The Real Cause(s) of Stocks’ Big Stumble

Gleaned here and there as everybody is busy trying to figure out why equity markets finally behaved like equity markets:

• Previous to the correction, what was a positive development for Main Street—rising wages, low inflation, falling unemployment—was also promising for Wall Street. It meant, for example, that consumers enjoyed increasing income and with that a rising capacity to buy more of the things that Corporate America produced.
• But Mr. Trump is missing that faster growth requires a fundamental shift in the monetary policy of the past decade. In particular this means the looming end to the financial repression that the Federal Reserve has been practicing since the financial panic. In that sense this is the Ben Bernanke correction, as the Fed and other central banks unwind the former Fed chairman’s unprecedented monetary experiment.
• We are witnessing the beginning of the end of the radical monetary policies that brought interest rates down to zero—and in some cases, below zero—and flooded the global financial system with excess liquidity. That has resulted in the inflation of asset values and the subduing of market volatility. That, in turn, enriched investors and speculators. Until it didn’t.
• Jerome Powell formally took over the chairmanship of the Federal Reserve. And he is no clone of Janet Yellen, the recently retired chair, contends David Rosenberg, chief economist and strategist at Gluskin Sheff. “He is sensitive to the criticism of the Fed, that it is a serial asset-bubble blower. He is no fan of [quantitative easing] or ultralow interest rates. At his recent Senate confirmation hearing, he made it clear that it is time to normalize rates,” Rosenberg writes.
• Normalizing means a 2.75% rate for federal funds, which he notes is twice the midpoint of the current 1.25% to 1.5% target range for the Fed’s key interest-rate target. “This spells something more than two or three hikes this year, something I don’t think the stock market fully appreciates, but has begun to at least contemplate in recent weeks (which is why we have begun to see this intense volatility).” Reduced liquidity more than offset strong fundamentals in 1987, 1994, 1998, and 2007, which saw steep market drops.
• The specter of twin deficits—on trade and the budget—has begun to stir the long-dormant bond vigilantes, who had little appetite for the Treasury’s auctions of 10- and 30-year paper last week. Indeed, the striking aspect of the market’s turmoil was the lack of a rally in government bonds, which failed to see a flight to quality from investors fleeing riskier assets.
• The recent market volatility seems to be a result of investors finally realizing that the business cycle isn’t dead. Later-cycle inflation is becoming more obvious, and the market has needed to recalibrate valuations, earnings expectations, and asset allocations to the suddenly “new” inflationary environment.
• While fears about inflation and rising bond yields have played a role, markets aren’t behaving as they usually do during big equity selloffs. That could point to a market still driven by the aftershocks of misfired bets on low volatility, rather than a reappraisal of the global economy.

The late-cycle is often characterized by economic growth that outstrips the growth in capital spending and causes production bottlenecks, and that certainly describes the current environment. Vendor delivery time is a simple indicator of potentially increasing inflation, and measures how long it takes for suppliers to fulfill orders. Longer fulfillment times indicate that demand is greater than available supply, and that prices could increase.

Chart 3 is RBA’s indicator of vendor delivery time, which incorporates common delivery statistics. Vendor delivery times have been increasing and normal cyclical bottlenecks are forming. That implies further upward pressure on the CPI. (Richard Bernstein)

• US PMI signals further inflationary pressures lie ahead

I have been pointing to deteriorating vendor delivery capability in recent months. PMI surveys are both timely and direct from the horse’s mouth.

(…) Although 2017 fourth quarter US GDP growth was weaker than that of the third quarter, domestic demand growth accelerated and January PMI data indicate that demand pressures in both manufacturing and service sectors are above their respective long-run averages.

PMI indicates strong and accelerated demand growth

Meanwhile, PMI data point to increasingly elevated cost pressures. The US manufacturing PMI Input Prices Index registered 58.5 in January to signal a sharp pace of inflation, broadly in line with the strong annual growth observed in the official purchasing prices index.

The combination of strong demand and rising costs is encouraging firms to raise output prices, which could spur inflation higher. In fact, with deteriorating supplier delivery times and rising input costs, overall price pressures look set to build even further. As evidenced by the chart, greater costs in tandem with supply chain pressures usually feed through to consumer prices.

Production costs inflate sharply

Supply-side pressures intensify

To that end, mounting price pressures and robust demand questions how much further economic growth can continue before inflation begins to edge into unwanted territory for monetary policymakers.

(…) according to IHS Markit Manufacturing PMI data, the recent uptick in US 10-year Treasury yields is a fair reflection of economic fundamentals.

PMI supports higher bond yields

Overall, strong demand coupled with intensified cost pressures was observed across both surveyed sectors, according to January PMI data. The median member of the Federal Reserve Open Market Committee expects 3 rate hikes in 2018. If demand and supply-side pressures are to mount further, questions will be raised as to whether the Fed should seek an even quicker rate of policy normalisation to prevent the US economy from overheating.

In case you forgot, there were 5 corrections between 2010 and 2016 as Doug Short illustrates:

“The last correction came in February 2016, when stocks dropped 15%. Investors then fretted that Chinese economic growth might be slowing, which turned out to be a false alarm.” But inflation was rising in early 2016 and profits were weakening, a tough combo for investors.

Inflation was also rising swiftly in 2011, more than offsetting rising profits. In 2015, inflation was declining while profits were rising.

Inflation, profits rising or falling, corrections eventually occur.

The Rule of 20 Fair Index Value (yellow line below) simply plots a value for the S&P 500 Index using {trailing EPS X (20 minus inflation)}. At the time of all 4 recent corrections, the Rule of 20 Fair Value was flattening (2010, 2011, 2015) or declining (2016), indicating flat or declining momentum to feed investors’ sentiment.

This time, the Rule of 20 Fair Value is rising very strongly owing to a powerful boost to earnings from near-15% growth in Q4’17 EPS accelerating to +15.7% in Q1’18 and +18.5% estimated for all of 2018 with about a third of the growth stemming from the tax bill. Unless inflation also accelerates sharply, this very strong profit backwind should help prevent much more damage unless credit accidents erupt, something the High Yield market, generally quick to smell rats, is currently not pricing in, unlike in previous equity corrections. Hopefully, there is nothing ugly to pop from this correction, particularly from counterparties to all these “fancy” VIX, ETF and ETN products (see end of post).

• Corporate Bonds Beg to Differ with Their Equity Brethren

(…) Corporate credit’s comparative calm stems from expectations of continued profit growth that underpins a still likely slide by the high-yield default rate. (…) Since the VIX index’s current estimation methodology took effect in September 2003, the high-yield bond spread has generated a strong correlation of 0.90 with the VIX index. However, for now that ordinarily tight relationship has broken down. Never before has the high-yield bond spread been so unresponsive to a skyrocketing VIX index. (…)

The comparatively unperturbed and still atypically thin corporate bond yield spreads suggest that the latest sell-off of equities is overblown from the perspective of fundamentals. Perhaps the high-yield bond spread correctly senses that Treasury bond yields are not about to remain at levels that suppress interest sensitive business activity.

However, the failure of Treasury yields to drop sharply in response to deep equity market sell-offs increases the risk of a climb by interest rates that curbs interest-sensitive spending. Thus, the upcoming peak spring selling season for housing may have much to say about where both interest rates and share prices are headed. A subdued pace for home sales might well establish a top for 2018’s 10-year Treasury yield.

The 10% drop by the PHLX index of housing-sector share prices since January 26 may be warning of a disappointing pace for home sales. The possible combination of softer home sales and fewer auto sales would favor a less-than-3% peak for the 10-year Treasury yield. (…)

Typically, swift rises in mortgage rates rapidly impact the housing market. It did in the fall of 2010 (+100 bps), the spring of 2013 (+100 bps), the spring of 2015 (+50 bps) but not in the fall of 2016 (+90 bps). We have had a 55 bps rise since September 2017. Was November the peak in housing?

Car sales also appear to be peaking out.

Financial markets generally feed on momentum. The U.S.manufacturing PMI could hardly get much better…

…while the much larger Services sector is decelerating…

…resulting in a Composite PMI that signals no acceleration in GDP growth:

And, by the way, with a 2.6% savings rate and rising short-term rates, it seems unlikely that American consumers will keep spending as aggressively as during the second half of 2017. The savings drawdown coupled with the post-hurricane necessary outlays have no doubt impacted Q4 economic stats as well as corporate revenues and profits.

30Y Treasury yields troughed at 2.1% in July 2106, rose to 3.2% after the elections, dropped back to 2.7% in December and jumped back up to 3.15% last week.

Looking at the chart above, many would say “What’s the big deal?”

This time, the precipitating factor appeared to be relatively benign: an uptick in wage gains in a strengthening labor market.

• The labor market is not strengthening:

  

• Wage growth is not accelerating for the mass of workers:

The highlight of the report was the sharp acceleration in wage growth, with average hourly earnings rising 2.9% year-on-year (y-o-y), the highest rate since 2009. But the wage gains were not broad-based. Manufacturing workers, for instance, saw only +1.9% y-o-y growth in wages. More broadly, production workers’ earnings rose 2.4% y-o-y, barely above the one-year average of 2.3%. (Pictet)

Production workers account for 80% of the work force so the bulk of workers have yet to see their wages accelerate. The challenge to profit margins is not happening just yet to incite corporate executives to aggressively push through their cost increases.

This Wednesday is an important day with the release of U.S. retail sales along with CPI data for January. Strength in both series would feed the inflation scare. And while I have been warning that investors were too complacent about inflation, the current evidence does not support runaway inflation that would more than offset the strong profit trend.

• Commodity prices are not running wild and world demand is not any stronger than it has been this cycle:

(charts from Ed Yardeni):

• MIT tracks prices on the internet in real time. Its “Billion Prices Index” has tracked CPI (blue line) closely, currently suggesting that CPI will decelerate:

(via Financial Sense)

• Inflation from Shelter (34% of total CPI) rose 3.2% in 2017 (total CPI: +2.1%) and +4.1% annualized since July 2017. Raymond James sees a “deluge of new apartments” starting in Q1’18 which should impact rents across the U.S. and, by ricochet, new housing demand.

• Energy prices could also help (charts from The Daily Shot):

  

• And there is still an Amazon effect:
• Amazon Is Turning These Four Cities Into Grocery Battlegrounds

• Amazon to Launch Delivery Service That Would Vie With FedEx, UPS

There is thus a case for a fading of the current inflation scare which would ease pressures, at least temporarily, on interest rates, long and short.

Meanwhile, the Q4’17 earnings season keeps rolling with more than two-thirds of the S&P 500 companies having reported, sporting a 74% beat rate and a +4.1% surprise factor that should provide for a 14.7% EPS growth rate for the quarter (+12.7% ex-Energy).

The beat rate on revenues is even more impressive at 79%, well above the 60% long-tem average. Revenues are expected up 8.0% in total, +6.9% ex-Energy!

Moreover, 38 out of the 83 companies that offered guidance for Q1’18 guided positively. This 46% positive guidance ratio is well above the 28% and 31% ratios at the same time in Q1’17 and Q4’17 respectively and nearly double the 26% long-term average.

Analysts are thus enthusiastically upping their estimates for 2018, partly because of the favourable economic background but also because of the tax reform which “automatically” adds a 6-8% boost to 2018 earnings.

Trailing EPS are now $132.84, up 12.1% YoY and +3.6% from their level 3 months ago (+15.2% a.r.). If we pro forma for a 7% average tax effect, trailing EPS rise to $142.14, a more appropriate number to value equities currently.

The Rule of 20 P/E is now 20.2, a smidge above the “20 fair level” and no longer into high risk area. After Q1’18, if analysts are right, trailing pro forma EPS would rise to $145.00 which would bring the Rule of 20 P/E to 19.8 (chart below).

This dip does not make equities bargain buys but it brings them back to their median valuation per the Rule of 20 which, unlike the traditional P/E ratio, takes low inflation into account.

The actual P/E on the $145 pro forma Q1’18 trailing EPS is 18.0, still measurably higher than its long-term median and average of 16. It is only if one stops history at 1993 that one can qualify P/Es as “reasonable” given the 20.8 median and average of the last 25 years, a period which, it should be said, includes 7 years of truly obscene P/Es.

Using forward EPS of $156 for 2018, equities sell at 16.8 times, still above their 13.8 LT average (since 1953) but in line with their last 25-year average (with the same important caveat as above).

If this correction ended now, we would again reset history with a 13-day correction (see Ed Yardeni’s chart below). Previous “flash” corrections were 18 days in 1955 (-10.6%), 20 days in 1997 (-10.8%), 21 days in 1946 (-10.1%), 23 days in 1936 (-12.8%) and 28 days in 2011 (-9.8%).

• All these flash crashes except 1946 occurred when inflation was slowing and profits were rising.
• All these flash crashes troughed at their rising 200-day m.a. (current: 2537).

Sentiment has declined, but mainly among the smaller investors (AAII chart) who, coincidentally, bought some $100 billion worth of equity funds in January. They must be rethinking the wisdom of these purchases.

To watch in what will surely be a much more volatile world:

• Inflation data.
• High yield securities.
• The bond market ( see John Mauldin’s excellent piece on Saturday: Where Will We Get the Cash?)

FYI, Lowry’s Research remains a LT bull but awaits evidence that “this selling has driven prices low enough to generate the enthusiastic buying needed for a sustainable rally.”

More FYIs:

• Two Years After Meltdown, Third Avenue Fund Drops Again

Third Avenue Management LLC’s Focused Credit Fund imploded in late 2015 when credit markets turned rocky. On Wednesday, Third Avenue told investors it marked down the value of its remaining positions by more than 50%. (…)

“This evening, the fund’s published net asset value was $0.51, a reduction of $0.61 from its previous net asset value,” Third Avenue wrote in its Feb. 7 letter to investors.  “At this time, because of our confidentiality obligations, the fund is extremely limited regarding the information it may disclose regarding the NAV change. We will provide additional information when we are permitted to do so.” (…)

The fund managed $132 million as of Dec. 31, some 40% of which was cash.

The fund’s largest remaining position, accounting for more than 58% of its assets as of December, was in Ideal Standard International SA, a Belgian maker of bathroom sinks and fixtures. (…)

Third Avenue wrote that it would tell investors how it plans to return its remaining cash “within the next several months.”

So, the fund had cash and only one position in Idea Standard, obviously not standard for the industry nor ideal for investors. Third Avenue managers were way too literal with their sinking Focused Credit Fund. If and when cash finds its way back, investors would be wise to seek other avenues…

• Investors Are the Guinea Pigs in U.S. Fiscal Experiment 

• U.S. Budget Director Warns Interest Rates May ‘Spike’ on Deficit

• Goldman’s Shocking Capitulation: The Buy-The-Dip Era Is Dead, “This Is A Genuine Regime Change”

• The Tax Law Is About to Make Analyzing Earnings Trickier The new U.S. tax law could throw a monkey wrench into a method many analysts and investors use to gauge the strength of companies’ earnings.

A provision of the tax overhaul enacted in December assesses a one-time tax on companies’ accumulated earnings from outside the U.S. But while the tax is typically charged to companies’ 2017 earnings, firms have the option of stretching the actual tax payment over the next eight years, interest free.

That decision, which companies need to make this year, could throw off the comparison of a company’s earnings to its cash flow, a traditional way of assessing earnings quality. (…)

Under the law, companies can make payments over eight years on a back-loaded schedule that puts the maximum burden, 25% of the total, in year eight. (…)

The disconnect between earnings and cash flow will force analysts and investors to do some reverse-engineering of company numbers to make sure they’re comparing apples to apples. If they don’t do so—or are unaware of the need to—they could be misled. (…)