I’ve just updated my Keeping Score page for November. …finally an up month!
In an ideal world, portfolio investing is all about comparing the returns available among the three liquid asset classes–stocks, bonds and cash–and choosing the mix that best suits one’s needs and risk preferences.
In the real world, the markets are sometimes gripped instead by almost overwhelming waves of greed or fear that blot out rational thought about potential future returns. Once in a while, these strong emotions presage (where did that word come from?) a significant change in market direction. Most often, however, they’re more like white noise.
In the white noise case, which I think this is an instance of, my experience is that people can sustain a feeling of utter panic for only a short time. Three weeks? …a month? The best way I’ve found to gauge how far along we are in the process of exhausting this emotion is to look at charts (that is, sinking pretty low). What I want to see is previous levels where previously selloffs have ended, where significant new buying has emerged.
I typically use the S&P 500. Because this selloff has, to my mind, been mostly about the NASDAQ, I’ve looked at that, too. Two observations: as I’m writing this late Tuesday morning both indices are right at the level where selling stopped in June; both are about 5% above the February lows.
My conclusion: if this is a “normal” correction, it may have a little further to go, but it’s mostly over. Personally, I own a lot of what has suffered the most damage, so I’m not doing anything. Otherwise, I’d be selling stocks that have held up relatively well and buying interesting names that have been sold off a lot.
What’s the argument for this being a downturn of the second sort–a marker of a substantial change in market direction? As far as the stock market goes, there are two, as I see it:
–Wall Street loves to see accelerating earnings. A yearly pattern of +10%, +12%, +15% is better than +15%, +30%, +15%. That’s despite the fact that the earnings level in the second case will be much higher in year three than in the first.
Why is this? I really don’t know. Maybe it’s that in the first case I can dream that future years will be even better. In the second case, it looks like the stock in question has run into a brick wall that will stop/limit earnings advance.
What’s in question here is how Wall Street will react to the fact that 2018 earnings are receiving a large one-time boost from the reduction in the Federal corporate tax rate. So next year almost every stock’s pattern in will look like case #2.
A human being will presumably look at pre-tax earnings to remove the one-time distortion. But will an algorithm?
–Washington is going deeply into debt to reduce taxes for wealthy individuals and corporations, thereby revving the economy up. It also sounds like it wants the Fed to maintain an emergency room-low level of interest rates, which will intensify the effect. At the same time, it is acting to raise the price of petroleum and industrial metals, as well as everything imported from China–which will slow the economy down (at least for ordinary people). It’s possible that Washington figures that the two impulses will cancel each other out. On the other hand, it’s at least as likely, in my view, that both impulses create inflation fears that trigger a substantial decline in the dollar. The resulting inflation could get 1970s-style ugly.
My sense is that the algorithm worry is too simple to be what’s behind the market decline, the economic worry too complicated. If this is the seasonal selling I believe it to be, time is a factor as well as stock market levels. To get the books to close in an orderly way, accountants would like portfolio managers not to trade next week.
One of Mr. Trump’s first actions as president was to withdraw the US from the Trans-Pacific Partnership, a consortium of world nations seeking, among other things, to halt Chinese theft of intellectual property.
Trump has apparently since discovered that this is a serious issue but has decided that the US will go it alone in addressing it. His approach of choice is to place tariffs on goods imported from China–steel and aluminum to start with–on the idea that the harm done to China by the tax will bring that country to the negotiating table. In what seems to me to be his signature non-sequitur-ish move, Mr. Trump has also placed tariffs on imports of these metals from Canada and from the EU.
This action has prompted the imposition of retaliatory tariffs on imports from the US.
the effect of tariffs
–the industry being “protected’ by tariffs usually raises prices
–if it has inferior products, which is often the case, it also tends to slow its pace of innovation (think: US pickup trucks, some of which still use engine technology from the 1940s)
–some producers will leave the market, meaning fewer choices for consumers; certainly there will be fewer affordable choices
–overall economic growth slows. The relatively small number of people in the protected industry benefit substantially, but the aggregate harm, spread out among the general population, outweighs this–usually by a lot
is there a plan?
If so, Mr. Trump has been unable/unwilling to explain it in a coherent way. In a political sense, it seems to me that his focus is on rewarding participants in sunset industries who form the most solid part of his support–and gaining new potential voters through trade protection of new areas.
Mr. Trump has proposed/threatened to place tariffs on automobile imports into the US. This is a much bigger deal than what he has done to date. How so?
–Yearly new car sales in the US exceed $500 billion in value, for one thing. So tariffs that raise car prices stand to have important and widespread (negative) economic effects.
–For another, automobile manufacturing supply chains are complex: many US-brand vehicles are substantially made outside the US; many foreign-brand vehicles are made mostly domestically.
–In addition, US car makers are all multi-nationals, so they face the risk that any politically-created gains domestically would be offset (or more than offset) by penalties in large growth markets like China. Toyota has already announced that it is putting proposed expansion of its US production, intended for export to China, on hold. It will send cars from Japan instead. [Q: Who is the largest exporter of US-made cars to China? A: BMW –illustrating the potential for unintended effects with automotive tariffs.]
More significant for the long term, the world is in a gradual transition toward electric vehicles. They will likely prove to be especially important in China, the world’s largest car market, which has already prioritized electric vehicles as a way of dealing with its serious air pollution problem.
This is an area where the US is now a world leader. Trade retaliation that would slow domestic development of electric vehicles, or which would prevent export of US-made electric cars to China, could be particularly damaging.
This has already happened once to the US auto industry during the heavily protected 1980s. The enhanced profitability that quotas on imported vehicles created back then induced an atmosphere of complacency. The relative market position of the Big Three deteriorated a lot. During that decade alone, GM lost a quarter of its market share, mostly to foreign brands. Just as bad, the Big Three continued to damage their own brand image by offering a parade of high-cost, low-reliability vehicles. GM has been the poster child for this. It controlled almost half the US car market in 1980; its current market share is about a third of that.
In sum, I think Mr. Trump is playing with fire with his tariff policy. I’m not sure whether he understands just how much long-term damage he may inadvertently do.
stock market implications
One of the quirks of the US stock market is that autos and housing are key industries for the economy but neither has significant representation in the S&P 500–or any other general domestic index, for that matter.
Tariffs applied so far will have little direct negative impact on S&P 500 earnings, although eventually consumer spending will slow a bit. So far, fears about the direction in which Mr. Trump may be taking the country–and the failure of Congress to act as a counterweight–have expressed themselves in two ways. They are:
–currency weakness and
–an emphasis on IT sector in the S&P 500. Within IT, the favorites have been those with the greatest international reach, and those that provide services rather than physical products. My guess is that if auto tariffs are put in place, this trend will intensify. Industrial stocks + specific areas of retaliation will, I think, join the areas to be avoided.
Of course, intended or not (I think “not”), this drag on growth would be coming after a supercharging of domestic growth through an unfunded tax cut. This arguably means that the eventual train wreck being orchestrated by Mr. Trump will be too far down the line to be discounted in stock prices right away.
I’m taking off my hat as an American and putting on my hat as an investor for this post.
That is, I’m putting aside questions like whether the Trump agenda forms a coherent whole, whether Mr. Trump understands much/any of what he’s doing, whether Trump is implementing policies whispered in his ear by backers in the shadows–and why congressmen of both parties have been little more than rubber stamps for his proposals.
My main concern is the effect of his economic policies on stocks.
the tax cut
The top corporate tax rate was reduced from 35% to 21% late last year. In addition, the wealthiest individuals received tax breaks, a continuation of the “trickle down” economics that has been the mainstay of Washington tax policy since the 1980s.
The new 21% rate is about average for the rest of the world. This suggests that US corporations will no longer see much advantage in reincorporating abroad in low-tax jurisdictions. The evidence so far is that they are also dismantling the elaborate tax avoidance schemes they have created by holding their intellectual property, and recognizing most of their profits, in foreign low-tax jurisdictions. (An aside: this should have a positive effect on the trade deficit since we are now recognizing the value of American IP as part of the cost of goods made by American companies overseas (think: smartphones.)
My view is that this development was fully discounted in share prices last year.
The original idea was that tax reform would also encompass tax simplification–the elimination of at least part of the rats nest of special interest tax breaks that plagues the federal tax code. It’s conceivable that Mr. Trump could have used his enormous power over the majority Republican Party to achieve this laudable goal. But he seems to have made no effort to do so.
Two important consequences of this last:
–the tax cut is a beg reduction in government income, meaning that it is a strong stimulus to economic activity. That would have been extremely useful, say, nine years ago, but at full employment and above-trend growth, it puts the US at risk of overheating.
–who pays for this? The bill’s proponents claim that the tax cut will pay for itself through higher growth. The more likely outcome as things stand now, I think, is that Millennials will inherit a country with a least a trillion dollars more in sovereign debt than would otherwise be the case.
One positive consequence of the untimely fiscal stimulus is that it makes room for the Fed to remove its monetary stimulus (it now has rates at least 100 basis points lower than they should be) faster, and with greater confidence that will do no harm.
Two complications: Mr. Trump has begun to jawbone the Fed not to do this, apparently thinking a supercharged, unstable economy will be to his advantage. Also, higher rates raise the cost of borrowing to fund a higher government budget deficit + burgeoning government debt.
Tomorrow: the messy trade arena
I started watching the Murdoch family in the mid-1980s, when I was managing a large Australian portfolio. The original business of News Corp, the parent of FOX, was politically-oriented media targeted at right-of-center blue collar workers in Australia. As I saw it, News consistently traded positive news coverage to its right-of-center audience in return for regulatory favors. Rupert Murdoch’s genius was to replicate this model on successively larger stages, first in the UK and then in the US.
Today–again, as I see it–Rupert is moving to turn the family business over to his two sons, on the idea that they will follow in his footsteps as he did his father’s. This desire has two implications for the bidding war between DIS and CMCSA for the FOX media assets:
–the Murdoch family wants equity, not cash. That’s only partly for tax reasons (because taking cash would presumably trigger a big capital gains bill, while taking equity in the successor company wouldn’t). Just as important,
–the next generation of Murdochs wants to continue to have a seat at the media table. The fact that they would own a lot of DIS stock and the fact that there’s no clear successor to the current DIS chairman make it an ideal landing spot. Comcast, in contrast, is another family-controlled company. The last thing Comcast wants is to let in a potentially powerful internal rival. This means CMCSA issuing stock is probably out of the question–and certainly not the favored class of stock the Roberts family uses to maintain control. So Comcast doesn’t suit the Murdochs at all.
Most institutional investors don’t pay taxes, so they’re indifferent to whether they get stock or cash.
I don’t think it’s an accident that the Comcast offer for FOX is at a level that more than compensates any long-term holder of FOX for the tax he would owe on selling. In other words, FOX directors can’t use the grounds that they’re “protecting” shareholders from tax by rejecting the Comcast offer in favor of DIS. After the Supreme Court ruling allowing the ATT/Time Warner merger, they may not be able to argue that a Comcast/Fox merger would run afoul of regulators, either.
At first blush, the Comcast position seems a lot weaker than DIS’s. The Murdochs want to sell to DIS and, I think, actively don’t want to sell to Comcast. As for DIS, it faces a continuing problem finding places to reinvest its huge media cash flows. And opportunities like FOX don’t turn up every day.
What is Comcast’s strategy? My guess is that it’s hoping to raise the offer price to a point where DIS drops out and public pressure forces FOX to sell itself to Comcast. From what I can tell, it would likely need a partner to do so.
I’ve got no desire to participate, but this will be an interesting battle to watch.
rising interest rates
Yesterday interest rose in the US to the point where the 10-year Treasury yield cracked decisively above 3.00% (currently 3.09%). Also, the combination of mild upward drift in six month T-bill yields and a rise in the S&P (which lowers the yield on the index) have conspired to lift the three-month bill yield, now 1.92%, above the 1.84% yield on the S&P.
What does this mean?
For me, the simple-minded reading is the best–this marks the end of the decade-long “no brainer” case for pure income investors to hold stocks instead of bonds. No less, but also no more.
The reality is, of course, much more nuanced. Investor risk preferences and beliefs play a huge role in determining the relationship between stocks and bonds. For example:
–in the 1930s and 1940s, stocks were perceived (probably correctly) as being extremely risky as an asset class. So listed companies tended to be very mature, PEs were low and the dividend yield on stocks exceeded the yield on Treasuries by a lot.
–when I began to work on Wall Street in 1978 (actually in midtown, where the industry gravitated as computers proliferated and buildings near the stock exchange aged), paying a high dividend was taken as a sign of lack of management imagination. In those days, listed companies either expanded or bought rivals for cash rather than paid dividends. So stock yields were low.
three important questions
dividend yield vs. earnings yield
During my investing career, the key relationship between long-dated investments has been the interest yield on bonds vs. the earnings yield (1/PE) on stocks. For us as investors, it’s the anticipated cyclical peak in yields that counts more than the current yield.
Let’s say the real yield on bonds should be 2% and that inflation will also be 2% (+/-). If so, then the nominal yield when the Fed finishes normalizing interest rates will be around 4%. This would imply that the stock market (next year?) should be trading at 25x earnings.
At the moment, the S&P is trading at 24.8x trailing 12-month earnings, which is maybe 21x 2019 eps. To my mind, this means that the index has already adjusted to the possibility of a hundred basis point rise in long-term rates over the coming year. If so, as is usually the case, future earnings, not rates, will be the decisive force in determining whether stocks go up or down.
stocks vs. cash
This is a more subjective issue. At what point does a money market fund offer competition for stocks? Let’s say three-month T-bills will be yielding 2.75%-3.00% a year from now. Is this enough to cause equity holders to reallocate away from stocks? Even for me, a died-in-the-wool stock person, a 3% yield might cause me to switch, say, 5% away from stocks and into cash. Maybe I’d also stop reinvesting dividends.
I doubt this kind of thinking is enough to make stocks decline. But it would tend to slow their advance.
Since the inauguration last year, the dollar has been in a steady, unusually steep, decline. That’s the reason, despite heady local-currency gains, the US was the second-worst-performing major stock market in the world last year (the UK, clouded by Brexit folly, was last).
The dollar has stabilized over the past few weeks. The major decision for domestic equity investors so far has been how heavily to weight foreign-currency earners. Further currency decline could lessen overseas support for Treasury bonds, though, as well as signal higher levels of inflation. Either could be bad for stocks.
my thoughts: I don’t think that current developments in fixed income pose a threat to stocks.
My guess is that cash will be a viable alternative to equities sooner than bonds.
Continuing sharp currency declines, signaling the world’s further loss of faith in Washington, could ultimately do the most damage to US financial markets. At this point, though, I think the odds are for slow further drift downward rather than plunge.
I’m not a big fan of Lawrence Summers, but he had an interesting op-ed article in the Financial Times early this month. He observes that, unnoticed by most domestic stock market commentators, the foreign- exchange value of the dollar has steadily deteriorated since Mr. Trump’s inauguration. Currency futures markets are predicting a continuing deterioration in the coming years. He thinks the two things are connected. I do, too.
To my mind, what is happening on Wall Street recently is that currency market worry is now seeping into stock trading as well. If someone forced me to pick a catalyst for this move (I would prefer not to), I’d say it was the possibility, introduced in the press investigation of Cambridge Analytica, that what we’ve believed to be Mr. Trump’s uncanny insight into human motivation (arguably his principal redeeming feature) may be nothing more than his reading a script CA has prepared for him. This would echo the contrast between the role of successful businessman he played on reality TV vs. his sub-par real-world record (half the return of his fellow real estate investors while assuming twice the risk).
The real economic issue is not Mr. Trump’s flawed self, though. Rather, it’s the idea that public policy in Washington generally, White House and Congress, seems to have shifted from laissez faire promotion of businesses of the future to the opposite extreme–protecting sunset industries at the former’s expense. In this scenario, overall growth slows, and the country doubles down on areas of declining economic relevance.
We’ve seen this movie before–in the conduct of Tokyo, protecting the 1980s-era businesses of the descendants of the samurai while discouraging innovation. The result has been over a quarter-century of economic stagnation + a collapse in the currency.