The consensus among Wall Street pundits and stock market investors - after a year of unprecedented volatility declines, unrealized concerns, and outsized capital gains - is for a continuation of the second-longest bull market in U.S. history. Recent economic data indicates renewed growth here and abroad, our unemployment rate has more than halved even as payrolls still expand at a solid pace, and inflation is low while deflation is a forgotten threat. Corporate profits have rebounded sharply and will be boosted further by the new tax law.
In past TSP Pilot Commentaries, we have argued the long-term case for stocks. At this time, however, we are bearish at current valuations and are concerned about the impact of unexpected consequences during 2018.
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ECONOMIC GROWTH
The Citi U.S. Economic Surprise Index is now at its most-positive level in six years, "higher than 99.6% of the readings since January 2003," according to Jim Paulsen of Leuthold Group. Gross domestic product (GDP), adjusted for inflation, grew 3.1% in the second quarter and 3.2% in the third, a widely heralded acceleration from the 2.2% annual average since the 2009 recession.
The more elevated the Citi Index, however, the more likely are negative economic surprises going forward. As for recent results, the reported GDP results are based on quarter-to-quarter changes, which are then annualized, providing a distorted picture. On a more-relevant year-over-year basis, the gains have been in line with the averages.
The fourth-quarter estimate from the GDPNow model of the Atlanta Federal Reserve branch is for only 2.8% growth, down from a 3.5% estimate a month ago. Another concern is that U.S. Short Leading Index from the well-respected Economic Cycle Research Institute (ECRI) has been declining since the first quarter of 2017, which in combination with a more-recent uptrend in the yield spread between junk bonds and Treasuries as well as the flattening of the yield curve (10-yr vs 2-yr Treasuries) "are telegraphing an economic slowdown that nobody sees coming," concludes ECRI in its December analysis. "It certainly threatens to blindside the Fed, which - fixated on the Phillips Curve - keeps projecting multiple rate hikes over the next year."
SENTIMENT, SPENDING, SAVINGS
This past year, investors benefited from the rise in business & consumer enthusiasm regarding our economy. Although sentiment measures dipped during December in the Conference Board and University of Michigan surveys, both are recording their highest readings in 2017 since the dot-com boom at the turn of the century.
Sentiment is self-fulfilling in the short run, since it encourages higher spending. The most-recent example is the strength in retail purchases this holiday season, up 4.9%, twice the gain in personal incomes.
Several troubling notes:
- The personal savings rate fell to 2.9% in the latest Commerce Department report, the first sub-3% level in ten years, prior to the financial crash.
- In the past two years, credit-card debt among subprime borrowers increased 25% and auto-loan delinquencies have turned higher, up 20%; in the past decade, student loans more than doubled to $1.4 trillion.
- Consumer sentiment readings for future expectations are nearly thirty points lower than those for current economic conditions...and are down 5.8% since last year.
- The Fed's Housing Affordability Index declined 25% during the past five years as national home prices rose 35%, tracked by Case-Shiller.
MONETARY POLICY
Our central bank expects to raise its benchmark fed funds rate three times in 2018 after five hikes since late 2015, the majority during the past year. The Federal Reserve continues to believe in the correlation between unemployment and inflation (the Phillips Curve), a belief based on faith rather than evidence these past 8 years.
Equally disconcerting is the inaccuracy of both measures. The headline unemployment rate doesn't account for discouraged job seekers, part-time workers (especially important with the advent of the 'gig economy'), and the labor participation percentage while the inflation rate varies widely depending on the methodology.
The Federal Reserve's preferred measure, the PCE, has ranged between 1% and 2% since 2012. By contrast, the Underlying Inflation Gauge (UIG), calculated by the New York Fed, "incorporates additional macroeconomic and financial variables" and has signaled a faster growth rate in prices - the latest UIG reading is nearly 3%, supporting the case for aggressive Fed tightening. Meanwhile, the Adobe Digital Price Index, which tracks real-time online purchases of 2.2 million items, has indicated almost no inflation at all, suggesting the need for an easier monetary policy.
Most important, our central bank is facing a challenge of its own creation - in order to revive and then support the economy & financial markets in the wake of the 2008 crash, the Federal Reserve more than quintupled its net purchases of bonds. Now, it is trying to unwind its holdings "in an orderly manner," which limits its options in the event of disappointing economic growth or another recession.
Overlaying this concern regarding Federal Reserve policy is the conclusion of a comprehensive study of Fed actions over the decades, that in most years our central bank was tightening when the economy needed easing, and vice versa - in effect, more often than not, those in control of the money supply exacerbated existing problems rather than neutralized them.
FISCAL ACTIONS
Politics usually generate more heat than light in predicting financial trends. We do expect, however, that legislative gridlock and institutional chaos in 2018 will ratchet up the level of market volatility and weigh on stock prices.The passage of a major tax bill was an exception to the rule. The legislation survived the Senate under the arcane procedures of reconciliation which allows for a simple majority vote, not vulnerable to filibuster, on only one bill each fiscal year. Going forward, legislation will require 60 votes in a chamber in which the Republicans will have 51 after the seating of Alabama's new senator.
Given the increasingly bitter partisan divide, the deficit implications of the tax bill and the political dividends of the just-say-no strategy of 2009 & 2010, no consequential legislation is expected in 2018. Of greater concern is the possibility of a government shutdown, in which game theory might win out over common sense - we assess a one-in-four chance of a self-inflicted shutdown or catastrophic debt default.
Contrary to consensus, we expect the full economic impact of the tax bill to be a net negative when higher deficits are included in the mix of considerations. There are compelling theoretical arguments on both sides of the debt debate, but the real-world implications are troubling given the ongoing transfers of wealth to those with a lower propensity to consume in addition to the costs of servicing Treasury debt held beyond our shores ($6 trillion and rising).
The fallout from the tax bill, in which foreign equity investors are projected to benefit more than the entire working- and middle-class populations of every state which voted for the president (according to the Institute for Taxation and Economic Policy), is likely to be a central factor in shifting control of the House of Representatives later this year. The political tsunami might reach the Senate as well, where Democrats currently have a 45% chance of regaining the majority, even though they need to win 27 of 33 races.
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LEGAL CONTROVERSY
Contrary to expectations of the president and his lawyers, our proprietary analysis indicates that the special counsel will recommend not only impeachment but also indictments. Further, the special counsel might seek to secure the indictments directly, opening up a constitutional battle.
To date, guiding Department of Justice policy is that a sitting president cannot be indicted, per the opinions issued by the Office of Legal Counsel in 1973 and 2000. The Supreme Court ruled in 1997 that a civil case was permissible, but has never taken a stance on alleged criminal conduct. Two special prosecutors, Leon Jaworski and Kenneth Starr, concluded that criminal indictments were permissible, based on the concept that no citizen is above the law (underscored by the Supreme Court's interpretation of the Constitution's speech-or-debate clause) and the time constraints imposed by statutes of limitations.
The common wisdom that the president can avoid legal exposure by summarily firing the special counsel or granting pardons (himself included) is flawed. Mueller can be fired by the relevant DOJ official but only for cause, which could then be challenged in federal court and on appeal, with the investigation continuing in the meantime. As for pardons, they only apply to federal crimes, whereas most of the principal targets are also vulnerable to state indictments.
We are heading for a constitutional crisis between a president and the department under his jurisdiction as well as a test of the separation of powers among the three branches of government. Whatever anyone's political affiliation, the ensuing chaos will undermine investor confidence.
NORTH KOREA
A more-serious conflict threatens the financial markets (and the world order) - here again, the consensus acknowledges the risks but underestimates the odds. Pundits and politicians continue to talk in circles, emphasizing the unacceptability both of a North Korean regime able to reach U.S. cities with nuclear-tipped intercontinental ballistic missiles (ICBMs) and of a shooting war with that regime - the only course of action they highlight is a diplomatic solution, skirting the question of whether such as solution is possible.North Korea has three choices: (1) accept denuclearization of the peninsula, dismantling its 11-year program, (2) agree to a "freeze-for-freeze" in which the United States validates North Korea as a nuclear state, forswears any intention to overturn the regime, and ceases its military exercises with South Korea, or (3) race to achieve the ability to threaten U.S. cities within the next year.
The first option, the only one which the United States has endorsed, is a non-starter - as a senior official told a U.S. delegation, North Korea didn't endure more than a decade of sanctions to give up its nukes (particularly now that the country has developed hydrogen bombs), not to mention its increasingly aggressive chemical & biological weapons programs. North Korea believes that nuclear blackmail provides the only insurance policy for regime survival, given the outcomes in Iraq and Libya as well as the new U.S. policy towards the existing agreement with Iran. Equally important, the ability to directly threaten the United States would presumably give North Korea a free hand to coerce or once again invade its southern neighbor, abdicating regional hegemony to a nation with a per capita income of $600 (vs $36,000 in South Korea).
The second option, however viable in theory and preferable to military conflict, is rejected by both sides, with official statements descending into juvenile taunts. What might have been framed as conciliation from each country is now dismissed as capitulation. Underlying each country's approach is the calculation that brinksmanship is the winning strategy: North Korea's dictator believes that the United States, which has considered military action since the Nixon Administration, will never make good on that threat, whereas our president appears to believe that only a truly credible, even eager, military posture can resolve the crisis in our favor, whether by cowing Kim Jong-un or, more likely, by spurring Chinese Premier Xi and Russian President Putin to exert their economic & political influence over the Hermit Kingdom.
China's and Russia's influence is illusory, however, even if Xi and Putin were willing to adopt the U.S. policy of "maximum pressure", which they are not. North Korea's self-identity was forged by a philosophy of Juche (self-reliance) - simply put, if the leadership was willing to endure a 1990s famine which killed up to 10% of its population rather than abandon a nascent nuclear program, stepped-up sanctions are an inadequate deterrence when the finish line is in sight. As for political leverage over North Korea, China has almost none and Russia has even less.
Our president is facing a slow-motion Cuban Missile Crisis, the consequence of three administrations which opted to kick the can down the road. Now, with little room left to maneuver, historical precedents offer a misleading lesson. The innumerable crises with North Korea since the 1953 armistice, all of which were defused short of war, bolster the recency & confirmation biases which underlie the consensus belief that some agreement will be reached, since the alternatives are too awful to consider.
In financial markets, the adage is that the most-dangerous words are "this time is different" but here, with the stakes so high, the opposite is true. The North Korean dictator provided a measure of hope in his New Year's address today, mixing the customary apocalyptical threats with an offer of limited talks regarding the upcoming Olympics in South Korea.
This overture, however welcome, doesn't preclude a continuation of ICBM testing, which will likely provoke a precision U.S. military response and raise the specter of escalation. Neither does Kim Jong-un's speech reset the more-fundamental disconnect of perceptions between North Korea and the United States, which could lead both sides down a path that, beyond the rhetoric, each is desperate to avoid.
A NEW COLD WAR
The honeymoon is over. The mutual charm offensive between Trump and Xi has accrued almost entirely to China's benefit, which our president has come to realize. The ratcheting up of economic sanctions against North Korea, which depend largely on Chinese enforcement, are an ineffective strategy at this stage, more so given China's insistence on diluting the sanctions and its willingness to allow circumvention of those to which it agreed. As for Russia (which, wittingly or not, allowed the export of sophisticated missile engines that leapfrogged North Korea's ICBM program), that country's technology is no longer needed by the Korean regime.President Xi wanted stability at home and peace abroad heading into the recent Party Congress, held only once every 5 years, and he was successful on both fronts. Not only was Xi's authority reaffirmed until 2022 at least, his philosophy was incorporated into the Chinese constitution, conferring on him a stature comparable only to Mao. Now that his power is secured, Xi can pursue his dream of a Chinese century.
To achieve his goals, Xi must reconcile the internal conflicts of an economy controlled by top-down political authority yet driven by bottom-up free markets. After trying to reign in financial excesses and inefficient state-owned enterprises, triggering a stock-market crash and massive capital outflows beginning in mid-2015, Xi has followed the U.S./European/Japanese monetary model of throwing money at every potential problem. The short-term results have been predictably favorable; the long-term costs are yet to be seen.
Beyond its shores, China has taken an increasingly militaristic approach to the East & South China Seas. Its adventurism was dialed back in 2017, as Xi took the measure of the new American president and assured himself a quiet ride to his Party Congress coronation. Between now and the 100th anniversary of the Chinese Communist Party in 2021, however, Xi will likely revitalize his strategy to assert military dominance over Asia even as he expands his country's economic influence in the region through the trillion-dollar "One Belt, One Road" infrastructure initiative.
With international trade, China continues the "heads we win, tails you lose" tactics in favoring its export-driven industries while restricting access by foreign companies. Whereas our president tolerated the unlevel playing field, openly acknowledging throughout the year and as recently as this past week that Chinese assistance with North Korea outweighed any concerns about trade, the belated recognition that China has neither the influence nor the inclination to resolve the crisis on the peninsula could spark a trade war in 2018. The cut in the U.S. corporate tax rate has already raised objections and prompted China to entirely eliminate its tax on foreign businesses for the foreseeable future. More targeted measures are likely in the first quarter, to which China will inevitably respond or overreact.
In Russia, meanwhile, President Putin is trying to figure out, in the words of football legend Vince Lombardi, "what the hell is going on out there?" Economic sanctions, in particular those related to the Magnitsky Act which constrains the money-laundering machinations of Putin's inner circle, are still very much in place. Further, the U.S. military was recently authorized to provide lethal assistance to the Ukrainian government, in particular .50 caliber sniper rifles and Javelin anti-tank missiles.
Although Putin is assured to win his Kabuki nod to democracy in Russia's March 18th presidential elections, he is sensitive to the corrosive nature of oppression and the fine line between national pride and disaffection in the accounting of military excursions. Although Putin is often characterized as a new tsar reasserting Russia's status as a world power, most evident in the annexation of Crimea and his country's central role in the Syrian civil war, the economic cost of his successes far outweighs the geopolitical propaganda regarding a new empire.
Putin is trapped in a maze of his own construction. In order to hold together his vision of a resurgent Russia and leverage an appeal to patriotism for political gain, he has intervened in Chechnya, Georgia, Syria, and Ukraine. In each conflict, he has acted out of defensive reflex rather than strategic vision, despite the praise showered upon him by many in the West.
Putin has few tangible benefits to show his people and his view of U.S./Russian relations is deteriorating rapidly, raising the risks of an inadvertent conflict over the skies in Syria or upon the Baltic Sea. The measure of Putin's frustration was highlighted a few days ago by Masha Gessen, author of The Future Is History: How Totalitarianism Reclaimed Russia (winner of the 2017 National Book Award for Nonfiction), who argued that at this point the Russian president would prefer a more predictable and adversarial relationship with a United States. If history is any guide, Putin won't go "gentle into the night".
VALUATION
Each of the concerns highlighted above could trigger a bear market. Moreover, the overriding valuation of stocks, even in the absence of a crisis, is currently unfavorable for TSP participants. The low level of interest rates, combined with the rapid growth of corporate profits during the past 6 quarters, is deceptive.
Prior to the recent run of earnings gains, profits declined for an equal number of quarters - although our economy has grown steadily if slowly since the recession, profit growth has varied widely. Equally important, the measure of profits is an elusive target: Wall Street and the media focus on "operating earnings", which permit companies to exclude any charges they consider non-recurring. Based on this measure and the expected growth in profits next year, the S&P 500 (comparable to the C Fund) trades at a price-earnings (P-E) multiple of 18.4 - in relation to a 10-year Treasury note which yields 2.5% (which equates to a P-E of 40), stocks are still attractive.
This measure is flawed, however: a more-accurate reading of what corporations earn is what they actually report; when viewed over time, non-recurring elements net out. The widely followed Shiller CAPE (Cyclically Adjusted Price Earnings) ratio, which aggregates a decade of data, now exceeds 32, higher than at any time since 1880 with the exception of a brief spike in late 1999 and early 2000.
A more-relevant measure which we compute is the average of reported earnings for the past 8 years, which unlike CAPE isn't distorted by the collapse in profits during the 2009 recession. By our measure, the S&P 500 sells at a P-E multiple of 27. Even allowing for 20% growth in profits in 2018, the multiple remains above 26, an elevated number by historical standards: since 1950, the average P-E when inflation was 0-2% was 18 (and lower still for other inflation ranges) according to FactSet, Strategas, and SunTrust IAG.
Another concern is that profit gains, after the exceptional growth of recent quarters and the boost next year from the corporate tax cut, cannot sustain the pace. Over time, profits are unlikely to grow faster than GDP growth, particularly since profit margins in recent years are already higher than in previous decades. For profit growth to exceed 5%, inflation will need to ramp up, which means that interest rates will rise as well, offsetting the benefits of earnings gains.
The problem with stock valuations at current prices is highlighted in a simple chart with an excellent track record in predicting stock market returns over the long term. The chart, compiled by Dr. John Hussman and reproduced below, tracks (1) the ratio of the total value of U.S. stocks relative to the size of our economy and (2) the subsequent performance of stocks.
The ratio at present suggests that stocks will provide a zero total return over the next dozen years. During that timeframe, volatility will return to the markets and we should expect periods of meaningful declines - Hussman predicts a 60% sell-off in the near-term given his analysis of current technical indicators.
CONCLUSION
We could experience a continuation of the "calm before the storm" as in 1967, 1986, 1999 or 2006, but TSP participants are investing for retirement and the current risk-reward trade-off is unfavorable.
As noted in last month's Commentary, volatility has declined to historically low levels even as bubbles take hold in several asset classes. Meanwhile, the continued, steady advance of stock prices in general encourages a risky "buy the dips" mind-set, similar to the first ten months of 1987.
Over the past six decades, the stock market suffered three of its largest declines in the absence of economic or geopolitical crises, the most notable being the Crash of '87. Our concern is that, at current valuations, the market is vulnerable and that a serious crisis, which could trigger or fuel a major sell-off, is more likely than the consensus believes.
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