Introduction: In Which I Stupidly Predict Timed Market Moves
There are many ways to measure the valuation of the market: P/E ratio, PE10, the "Buffet Indicator", etc. They all stand at historically high levels at the moment, only eclipsed by the insane valuations during the dot-com bubble. But as we saw in 1999, prices can break through these historical levels, as investors convince themselves that "this time it's different". Spoiler alert: it's never different.
Driving the 2017-2018 rally were the GOP tax cuts and deregulation which led to great year-on-year earnings comps in 2017 and 2018, but that party is over. Supply-side types will argue that these policies will lead to greater capital expenditure, which will increase productivity and thus profits and wages, leading to a self-sustaining virtuous cycle. But capital expenditure is driven by expected future demand, which is exogenous to all this, and the tax cuts and deregulation come with tremendous long term costs. Add in the trade war with China that I believe will be measured in years not months, rising rates, and 2019 begins to look grim.
Right now the economy is extremely strong by any measure, consumer sentiment is high, and though the Fed remains on a restrictive path, they are cautious. As such, I expect a blowout Christmas quarter, after which things begin to turn sour.
Market Valuation: At Historically High Levels
General disclaimer: None of the measurements in this section are good indicators of short-term movements in the market, but are rather presented as evidence of the high valuation of the S&P 500.
Charts? I love charts. Let's start with the S&P P/E ratio
As you can see, with the exception of 1999-2001 and 2008, we are at an historically high level, though it peaked in January at almost 25 and has been coming down since. This is a result of strong 2018 earnings growth coupled with so-so market performance. Possible explanations:
- The market is still underpriced at this level.
- 2018 growth expectations were already baked into 2017 performance.
- Investors fear that the earnings growth effects of tax cuts and deregulation will be temporary, coupled with global trade and interest rate fears.
In any event, a return to the median historical P/E of 14.73 would drop the S&P to about 1800.
In my opinion, PE10, the inflation-adjusted 10-year PE developed by Professor Robert Shiller of Yale is a much better measure that smooths out much of the noise in the straight P/E number.
The PE10 peaked in January at over 33 and then again at the end of the September rally. (An interesting side note here is the distortionary effects of the dot-com bubble on valuations, which have still not receded entirely a couple of decades later.) This is high by historical standards, eclipsing all but the dot-com bubble. A return to the median historical PE10 of 15.68 would drop the S&P to about 1400.
Price-to-sales is another simple measurement of where we're at. (TTM revenue in the denominator)
Again, we are at levels not seen since the dot-com bubble. A return to the median of 1.46 brings the S&P down to around 1900.
Price-to-book is yet another simple measurement. Again, we are at levels not seen since the dot-com bubble, though not exceptionally high.
One of the more obscure market valuations is the "Buffet Indicator". In a 2001 interview with Fortune, Warren Buffett said:
...the market value of all publicly traded securities as a percentage of the country's business--that is, as a percentage of GNP. The ratio has certain limitations in telling you what you need to know. Still, it is probably the best single measure of where valuations stand at any given moment.
Our data here is helpfully compiled by Jill Mislinski at Advisor Perspectives.
Source: Advisor Perspectives
As you can see, we are again getting into dot-com bubble levels. But like in the PE10 chart, we can also see that the distortionary effects of the bubble have still not fully dissipated. A return to the median would send the S&P to about 1725.
But, What About Tax Cuts?
The 2017 GOP tax bill was designed to add $1.5T to the debt, though I would argue the final number will be much larger due to
- Rising long-term rates
- The pass-through income loophole
- Congress may make certain expiring cuts permanent
Forgetting for a moment that this represents an unprecedented transfer payment from future generations to current shareholders, it is also an unprecedented experiment in fiscal stimulus at the end of what was already a long cycle. It's Bizarro Keynesian.
But, counter the supply-siders, companies will take this extra cash and plow it back into the business in the form of capital expenditure. This will lead to long-term growth in productivity, which will translate into both higher profits and wages, leading to higher demand, leading to more CapEx, etc. The deficit gets wiped out by growth, and everyone sings Kumbaya.
Let's look at this argument one step at a time
- Lower statutory corporate tax rates lead to higher profits
- Higher profits lead to higher capital expenditures
- Higher capital expenditures increases worker productivity
- Higher worker productivity leads to higher profits and wages
- Higher wages increases demand
- Higher profits and demand increases capital expenditures
- The growth from this virtuous cycle wipes out the deficit
1. Though the jury is still out on 2018, I think we can stipulate that the lower statutory rate will decrease the effective tax rate paid by corporations. But their effective rate has been declining for decades, settling at only 13% of pretax profits in 2017. Source: Chart is mine; data from US Dept of Commerce BEA. Numerator is taxes paid by corporations; denominator is corporate pretax profits.
As you can see, the regression puts the mean decline in effective rates at about 21 bps/year. So contrary to the rhetoric of 2017, effective corporate tax rates have been historically low, even before the tax cuts.
2. So tax cuts will lead to higher profits, but will that spur capital expenditure and formation? The jury is still out on 2018, but we can look at the historical relationship. First, does corporate profit growth lead to capital formation in the same year?
The answer here is a definite "no". The weak relationship is evidenced by the very low R2 of 0.0069. But maybe there is a lag to the effect; that is corporate profit growth leads to capital formation in the following year.
This is a tighter, though not strong correlation, with an R2 of 0.1507. The regression model predicts a 16 bps increase in capital formation growth for each percent of additional profit growth in the previous year. It's not a strong relationship, but within the realm of significance.
So where are the other 84 bps of increased profits going to? We won't know until next year, but my guess is cash, debt repayment, share buybacks, increased dividends and executive bonuses.
3. So is there a small but real effect of increased profits on capital formation, but does that necessarily lead to increased productivity? This is where the supply-side story falls apart. First, let's look at the same-year relationship between capital growth and productivity growth.
We can see that with an R2 of almost 0, there is no correlation at all. How about 1 year out?
Again, a very low R2. How about 3 years out?
With an R2 of 0.2567, this is a statistically significant result. But wait a minute. The relationship is the opposite of what we were looking for. That is to say, the regression predicts that productivity growth decreases significantly 3 years after high capital formation growth. The heck?
My guess is that there is no real correlation between capital formation and labor productivity, theory be damned, and other variables are at work here. The 3-year result may be due to recessions resulting from over-investment. Or something. This requires a lot more research and is beyond the scope of this article.
So we can see that the supply-side story breaks down at Logical Step Number 3 and we can dispense with the rest of it. But there is another, weaker version of the supply side story that says that increased corporate profits will be shared with employees ("shared" is much more 2018 than "trickle down"). What do the numbers say?
First, let's look at the historical effects of corporate profits on U-6 unemployment. There is little correlation in the same-year numbers, so let's start with 1 year out.
There is a loose but real correlation here (R2 = 0.1303) and the model predicts a 43 bps decline in U6 for every additional percent of corporate profit growth in the previous year. The 2-year-out numbers are very similar, but the effect goes to nil in the 3-year window. It's a loose correlation, but still, it's a little bit of something. What about real wage growth? Close your eyes, it's not pretty.
Oof. The R2 of almost 0.5 indicates a tight correlation, but the effect of higher corporate profits is lower real wage growth the next year. The effect disappears in year 2. Honestly, I have no explanation here, but we can see that corporate profits have a loose correlation to employment and either none or inverse to wage growth.
The CapEx Will Not Save Us and Other Depressing Thoughts
So what does this all mean? It means that almost 10 years into this rally, the Bizzaro Keynesian approach of this administration is about to reach its limits. The CapEx will not save us in 2019.
And there are further headwinds in 2019.
On top of everyone's list of anxieties is the trade war with China and the general neo-Mercantilist outlook of the current administration. Trump sees the global economy as zero-sum, so for us to win, everyone else must lose. Despite backing down to Mexico and Canada, Trump shows no signs of doing so with China, and seems determined to punish the Chinese economy into submission. The Chinese, who view themselves as the center of the world, the Middle Kingdom, do not respond well to this sort of bullying.
Moreover, this is a country that, just within living memory, has survived:
- The Rape of Nanking and other atrocities of Japanese occupation
- Civil War and the Communist Revolution
- The Great Leap Forward
- The Cultural Revolution
- The Death of Mao and the succession chaos that followed
- The ascension of Deng, the move towards a quasi-capitalist economy, and all the social dislocation that accompanied that.
- Tiennamen Square
I don't think they are scared of tariffs. This trade war will be measured in years, not months, unless we blink first, and the longer it goes on, the harder it is to unwind.
The Fed is raising interest rates, and quantitative tightening at the same time, and long end is beginning to respond. This of course effects every aspect of the economy. Moreover, the tightening is coming at a time of trillion-dollar deficits at the end of a cycle, and the Chinese seemingly holding back from buying more US Treasuries. With this huge supply of US debt coming on the market every month, at some point that may exceed demand, especially if European yields rise and become more attractive alternatives. In this case, the long end may rise faster than the Fed intended, and could lead to over-tightening.
While real wages have yet to really respond to the tight labor market, inflation is rising slowly from tariffs and general demand pressures. If wages were to rise as well, this will put further upward pressure on inflation, perhaps causing the Fed to have to tighten further.
The higher interest rates, along with Trump's neo-Mercantilism and the demand for dollars from repatriation have kept the dollar strong. This dampens growth everywhere else, which is sure to eat into US profits in the form of lower global demand, and currency exchange effects. Besides the VIX, the thing I sit and watch all day is the Dollar Index. When it spikes up, my own personal Fear Index goes up.
The 30-year mortgage is up a full percent in the last year, and home sales are down month after month this year. In expensive urban markets, prices are already dropping and the cap on the mortgage interest deduction in the tax bill will also depress prices further in those high-cost areas. While prices remain high outside of these metro areas, they will surely follow them down as rates continue to rise and affordability remains low. As we all recall, the housing market is often the first thing to go.
Dude, You Are Like the Prince of Darkness. Lighten Up.
I do have some good news. By any measure, the economy is still very strong, though I think we will come to see Q2 2018 as the peak. But that doesn't mean the economy is out of steam by any means. Consumer confidence, a trailing indicator, is sky-high and the Christmas season is soon upon us. Once we get past the midterms, regardless of the outcome, I think that will become the focus. Strong retail, led of course by Amazon (AMZN), and consumer discretionary sectors will lead, but I think there will be opportunities all over the place in November.
But once we get past the likely Fed rate hike on December 18 and then Christmas, I believe the party will be over. The 2018 Q4 numbers will remain strong (as they are still 2017 pre-tax-bill comps), but forward guidance is likely to be displeasing to analysts. The 2019-2018 comps will not look nearly as good as the 2018-2017 comps, margins will thin and earnings growth will suffer. Multiples will have to compress, and this will light up the bears, who already seem ready to pounce because of the high valuations. When the bear is loose, get out of the way.
Be very afraid of the following phrases in Q3/Q4 earnings calls:
- "Rising costs from tariffs"
- "Rising costs from inflation"
- "Increased labor costs"
- "Rising interest rates"
- Any mention of China
Any of the above will be good for an analyst downgrade.
Ways in Which I Can Be Totally Wrong
First, the current October market swoon could be the end of the cycle, but I think that is highly unlikely. Except for homebuilding and the federal deficit, you can't throw a stick and not hit some good data. Not dead yet.
But what if the market keeps going in 2019? This is the more likely Way in Which I Can Be Totally Wrong. Growth will remain strong, if declining, and most economists don't predict recession until late 2019 or 2020. We saw in 1999 that valuations blew through previous highs and kept going. When the bulls are running, hop on or get crushed.
[Charts and numbers updated after close 8/24/18]
Source: Schwab StreetSmartEdge
I redraw and look at this chart every day. It's a regression of the weekly S&P 500 with 0.6 standard deviation channels, beginning in March, 2009 at the bottom of the crash. As you can see the +/- 0.6 standard deviation range captures the action of this long rally quite nicely.
The yellow horizontal lines currently cross around 3030 at the high, 2700 at the mean and 2370 at the low. Zooming in to the 2-year:
Source: Schwab StreetSmartEdge
So my general outlook (with today's regression) is that if it tests 2695 and keeps going, I will look for it to test the low, currently 2370. [That happened today, 8/24/18, so my outlook turned short term bearish] If it breaks that, look out below. Similarly, if it breaks through the high, currently 3030, I will assume we are in 1999 territory, and valuations will continue to balloon.
Even while the market rallied this summer from its spring slump, I started detecting an air of negativity and bearishness in the analysts' reactions to what were generally speaking very good numbers in Q2 earnings; they seemed to be focusing in on whatever negative they could find in the balance sheets. Throughout the summer and into fall, negative sentiment seemed to rise with each headline. First it was the EM collapse, then it was the yield curve was flattening, then it steepened, but people instead focused on the new higher rates.
When the Dollar Index started rising during the Turkish lira mini-crisis, I started clearing my portfolio of anything that had too much exposure to EM, eventually clearing out almost all companies with significant operations outside the US (I almost cried when I sold Alibaba). In late September, I purchased some downside protection in the form of mid-October S&P puts and VIX calls, and some selected shorts, which more than made up for my long-position losses in October. I also changes my passive investments to more conservative postures.
Right now, I'm at over 50% cash [update on 8/24/18 -- now at 70% cash], and I hold very few stocks (again, very little exposure outside the US), but I'm waiting for the right time to jump back in. My best guess, as I said, is after the midterms, which I hear are getting close.
As always I will evaluate all new data, adjust my outlook accordingly, and fight hard against confirmation bias.
Thanks for reading this far. Comments/insults welcome.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.