by Asset Allocation Committee

After peaking at 2872.87 on January 26, the S&P 500 has been in a corrective phase.  The index fell just over 10% and has been range bound ever since, well below the aforementioned high.  Here are the primary reasons equities have struggled:

1. Valuations became a bit stretched: The P/E, as we calculate it (trailing except for the current quarter, which includes two previous and two forecast quarters), reached 20.8x. This level is at the high end of the dispersion of the multiple for our P/E models and is no way inexpensive.  The rally seen after the tax cuts became rather excessive and a pause to consolidate would be normal.
2. Trade war fears: The administration, which had put trade policy on the backburner as it tried to overturn the Affordable Care Act and enact the tax bill, has recently turned its attention to trade. Trade impediments and the pullback from globalization would weaken the policy commitment to low inflation that has been in place since the late 1970s.
3. Political instability: It is common for the personnel in the White House to change over time. Under normal circumstances, when a party has been out of power for an extended period, a plethora of experienced officials are poised to join the new administration when the party regains power.  As time passes and the new president becomes more comfortable in his role, less powerful aides are recruited and the powerful, often with their own agendas, leave the White House.  President Trump was enough of an outsider to disrupt this process to some degree.  Still, the president did surround himself with some seasoned advisors from the military and business sectors.  Although the media probably overstated the case that these figures “corralled” the president’s instinctual management style, it does appear that the White House became less chaotic after Gen. Kelly took over as chief of staff.  In the past few weeks, however, there has been a wholesale change in personnel, including Secretary of State, Head of the CIA, and National Security Director. The replacements have hawkish reputations and could bring geopolitical instability.  These changes have increased uncertainty and weighed on market sentiment, as have the prospects for political disruption stemming from the upcoming midterm elections.
4. Policy tightening: The Federal Reserve is steadily tightening monetary policy. Although current policy has not reached a point where it would be considered restrictive, the direction for interest rates is clear.  Monetary policy has tended to support financial asset prices since the 1987 crash, in that declines in equity prices have led Fed chairs to either reduce rates during pullbacks or promise to act if financial conditions deteriorate.  However, the new Fed chair, Jerome Powell, made no mention of current market volatility, raising concerns that the “Fed put” may no longer exist.

All these worries have some basis in fact.  However, we believe the bearish case is overstated based on what we know now.

1. Earnings will be robust: The tax law will shift, in our estimation, about 1.3% of GDP to after-tax profits. If equity prices hold near current levels, valuations will improve in coming months.
2. Trade policy: Although we are concerned about the turn toward protectionism, in the short run we have seen initially aggressive positions that have been adjusted to become less onerous. A retreat from globalization is probably underway but it hasn’t progressed enough yet to trigger higher inflation.
3. Policy instability: President Trump will likely be considered one of the most unique presidents in history. His extensive use of social media has overturned the Washington order, for better or worse.  Future presidents will likely have to decide if they will continue to use microblogging as a way to message the country, unfiltered by the media.  At the same time, financial markets rapidly discern signal from noise.  If markets determine that a social media rant is not material to market action, the markets will begin to ignore what is coming out of the White House.  It is true that this president values flexibility and does not want to be contained.  And, a president with such characteristics can make unexpected decisions.  At the same time, it should be noted that President Trump’s period of greatest influence is coming to a close.  History shows that the bulk of a president’s political capital is exhausted within about 18 months after the election.  That’s because, in most cases, the midterms lead to a decline in congressional support and lawmakers realize that the influence of a president wanes once the midterm election season is underway.  Simply put, by early summer, President Trump’s ability to make major changes in domestic policy will decline rapidly.
4. Monetary policy: The Federal Reserve has engineered three “soft landings” since becoming independent in the early 1950s. Every other tightening cycle generally resulted in a recession.  However, the timing from the end of the tightening cycle to the onset of recession can vary widely.

In many cases, especially prior to the 1981-82 recession, the onset of recession coincided with the peak in fed funds.  However, in the three recessions since 1982, the peak in rates has preceded the recession by an average of 14 months.  If the same pattern holds, we are probably at least 12 to 18 months away from the next recession[1] as policy tightening will likely continue into next year.

In conclusion, although the aforementioned concerns are legitimate, we think they are probably overdone, at least in the short run.  In addition, there appears to be ample liquidity to fuel higher equity prices.

This chart shows the level of retail money market fund holdings along with the S&P 500 Index.  The shaded areas show periods when money market funds are at levels of $920 bn or less.  These periods tend to coincide with sluggish equity performance.  Current fund levels exceed $1.0 trillion; unless investors now view returns on cash as adequate enough to consider it an asset class, we suspect the high levels of liquidity are an indication of caution.  If a degree of calm returns to the market environment, it appears there is enough liquidity to at least challenge the previous highs in equities.

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[1] Assuming a geopolitical event isn’t responsible for the next downturn.

by Asset Allocation Committee

Last week, the Federal Reserve published its Financial Accounts of the United States report, formerly known as the Flow of Funds report.  The report is a storehouse of important financial information.  In this most recent report, a few things emerged that raised concerns.  The first issue is net saving.  Net saving is a macroeconomic identity; for every sector that saves, some other sector must dissave so the four major sectors of the economy—business, households, government and foreign—balance to zero each quarter.

The chart on the left shows the four major sectors.  Household saving is income less consumption, business saving is revenue less investment, government saving is taxes less spending and the foreign sector is the inverse of the current account.  All the data are scaled by GDP.  Business saving vacillates between saving and dissaving; when businesses dissave, it means their investment exceeds their income and they are using the capital markets for funding.  This chart shows important long-term trends in the economy; household saving peaked in the mid-1970s and fell steadily into the Great Financial Crisis, with dissaving in 2004-05.  Foreign saving (a larger trade deficit) became common during the 1980s and has remained elevated ever since.  To accommodate the foreign saving, either government or the private sector has lowered saving rates.

The chart on the right shows a rather disturbing development—a sharp drop in household saving and a commensurate rise in business saving.  It isn’t clear what exactly caused households to lower their saving, but it could be that households were anticipating the tax cut and increased their spending.  It’s also not clear why businesses boosted saving.  In general, rising business saving comes at the expense of lower investment.  One quarter’s data doesn’t make a trend, but if this pattern persists it would suggest lower future household consumption (eventually, the lack of saving undermines spending) and a decline in investment.  Given that government dissaving is poised to rise and the president wants to impede trade, the domestic private sector would be called upon to fund the public deficit.  That development would likely lead to slower growth.

The second issue shown in the recent report is that household deleveraging appears to have ended in Q4.

This chart shows household debt as a percentage of after-tax income.  Although this ratio stabilized in 2016, it rose this quarter to its highest level since Q4 2014.  Although not a major increase, the trend is disturbing because we doubt households have much additional debt capacity.

The two upper lines in this chart show the household financial obligations ratio, which includes debt payments plus auto leasing payments, rent, property taxes and homeowners insurance relative to after-tax income, and the household debt service ratio, which is just debt service (mortgage and consumer credit) relative to after-tax income.  The lower line on the chart shows the difference between the two ratios.  Both ratios have been rising but the financial obligations ratio has been increasing faster, likely reflecting higher rent payments.  The difference, which has distributional effects, is now at record levels.  The other concern is that both ratios are rising at the same time as tightening monetary policy.  Rising interest rates coupled with higher levels of debt will likely mean rising debt obligations, which will eventually weaken consumption.

While our analysis of the economic data still suggests a recession won’t happen this year, the trends in some series do suggest the cycle is aging and the potential is rising for a slowdown in 2019.  We continue to monitor the data closely as this year unfolds.

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by Asset Allocation Committee

Last week, we discussed the fact that the generally strong economy should be supportive for equity markets as economic growth will tend to support earnings.  However, the other important element of equity valuation is what multiple investors put on those earnings.  The most common valuation metric is the price/earnings ratio (P/E).  Our equity market forecast is based upon expectations for earnings and the multiple investors put on those earnings.

This week we will discuss modeling the multiple.  The most common way to estimate the P/E is to compare it to the 10-year T-note yield.  This is known as the “Fed model” on the idea that the P/E represents the “yield” on equities.[1]

The chart on the left shows the 10-year yield and the S&P earnings yield from 1960.  There have been periods when the two series moved closely together—the early 1980s into 2002 is notable.  However, there have been significant deviations as well, such as the mid-1970s and the past 15 years.  The chart on the right shows a regression model of the earnings yield using the T-note yield.  The variation is rather wide; in addition, the model suggests equity markets were mostly overvalued from the 1980s into 2000.

The primary argument for the Fed model is that portfolios tend to be constructed of equities and fixed income.  Thus, measuring the relative valuation between these two assets makes sense.  However, it also has some serious weaknesses.  First, there are different motivations for owning each asset.  One buys equities to own a portion of the productive capacity of the nation’s economy.  Owning fixed income gives one a return for forgoing current consumption.  Thus, it would make sense for someone to buy equities when they are upbeat about the future; equities are the asset for optimists.[2]  Treasuries, on the other hand, are serviced by the taxing power of the U.S. government.  The risk of equity earnings is fundamentally different than that of Treasuries.  Second, it’s a relative valuation model.  Consequently, during periods when there is a deviation from fair value, it’s hard to know which market is “out of whack.”

Another way of looking at equity valuation is relative to the economy.  The trick is which combination of economic variables has the most explanatory power?  Earnings are, in part, a function of economic growth, and inflation determines the “real” value of those earnings.  A classic indicator that captures both economic activity and inflation is the “misery indicator,” which is the sum of the unemployment rate and the yearly change in inflation.  Created by the Nobel Laureate Arthur Okun, it is designed to measure the degree of “pain” from a weak economy and inflation.

The misery index is clearly inversely correlated to the P/E.  The unemployment rate is an indicator of overall economic health and inflation is, to a great extent, a measure of the relative attractiveness of real assets compared to financial assets.  Although the misery index model isn’t perfect, it gives rather consistent results and generally offers better signals of valuation—in other words, it suggests periods when the market is overvalued or undervalued, whereas the Fed model tends to have longer swings in valuation.  On the other hand, the misery index has one significant flaw—it would not work well during periods of deflation as it would be signaling improvement when, in fact, deflation tends to occur during periods of economic turmoil.

Both models suggest the current P/E is not excessive.  We expect unemployment to remain low and inflation contained, which should mean the misery index model would support equities.  Additionally, the Fed model indicates that the recent rise in yields has simply reduced the undervaluation of equities.  Thus, we remain bullish equities despite recent turmoil.

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[1] The inverse of the P/E is the “earnings yield.”

[2] However, buying equities when one is hopeful about the future might not be the best investment plan; history suggests buying equities when times are dire may actually be more prudent because they tend to be less expensive.

by Asset Allocation Committee

Last year, we introduced an indicator of the basic health of the economy and added it to the many charts we monitor in gauging market conditions.  The indicator is constructed with commodity prices, initial claims and consumer confidence.  The thesis behind this indicator is that these three components should offer a simple and clear picture of the economy; in other words, rising initial claims coupled with falling commodity prices and consumer confidence is a warning that a downturn may be imminent.  The opposite condition should support further economic recovery.

This chart shows the results of the indicator and the S&P 500 since 1995.  We have placed vertical lines at certain points when the indicator falls below zero.  Although it works fairly well as a signal that equities are turning lower, there is a lag.  In other words, by the time this indicator suggests the economy is in trouble, the recession is likely near or underway and the equity markets have already begun their decline.

To make the indicator more sensitive, we took the 18-month change and put the signal threshold at -1.0.  This provided an earlier bearish signal and also eliminated the false positives that the zero threshold generated.  Notwithstanding, we will pay close attention when the 18-month change approaches zero.

What does the indicator say now?  The economy is healthy and currently supportive for equity markets.  Future market performance is likely to be more affected by the P/E multiple rather than earnings, which are dependent on economic growth.  The P/E is mostly a function of interest rates and inflation, although there is also an element of sentiment to the ratio.  For now, we expect the multiple to remain elevated but the risk of contraction will grow over time, especially if inflation worries increase.  We will have more to say on this issue in the coming weeks.

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