Strategy I: Flash Crash? Joe and I are still bullish on stocks, but experiencing whiplash from watching February’s wild market action so far. We attribute most of it to computerized trading systems and a flash crash in some cockamamie algorithm-driven ETFs. We remain focused on the outlook for earnings, which remains fundamentally sound for stocks, in our opinion.
With the benefit of hindsight, we are thinking that perhaps the meltup scenario in the S&P 500, which we had been anticipating since early 2013, might have ended at this year’s January 26 record high, when the index was up 57.1% measured from February 11, 2016 (that year’s low) (Fig. 1). The forward P/E of the S&P 500 stock price index rose from 14.8 to 18.6 over this period (Fig. 2). It then plunged back to 16.3 this past Thursday. That’s a significant meltup and meltdown in the P/E.
Joe and I are experiencing future shock. At the start of this year, we thought that the meltup might be sustainable for a while since it was driven by rapidly rising earnings expectations following the December 22 passage of the Tax Cuts and Jobs Act (TCJA). Last year, in our 9/6 Morning Briefing, we did mention the possibility of a meltdown led by an ETF flash crash, but it took us by surprise when it happened in February despite all the giddiness over the outlook for earnings. We still are giddy about the earnings outlook meltup.
Now that the market’s meltup/meltdown scenario may have played out, what’s next? We are lowering the odds of another meltup in stocks to 30% from the 70% meltup odds we have held since January 16 (when we had raised the odds from 55%). We are keeping the meltdown scenario at 25%. So the odds of a more leisurely paced bull market are now the greatest of the three scenarios, at 45%, in our opinion.
Consider the following:
(1) From meltup to meltdown. The S&P 500 hit a record high of 2873 on January 26 (Fig. 3). That put the index up 7.5% ytd, 25.1% y/y, 7.1% since the December 22 tax cut, and 34.3% since Trump was elected POTUS. It then experienced a flash crash, which brought it down 8.8% through Friday’s close. It is now down 2.4% since the tax cut, but up 22.4% since Election Day 2016.
(2) Another tightening tantrum. Granted, there were some good fundamental reasons for the plunge, which was triggered by the February 1 Employment Report showing a pickup in wage inflation. January’s average hourly earnings rose 2.9% y/y, the fastest pace since June 2009 (Fig. 4). However, the same measure for production and nonsupervisory workers rose only 2.4%. Nevertheless, the report triggered another “tightening tantrum” on fears that the Fed will raise interest rates at a faster pace. A similar tantrum occurred at the start of 2016.
Back then, both the 10-year Treasury bond and TIPS yields actually fell (Fig. 5). This time, both yields have risen sharply since the start of the year. The spread between the two, which is widely viewed as a proxy for expected inflation, fell in early 2016 (Fig. 6). It has been rising during the current tantrum. That’s because the labor market is tighter now than it was back then, and fiscal policy has turned much more stimulative, as discussed below.
(3) Hitting the 200-dma. On January 29, the S&P 500 exceeded its 200-day moving average by 13.5%, the greatest divergence since February 2011 (Fig. 7 and Fig. 8). On Friday, the index fell slightly below this average on an intraday basis but then rallied dramatically by the end of the day to close slightly above this average. Could it be that computer trading algorithms precipitated the recent freefall in stock prices, but will reverse course now that the S&P 500 has held its 200-day moving average? We think so, but Joe and I are fundamental analysts, not chart-watching technicians. So we take more comfort in the strong outlook for earnings.
(4) Earnings continue to melt up. While the S&P 500’s forward P/E took a dive, the forward revenues and earnings of the S&P 500 companies continued to rise to new highs last week (Fig. 9). Again, we are especially impressed by the strength of the former since it shouldn’t have much to do with Trump’s tax cut, unless industry analysts have all turned into supply-siders, believing that lower tax rates in the US will boost sales. Our hunch is that the strength in revenues expectations is attributable to strong global economic growth.
The time-weighted average of analysts’ consensus expected operating earnings for this year and next year rose to a record $158.70 during the February 8 week. Over the past eight weeks since the enactment of the TCJA, analysts have raised their 2018 and 2019 earnings estimates for the S&P 500 by $10.62 to $156.88 and $11.60 per share to $172.67, respectively, implying growth rates of 18.5% and 10.1%.
Strategy II: Swans & Potatoes. Now let’s consider some of the fundamental risks to the bull market. While the recent correction came as a surprise, it wasn’t attributable to a Black Swan event. Such events are deemed to be total surprises, springing from conditions that materialized out of the blue. It is no surprise that the Fed is normalizing monetary policy. It is no surprise that the labor market is tight. It is no surprise that Trump’s agenda will provide a great deal of fiscal stimulus from tax cuts, and more spending on defense and infrastructure. The jury is still out on whether all that fiscal stimulus will revive inflation. Debbie and I don’t think so, but the Bond Vigilantes are saddling up. Let’s have a closer look at the monetary and fiscal policy issues that may be behind the recent selloff in the stock market:
(1) Dudley’s small potatoes. Among the worst days for the stock market this month was last Thursday, when the Dow dropped 1033 points. It was the second-worst single-day point drop in history, beaten only by the record set after last Monday’s 1175-point drop. FRB-NY President Bill Dudley might have contributed to the selloff that day when he said in a Bloomberg interview that recent market moves are “small potatoes.” He added, “The little decline that we’ve had in the equity market today has virtually no implications for the economic outlook.” The market proceeded to give Mr. Dudley bigger potatoes over the rest of that day.
The big worry for the stock market is the bond market. As widely expected, the Fed remains on course to raise the federal funds rate three times this year from 1.50% to 2.25%. Perhaps even more troublesome is that the Fed started to taper its balance sheet last October at an announced pace that will reduce its holdings of US Treasury securities and mortgage-backed securities (MBS) by $300 billion over the current fiscal year (through September 2018) and then by $600 billion during the following fiscal years (Fig. 10 and Fig. 11). At this pace, the Fed’s balance sheet will be back down to where it was in August 2008 by June 2024 (Fig. 12). Over the 2018 and 2019 fiscal years, the Fed is scheduled to reduce its holdings of Treasuries by $540 billion and MBS by $360 billion (Fig. 13 and Fig. 14).
(2) Trump’s big potatoes. A related big worry for the bond market (and therefore the stock market) is that fiscal policy is turning extremely stimulative as a result of tax cuts enacted at the end of last year. Furthermore, deeply divided Republicans and Democrats in Congress set their differences aside last Wednesday. They agreed that the only way to avoid a government shutdown was to agree to spend lots more money, i.e., $300 billion over the next two years! This means larger deficits and raises the risks of overheating the economy with inflationary consequences.
The federal deficit, which was $666 billion (there’s that devilish number again!) during fiscal 2017, is set to widen again—back to over $1.0 trillion this fiscal year and next—just as the Fed is set to reduce its holdings of US Treasury securities by $180 billion this fiscal year and $360 billion in fiscal 2019 (Fig. 15). It’s no wonder that the Bond Vigilantes are getting agitated. Debbie and I are raising our 10-year Treasury bond yield forecast to 3.00%-3.50% for this year.
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.
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