017.
They were looking for about 2,300 on the S&P 500. The most aggressive forecast was 2,500 — coming from the Canadian bank, RBC (Royal Bank of Canada).
Here’s another look at the snapshot of those projections for 2017:
They undershot by a lot. The S&P finished just shy of 2,700 for the year. And S&P 500 earnings came in around $131. Wall Street was looking for $127.
But their big miss was underestimating the outlook for “multiple expansion.” The reason: They continue to underestimate the demand for stocks, in a world where ultra-low yields continue to incentivize people to reach for higher returns (i.e. opt for the choice of more risk for more return).
Investors will pay more for each dollar of future earnings if they expect to earn a higher future rate of return. And they have expected just that over the past few years, because 1) central banks promised to keep pumping up asset prices through QE and to continue warding off any shock risks that could derail the recovery for the economy and stocks, and 2) we’ve had the major shift away from austerity, which has promoted a weaker than typical recovery out of recession (and worse, stall speed growth) and toward big and bold fiscal stimulus (one that can potentially return the economy to a more normal, higher long term growth rate).
That’s why the P/E on stocks can and should rise well north of 20 times earnings in this environment, just as it has over the past three years.
The P/E on the S&P 500 was 20 in 2015, 22 in 2016 and 23 for 2017 (on trailing earnings). In each case, we came into the year, with the market undervaluing earnings — given what people have proven to be willing to pay up for them.
The market is now valuing the New Year’s earnings at 19 times earnings. And that ignores the probability that actual earnings can come in much better than estimates next year, given the corporate tax cut. That would ratchet down that “19 times” earnings valuation – making stocks cheaper.
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The Fed decided to hike interest rates by another quarter point yesterday. That was fully telegraphed and anticipated by markets. That’s the third rate hike this year, and the fifth in the post-crisis rate hiking cycle.
Still, the yield on the 10-year Treasury note (the benchmark market determined interest rate), moved lower today, not higher — and sits unchanged for the year.
We talked earlier in the week about the biggest central bank event of the month. It wasn’t the Fed, but it will be in Japan next week. Japan’s policy on pegging their 10-year yield at zero has been the anchor on global interest rates.
When they signal a change to that policy, that’s when rates will finally move.
With this divergence between what the Fed is doing (setting rates) and what market rates are doing (market-determined), people have become convinced that the interest rate market is foretelling a recession coming — i.e. short term rates have been rising, while longer term rates have been quiet, if not falling. For example, when the Fed made it’s first rate hike in December of 2015, the 30-year government bond yield was 3%. Today, after five rate hikes on the overnight Fed determined interest rate, the 30-year is just 2.72% (lower, not higher than when the Fed started).
This dynamic has created a flattening yield curve. That gets people’s attention, because historically, when the yield curve has inverted (short term rates rise above long term rates), recession has followed every time since 1950, with one exception in the late 60s.
And it turns out, this “flattening of the yield curve” indicator, historically (and ultimate inversion, when it happens), is typically driven by monetary policy (i.e. rate hikes — check). In these cases, the market anticipates the Fed killing growth and eventually leading rate cuts! They find more certainty and stability in owning longer term bonds (leaving short term bonds pushing those rates up and moving into long term bonds, pushing those rates down — inverting the curve).
The question, is that the case this time? Or is this time different. It’s rarely a good idea in markets to think this time is different than the past. But in this case, following trillions of dollars of central bank intervention and a near implosion in the global economy, it’s probably safe to say that this time is certainly different than past recessions. Though the Fed is in a hiking cycle, rates remain well below long term averages. And, as we know, we have unconventional monetary policies at work in other key areas of the world — stoking liquidity, growth and skewing demand for U.S. Treasuries (which suppresses those long term interest rates).
So the flattening yield curve fears are probably misplaced, especially given big fiscal stimulus is coming. And when Japan moves off of its “zero yield policy,” the U.S. yield curve may steepen more quickly than people think is possible.
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