what to do on a rebound day

It doesn’t appear to me that the economic or political situation in the US has changed in any significant way overnight.  Yet stocks of most stripes are rising sharply.

What to do?   …or if you prefer, what am I doing?

Watching and analyzing.

A day like today contains lots of information, both about the tone of the market and about every portfolio’s holdings.  Over the past month, through 2:30 pm est today, the S&P is down by 4.8%.  The small-cap Russell 2000 has lost 7.7%, NASDAQ 7.8%.   All three important indices are up significantly so far today—NASDAQ +2.2%, Russell 2000 +1.9%, S&P 500 +1.8%.  So this is a general advance.  Everything is up by more or less the same amount, meaning investors aren’t homing in on size or foreign/domestic as indicators for their trading.

What we should all be looking for, I think, is what issues that should be going up–either because they’re high beta or have been beaten up recently–are shooting through the roof and which are lagging.  (“Lagging” means underperforming other similar companies or underperforming the overall market.)  The first category are probably keepers.  The poor price action for the latter says they should be subjects for further analysis to figure out why the market doesn’t appreciate their merits.  Maybe there aren’t any.  

We should also note defensive stocks that are at least keeping up with the S&P.  That’s better than they should be doing.  They may well be true defensives, meaning they stay with the market (more or less) on the way up and outperform on the way down.  This is a rare, and valuable, breed in today’s world, in my view, and can be a way to hedge downside risk.

 

 

Another topic:  Over the past few days, I’ve been in rural Pennsylvania filming my art school thesis project–yes, I’ve gone from stills to video–so I haven’t kept up with the news.  I’m surprised to see that the UK, which still remembers the enormous price it paid a generation ago resisting fascism, has done an abrupt about-face and allowed Mr. Trump to make a state visit.  The anticipated consequences of Brexit must be far more dire than the consensus expects.

more tariffs?

Wall Street woke up today to an announcement from Mr. Trump that he intends to place a tariff on all goods coming into the US from Mexico.  The levy will be in effect until that country prevents immigrants/asylum seekers from reaching its border with the US.  The initial rate will be 5%, escalating to 25% by October.

As an American, I think I can understand the issues the administration wants to address.  But I find it more than a little unsettling that there seems to be no coherent, well-reasoned plan being implemented.  I’m pretty sure tariffs are not the way to go.  Also, both sides of the aisle in Congress appear to be eerily content to watch from the sidelines, rather than make it clear that Mr. Trump does not have authority to levy tariffs without legislative consent (my personal view, for what it’s worth) or limit/revoke that authority if the president does have it now.

 

As an investor, however, my main concern is the much narrower question of how Washington will affect my portfolio.

As to Mexico:  let’s say the US sells $300 billion yearly to Mexico and buys $350 billion.  Most of that is food and car parts.  Even if we sell less to Mexico because of retaliatory tariffs and if imported goods are 15% more expensive–to pluck a figure out of the air–the total direct negative impact on the US + Mexican economies would probably be a loss of around $100 billion in GDP.  How that would be split between the two isn’t clear, but the aggregate figure is 8% of Mexican GDP and 0.5% of US GDP.  So, potentially much worse for Mexico than for the US.

Given the nature of US-Mexico trade, the negative economic impact in the US will be concentrated on lower-income Americans.  If earnings reports from Walmart and the dollar stores are to be believed (I think they are), these are people whose fortunes have finally, and only recently, begun to turn up post-recession.

From a US stock market point of view, neither autos nor food has large index representation.  My guess is the negative impact will be roughly equally divided between negative pressure on directly-affected stocks, including names that cater to the less affluent, and mild downward pressure on stocks in general from slower domestic growth.  Because small caps are more domestically focused than the S&P 500, only half of whose earnings come from the US, the Russell 2000 will likely suffer more than large caps.

 

There are deeper, long-term questions that Washington is raising–about whether the US is an attractive place to establish manufacturing businesses and whether it can be relied on as a supplier to buy from.  In addition, it’s hard to figure out what government policy today is–for example, how new tariffs on Mexican imports square with just-reworked NAFTA, or how imposing tariffs that hurt domestic car manufacturers square with the threat of tariffs on imported vehicles, which do the opposite.

Neither of these concerns are likely to have a significant impact on near-term trading.  But heightened Washington dysfunction must even now be becoming a red flag in multinationals’ planning.

 

 

the threat in Trump’s deficit spending

In an opinion piece in the Financial Times a few days ago, Gillian Tett points to and expands on a comment in a Wall Street advisory committee letter to the Treasury Secretary.  Although it may not have implications for financial markets today or tomorrow, it’s still worth keeping in mind, I think.

The comment concerns the changes in the income tax code the administration pushed through Congress in late 2017.  Touted as “reform,” the tax bill is such only because it brings down the top domestic corporate tax rate from 35%, the highest in the world, to about average at 21%.  This reduces the incentive for US-based multinationals (think: drug company “inversions”) to recognize profits abroad.  But special interest tax breaks remained untouched, and tax reductions for the ultra-wealthy were tossed in for good measure.  Because of this, the legislation results in a substantial reduction in tax money coming in to Uncle Sam.

Ms. Tett underlines the worry that there are no obvious buyers for the trillions of dollars in Treasury bonds that the government will have to issue over the coming years to cover the deficit the tax bill has created.

 

A generation ago Japan was an avid buyer of US government debt, but its economy has been dormant for a quarter-century.  Over the past twenty years, China has taken up the baton, as it placed the fruits of its trade surplus in US Treasuries.  But Washington is aggressively seeking to reduce the trade deficit with China; the Chinese economy, too, is starting to plateau; and Beijing, whatever its reasons, has already been trimming its Treasury holdings for some time.

Who’s left to absorb the extra supply that’s on the way?   …US individuals and companies.

 

The obvious question is whether domestic buyers have a large enough appetite to soak up the increasing issue of Treasuries.  No one really knows.

Three additional observations (by me):

–the standard (and absolutely correct, in my view) analysis of deficit spending is that it isn’t free.  It is, in effect, a bill that’s passed along to be paid by future generations of Americans–diminishing the quality of life of Millennials while enhancing that of the top 0.1% of Boomers

–historically, domestic holders have been much more sensitive than foreign holders to creditworthiness-threatening developments from Washington like the Trump tax bill, and

–while foreign displeasure might be expressed mostly in currency weakness, and therefore be mostly invisible to dollar-oriented holders, domestic unhappiness would be reflected mostly in an increase in yields.  And that would immediately trigger stock market weakness.  If I’m correct, the decline in domestic financial markets what Washington folly would trigger implies that Washington would be on a much shorter leash than it is now.

 

looking at today’s market

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.

Trump on trade

so far:

intellectual property…

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.

…and metals

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.

automobiles next?

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.

 

 

the administration, the economy and the stock market

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