The Dow Jones Industrial Average, Nasdaq Composite, and S&P 500 have all shown resiliency in the face of lackluster earnings and tumultuous events abroad and a U.S. election campaign that has featured uninspiring behavior by both candidates leaving us with a choice between two “deplorable” candidates.
The gains so far this year are not huge when viewed in isolation, yet when pitted against a period of six straight quarterly declines in S&P 500 earnings, they look “yuuge” as one presidential candidate might be inclined to say.
It has been a remarkable show of strength considering those record highs were also established on the other side of real GDP growth averaging less than 1.0% in the first half of the year, UK voters shocking the world with a majority decision to leave the European Union, and both presidential candidates exhibiting an inclination to favor protectionist trade practices.
Ah, but the idiom holds true that the devil is in the detail.
The Fed’s Policies Have Left Us to believe that There is No Alternative to Stocks: The T.I.N.A. Trade
“We stand ready to do more if necessary.”
Sound familiar? It should.
That has been the guiding mantra of central bankers around the world and it is a declarative statement, combined with the persistence of low policy rates that has underpinned the stock market during a fundamentally challenging time that has featured weak economic growth and no earnings growth.
The European Central Bank (ECB) and the Bank of Japan (BoJ) have worn out the aforementioned line. The Federal Reserve uses it more these days in an obligatory fashion. Its preferred path — we think — is to raise the fed funds rate as soon as it is convinced the data suggests it should.
Anyhow, if the Fed truly has to do more before it does less, the world isn’t likely to be in a happy place.
That understanding boils down to two considerations: (1) increasing policy accommodation would occur only after another nasty downturn in growth and/or inflation, which would (and should) have all investors on edge and (2) market participants are already starting to question the effectiveness of the Fed’s policies to date and whether doing more would (or could) even make a difference.
Why, then, has the stock market hit new record highs? In one sense, it has almost been forced to by the persistence of low interest rates.
That condition has forced investors to seek higher rates of return outside the Treasury market where the yield on the benchmark 10-yr Treasury note languishes below 2.0%.
Accordingly, REITs, utilities, telecom services, consumer staples companies, and basically just about anything with a dividend yield above 2.0% has been the beneficiary of a forced march driven by the Fed’s monetary policy.
That move has inflated the major averages without any corresponding earnings growth. That’s a sad reality, because it demonstrates how the Fed’s monetary policy has facilitated the disavowal of fundamentals in many instances in favor of money flows.
It is the essence of the so-called TINA trade.
Reasons and Risk
It’s a blind trust of a different sort. Market participants are blindly accepting, as they have for years now, that the persistence of low rates is going to be the ticket to escape velocity for the U.S. economy and a halcyon period of robust earnings growth.
That’s why many have been undeterred by the prolonged period of negative earnings growth mentioned above and a market valuation that is stretched at 25.1 trailing twelve-month GAAP earnings and 22.2x trailing twelve-month operating earnings.
The Shiller PE ratio, which is based on average inflation-adjusted earnings from the previous 10 years, stands at 26.5x today versus 27.3x just before the stock market peak in October 2007. Granted interest rates are lower today than they were then, yet interest rate risk is even greater today than it was then.
Long-term rates are at generational lows.
The Fed would like to raise its policy rate, and there is a burgeoning sense that the ECB and BoJ have effectively reached policy limits with their asset purchase programs, which could lead to some upsetting adjustments at the back end of sovereign bond curves that have the potential to create some real fits for global equity markets.
There has been a taste of that potential upset more recently after the ECB held off on increasing the size of its asset purchase program. Further upset could occur if the BoJ does the same.
Bond markets aren’t in a comfortable place right now and they pose a real risk factor for the stock market in the second half of the year if they become unhinged, leading to a jump in long-term rates for the wrong reasons.
The stock market could probably tolerate long-term rates going up gradually for the right economic reasons (i.e. faster growth and a gradual pickup in inflation), but if they go up for the wrong reasons (i.e. reverse money flows driven by a loss of faith in central bank policies), that would trigger insecurities and valuation concerns that would be resolved with lower equity prices.
Data Needs to Deliver
It is becoming increasingly important for the economic data to start validating the growth assumptions embedded in highly-valued stock prices. That would not only temper the market’s concerns about monetary policy being feckless, it would also spur a belief that companies will indeed have the earnings to justify some lofty earnings multiples.
At the moment, the consensus estimate for third quarter earnings calls for a 0.7% decline year-over-year. That compares to a prior growth estimate of 2.2% seen on July 1.
On the oft chance readers don’t see the disconnect between that fundamental reality and the market reality, bear in mind that the S&P 500 climbed to a new record high as the third quarter, fourth quarter, and calendar year 2016 earnings per share growth estimates were all being revised lower.
|Period||Jan. 1||April 1||July 1||Today|
(Source: S&P Capital IQ)
It did so on the persistence of low interest rates, the belief central banks won’t be withdrawing their accommodation anytime soon, and a nod to calendar year 2017 when S&P 500 earnings are expected to be up 13.8%, according to S&P Capital IQ.
The key to all things GDP will continue to be consumer spending, which accounts for close to 70% of real GDP.
If consumers start spending more of their increased wages, as opposed to saving them or using them to pay down debt, and show an increased willingness to take on new debt, a virtuous cycle could take root that has higher consumer spending leading to higher levels of business investment, increased lending activity, and increased global trade predicated on the world’s largest and most influential economy flexing some recovery muscle.
The Atlanta Fed’s GDPNow model forecast currently shows third quarter real GDP increasing at a seasonally adjusted annual rate of 3.0%. That would be the highest growth rate since the third quarter of 2014.
There have been periods since the financial crisis when real GDP growth has exceeded 3.0%. The problem is that it hasn’t been sustained. To wit, real GDP growth in the fourth quarter of 2014 dipped to 2.3% and it hasn’t exceeded 2.6% in the last six quarters.
So, one might need to hold their enthusiasm for real GDP growth in the third quarter that has a 3-handle on it until it can be seen if real GDP growth for the fourth quarter also sports a 3-handle (or better).
That won’t be an easy hurdle given the uncertainty surrounding the presidential election, which falls smack in the middle of the fourth quarter and is being discussed today as an impediment for business investment.
What It All Means
The market’s valuation is stretched, political uncertainty is high, global economic growth remains weak, and the central bank security blanket that has warmed the market time and again is starting to get frayed around the edges.
All things considered, however, the stock market continues to hang in there, propped up by money flows that have been driven by the artificial persistence of low rates and performance chasing by money managers and investors not wanting to miss out on further gains should the central bank put remain intact.
In thinking of the stock market, we can’t help but evoke the image of a devil sitting on one shoulder and an angel sitting on the other.
The devil is telling investors they can’t go wrong and to keep buying stocks because money flows driven by easy monetary policy matter more than fundamentals. The angel is telling investors not to abandon their moral investing compass and that stocks should be bought and sold based on fundamentals.
It’s hard not to listen to the devil. Just know that you are playing with fire with the money-flow trade, because those flows aren’t fundamentally-based in many instances.
They have created crowded trades in a number of areas that could get less crowded in a hurry if the rationale for those money flows breaks down.
From our vantage point, the fundamentals have yet to validate the stock market’s performance. Earnings growth remains elusive, productivity growth is weak, and valuation is stretched.
Against a fundamental backdrop like that, there is no basis for the stock market to log large gains. One could go so far as to say there is no basis for logging any gains, but as this market has shown, money flows can trump fundamentals as a primary driver.
The devil right now is in the detail of the Fed’s monetary policy and participants giving in to the temptation to ride it for all of its artificial worth. It’s hard to fight that temptation, but over time, you always get tripped up dancing with the devil.
This is a challenging time for investors and a crucial time not to lose sight of the fact that long-term investing salvation comes from staying the fundamental course when making decisions to buy and sell stocks.
I look forward to catching up with you soon!
John P. Swift, CFA, CPA
Chief Investment Officer & Managing Partner