Strategy: Draining the Swamp

Joe and I are hoping that the stock market bull will celebrate his eighth anniversary by taking a rest. As you get older, it’s not healthy to be sprinting. It makes more sense to jog at a leisurely pace. Taking regular naps is also widely recommended by health professionals for older folks. Presumably that advice applies to all aging animals.

The bull obviously got recharged by the animal spirits unleashed following Election Day. Undoubtedly, investors got into the spirit as well on expectations that Trump’s Electoral College win along with the Republican majorities in both houses of Congress would allow the new administration to charge ahead with its program, particularly deregulation and tax reform. So far so good on the former, but the latter is on hold while Washington focuses on Affordable Care Act repeal and replace (ACA-R&R). Trump has declared that he intends to drain the swamp. Doing so is already proving to be hard and tedious work. The bull may also find it hard to charge ahead in the swamp water.

Melissa is our resident Washington watcher. Her theory is that Trump doesn’t care if the GOP’s healthcare bill doesn’t pass through Congress. If R&R fails to happen soon, he won’t press the issue. He’ll let it go and move on to tax reform under a 2018 budget resolution, which is being worked on behind the scenes as ACA-R&R takes center stage and flounders. Trump will be happy to let Obamacare implode on its own. Politically, Trump still can say he made ACA-R&R his first priority to protect healthcare for Americans, as he promised during the campaign. He can later also say “I told you so” to Congress once Obamacare totally implodes. “It could self-repeal in this scenario,” says Melissa. “Then Congress will have no choice but to replace it.”

Melissa’s theory is backed up by a 3/9 CNN report: “In an Oval Office meeting featuring leaders of conservative groups that already lining up against House Republicans’ plan to repeal and replace Obamacare, President Donald Trump revealed his plan in the event the GOP effort doesn’t succeed: Allow Obamacare to fail and let Democrats take the blame, sources at the gathering told CNN.” Sources said that Trump strongly expressed that now is the chance for repeal and replace.

Trump’s secret ploy has been hidden in plain sight. In his 2/24 Conservative Political Action Committee speech, he stated: “[F]rom a purely political standpoint, the single best thing we can do is nothing. Let it implode completely, it's already imploding. You see the carriers are all leaving. I mean, it's a disaster. But two years, don't do anything. The Democrats will come to us and beg for help, they'll beg and it's their problem. But it's not the right thing to do for the American people, it's not the right thing to do.” So either Trump will get a plan that might work, or he’ll get zippo and let the Dems take the fall if Obamacare continues to implode.

Trump must know—because the stock market has been telling him so—that his big win would be tax reform. Market commentators have been baffled as to why the administration has put ACA-R&R ahead of tax reform. The answer is to get ACA-R&R out of the way whether it passes or not. Either way, we expect tax reform to remain on the timeline that officials have been signaling, which is to finalize writing it over the summer.

CNN also reported that on Monday, Breitbart News escalated its battle against House Speaker Paul Ryan by publishing audio of Ryan saying in October that he is “not going to defend Donald Trump—not now, not in the future.” The website, which was previously run by current White House strategist Steve Bannon, has blasted the House GOP’s plan as “House Speaker Paul Ryan’s Obamacare 2.0 plan.” Bannon certainly won’t shed a tear if Ryan sinks in the swamp along with the current ACA-R&R bill.

The good news is that while the bull may be forced to nap on high ground surrounded by the swamp as Trump tries to drain it, the economy and earnings may continue to thrive on animal spirits. In the next section, let’s examine the latest survey of small business owners. Then let’s see if animal spirits are having any impact on earnings.

US Economy: Small Business Owners Remain Upbeat. Of all the so-called “soft data” showing the surge in animal spirits following Election Day, the survey of small business owners (SBOs) conducted by the National Federation of Independent Business (NFIB) certainly stands out. That matters a great deal for the economy, since SBOs account for lots of employment and business spending, as we have previously shown on numerous occasions. If they are happy, that augurs well for the economy.

As Debbie discusses below, the NFIB survey’s optimism index jumped from 94.9 during October to 105.9 during January, and edged down to 105.3 last month (Fig. 1). The past two months are the best readings since December 2004. There was a dip in the percentage of SBOs saying that the number one problem they face is government regulation to 18.2%, the lowest since November 2011 (Fig. 2). Taxes remain their number-one problem, with 21.0% saying so last month, but that could change for the better if Trump succeeds in cutting the corporate tax rate. This rate is probably effectively higher for SBOs than large corporations, which have more resources for gaming the tax system to their advantage.

Let’s take a deeper dive into the survey, which is much more fun than doing the same into Washington’s swamp:

(1) Future looking up. When I was an undergraduate at Cornell, I read a novel by a former Cornelian, Richard Fariña, titled Been Down So Long It Looks Up to Me. Sadly, he died in a motorcycle accident two days after his book was published by Random House. But I digress. SBOs have been mostly depressed during the current economic expansion, but now are looking up again. The percentage expecting better rather than worse business conditions six months ahead was mostly negative since 2009 (Fig. 3). This diffusion index shot up from -7.0% during October to 47.0% in February. The net percentage expecting higher real sales in six months jumped from 1.0% during October to 26.0% during February (Fig. 4).

(2) Expansion plans. That’s influencing SBOs’ decisions to expand over the next three months, with this diffusion index jumping from 9.0% during October to 22.0% last month (Fig. 5). That’s great news. However, their new number-one problem may be finding workers. During February, 32.0% of SBOs said that they have one or more job openings, the highest since February 2001 (Fig. 6).

(3) Full employment. Last month, the percentage of SBOs with positions that they were unable to fill, based on the three-month average of this volatile series, rose to 30.7%, also the highest since February 2001 (Fig. 7). This series happens to be highly inversely correlated with the official unemployment rate, which has been below 5.0% for the past 10 months. In other words, it is confirming that the economy is probably at full employment.

Earnings: Industry Analysts More Bullish. There are plenty of other soft data showing animal spirits, including surveys of consumer confidence, purchasing managers, and regional businesses. February’s better-than-expected increase in employment measures was widely attributed to mild weather boosting construction payrolls.

Meanwhile, our Boom-Bust Barometer (BBB), which is the ratio of the CRB raw industrials spot price index to initial unemployment claims, continues to boom (Fig. 8). Debbie and I consider it to be one of the most reliable, high-frequency, hard-data business-cycle indicators. It has gone almost rocket-ship vertical since bottoming during the week of January 16, 2016. It is up 50% through early March.

Our BBB is based on hard rather than soft data. The S&P 500 stock price index has been highly correlated with it since 2000 (Fig. 9). That’s because our BBB has been highly correlated with S&P 500 forward earnings (Fig. 10). Needless to say, it is wildly bullish for earnings and for stocks, though it does tend to be more volatile than both. For now, S&P 500 forward earnings continues to climb into record-high territory.

Let’s review the latest data:

(1) Looking at forward earnings. S&P 500 forward earnings remained at a record high of $133.99 last week (Fig. 11). This metric is a good year-ahead leading indicator of four-quarter trailing earnings, as measured by Thomson Reuters, with just one important proviso: It doesn’t anticipate recessions. As the year progresses, it will converge toward the analysts’ consensus expected earnings for 2018 (Fig. 12). Their 2018 estimate has been remarkably stable since Election Day around $146 per share, while the 2017 estimate has continued to decline, as is typical for annual estimates.

Industry analysts may be assuming that Trump’s tax reform will boost earnings in 2018. Joe and I are still estimating $143 per share for this year’s earnings and $150 for next year. If the corporate tax cut doesn’t hit until next year, then this year’s figure will be around $130 and next year’s will still be $150, in our opinion. As we’ve previously written, the timing shouldn’t matter much, since by the time we know whether tax reform is or is not retroactive to 2017, the market will be focusing increasingly on 2018. (See YRI S&P 500 Earnings Forecast.)

(2) Looking at forward revenues. S&P 500 forward earnings is rising in record-high territory because forward revenues is doing the same (Fig. 13). Analysts are expecting revenues per share to rise 5.7% in 2017 and 4.8% in 2018. The estimates for both years have been holding up quite well in recent weeks. While a cut in the corporate tax rate directly boosts earnings, it can have only an indirect impact on revenues. In other words, some of the animal spirits in next year’s consensus earnings estimate may reflect a more constructive outlook for the global economy, which drives revenues.

(3) Looking at 2017 earnings. The one downer in the weekly data that Joe and I track is the 3.5% drop in the consensus estimate for Q1-2017 since the beginning of the year (Fig. 14). This is a typical occurrence, and typically sets the upcoming earnings season for an upside “hook” once the actual results are reported. In any event, industry analysts currently predict that 2017 earnings will be up 10.7% over 2016, with the following quarterly profile: Q1 (9.5%), Q2 (8.5), Q3 (9.0), and Q4 (13.0). Of course, if the price of oil continues to drop, that could weigh on earnings, though not as much as during 2015.

Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.