While the President’s pro-growth plan had some wins this year, it was a slow start.
Going after healthcare first was a mistake. Fortunately, a pivot was made, and we now have a big tax bill delivered. And we have what will likely exceed a couple hundred billion dollars in government spending on hurricane/natural disaster aid underway (the early stages of a big government spending/ infrastructure package).
Last year this time, I predicted that Trump’s corporate tax cut would cause stocks to rise 39%. That’s a big number, that’s only been done a handful of times since the 1920s. We got a little better than half way there.
But, here’s the good news: We got there on earnings growth, ultra-low rates and an improving economy. All of that still stands for next year, PLUS we will have the addition of an aggressive tax cut that will be live day one of 2018.
With that, my analysis from last year still stands! Let’s walk through it (yet) again.
S&P 500 earnings grew by 10% this year. S&P 500 earnings are expected to grow at about the same rate next year. And that’s before the impact of a huge cut in the corporate tax rate. The corporate tax rate now goes from 35% to 21% – and for every percentage point cut in that rate, we should expect it to add at least a dollar to S&P 500 earnings.
With that, the forecast on S&P 500 earnings for next year is $144. If we add $14 to that (for 14 percentage points in the corporate tax rate) we get $158. That would value stocks on next year’s earnings, at today’s closing price on the S&P 500, at just 17 times earnings (just a touch higher than the long-term average). BUT, the Fed has told us that rates will continue to be ultra-low next year (relative to history). When we look back at ultra–low interest rate periods, the valuation on stocks runs higher than average—usually north of 20 times earnings.
If we take the corporate tax cut driven earnings of $158 and multiply it times 20, we get 3,160 on the S&P 500. That’s 18% higher than current levels. This analysis doesn’t incorporate the impact of a potentially hotter than expected economy next year (thanks to the many other areas of fiscal stimulus). So, as we’ve discussed throughout the year, the backdrop continues to get better and better for stocks.
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As I said on Friday, people continue to look for what could bust the economy from here, and are missing out on what looks like the early stages of a boom.
We constantly hear about how the fundamentals don’t support the move in stocks. Yet, we’ve looked at plenty of fundamental reasons to believe that view (the gloom view) just doesn’t match the facts.
Remember, the two primary sources that carry the megahorn to feed the public’s appetite for market information both live in economic depression, relative to the pre-crisis days. That’s 1) traditional media, and 2) Wall Street.
As we know, the traditional media business, has been made more and more obsolete. And both the media, and Wall Street, continue to suffer from what I call “bubble bias.” Not the bubble of excess, but the bubble surrounding them that prevents them from understanding the real world and the real economy.
As I’ve said before, the Wall Street bubble for a very long time was a fat and happy one. But the for the past ten years, they came to the realization that Wall Street cash cow wasn’t going to return to the glory days. And their buddies weren’t getting their jobs back. And they’ve had market and economic crash goggles on ever since. Every data point they look at, every news item they see, every chart they study, seems to be viewed through the lens of “crash goggles.” Their bubble has been and continues to be dark.
Also, when we hear all of the messaging, we have to remember that many of the “veterans” on the trading and the news desks have no career or real-world experience prior to the great recession. Those in the low to mid 30s onlyknow the horrors of the financial crisis and the global central bank sponsored economic world that we continue to live in today. What is viewed as a black swan event for the average person, is viewed as a high probability event for them. And why shouldn’t it? They’ve seen the near collapse of the global economy and all of the calamity that has followed. Everything else looks quite possible!
Still, as I’ve said, if you awoke today from a decade-long slumber, and I told you that unemployment was under 5%, inflation was ultra-low, gas was $2.60, mortgage rates were under 4%, you could finance a new car for 2% and the stock market was at record highs, you would probably say, 1) that makes sense (for stocks), and 2) things must be going really well! Add to that, what we discussed on Friday: household net worth is at record highs, credit growth is at record highs and credit worthiness is at record highs.
We had nearly all of the same conditions a year ago. And I wrote precisely the same thing in one of my August Pro Perspective pieces. Stocks are up 17% since.
And now we can add to this mix: We have fiscal stimulus, which I think (for the reasons we’ve discussed over past weeks) is coming closer to fruition.
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Stocks are sliding more aggressively today. Wall Street and the media always have a need to assign a reason when stocks move lower. There have been plenty of negatives and uncertainties over the past seven months — none of which put a dent in a very strong opening half for stocks.
But markets don’t go straight up. Trends have retracements. Bull markets have corrections. And despite what many people think, you don’t need a specific event to turn markets. Price can many times be the catalyst.
If we look across markets, it’s safe to say it doesn’t look like a market that is pricing in nuclear war. Gold is higher, but still under the highs of a month ago. The 10 year yield is 2.21%. Two weeks ago, it was 2.22%. That doesn’t look like global capital is fleeing all parts of the world to find the safest parking place.
Now, on the topic of North Korea, the media has found a new topic to obsess about– and to obsessively denounce the administration’s approach. With that, let’s take a look at the Trump geopolitical strategy of calling a spade a spade.
As we know, Mexico was the target heading into the election. Trump’s tough talk against illegal immigration and drug trafficking drew plenty of scrutiny. People feared the protectionist threats, especially the potential of alienating the U.S. from its third biggest trading partner. We’re still trading with Mexico. And the U.S. is doing better. So is Mexico. Mexican stocks are up 11% this year. The Mexican currency is up 13% this year.
China has been a target for Trump. He’s been tough on China’s currency manipulation and, hence, the lopsided trade that contributed heavily to the credit crisis. Despite all of the predictions, a trade war hasn’t erupted. In fact, China has appreciated its currency by 5% this year. That’s a huge signal of compliance. That’s among the fastest pace of currency appreciation since they abandoned the peg against the dollar more than 12 years ago (which was China’s concession to threats of a 30% trade tariff that was threatened by two senators, Schumer and Graham, back in 2005). And even in the face of a stronger currency (which drags on exports, a key driver of the economy), stocks are up 5% in China through the first seven months of the year.
Bottom line: It’s fair to say, the tough talk has been working. There has been compromise and compliance. So now Trump has stepped up the pressure on North Korea, and he has been pressuring China, to take the side of the rest of the world, and help with the North Korea situation – and through China is how the North Korea threat will likely get resolved.
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With some global stock barometers hitting new highs this morning, there is one spot that might benefit the most from this recently coordinated central bank promotion of a higher interest environment to come. It’s Japanese stocks.
First, a little background: Remember, in early 2016, the BOJ shocked markets when it cut its benchmark rate below zero. Counter to their desires, it shook global markets, including Japanese stocks (which they desperately wanted and needed higher). And it sent capital flowing into the yen (somewhat as a flight to safety), driving the value of the yen higher and undoing a lot of the work the BOJ had done through the first three years of its QE program. And that move to negative territory by Japan sent global yields on a mass slide.
By June, $12 trillion worth of global government bond yields were negative. That put borrowers in position to earn money by borrowing (mainly you are paying governments to park money in the “safety” of government bonds).
The move to negative yields, sponsored by Japan (the world’s third largest economy), began souring global sentiment and building in a mindset that a deflationary spiral was coming and may not be leaving, ever—for example, the world was Japan.
And then the second piece of the move by Japan came in September. It was a very important move, but widely under-valued by the media and Wall Street. It was a move that countered the negative rate mistake.
By pegging its ten-year yield at zero, Japan put a floor under global yields and opened itself to the opportunity to doing unlimited QE. They had the license to buy JGBs in unlimited amounts to maintain its zero target, in a scenario where Japan’s ten-year bond yield rises above zero. And that has been the case since the election.
The upward pressure on global interest rates since the election has put Japan in the unlimited QE zone — gobbling up JGBs to push yields back down toward zero — constantly leaning against the tide of upward pressure. That became exacerbated late last month when Draghi tipped that QE had done the job there and implied that a Fed-like normalization was in the future.
So, with the Bank of Japan fighting a tide of upward pressure on yields with unlimited QE, it should serve as a booster rocket for Japanese stocks, which still sit below the 2015 highs, and are about half of all-time record highs — even as its major economic counterparts are trading at or near all-time record highs.
There’s little in the way of economic data next week to move the needle on markets and the economic outlook. With that said, the catalyst will continue to be Trumponomics, and the President said yesterday that we should expect to hear “big things” coming in the next week or two.
As we head into the weekend, let’s take a look at some charts of interest.
The S&P 500 is now up 10% since election day (November 8). For some perspective, since the 2009 bottom, when the global central banks stepped in to pull the world back from the edge of collapse, you can see the trend has been a 45 degree angle UP. And despite all of the fear and pessimism along the way, the sharp corrections along the way were quickly reversed, most of which were completely recovered inside of ONE MONTH.
With central bank policy around the world still promoting higher global asset prices, and with pro-growth policies underway in the U.S., any dip in stocks will be a gift to buy.
We looked at this next chart last week. It’s the inverse price of gold versus the U.S. 10 year yield. You can see they have tracked nicely since the election.
With Yellen’s session on Capitol Hill this week, the yield has whipped around from 2.40 back to 2.50 and back to 2.41 today.
Meanwhile, with the continued hostility surrounding the Trump administration, and accusations about Russian conflicts, gold has been stepping higher. This all looks like higher gold and lower yields coming. As questions arise about the execution of (or speed of execution) growth policies, some of the inflation optimism that has been priced in may begin to soften. That would also lead to a breather for the stock market. In both cases, it would create opportunities — to buy any dip in stocks, and sell any rally in bonds.
I talked yesterday about the Fed. As I said, I think we’ll find that the Fed will shift gears again to stay behind the curve on inflation, to let the economy run a little hot. They met today and it was a non-event. They said nothing to build momentum on their rate hike from December.
The news of the day has been Apple (NASDAQ:AAPL) earnings. People over the past couple of years have been calling for the decline in Apple. They’ve said it’s topped. They can’t innovate in the post-Steve Jobs era. The iPhone was magic. But reproducing magic isn’t easy. Once you put a computer in everyone’s pocket, there’s not much more they can do to it with it. These are all of the quips about Apple’s peak. They may be right. But Apple’s peak, at least as a stock, is greatly exaggerated.
They reported a huge positive surprise on earnings yesterday after the close. The stock was up 6% on the day. But even before that, I suspect it has become a much loved stock in the past two months in the “smart money” investor community.
We should see in the coming weeks, as big investors disclose their positioning for the end of Q4, Apple will have returned to a lot of portfolios again. Warren Buffett, an investor that has made his fortune buying when others are selling, built a big stake at the lows of the year last year. And it’s a perfect Buffett stock.
It’s incredibly cheap compared to the market.
The stock still trades at 15x earnings. Much cheaper than the market. Apple trades at 13x next year’s projected earnings. The S&P 500 trades at 16.5x. What about Apple’s monster cash position? Apple has even more cash now — a record $246 billion. If we excluded the cash from the valuation, Apple market cap goes down from $675 billion to $429 billion. That would equate to Apple trading at closer to 9x earnings. Though not an “apples to apples” that valuation would group Apple with the likes of these S&P 500 components that trade around 9 times earnings, like: Dow Chemical, Prudential Financial, Bed Bath & Beyond, a Norwegian chemical company (LBY), and Hewlett Packard Enterprise. It’s safe to say no one is debating whether or not Hewlett Packard is at the pinnacle of its business. Yet, if we strip out the cash in Apple, AAPL shares are trading closer to an HPE valuation.
Add to that, Apple now has a fresh catalyst coming in, Trump policies. The new President Trump is incentivizing Apple (and others) to bring offshore cash hoards back home with a flat 10% tax. And Apple makes money – a lot of it. A cut in the corporate tax rate will be a boon for earnings. Two years ago, Carl Icahn argued that Apple should use (a lot more of) their cash to buyback shares – and, with that, valued the stock at double its current levels.
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The Trump agenda continues to dominate the market focus as we entered the second week of Trumponomics.
To this point the market focus has been on the pro-growth agenda. With that, stocks have been higher, yields have been higher, the dollar has been higher, and global commodities have been broadly rising. Meanwhile, gold (the fear trade) has been falling and the VIX has been falling, toward ultra-low levels. The VIX, like gold, is a good market indicator of uncertainty and/or fear.
Let’s talk about the VIX…
The VIX measures the implied volatility of options on the S&P 500. This is a key component in the price investors pay for downside protection on their portfolios.
So what is implied volatility? Implied volatility measures both actual volatility and the options market maker community’s expectations (or perception of certainty) about future volatility. When market makers feel confident about the stability in markets, implied vol is lower, which makes the price of options cheaper. When they aren’t confident in stability, implied vol goes up, which makes the price of an option go up. To compensate those that are taking the other side of your trade, for the lack of predictability, you pay a premium.
With that in mind, on Friday, the VIX traded to the lowest levels since the days before the failure of Lehman Brothers. That indicates that the market had (or has) become a believer that pro-growth policies, combined with ultra-easy central bank policies have created a buffer against the downside in stocks. But that perception of downside risk is changing today, with the more vocal uprising against Trump social policies. You can see the spike (in the far right of the chart) today…
So as big money managers were closing the week last Friday, looking at Dow 20,000+ and a VIX sliding toward levels not too far from pre-crisis levels, buying downside protection was dirt cheap. This morning, they’re paying quite a bit more for that protection.
With that said, this pop in the VIX and the Dow trading off by more than 100 points today gets a lot of attention. But is there justification to think that market turbulence will begin to reflect the turbulence and division in public opinion toward Trump policies? Just gauging the extent of the market reaction from the VIX today, it’s unlikely. The chart below is the longer term view of the VIX.
My observations: The VIX has had a small bounce from very, very low levels. On an absolute basis, vol is still very cheap. When there is real fear in the air, real uncertainty about the future, you can see from the spikes in the longer term chart above, the premium for the unknown gets priced in quickly and aggressively. Given that there has been virtually no risk premium priced into the market for any falter in the Trump Presidency, or the execution of Trump policies, the moves today have been very modest. And gold (as I write) is barely changed on the day.
We are likely entering an incredible era for investing, which will be an opportunity for average investors to make up ground on the meager wealth creation and retirement savings opportunities of the past decade. For help building a high potential portfolio for 2017, follow me in our Billionaire’s Portfolio, where you look over my shoulder as I follow the world’s best investors into their best stocks. Our portfolio more than doubled the return of the S&P 500 in 2016. You can join me here and get positioned for a big 2017.
Stocks hit new record highs again in the U.S. today. This continues the tear from the lows of election night. But if we ignore the wild swing of that night, in an illiquid market, stocks are only up a whopping 1.2% from the highs of last month — and just 8% for the year. That’s in line with the long term average annual return for the S&P 500.
And while yields have ripped higher since November 8th, we still have a 10 year yield of just 2.32%. Mortgages are under 4%. Car loans are still practically free money. That’s off of “world ending” type of levels, but very far from levels of an economy and markets that are running away (i.e. you haven’t missed the boat – far from it).
Despite this, we’re starting to see experts come out of the wood works telling us that the economy has been in great shape for a while. That’s what this is about – what’s with all the fuss? Not true.
Remember, it was just eight months ago that the world was edging toward the cliff again, as the oil price bust was threatening to unleash another global financial crisis. And that risk wasn’t emerging because the economy was in great shape. It was because the economy was incredibly fragile — fueled by the central banks ability to produce stability, which produced confidence, which produced some spending, hiring and investment, which produced meager growth. But given that global economic stability was completely predicated on central banks defending against shocks to the system, not on demand, that environment of stability was highly vulnerable.
Now, of course, we finally have policies and initiatives coming down the pike that will promote demand (not just stability). If have perspective on where markets stand, instead of how far they’ve come from the trough of election night, we’re sitting at levels that scream of opportunity as we head into a new pro-growth government.
When the economic crisis was in the early stages of unraveling, the most thorough study on past debt crises (by Reinhart and Rogoff) found that delevering periods (the time after the bust) took about as long as the leveraging period (the bubble building period before the bust). With that, it was thought that the deleveraging period would take about 10 years. History gave us the playbook, in hand, from very early on in the crisis.
With that in mind, the peak in the housing market was June of 2006. That would put 10 years at this past June. The first real event, in the unraveling of it all, was the bust of two hedge funds at Bear Stearns in mid 2007. That would put the 10 year mark at seven months out or so.
That argues that we’re not in the late stages of an economic growth cycle that was just unfortunately weak (as some say), but that we should just be entering a new growth phase and turning the final page on the debt crisis. And that would argue that asset prices are not just very cheap now, but will be for quite some time as a decade long (or two) prosperity gap closes.
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We headed into the weekend with a market that was spooked by a sharp run up in global yields. On Friday, we looked at the three most important markets in the world at this very moment: U.S. yields, German yields and Japanese yields.
On the latter two, both German and Japanese yields had been deeply in negative yield territory. And the perception of negative rates going deeper (a deflation forever message), had been an anchor, holding down U.S. market rates.
But in just three days, the tide turned. On Friday, German yields closed above the zero line for the first time since June 23rd. Guess what day that was?
Brexit.
And Japanese 10-year yields had traveled as low as 33 basis points. And in a little more than a month, it has all swung back sharply. As of today, yields on Japanese 10-year government debt are back in positive territory – huge news.
So why did stocks rally back sharply today, as much as 2.6% off of the lows of this morning – even as yields continued to tick higher? Why did volatility slide lower (the VIX, as many people like to refer to as, the “fear” index)?
Here’s why.
First, the ugly state of the government bond market, with nearly 12 trillion dollars in negative yield territory as of just last week, served as a warning signal on the global economy. As I’ve discussed before, over the history of Fed QE, when the Fed telegraphed QE, rates went lower. But when they began the actual execution of QE (buying bonds), rates went higher, not lower (contrary to popular expectations). Because the market began pricing in a better economic outlook, given the Fed’s actions.
With that in mind, the ECB and the BOJ have been in full bore QE execution mode, but rates have continued to leak lower.
That sends a confusing, if not cautionary, signal to markets, which is adding to the feedback loop (markets signaling uncertainty = more investor uncertainty = markets signaling uncertainty).
Now, with government bond yields ticking higher, and key Japanese and German debt benchmarks leaving negative yield territory, it should be a boost for sentiment toward the global economic outlook. Thus, we get a sharp bounce back in stocks today, and a less fearful market message.
Keep in mind, even after the move in rates on Friday, we’re still sitting at 1.66% in the U.S. 10-year. Before the Fed pulled the trigger on its first rate hike, in the post-crisis period, the U.S. 10-year was trading around 2.25%. As of last week, it was trading closer to 1.50%. That’s 75 basis points lower, very near record lows, AFTER the Fed’s first attempt to start normalizing rates. Don’t worry, rates are still very, very low.
Still, the biggest risk to the stability of the bond market is, positioning: The bond market is extremely long. If the rate picture swung dramatically and quickly higher, the mere positioning alone (as the longs all ran for the exit door) would exacerbate the spike. That would pump up mortgage rates, and all consumer interest rates, which would grind the economy to a halt and likely destabilize the housing market again. And, of course, the Fed would be stuck with another crisis, and little ammunition.
As Bernanke said last month, the Fed has done damage to their own cause by so aggressively telegraphing a tighter interest rate environment. In that instance, he was referring to the demand destruction caused by the fear of higher rates and a slower economy. But as we discussed above, the Fed also has risk that their hawkish messaging can run market rates up and create the same damage.
Bottom line: The Fed is walking a fine line, which is precisely why they continue to sway on their course, leaning one way, and then having to reverse and shift their weight the other way.
The Fed’s Janet Yellen was the focal point for markets for the week. She had a scheduled speech at the annual Fed conference at Jackson Hole.
When her speech was finally made public Friday morning, the response in markets was uncertainty (the most used word for the past nine years).
Stocks went up, then down. Yields went down, then up.
So what do we make of it? Let’s start with the headlines that hit the wire Friday morning.
The world was wondering if Yellen would support the messaging from some of her fellow Fed members–that a September rate hike is on the table. Or would she continue the backstepping (dovish speak) the Fed has done for the past five months. The answer was ‘yes.’ She did both.
Yellen said the case for rate hikes has strengthened (yellow marker) because the data is nearing their goals (employment and inflation–the white marker). Ah, rate hike. But then she said the Fed expects inflation to hit the target 2% in the next few years (circled)! And then talked about the strategy for more QE. Huh? And then to top it off, she said they might move the goalposts. They might move the inflation target higher, and start targeting GDP. That means they would be happy to leave conditions ultra accommodative until those higher targets are met. Clearly dovish.
As I said Thursday, they want to raise rates to get the financial system closer to proper functioning, but they don’t want to cause a recession. The Fed wants to raise short-term rates, but promote a flatter yield curve (i.e. promote expectations that the economy will continue to be soft) to keep the market interest rates low, which keeps the housing market on the rails and the economic activity on the rails.
Remember, we talked about the piece Bernanke wrote a couple of weeks ago, where he suggested exactly this type of perception manipulation from the Fed, to balance the need to raise rates, without killing the economy.
That looks like the game plan.
Have a great weekend!
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As I said 
With some global stock barometers hitting new highs this morning, there is one spot that might benefit the most from this recently coordinated central bank promotion of a higher interest environment to come. It’s Japanese stocks.
