slowdown in China

In the late 1970s Deng Xiaoping was forced to tackle the gigantic mess that central planning had made of the Chinese economy during Mao’s rule.  The problem:  highly inefficient, loss-making, corruption-infested, Soviet-style (feel free to add more negative, hyphenated adjectives) state-owned enterprises dominated the industrial base.  The products were poor;  the books more fiction than not.  Deng’s solution was to adopt Western-style capitalism under the banner of “Socialism with Chinese Characteristics.”  This meant pulling the plug on bank credit and political favor for state-owned enterprises and redirecting support toward the private sector.

The result has been 30+ years of economic growth so strong that it has vaulted China from nowhere into first place among world economies.  In fact, the PRC is now 10%+ larger than #2, the US, using Purchasing Power Parity as the yardstick.

According to an astute observer of China, Nicholas Lardy, writing in the Financial Times, however, current Chinese leader Xi Jinping has not simply been cracking down on the cumulative excesses of the private sector over the past couple of years.  He has also reversed Deng’s policy in favor of building up the state-owned sector again.  Lardy thinks this decision is reducing China’s annual GDP growth rate by a whopping two percentage points.

I’m not sure why this is happening.  But for China, the highest economic principle has never been about achieving maximum sustainable GDP growth.  Rather, it’s whatever is necessary to maintain the Communist Party in power.  Reduction in GDP growth is a secondary concern.


I don’t know how this affects China’s stance in tariff negotiations with the US, especially since White House economists seem to be suggesting that the US economy is already beginning to contract under the weigh of current tariffs plus the government shutdown   (increased tariffs slated for March will only deepen any decline).  From a longer-term point of view, though–and assuming Chinese policy doesn’t change–for a company to simply have exposure to China will no longer be any guarantee of success.


steering through the shoals

issues for the S&P 500 in 2019:

–about half the earnings of the S&P come from outside the US.  For 2019, that’s not a good thing, since China is slowing down (more tomorrow) and the UK’s ham-fisted approach to Brexit is stalling business activity in the EU

–in the US,

—-last year’s corporate tax cut is no longer a source of year-on-year aftertax earnings growth

—-tariffs continue in place.  Tariffs redistribute,  but in the aggregate also slow, economic growth. The current ones are designed to shift economic energy toward sunset (often private) industries and away from ones with better prospects.  Some, like those on steel and aluminum, appear arbitrary, adding a layer of uncertainty to the whole process

—-the government shutdown is already pushing the US economy from a plodding advance into reverse, according to White House economists.  The central issue is a border wall, which, if news reports are correct, was originally intended only as a memory aid for a candidate who couldn’t remember his key policy positions very well

—-the lack of sensible–or even coherent–economic strategy from Washington is making corporations accelerate domestic restructuring plans and to question future investment in the country.  The administration’s hostility to admitting highly skilled foreign workers based on their religion/ethnicity is making the shift of r&d activity across the border to Canada an easy decision

In short, an embarrassing parade in Washington of own goals/self-inflicted wounds.


where to look for growth

The business cycle isn’t going to be much help.  In times like this, the defensive sectors–utilities and telecom, and, to a lesser extent healthcare and consumer discretionary–typically come to the fore.  But utilities + traditional telephone now amount to much less than 10% of the S&P.  More important, both areas are in the throes of fundamental alteration that is damaging to incumbents.  This leaves us with healthcare and consumer discretionary.

In both these areas, I think it’s important not to implicitly take a business cycle approach.  A key factor here is Millennials vs. Baby Boomers.

In very rough terms, a Baby Boomer earns about twice what a Millennial does.  But Millennials are entering a period of rapid growth in wages.  In contrast, as Boomers retire, their incomes are typically cut in half.  It seems to me that in all consumer areas it’s important to concentrate on firms that serve mostly Millennials, and avoid those (department stores are an easy example) that serve mostly Boomers, no matter what the level of current profits is.

My personal belief is that Americans don’t approve of making money from others’ illnesses.  That’s the simplest reason (there are others) I can give for avoiding hospitals or nursing care or other healthcare service providers.  But the premise of no business cycle help implies as well looking for smaller, more innovative, say, medical treatment development, firms    …early-stage companies with the potential for explosive growth.

In the tech area–a more business cycle-sensitive area than healthcare–I think seeking out smaller, more innovative firms is also the way to go (but I always say this).  In a so-so economy these should continue to prosper.  The big risk is that they would likely be hurt very badly if the administration continues to add to the damage to the domestic economy that it is already doing.





threatening Federal Reserve independence

trying to intimidate the Fed?

Just before Christmas, news reports surfaced that President Trump was discussing how to go about firing Jerome Powell, Chairman of the Federal Reserve, ten months after having him appointed to the post.  The purported reason:  Mr. Trump was blaming stock market turbulence–not on his tax bill, which failed to reform the system and increased the government deficit, nor on the negative effect of his tariffs–but on Mr. Powell’s continuing to gradually raise short-term interest rates from their financial crisis lows back toward normal.

Ironically, the S&P 500 plunged by about 10%, making what I think will be seen as an important low, as the president’s deliberations became public.

why this is scary

The highest-level economic aim of the US is maximum sustainable GDP growth, with low inflation.  In today’s world, the burden of achieving this falls almost entirely on the Fed (even I realize I write this too much, but: the rest of Washington is dysfunctional).  The unwritten agreement within government is that the Fed will do things that are economically necessary but not politically popular, accepting associated blame, and the rest of Washington will leave it alone.

Mr. Trump seems, despite his Wharton diploma, not to have gotten the memo.  This despite the likelihood that his strange mix of crony-oriented tax cuts and trade protection has made so few negative ripples in financial markets because participants believe the Fed will act as an economic stabilizer.

What happens, though, if the Fed is politicized in the way Mr. Trump appears to want?

The straightforward US example is the 1970s, when the Fed succumbed to Nixonian pressure for a too-easy monetary policy.  That resulted in runaway inflation and a plunging currency.  By 1978, foreigners were requiring that Treasury bonds be denominated in German marks or Swiss francs rather than dollars before they would purchase.   The Fed Funds rate rose 20% in 1981 as the monetary authority struggled to get inflation under control.

The point is the negative effects are very bad and happen surprisingly quickly.  This is more problematic for the US than for, say, Japan because about half the Treasuries in public hands are owned by foreigners, for who currency effects are immediately apparent.







the business cycle, interest rates and the tax cut

past cycles

The garden-variety business cycle since WWII has played out over about four years.   Stock market rises and falls have typically led this cycle by about six months.  Movement breaks out into around 2 1/2 years of up followed by 1 – 1 1/2 years of down.

The driving factor in the cycle has been government policy, in the form of Federal Reserve’s control of short-term interest rates.  Half a century ago, conventional wisdom held that fiscal policy took effect with such long lags that extra government spending or tax changes might end up addressing a problem that was no longer there.  So, the argument went, Congressional action would do more harm than good.  More recent Congresses have been dysfunctionally unable to pass potentially helpful bills.

a typical pattern

Let’s look at the beginning of an up cycle.  The economy has been sputtering–perhaps even declining–so the Fed lowers short-term interest rates.  In the world outside the US, lower borrowing costs make economically viable industrial projects that were previously on the shelf.  So companies build new plants and then hire new workers.  This leads to a pickup in consumer spending, which leads to more investment, which leads to more hiring…

At some point, the economy runs out of workers.  Companies still want to expand, so they begin to poach staff from rivals by offering (a lot) more money.  In advanced economies, inflation is always wage inflation, so price increases start to accelerate at unhealthy speed.

The Fed reacts by raising interest rates to cool the economy down.  Typically, the central bank goes too far.  Monetary policy doesn’t simply return to neutral.  It becomes restrictive, meaning the economy begins to sputter again.  Realizing its mistake, the central bank reverses course  …and an upcycle begins once more.

The US is different.  For whatever reason, consumer spending here doesn’t wait for new jobs to materialize.  Unlike the rest of the world, consumer doesn’t lag investment; it leads.

stocks and bonds

As the upcycle matures, bonds start to weaken because interest rates are beginning to rise.  Stocks, on the other hand, have an initial hiccup but then tend to go sideways to up.  That’s because earnings growth continues to be strong, offsetting the negative impact of rising rates.  Eventually, if/as the central bank become restrictive, stocks begin to decline as well–both because rates are continuing to rise and because investors begin to anticipate future profit declines.

this time is different

Normally, those words send chills up and down the spines of investors.  This time, however, the business cycle really is way different than the garden variety, in three ways:

–interest rate policy has been extremely stimulative for most of the past decade, as a necessary aid to rebuilding the economy after the (Washington-induced) financial crisis,  and because Congress has failed to help through fiscal policy.   Because short rates have been starting from essentially zero, they can rise a long way before beginning to damage the economy

–a little more than a year ago, as the Fed was continuing to withdraw stimulus to counter overheating (evidenced by crazy financial speculation), Congress passed tax cuts that, ten years too late, added over $100 billion annually to net stimulus

–the administration has implemented a hodge-podge of restrictions on trade, which appear, to me at least, to be much more damaging to the domestic economy than the consensus believes

the upshot

–if the trend of annual nominal GDP growth in the US is 4% – 5%, the tariffs may depress the figure for 2019 below that level

–it’s also up in the air as to how much the tariffs will take the edge off the earnings energy stocks need to fend off the negative effect of higher rates

–tax cuts boosted corporate eps in the US by about 20 percentage points.  The overall earnings gain will likely be about +25%.  Because both 2019 and 2018 figures contain the tax benefit (but 2017 numbers didn’t), the yoy eps gain for 2019 will likely drop to be on the order of +5% – +10%.  On the surface, then, earnings growth in 2019 will fall off a cliff.

Decelerating earnings growth like this is normally a sell signal.  On the other hand, the market traditionally doesn’t pay attention to one-off items, however large.  If this holds true again, the market should go sideways from here.

What are the algorithms thinking?  Better said, how are the algorithms programmed?


liquidity and stock price changes

daily liquidity and price movements

Liquidity has a lot of different meanings.  Right now, though, I just want to write about what I think is making stocks yo-yo to and fro on any given day.


The default response by market makers–human or machine–to a large wave of selling of the kind algorithms seem to trigger is to move the market down as fast as trading regulations allow.  This serves a number of purposes:  it minimizes the unexpected inventory a market maker is forced to take on at a given price; it allows the market maker to gauge the urgency of the seller; the decline itself eventually discourages sellers with any price sensitivity, so the selling dries up; and it reduces the price the market maker pays for the inventory he accumulates.

A large wave of buying works in the opposite direction, but with the same general result: market makers sell less, but at higher prices and end up with less net short exposure.


From my present seat high in the bleachers, it seems to me the overall stock market game–to make more/lose less than the other guy–hasn’t changed.  But we’ve gone from the old, human-driven strategy of slow anticipation of likely news not yet released to violently fast computer reaction to news as it’s announced.

Today’s game isn’t simply algorithmic noise, though.  Apple (AAPL), for example, pretty steadily lost relative performance for weeks in November, after it announced it would no longer disclose unit sales of its products.  Two points:  the market had no problem in immediately understanding that this was a bad thing (implying humans were likely involved)   …and the negative price reaction continued for the better part of a month (suggesting that something/someone constrained the race to the bottom).  As it turns out, decision #1 was good and decision #2 was bad.  Presumably short-term traders will make adjustments.

my take

On the premise that dramatic daily shifts in the prices of individual stocks will continue for a while:

–if investors care about the high level of daily volatility, its persistence should imply an eventual contraction in the market PE multiple.  Ten years of rising market probably implies that this won’t happen overnight, if it occurs at all.

–individual investors like you and me may have more time to research new companies and establish positions, if the importance of discounting diminishes

–professional analysts may only retain their relevance if they actively publicize their conclusions, trying to trigger algorithmic action, rather than keeping them closely held and waiting for the rest of the world to eventually figure things out

–the old (and typically unsuccessfully executed) British strategy of maintaining core positions while dedicating, say, 20% of the portfolio to trading around them, may come back into vogue.  Even long-term investors may want to establish buy/sell targets for their holdings and become more trading-oriented as well

–algorithms will presumably begin to react to the heightened level of daily volatility they are creating.  Whether volatility increases or declines as a result isn’t clear





machines vs. humans

…a financial Industrial Revolution?

I remember reading, years and years ago, an analysis of changes in the nature of work that happened during the Industrial Revolution.  The general idea is that, say, candlesticks had been made as one-of-a-kind items, out of precious materials and ornate decoration, worked for months by an artisan who had spent years learning how to do this.  Yes, the end product was useful, but it was also very expensive, meant for a niche audience, and acted as a sign of the owners’ superior wealth, taste and privilege.  In contrast, the “new” candlestick was made, fast and cheap, out of ordinary stuff, by a guy who knew how to operate a machine.

Today we find it hard to imagine the possible appeal of most pre-IR objects.  Yet they were once the norm.


The macro/microeconomic research-based stock market investment reports of the kind I used to create were made by people, like me, who served long apprenticeships under masters of the craft.  The work tended to only start to approach minimum standards after the author had, say, five years of practical experience in an investment management firm.  Buy-side portfolio managers like me also used the voluminous output of internal or brokerage house analysts who spent their careers studying a specific industry group.

By 2019, most of the experienced buy- and sell-siders have either retired or been laid off,  and have been replaced in many cases either by computer-controlled index-tracking products or by algorithms.  The main forces in today’s daily stock market trading have become machines, some programmed to carry out the wacky theories of the academic world, others to react to signals from the patterns of trading itself (i.e., technical analysis) or to news stories (typically written by reporters trained mostly as writers) or to extrapolate from the patterns of past business cycles.

progress or free-riding?

Are the research reports of a decade or two ago analogous to the candlesticks of the Pre-IR era?  Are algorithms like early industrial machines?  Are they a better and cheaper, although different, way of dealing with financial markets than having a very expensive group of human craftsmen?  Does this mean those who decry algorithms are simply Upper East Side-dwelling Luddites?

I don’t know about “simply.”  My feeling is that algorithms are here to stay.  And my experience as an investor is that it’s very dangerous to think that just because you don’t like or understand something that it serves no purpose.

Still, my suspicion is that as it stands now, there’s a healthy dose of free-riding to algorithmic trading.  In other words,  it looks to me as if some algorithms rely on reading the signals of human professional investors as they move in and out of stocks in response to their research findings.  As those humans are displaced by machines, however, those signals will disappear–implying algorithms will have to evolve if their raw material is to be something other than random noise.







Apple, industrial activity, the jobs report

the Employment Situation

The Bureau of Labor Statistics made its monthly Employment Situation report this morning:  +312,000 new jobs, +58,000 upward revision to the prior two months’ data, annual wage gains of an inflation-beating +3.2%.  Yes, it’s just one month and, yes, the margin of error is +/- 100,000 jobs, but it’s still a very strong report, indicating a robust domestic economy.


Despite this show of employment strength, the stock market has been on a sharply downward path since late September.  What is the market thinking/anticipating?

–the 10-year Treasury, which was yielding 3.22% in late September now yields 2.56%;  the middle of the yield curve is now mildly inverted.  This suggests bond buyers believe a marked slowdown in economic activity in the US is in the offing–one that will force the Fed to soon begin to lower short-term interest rates again.  Why would that be?

–the Trump tariff war with the rest of the world seems to be affecting publicly traded companies much more negatively than one might have imagined

–only about half the earnings of the S&P 500 come from the US.  Both the EU, dealing with Brexit and Italy, and China are slowing down

–some pundits argue from the bond market situation that the Fed is the problem, having –they think–raised short-term interest rates too far.


Two pieces of data from yesterday seem, on the surface at least, to reinforce the sharp slowdown narrative:  Apple (AAPL) and business investment activity.


–AAPL announced Wednesday night that its December quarter revenues would be about 8% below the midpoint of the guidance it gave in October.  What makes this significant, besides AAPL’s size, is that the company rarely misses its quarterly estimates.

Two reasons given:  falloff in sales in “greater China” and slower than expected takeup of the newest generation of iPhones by existing customers (the smartphone market is completely saturated–there are no more “new” customers).  Neither reason is clearly a sign of broad-based consumer distress, however.

AAPL recently said it would no longer reveal unit sales of its smartphones, a decision I take to mean it intends to make revenue gains through price increases rather than unit volume gains.  Is the slowdown in replacement demand caused by economic weakness or AAPL pricing new phones so high that other, cheaper phones are suddenly more attractive?

Also, the latest issue of Foreign Affairs reports that popular sentiment in China has turned sharply against the US in the past half year or so as Washington initiated its tariff war.  Maybe, in addition to higher prices, flaunting the newest iPhone is no longer as culturally acceptable in China (think:  the century of humiliation), as having a home-grown product.


–the Institute for Supply Management issued its monthly report on US manufacturing activity yesterday.  It shows a continuing slowdown in industrial activity.  The reason most often cited in survey respondents’ comments is the administration’s tariff war.  Manufacturers are, predictably, shifting production out of the US to avoid import tariffs on raw materials and export tariffs on finished goods.

It’s important to remember, too, that manufacturing is not the key to US economic strength that it was a generation or two ago.  Spending on software is the largest investment item for most service companies.  Yes, this activity is also being shifted abroad as the administration makes it more difficult for foreign-born computer scientists to work in the US.   But I don’t think the ISP report is “new” news, so I’m not sure why it had such a negative effect on the market yesterday.

my take

In the short term, figuring out the root cause of the worries about the US economy is probably less important than trying to gauge how far along in the selling we are now.  Better to figure out when the storm will be over than debate the direction of the wind.  My guess–and it may be more of a hope–is that we made the lows on Christmas Eve when stocks broke decisively through the February 2018 lows.

Personally, I think the ultimate problem is Washington and the tariffs, not the Fed.  I’m all for protecting US intellectual property, but the levies on, say, steel and aluminum seem so arbitrary and generally harmful.  In a way, it would be a lot better if the Fed is the issue, since then the problem would be a familiar one, the market situation clearer and the fix relatively easy.