Strategy: Finding the Signal
Joe and I were struck by a 6/6 Bloomberg article titled “Trade War Yanked $1.25 Trillion From U.S. Stocks, JPMorgan Says.” According to this story, “Derivatives analysts at the firm devised a technique [to] plot the approximate impact of newsflow in the trade saga, which began in March. They found that weeks of back-and-forth have pushed stocks down by a net 4.5 percent, nixing $1.25 trillion from the S&P 500’s market value.”
I guess we can blame Trump for that loss thanks to his protectionist saber-rattling. On the other hand, he deserves credit for enacting a HUGE corporate tax cut at the end of last year. We don’t recall a President who has been simultaneously so bullish and bearish for stocks. That might explain why the S&P 500 has been zigging and zagging since the start of this year (Fig. 1).
Joe and I aren’t going to quibble with the quants at JP Morgan. However, it is interesting to note that most of the cyclical sectors of the S&P 500 have significantly outperformed the interest-rate-sensitive ones so far this year (Fig. 2). Here is the ytd performance derby: Information Technology (13.6%), Consumer Discretionary (11.2), Energy (5.9), S&P 500 (3.9), Health Care (2.7), Industrials (0.4), Materials (0.2), Real Estate (-3.2), Utilities (-8.4), Telecom Services (-9.6), and Consumer Staples (-11.5). Now consider the following:
(1) Growth beating Value. The S&P 500 Growth Index, which has been outperforming the S&P 500 Value Index since roughly mid-2007, has been doing so at a faster pace so far this year (Fig. 3 and Fig. 4).
We think the market is telling us that the signal is earnings that have been supercharged by the tax cut, while the noise is protectionist saber-rattling. That’s been great for cyclical and growth stocks. The weakness in interest-rate-sensitive stocks is obviously related to the Fed’s ongoing normalization of monetary policy, which has boosted the bond yield back to 3.00% recently. The Fed is doing so because the US economy is doing well, which is bullish for cyclical and growth stocks.
From our perspective, protectionism hasn’t weighed on the market as much as the Fed has. Meanwhile, the global economy seems to be doing well enough to boost cyclical and growth stocks, notwithstanding protectionist saber-rattling.
(2) SMidCaps outperforming LargeCaps. Perversely, protectionism is actually providing a tailwind for the stocks of some companies. They are the ones that have relatively little exposure to the global economy. For example, the Russell 2000 SmallCap stock price index rose to yet another record high. It is up 8.9% ytd vs a gain of 4.2% for the Russell 1000 Large Caps ytd (Fig. 5 and Fig. 6).
(3) Copper heating up. Dr. Copper, the commodity with a PhD in economics, has been zigzagging since late 2017 (Fig. 7). However, it zagged higher last week. What it isn’t doing is taking a dive, confirming that the global economy continues to grow and that protectionism isn’t likely to become a significant drag on growth.
(4) Effective corporate tax rate takes a dive. The Fed updated its quarterly Financial Accounts of the United States last week through Q1-2018. Melissa and I immediately focused on Table 1.03 for nonfinancial corporations (NFCs). We calculated their effective tax rate and found that it had plunged 35.8% from 21.5% during Q4-2017 to 13.8% during Q1-2018 (Fig. 8).
The statutory corporate tax rate was cut 40.0% from 35.0% to 21.0%. You might be wondering why Q1’s effective tax rate was so much lower (at 13.8%) than the statutory rate (at 21.0%). The answer is that the pretax profits of NFCs (in both the Fed’s and the Bureau of Economic Analysis’ [BEA] accounts) includes the profits of nonfinancial S corporations. With an S corporation, income and losses are passed through to shareholders and included on their individual tax returns. So their profits are included in pretax profits, while their taxes are excluded from the taxes paid by NFCs.
(5) Forward earnings flying high. Meanwhile, analysts’ consensus expectations for S&P 500 revenues and earnings this year and next year continued to rise to record highs through the May 31 week (Fig. 9 and Fig. 10). The forward earnings of the S&P 500/400/600 all rose to record highs at the end of May (Fig. 11). They’ve been driven to new heights by the tax cut at the end of last year. They show no signs of flinching in reaction to protectionist saber-rattling.
(6) Bottom line. All of the above suggests that, despite the zigs and zags, the market has been picking up the strong signal of earnings for stocks in general and growth stocks in particular. It has also been tuning in to the signal that the Fed is sending about higher interest rates. The market has managed to tune out most of the protectionist noise, in our opinion.
US Economy: What Is GDPNow?
The Atlanta Fed’s (FRB-ATL) GDPNow forecast for real GDP growth during the current quarter was an impressive 4.8% as of June 1, which was lowered slightly to 4.5% by June 6, and then raised to 4.6% on June 8. However, many monthly data releases have yet to be incorporated into the overall forecast before the first official estimate by the BEA is released on July 27. Debbie and I don’t give much weight to the GDPNow estimates until about four weeks before the release, when they start becoming more accurate instead of skewing high. However, we do follow the trend of the revisions. Here’s more:
(1) GDPNow 101. About six or seven times a month, the FRB-ATL releases its GDPNow forecast for the next quarter’s real GDP. The forecast is based on 13 subcomponents of GDP. As macroeconomic data are released during the month, the GDP components are updated in the forecast. Econometric techniques are used to fill the gap when the next quarter’s data are not yet available for any of the subcomponents.
GDPNow is an entirely mathematical model, and as such, does not include any subjective components. It provides a very short-term view, becoming more accurate as more economic data are released and incorporated into the model. The FRB-ATL likes to think of GDPNow as a “nowcast,” or forecasting tool, rather than a forecast, an FRB-ATL economist explained in a video on the FRB-ATL’s GDPNow webpage. The FRB-ATL president issues a separate GDP forecast that is included in the FOMC’s quarterly Summary of Economic Projections, though his forecast is informed by the nowcast. Accordingly, the nowcast may influence the FOMC consensus forecast, since the committee’s policy meetings tend to occur prior to the release of the advance GDP estimate.
(2) More accurate later. We do not place a lot of weight on the accuracy of the GDPNow until about four weeks ahead of the BEA’s advance GDP release. That’s about when the accuracy of the nowcast stops improving, according to the FRB-ATL’s July 2014 white paper on the model (see the last chart in Section 4 titled “Root Mean Square Forecast Error of GDP Growth [SAAR]”).
The paper states that “it is probably safe to say that the GDPNow model forecasts are not as accurate as the best judgmental forecasts.” We are particularly mindful that, based on our observation, the initial GDPNow tends to be higher than the last one released for the quarter. On its website, the FRB-ATL displays its nowcasts by quarter for each of the release dates from initial to final.
For Q1-2018, for example, one of our accounts questioned why the nowcast released on February 2 seemed incredibly high at over 5.0%. That turned out to be a good observation. The first BEA GDP estimate released on April 27 was 2.3%, less than half the initial projection. Given the above, however, the inaccuracy isn’t surprising. On April 26, the final Q1 GDPNow was released at 2.0%, not far from the BEA’s advance estimate. The GDPNow forecast done a few weeks prior to the final release, on April 2, was also relatively accurate at 2.5%.
(3) Subcomponent insights. The GDPNow releases are accompanied by a breakout of the subcomponent contributions, which we find to be very useful: It can provide some early insight behind the expectations for the overall figure. Looking at these data for Q1-2018, the first chart on the website linked above shows that consumer spending was largely responsible for the adjustment to the GDPNow from early January to late April. The forecast’s accuracy substantially improved once retail sales data were released on February 14 and again on March 14.
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.
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