- The current bull market is getting long in the tooth.
- The Fed is promising higher rates, and hinting of balance sheet unwind.
- Will fiscal stimulus combined with tax cuts be enough to keep the bull going?
One thing is certain - this bull market has gone on a lot longer, and moved a lot higher than I would have imagined possible back in January of 2013. I had been a big proponent of the Fed's ZIRP policy combined with their asset buying when they first started on that course in 2008. Of course, at the time I saw their asset buying as designed to bolster the too big to fail banks, not as a market driver. ZIRP on the other hand, could work to drive GDP, and that of course translated to higher sales. Tax cuts and other fiscal stimulus programs also made sense. We went from $9.9 trillion to $11.7 trillion in federal debt from 2008 to 2009. GDP in 2008 was $14.549 trillion so the $1.8 trillion in deficit financed fiscal stimulus represented 12.7% of GDP.
It all made sense to me, and I was a bull frothing at the bit to get long the market once it was apparent both monetary and fiscal policy were going to be used - and used aggressively. Problem is, by late 2012 it had become apparent we weren't growing GDP at a rate that I would have expected considering the fiscal stimulus being injected into the economy. GDP went from $14.549 trillion in 2008 to just $16.155 trillion by the end of 2012 - 5 years to move up $1.606 trillion, and at a cost in terms of fiscal stimulus of $6.6 trillion when calculating the increase in federal debt from 2008 to 2012.
As it turned out the real driver of equities coming off the 2009 low was predominantly inflation - not economic growth. It was an engineered market, and there was an invisible hand in play whenever the market became a little shaky. We were finding ways to inject money into the risk asset system while simultaneously reducing the supply of assets one could buy with that money. Mergers and acquisitions, stock buybacks, and of course quantitative easing were contributors to a shrinking supply of assets to buy, and of course the money used for these activities, newly created money, moved into the risk asset system resulting in an increase in money to buy risk assets while simultaneously reducing the supply of those things that could be bought with that money.
Take for example quantitative easing. As the Fed built their balance sheet they were taking assets out of the system with newly created money. The same with stock buybacks. They could be funded with profits - money that previously resided in the real economy and was considered a part of M2 money supply - or they could be funded with loans which were newly created money that moved directly into the risk asset system. In both cases the supply of newly created money was flowing, not into the economy, but rather into the risk asset system. And, the supply of things that newly created money could buy was shrinking. This trend had been going on for a long time, unbeknownst to me, as the numbers of stocks being traded had fallen from 6,364 in 1997 to just 3,267 by September of 2016 according to the University of Chicago's Center for Research in Securities Prices:
Those puzzled by the lack of inflation in the real economy in spite of so much newly created money were baffled, and unable to explain how this could be possible. Gold bugs swore it was manipulation, and if you consider that gold is a risk asset too, it makes sense that manipulation was a factor in the relative underperformance of gold, but that is a subject for another time. Usually there is always a way to explain a phenomenon in ways people understand once the person explaining it understands it, but even today there is very little commentary on why stocks have risen so dramatically while the economy has remained stagnant.
The main takeaway here - at least in my opinion - is that we've seen stocks climb consistently as economic growth has remained stagnant at best, and it has happened, not because we've seen economic growth - the traditional driver of equities - but because we've seen a systematic effort, intended or not, to produce higher stock prices through financial engineering. Once we recognize this fact, we can move on to ask whether or not this process is sustainable. In other words, at what point will the bubble burst, or will it ever burst?
It is a bubble by the way - at least as I define that term. We can look at the housing bubble for context. I used this chart in an article I wrote back in 2014 to illustrate this phenomenon. We see housing starts pushing upward off the 1990 lows with mortgage debt also moving higher, but at a point we see housing starts begin to fall rapidly as mortgage debt continues to climb for a time. When that newly created mortgage debt stopped being used to increase inventory, it was used to bid up the price of existing inventories thus creating an inflationary bubble, and of course that bubble did burst just as all bubbles have done in the past.
The important point here isn't that housing starts began to fall - that was more a result of oversupply relative to demand - and that is certainly not the situation with stocks today. To the contrary, we have an undersupply of stocks relative to demand where demand is easily defined by the amount of money supply in the risk asset system. And, that more than anything else, is what matters. It matters more than PE ratios; it matters more than earnings; and it matters more than top line sales. Stocks will remain at these levels so long as no new money is added to the system, and the aggregate supply of stocks remains static. Stocks will move higher regardless of PE ratios or earnings so long as the supply of stocks continues to shrink, or the amount of new money in the system continues to increase, or both. And, stocks will begin to fall if we see the supply of stocks increase via IPO's, or if we see the supply of money decrease.
Of course, the systems fragility must be considered here. At some point it seems there is always a recognition that we've just taken it too far. It is a psychological phenomenon more than anything else - a recognition that plowing more money into the system at these levels doesn't make sense anymore. We can see where that point was reached regarding housing starts in the chart above. Builders just quit building even though the supply of money continued to rise. The money supply was still growing meaning we probably could have seen housing starts continue to climb, but we didn't. It could have been the psychological mindset of bankers, or it could have been the psychological mindset of builders. It doesn't matter which, it just matters that there came a point where housing starts seized up, and again, that has nothing to do with the housing bubble bursting except to the extent that it contributed to high inflation in housing prices as the newly created money was no longer being used to increase supply, rather it was being used to drive house prices higher.
The invisible hand at work
I can't emphasize enough the importance of central banks in terms of perpetuating, and even extending the risk asset bubble. It is the one thing we simply don't have an historical context for in that we've never seen such an aggressive effort to drive stock prices higher by the one entity that has the wherewithal to do so - perhaps without constraint. In times past when a market reaches a certain level we see participants start to pull back - that is they take their money out of the system based on a perception that price is no longer attractive. We've seen instances of this over the last 4 or 5 years, and the stock market has reacted violently.
The 2 year chart below shows what I refer to as the invisible hand stepping in when markets sell off violently. These V-ramps have the appearance of manipulation - i.e., a very rapid acceleration off the lows once sell volume subsides. In the first two instances the market participants seemed to take the initial surge as an opportunity to sell into the ramp higher thus causing a more concerted effort to push prices back to the highs. In the third and fourth instance the sell-offs were caught a lot quicker, and so the surge pushed stocks to new highs before stalling out. This could be nothing more than investors seeing the violent sell-offs as great buying opportunities, or it could be a market maker fading the sell-off for the purposes of providing market stability, and therefore avoiding a panic bear market crash:
By contrast, the following chart leading up to the bursting of the dotcom bubble looks strikingly different. The sell-offs are not as violent, and we don't see the almost instantaneous V-ramps occurring as we do in the post 2009 period. Maybe you don't see the subtle differences in these two periods in the same way I do, and that is certainly OK, but we all know the term Fed put, and few are inclined to deny the existence of that put since the 2009 lows - including the Fed. For me it's not a great stretch to assume that the Fed put goes beyond just monetary policy, and beyond QE, and could easily include backstopping sell-offs when necessary by using surrogates to intervene in the markets in these instances.
I have made the point to my partners on numerous occasions that these violent sell-offs followed by equally dramatic ramps higher are not the result of investor enthusiasm so much as the result of central banks protecting against a bear market, and once we move back into the vicinity of the highs we will stall out without seeing a major leg higher. My hypothesis is that the central banks are just as concerned about an irrational parabolic spike fueled by irrational exuberance as they are with a panic bear market sell-off. Once the threat of the later is off the table the invisible hand retreats and markets normalize.
Keep in mind this sort of market control is much easier today than it has been in the past. Primary dealer banks for instance now play the role of market makers, whereas prior to the repeal of Glass Steagall that wasn't the case. And, of course these banks have a relationship with the Fed that market makers in the Glass Steagall era didn't have. Furthermore, the Fed has demonstrated how they can expand the money supply within the risk asset system through these banks by use of QE. It is, by all rights - if true, and I believe it is - a form of manipulation that we simply didn't see in the Glass Steagall era.
And, don't get offended by the suggestion that the Fed is purposely manipulating risk asset prices as that is what they have always done, or at least tried to do. The fact that they upped their game in the post-recession era should not be viewed with disdain, although I admit to expressing more than a little disdain at times when I've seen this happen. It is not so hard to understand when you also understand that a lot of hedge funds have underperformed the major averages. And, the reason they have is because the markets no longer function in ways they have in the past.
I know that is true, but each time we do see a sell-off my assumption is that this may well be the beginning of the bursting of a market bubble. Even being fully cognizant of the fact that this is going on, I remain cautiously bearish, and I just can't make my mind see it any other way. I can of course trade the long side of the market, and do so frequently, but it always makes me uncomfortable. And the hardest trade of all is when we do sell-off, pushing down to the 2 standard deviation band. That is where I typically go long, and that is also where I experience my greatest anxiety.
So what about Trumponomics?
Donald Trump's policy proposals put a new slant on the matter of a bull market that may be based on economics, and not on financial engineering. For the first time in 4 years I can see a reason to be bullish as I think his policy proposals make sense - economically at least. And, if effectively implemented, in time we very well could see a return to a consumer driven period of economic growth.
Of course, I also see a lot of short term risks in his proposals as it relates to the stock market. The biggest risk of course is his protectionist stance that is almost certainly going to negatively impact large cap multi-nationals. Although his argument is that he wants to put the people first, the more important point is that in doing so he can positively impact the demand side of the supply/demand curve. That is the side that has been sorely lacking post-recession, and the reason we've seen stocks move higher on the back of financial engineering rather than the result of a true demand driven period of economic growth.
Keep in mind no corporation is going to voluntarily agree to an increase in cost of goods sold - in this case the labor cost component of cost of goods. Still, in the long run, these corporations could be big beneficiaries of those labor cost increases as crazy as it might sound on the surface. As it stands now, we have seen a consistent lack of growth in inflation adjusted top line sales for the S&P 500:
Clearly, an increase in labor costs will impact corporate profits - either in terms of an increase in cost of goods sold, or a decrease in sales if they attempt to pass those costs on to consumers. However, to the extent that demand increases as more high paying jobs come back to the US, there is a point where the sales increase could effectively offset the production cost increase, and thereafter corporate profits begin to rise again solely as a result of demand driven sales increases. And, keep in mind it isn't just the manufacturing jobs that make a difference - it is also the demand for goods and services from other sectors created by those new wage earners that should spur job growth in other sectors. It ends up being a feedback loop that can, if done properly, benefit consumers, corporations, and government - government being the result of a reduced need for deficit financed fiscal stimulus resulting from an increase in the tax base.
The problem of course is turning the ship, and that won't be an easy thing to do. In the short term, common sense suggests that if we are going to shift the trend in the share of income going to the working class upward - even slightly - the cost of that shift will be borne by corporate America.
The quid pro quo offered by Trump are corporate tax cuts, but I am not so sure that will be sufficient to offset the cost of bringing jobs back under threat of an import tax to those who continue to manufacture offshore. The industry most at risk are the auto manufacturers who already operate on comparatively thin profit margins as a percent of sales. Of course, one can't ignore the impact of an import tax on companies like Apple either. Back to that in a minute though as it seems relevant to the discussion to look at just how much corporate taxes amount to in the first place. According to the US Treasury, not really that much - $344 billion in 2015.
Still, to really understand the impact to profits in the aggregate, say for all S&P 500 stocks, would take an immense amount of work. Thinking someone might have done this heavy lifting, I did a key word search that produced nothing. In lieu of doing an analysis on each of the stocks, I chose to limit my analysis to just one stock - Apple. The goal here is to determine the combined impact of tax cuts which would be a positive, and a 35% import tariff, which would be a negative.
We can start by reviewing Apple's 10-K filing for 2015. Apple's taxable income in the US is approximately $43.25 billion, and foreign income is $47.6 billion, noted as follows:
The foreign provision for income taxes is based on foreign pre-tax earnings of $47.6 billion, $33.6 billion and $30.5 billion in 2015, 2014 and 2013, respectively. The Company's consolidated financial statements provide for any related tax liability on undistributed earnings that the Company does not intend to be indefinitely reinvested outside the U.S. Substantially all of the Company's undistributed international earnings intended to be indefinitely reinvested in operations outside the U.S. were generated by subsidiaries organized in Ireland, which has a statutory tax rate of 12.5%. As of September 26, 2015, U.S. income taxes have not been provided on a cumulative total of $91.5 billion of such earnings. The amount of unrecognized deferred tax liability related to these temporary differences is estimated to be $30.0 billion.
The relevant part of this analysis is how much will Apple add to bottom line profits if Trump's tax proposal is implemented. A reduction from 35% to 15% would be 57% so we can quickly determine that Apple would benefit by an amount of $15.138 billion X .57 = $8.65 billion. And, per the earnings reflected in the Consolidated Income Statement, we see after tax earnings for the company for 2015 totaled $53.394. So, a reasonable rough estimate of the benefits resulting from Trump's proposed tax cut would increase bottom line earnings by $8.65 billion/$53.394 billion = 16%, or a change from $9.28 per share to $10.76 per share.
The second half of this process is to make an attempt to assess the negative impact to Apple if Trump were to impose a 35% tariff on Apple products manufactured outside the US and sold in the US. Data on the dollar amount of Apple product sales in the US that are manufactured outside the US is sketchy at best, but we can start here with this statement found in the company's 10-K filing that confirms that almost all of Apple's product line is manufactured in Asia:
While some Mac computers are manufactured in the U.S. and Ireland, substantially all of the Company's hardware products are currently manufactured by outsourcing partners that are located primarily in Asia. A significant concentration of this manufacturing is currently performed by a small number of outsourcing partners, often in single locations. Certain of these outsourcing partners are the sole-sourced suppliers of components and manufacturers for many of the Company's products. Although the Company works closely with its outsourcing partners on manufacturing schedules, the Company's operating results could be adversely affected if its outsourcing partners were unable to meet their production commitments. The Company's purchase commitments typically cover its requirements for periods up to 150 days.
We can also see from the exhibit below that net sales in the America's total $93.9 billion, but that number includes both North and South America leaving us with the need to separate out that portion of the total that is exclusive to the US. According to Statista.com, Latin American iPhone sales totaled $26.8 billion in 2015. Based on that number it seems safe to assume that at least 2/3's of the America's sales, or about $63 billion, were attributable to the US, and therefore subject to the Trump tariff.
Tariffs would be imposed on the wholesale amount, not the retail amount so it is necessary to make some dollar adjustment to the $63 billion. The company's overall cost of sales is 60%, and so we can use that as a best guess as to the wholesale value of Apple products. In other words, we would end up with $63 billion X .60 = $37.8 billion in imports that would be subject to a 35% tariff. In other words, based on this analysis - admittedly incorporating a lot of assumptions - Apple would be negatively impacted by $13.23 billion from Trump's 35% tariff.
This analysis is admittedly a little subjective in a number of areas. First, it makes assumptions on both the corporate income tax cut, and on the likelihood that Trump will move forward with his import tax proposals - proposals that are ambiguously defined at best. That said, there is ample reason for a high degree of anxiety in spite of the euphoric Trump ramp we've seen over the last few months. If the assumptions made here prove to be true, the tax cuts will be more than offset for Apple by the tariffs - in fact to the tune of roughly $4.5 billion.
Of course, Apple is not representative of the stock market as a whole. Different companies have completely different dynamics. For instance, the impact to auto manufacturers if a 35% tariff were imposed would likely put them in an outright loss position due to their much higher cost of sales, and their much smaller profit margin as a percent of sales. Other companies - companies that are service oriented would be big winners. The same would apply to software companies - Oracle for instance.
Market direction still depends on money flows
As I stated above, what matters most is simply supply v. demand with demand being the amount of money moving into risk assets. The likelihood of a significant increase in supply seems remote at best at the present - just too much uncertainty to think IPO's or corporate bond issues will accelerate until we get a better idea on how all this will work out. It is reasonable to assume that the supply side of the equation favors the long side. But, stock buybacks - one of the primary factors driving equity prices - have been declining per Factset's Buyback Quarterly Report:
Q3 Buybacks Decline 28% Year-Over-Year
Companies in the S&P 500 spent $115.6 billion on share buybacks during the third quarter, which marked the smallest quarterly total since Q1 2013. Aggregate buybacks in Q3 represented a 28% decline from the year-ago quarter, which was the largest year-over-year decrease since Q3 2009. Keep in mind that Q3 2015 was the fifth largest quarterly total since FactSet began collecting this data in 2005 The third quarter marked the first time the index saw two consecutive quarters of year-over-year declines in buybacks since Q4 2014 and Q1 2015. On a quarter-over-quarter basis, buybacks fell nearly 8%, which marked the second consecutive quarter of sequential decreases in buybacks. It is interesting to note that the third quarter, on average, has produced the largest quarterly buyback totals for the S&P 500 index. That was not the case this year. Buybacks during the quarter now stand just 2.7% above the Q3 average going back to 2005. On a trailing twelve-month basis, shareholder buybacks amounted to $556.6 billion at the end of the third quarter. This was a 2.6% drop from the same time period a year ago.
On the risk side, we also have to consider the impact of a trade war. The bond market is reflecting a lot more anxiety than equities at the moment - in part due to the Fed's seemingly firm commitment to higher rates. Yellen indicated last week that the Fed plans to stay on course with Fed funds rate hikes of 3 per year - each one being ¼ of a point - until the Fed funds rate hits 3% in late 2019. However, there are other factors moving bond markets as well that are more directly related to Trump's protectionist stance. Specifically, we see a lot of countries who hold US Treasuries dumping them at a pretty fast clip as noted by Wolfstreet.com and found here:
Net "acquisitions" of Treasury bonds & notes by "private" investors amounted to a negative $18.3 billion in October, according to the TIC data. In other words, "private" foreign investors sold $18.3 billion more than they bought. And "official" foreign investors, which include central banks, dumped a net $45.3 billion in Treasury bonds and notes. Combined, they unloaded $63.5 billion in October.
In September, these foreign entities had already dumped a record $76.6 billion. They have now dumped Treasury paper for seven months in a row. Over the past 12 months through October, they unloaded $318.2 billion:
The recent strength in the US dollar has some positives as far as foreign countries are concerned, but only up to a point. The positives are that foreign countries gain significant export advantage, but after a point, that is offset by the risk of capital outflows. To counteract that, countries - China in particular - end up selling US Treasury holdings and then selling dollars to buy their own currency. So far they seem to be fighting a losing battle.
As far as the anxiety factor is concerned, rising rates are simply not a good thing despite the rhetoric that suggests the opposite. In particular, the short end of the curve can wreak havoc on the markets as the positive metrics for the carry trade turn negative. A flat curve tends to suck money out of the bond market rapidly. The yield curve below of US Treasuries reflects the current yield compared to the yields in January of 2007. It is easy to see that the current set-up still allows for a heavily leveraged position in US Treasuries that will produce positive returns. If I can borrow short term at .5% and use the proceeds to buy a 10 year at 2.5% I am netting 2%. If I can leverage that by a factor of 10 I am making 20% on the carry trade. Actually I could leverage it by a factor of 20 if I had a lot of courage, or better stated if I was stupid enough to do that as my margin requirement out to 10 years is 5% of market value.
The following chart of the US Treasury yield curve compares today's yield curve to that of the curve in January of 2007. The relatively flat 2007 curve - were we to return to that - would completely eliminate the opportunity to exploit short term rates with carry trades, and at 3% on the short end, it would also destroy the carry trade in equities producing a mass exodus in risk assets through a process of deleveraging margin debt - and this is a really big deal should it occur.
Again, it is a function of supply vs. demand that will dictate the direction of the market in the coming months with the expectation that supply will remain relatively flat in equities, while demand - being defined as the money flowing into equities - is less predictable. If one doubts the validity of the argument that money flows dictate price one need only look at this chart produced by Doug Short to get the point:
And, another way to assess the risk of cash flows moving in versus cash flows moving out of the market is this chart - again courtesy of Doug Short:
What I find particularly ironic is that I do think Trump's protectionist stance is clearly a positive long term as it focuses on swinging the pendulum back toward the middle as it relates to the balance - or imbalance in this case - between the working class and the capitalists they work for. There is an optimum balance, and we simply can't implement policy that favors the capitalists much longer if we hope to survive as a true capitalistic economy. Wealth begets more wealth when the system is tilted in favor of multi-national companies as it is today. An interesting commentary on the truth of that is Oxfam's recent report noting that these 8 people hold net worth equivalent to ½ the world's population:
The world's 8 richest people are, in order of net worth:
- Bill Gates: America founder of Microsoft (net worth $75 billion)
- Amancio Ortega: Spanish founder of Inditex which owns the Zara fashion chain (net worth $67 billion)
- Warren Buffett: American CEO and largest shareholder in Berkshire Hathaway (net worth $60.8 billion)
- Carlos Slim Helu: Mexican owner of Grupo Carso (net worth: $50 billion)
- Jeff Bezos: American founder, chairman and chief executive of Amazon (net worth: $45.2 billion)
- Mark Zuckerberg: American chairman, chief executive officer, and co-founder of Facebook (net worth $44.6 billion)
- Larry Ellison: American co-founder and CEO of Oracle (net worth $43.6 billion)
- Michael Bloomberg: American founder, owner and CEO of Bloomberg LP (net worth: $40 billion)
Winnie Byanyima, Executive Director of Oxfam International, made the following comment which seems to sum up the Trump view of the world today:
"It is obscene for so much wealth to be held in the hands of so few when 1 in 10 people survive on less than $2 a day. Inequality is trapping hundreds of millions in poverty; it is fracturing our societies and undermining democracy.
"Across the world, people are being left behind. Their wages are stagnating yet corporate bosses take home million dollar bonuses; their health and education services are cut while corporations and the super-rich dodge their taxes; their voices are ignored as governments sing to the tune of big business and a wealthy elite."
So, taking all that into account, I do think that we will see many - if not all - of Trump's policies implemented, and perhaps very rapidly. And, I do believe it has the potential to ignite the economy, and that will bode well for all of us as we move through the next 4 years. That said, I am less optimistic about the stock market in the coming months. I don't see this as a bad thing long term as we really do need to see some deleveraging occur.
As I noted earlier, there has been an invisible hand in play in the markets since coming out of the recession, but as Doug Short indicated with a short note on his chart above - "Fed Bubble?" - we may well be at the end of a cycle. Certainly there is ample reason to expect a lot more downside pressure in bonds in the near term, but I am not totally convinced we won't see that reverse if we see equity market money outflows, and keep in mind, in times past when bubbles do burst the ride to the bottom can be rapid, and extreme. Certainly from an economic perspective I would prefer to see the bond market stabilize as higher interest rates will almost certainly collapse demand as we are a credit driven society when it comes to consumption.
Since I am less pessimistic today than I have been in 4 years I am reluctant to close with this chart - again borrowing from Doug Short - but I guess I will do so anyway as I would not be at all surprised to see a mean reversion in equities even though I see much better things coming down the pike for the economy itself. First Doug's comments, and then the chart:
The peak in 2000 marked an unprecedented 141% overshooting of the trend - substantially above the overshoot in 1929. The index had been above trend for two decades, with one exception: it dipped about 15% below trend briefly in March of 2009. At the beginning of January 2017, it is 94% above trend, exceeding the 68% to 90% range it hovered in for 37 months. In sharp contrast, the major troughs of the past saw declines in excess of 50% below the trend. If the current S&P 500 were sitting squarely on the regression, it would be at the 1156 level.
My sincere hope is that we don't see a mean reversion for the simple reason that it could render Trump ineffective - a sort of we told you he was a loose cannon sort of thing. If that were to occur we could see the globalists who seem to be in retreat at the moment come back to life stronger than ever. That is my biggest fear as their vision of the world is not one I want to live in. One thing I am certain of is that the coming months will be a period of high drama.