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.
down by 12%
From its intra-day high on January 28th, the S&P 500 dropped to an intraday low of 12% below that last Friday before recovering a bit near the close.
What’s going on?
As I see it, at any given time, liquid investments (i.e., stocks, fixed income, cash) are in a rough kind of equilibrium. If the price of one of the three changes, sooner or later the price of the others will, too.
What I think the stock market is now (belatedly/finally) factoring into prices is the idea that the Fed is firmly committed to raising interest rates away from the intensive-care lows of the past decade. That is, rates will continue to rise until they’re back to “normal” –in other words, until yields on fixed income not only provide compensation for inflation but a real return as well. If we take the Fed target of 2% inflation as a guideline and think the 10-year Treasury should have a 2% real return, then the 10-yr yield needs to rise to 4% — or 115 basis points from where it is this morning. Cash needs to be yielding 150 basis points more than it does now.
One important result of this process is that as fixed income investments become more attractive (by rising in yield/falling in price), the stock market becomes less capable of sustaining the sky-high price-earnings ratio it achieved when it was the only game in town. PEs contract.
Stocks are not totally defenseless during a period like this. Typically, the Fed only raises rates when the economy is very healthy and therefore corporate earnings growth is especially strong. If there is a typical path for stocks during a cyclical valuation shift for bonds, it’s that there’s an initial equity dip, followed by several months of going sideways, as strong reported earnings more or less neutralize the negative effect on PEs of competition from rising fixed income yields.
living in interesting times
Several factors make the situation more complicated than usual:
–the most similar period to the current one, I think, happened in the first half of the 1990s–more than 20 years ago. So there are many working investment professionals who have never gone through a period like this before
–layoffs of senior investment staff during the recession, both in brokerage houses and investment managers, has eroded the collective wisdom of Wall Street
–trading algorithms, which seem not to discount future events (today’s situation has been strongly signaled by the Fed for at least a year) but to react after the fact to news releases and current trading patterns, are a much more important factor in daily trading now than in the past
–Washington continues to follow a bizarre economic program. It refused to enact large-scale fiscal stimulus when it was needed as the economy was crumbling in 2008-9, but is doing so now, when the economy is very strong and we’re at full employment. It’s hard to imagine the long-term consequences of, in effect, throwing gasoline on a roaring fire as being totally positive. However, the action frees/forces the Fed to raise rates at a faster clip than it might otherwise have
For the past year, the dollar has fallen by about 15%–at a time when by traditional economic measures it should be rising instead. This represents a staggering loss of national wealth, as well as a reason that US stocks have been significant laggards in world terms over the past 12 months. I’m assuming this trend doesn’t reverse itself, at least until the end of the summer. But it’s something to keep an eye on.
A 4% long bond yield is arguably the equivalent of a 25x PE on stocks. If so, and if foreign worries about Washington continue to be expressed principally through the currency, the fact that the current PE on the S&P 500 is 24.5x suggests that a large part of the realignment in value between stocks and bonds has already taken place.
If I’m right, we should spend the next few months concentrating on finding individual stocks with surprisingly strong earnings growth and on taking advantage of any individual stock mispricing that algorithms may cause.
This is mostly a reply to reader Alex’s comment on a post from early 2017 about Disney (DIS).
The most common, and in my opinion, most reliable method securities analysts use to project future earnings for multi-business companies is doing a separate analysis for each business line. This effort is aided by an SEC requirement that such publicly traded companies disclose operating revenues and profits for each line of business it is in.
In the case of DIS, it’s involved in: broadcast, including ESPN; movie production and distribution; theme parks and resorts; and sales of merchandise related to the other business lines.
There is plenty of comparative data–from trade associations, government bodies and the financials of publicly traded single-business firms–to help with the analysis. And every company has, in theory at least, an investor relations department that answers questions put to it by investors. ( My experience since retiring as a money manager for institutional clients is that many backward-thinking well-established companies–DIS and Intel come to mind–can be distinctly unhelpful to their most important supporters, you and me. (To be fair, I haven’t spoken with DIS’s IR people for several years, so they may be better now.))
Analysis consists in projecting revenues/ profits for each business line and using the results as the key to constructing a series of whole-company income statements–one each for this year, next year and the year after that.
The trickiest part is to decide how to value this earnings stream. The ability to do this well either comes with experience or from having worked for a professional investor who’s willing to teach.
More tomorrow, or in a day or two if I don’t get my film editing homework done today.