by Asset Allocation Committee

Equity markets had a very strong 2017, with the S&P 500 up over 20% for the year.  Earnings rose more than expected, the economy continued to expand and investor sentiment was buoyant, all of which contributed to rising equities.  The tax bill, signed in late December, will give equities a lift going into 2018.  In this report, we will examine equity market behavior as part of the presidential cycle.

To perform this exercise, we look at weekly closes for the S&P 500 starting in 1928.  We rebased the index for every four-year election cycle, so the first year is the actual election year (with elections held in November) along with the next three years of the term.  Using this database, we can sort by incoming party, incumbent party, high correlating terms, etc.  Earlier this year, we published this graph.

The red line on the chart shows the average S&P 500 performance for a new GOP president; the blue line shows the performance during the Trump administration.  From the beginning of 2016 into Q3 2017, the two lines closely followed each other.  However, they have diverged rather dramatically since then.  We suspect that the anticipation of tax reform has led to the sharp rise in equities.

The real question is how will equities perform in 2018?  The tax reductions built into the tax bill will likely have a significant impact on corporate earnings; we will have more to say about that in subsequent reports.  However, another way to look at equities is by comparing the performance of the current Trump term to other four-year cycles.

There are six other periods that correlate at 90% or above.  Three of the six show weakness in the second full year of the administration, 1960-63, 1964-67 and 1988-91.  In the first instance, the Cuban Missile Crisis likely led to the pullback.  The escalation of the Vietnam War and rising inflation (the highest rise in the CPI in nine years) weighed on equities in 1966.  The First Gulf War and the 1990-91 recession were behind weaker equities in the 1988 cycle.  The other three had mostly rising equity values in the second full year of the political cycle.

Interestingly enough, the highest correlating cycle is 2012-15, the second Obama term.  Although the current index is running a bit behind compared to that year, the index pattern is most similar.  If we continue to track that cycle and narrow the gap, the S&P 500 would end up at 3267.65 at the end of 2018.

How is this exercise useful?  This analysis looks at high correlation periods and projects what may occur assuming that no major exogenous events occur.  Obviously, a war or recession would lead to different outcomes.  But, if the U.S. avoids an economic downturn or a major political or geopolitical event, equity markets could have another strong year.

View the PDF

by Asset Allocation Committee

(N.B. This will be the last Asset Allocation Weekly for 2017.  We thank our readers and wish them a Merry Christmas and Happy New Year.  The next report will be published on January 5, 2018.)

As equity markets continue to trend higher, there are always worries about how long the bull market can last.  In general, bull markets over the past three decades have tended to end with recessions, triggered either by a policy mistake or a geopolitical event.  Unfortunately, the latter are binary events and difficult to predict.  We do pay close attention to such events in our Weekly Geopolitical Reports.

Due to its importance to financial asset performance, we also closely monitor the economy.  One of our more simple indicators is constructed with commodity prices, initial claims and consumer confidence.  We standardize the data and combine it into a single indicator.  The thesis behind this indicator is that these three components should offer clear signals on 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.

The above chart shows the results of the indicator and the S&P 500 since 1995.  We have placed vertical lines when the indicator falls below zero.  Although it works fairly well as a signal that equities are turning lower, it is a bit slow.

To make a more sensitive indicator, we took the 18-month change and put the signal at -1.0.  This triggers a more useful sell signal and also eliminates the false positives that setting it at zero would generate.  However, we do pay close attention when the 18-month change falls under zero.

What does the indicator say now?  Clearly, if we are going to have a pullback, it won’t be from the economy.  The economy is healthy and will be supportive for equity markets.  That doesn’t mean that valuation doesn’t matter, but it does suggest that the economy shouldn’t cause a bear market in the near term.

View the PDF

by Asset Allocation Committee

Last week, the Federal Reserve released its Financial Accounts of the United States, formerly called the Flow of Funds report.  It is a broad set of data that covers many aspects of the economy.  Here we present some key charts from the report.

This chart shows key private sector debt as a percentage of GDP.  We exclude the financial sector to avoid double counting.  We consider private sector debt more important to the economy for two reasons.  First, business sector investment is funded with debt and household sentiment is also tied to debt.  Leverage will boost growth, while deleveraging weighs on growth.  The other important factor is that private sector debt has different capacity constraints than public sector debt.  Private sector debt has to be serviced from income or revenue; the private sector cannot print its own money to service its debt.  The public sector can not only print money to service its debt, but it can use coercion to force compliance.  That is why government debt is a profoundly different risk to the economy; a large deficit is mostly an inflation risk, not a default risk.  When the private sector deleverages, it must either write down the debt (harming creditors) or create increased saving (harming debtors).  The current expansion is long in duration but growth has lagged previous growth periods in part because of deleveraging.  The above data suggests that the private sector has mostly stopped reducing debt relative to the economy but isn’t releveraging, which would tend to increase growth.

The other chart we closely watch is net saving by sector.

The chart on the left shows net saving by the four sectors of the economy—business, households (which represent the domestic private sector), government and the foreign sector.  They have been scaled to GDP.  Business saving is revenue less investment.  Household saving is income less consumption.  The government sector is the fiscal balance and foreign saving is the inverse of the current account.  For macroeconomic accounting, the four act like a balance sheet—the net sum always equals zero.  For the past few quarters, saving by sector has been mostly steady.  The combination of domestic private sector saving and foreign saving has been balancing the government’s deficit.  That is best observed on the chart on the right side.

One of the less discussed ramifications of the current tax bill is that it is expected to raise the government’s deficit; in other words, government dissaving must rise.  This must be offset by either rising domestic private sector saving or foreign saving (in other words, a rising trade deficit).  One of the other policy goals of the Trump administration is to lower the trade deficit but the tax bill may actually foster a wider deficit.  At the same time, if the administration meets that goal, domestic private sector inflation must rise.  If it is to come from the business sector, investment must fall without a significant rise in business revenue.  Of course, rising business investment is a key goal of the tax bill.  The other way saving could rise is from higher household saving, but that would likely come from lower consumption which would weaken growth.  That’s why getting a revenue-neutral tax bill was so important.  If the tax bill were revenue-neutral and simply improved efficiency through tax reform, investment could rise and perhaps be funded without a drop in business saving due to higher revenue.

Finally, net worth of households has reached a new record high.

Household net worth is now 673.0% of after-tax income, a new record.  The current level reflects rising equity markets and improved housing prices.  The chart does indicate that this number tends to fall rather abruptly during recessions.  As we noted in our 2018 Outlook, we do not expect a recession next year so this ratio probably has further to rise.

Overall, the Financial Accounts of the United States paints a picture of stability and slow healing.  Saving and debt are stabilizing and net worth is rising.  We will be watching how the tax bill affect this stability in the coming months.

View the PDF

by Asset Allocation Committee

We have received a number of requests to update our S&P 500/Fed balance sheet model.

This chart shows the results from our S&P 500/Fed balance sheet model.  We have projected the model’s forecast using the expected path of balance sheet reduction.  It shows that the equity index tended to follow monetary policy from the end of the recession in mid-2009 until the election of President Trump.  Since the election, the index has far outperformed what the balance sheet model projects for fair value.

This model was always problematic, potentially a classic example of data mining.  The problem of data mining and the current discussion of “big data” get at the philosophical problem of “how do we know?”[1]  Our basic procedure when looking at correlations is to try to formulate a theoretical reason for why the correlation should exist.  Simply finding correlations, otherwise called data mining, is fraught with risk.  Some correlations are spurious—they develop almost by accident and fade over time.  Others are true as far as they go but can lead one to draw inappropriate conclusions.

This chart shows the relationship between ice cream consumption and drowning in 2006.  The relationship of these two variables is a common pedagogical tool when teaching statistics.  It is clear that a relationship exists between these two variables.  However, they share a common factor that is the likely cause of the correlation—summer!  If a policymaker neglected to take the seasonal factor into account, a case could be made for a tax on ice cream in a bid to reduce drownings.  It is almost certain such a policy would fail.

We have concluded that the most likely reason the Fed’s balance sheet was related to the S&P 500 was because it showed that the U.S. central bank still had effective tools to stimulate economic growth.  In other words, QE was mostly a confidence builder.  It appears that Trump’s promises of deregulation and tax cuts have replaced QE in supporting investor confidence and thus, the relationship has broken down between the Federal Reserve’s balance sheet and the S&P 500.

However, we would be remiss if we didn’t examine another element of the balance sheet relationship.  With globalized financial markets, it is also possible that the behavior of foreign central banks affects U.S. equities as well.  Combining the exchange rate-adjusted balance sheets of the European Central Bank (ECB), the Bank of Japan (BOJ) and the Federal Reserve, with projections based on policy guidance, yields the following model.

The BOJ’s balance sheet path is more difficult to project because Japan is now fixing the 10-year JGB interest rate and adjusting the balance sheet accordingly.  We have developed a projection but with less confidence than our estimates for the Fed and the ECB.  We are also assuming mostly steady exchange rates.  This model shows that the rise in the S&P 500 can be explained by the combined effects of balance sheet expansion from the Federal Reserve, the BOJ and the ECB.  It also suggests the upside is likely limited because the ECB will begin tapering next year and is projected to stop expanding its balance sheet by the end of Q3 2018.

Thus, one possibility is that continued balance sheet expansion by the BOJ and ECB has supported equities, offsetting the lack of Federal Reserve expansion.  If this is the case, then ECB tapering and the end of its expansion and the uncertainty surrounding BOJ expansion may become significant headwinds next year.  However, as noted above, we believe QE was mostly a confidence booster; there is little evidence it had much of an impact on the economy.  At present, tax cuts and deregulation have lifted investor sentiment and supported higher equity prices.  However, we will be watching to see whether the slow end of unconventional monetary policy abroad has an impact on equities next year.

View the PDF

---

[1] We discussed this issue at length in the summer of 2016.  See WGRs, Thinking about Thinking: Part 1, 8/15/16; and Part II, 8/22/16.