I’ve just updated my Keeping Score page for February and year-to-date. What a strange time!
When a country is having economic problems–slow growth, outdated industrial base, weak educational system, balance of payments issues–there are generally speaking two ways to fix things:
–internal adjustment, meaning fixing the domestic problems through domestic government and private sector action, and
–external adjustment, meaning depreciating the currency.
The first approach is the fundamentally correct way. But it requires skill and demands a shakeup of the status quo. So it’s politically difficult.
Depreciating the currency, on the other hand, is a quick-fix, sugar-high kind of thing, of basically trying to shift the problem onto a country’s trading partners. The most common result, however, is a temporary growth spurt, a big loss of national wealth, and resurfacing of the old, unresolved problems a few years down the road–often with a bout of unwanted inflation. The main “pluses” of depreciation are that it’s politically easy, requires little skill and most people won’t understand who’s at fault for the ultimate unhappy ending.
the Great Depression of the 1930s;
the huge depreciation of the yen under PM Abe, which has impoverished the average Japanese citizen, made Japan a big tourist destination (because it’s so cheap) and pumped a little life into the old zaibatsu industrial conglomerates.
It’s understandable that Donald Trump is a fan. It’s not clear he has even a passing acquaintance with economic theory or history. And in a very real sense depreciation would be a reprise of the disaster he created in Atlantic City, where he freed himself of personal liabilities and paid himself millions but the people who trusted and supported him lost their shirts.
Elizabeth Warren, on the other hand, is harder to fathom. She appears to be intelligent, thoughtful and a careful planner. It’s difficult to believe that she doesn’t know what she’s supporting.
bull market = strong economy?
Does stock market strength always mean a booming economy?
The short answer is no.
Mexico in the 1980s
The best illustration I can think of is Mexico in the 1980s. That economy was a disaster, which played out first of all in the currency markets, where the peso lost 98% of its value vs. the US$ during that decade. Despite this, in US$ terms the Mexican stock market was hands down the best in the world over the period, far outpacing the S&P 500.
…a domestic form of capital flight is the short story.
An incompetent and corrupt government in Mexico was spending much more than it was taking in in taxes but was loathe to raise interest rates to defend the peso. Fearing currency depreciation triggered by excessive debt, citizens began transferring massive amounts of money abroad, converting their pesos mostly into US$ and either buying property or depositing in a bank. This added to downward pressure on the peso. In September 1982 the government instituted capital controls to stem the outflow–basically making it illegal for citizens to convert their pesos into other currencies (Texas, which had been a big beneficiary of the money flow into the US, will remember the negative effect stemming it had).
With that door closed, Mexican savers turned to the national stock market as a way to preserve their wealth. They avoided domestic-oriented companies that had revenues in pesos. They especially shunned any with costs in dollars. They focused instead on gold and silver mines or locally-listed industrial companies that had substantial earnings and assets outside Mexico. The ideal situation was a multinational firm with revenues in dollars and costs in pesos.
today in the US
To be clear, I don’t think we’re anything close to 1980s Mexico. But it trying to explain to myself what’s behind the huge divergence in performance between companies wedded to the US economy (bad) and multinational tech (good) I keep coming back to the Mexico experience. Why?
I don’t see the US economic situation as especially rosy. Evidently, the stock market doesn’t either. In tone, administration economic policy looks to me like a reprise of Donald Trump’s disastrous foray into Atlantic City gambling–where he made money personally but where the supporters who financed and trusted him lost their shirts.
What catches my eye:
–tariff and immigration actions are suppressing current growth and discouraging US and foreign firms from building new plant and equipment here
–strong support of fossil fuels plus the roadblocks the administration is trying to create against renewables will likely make domestic companies non-starters in a post-carbon world outside the US. Look at what similar “protection” did to Detroit’s business in the 1980s.
–threats to deny Chinese companies access to US financial markets and/or the US banking system are accelerating Beijing’s plans to create a digital renminbi alternative to the dollar
–the administration’s denial of access to US-made computer components by Chinese companies will spur creation of a competing business in China–the same way the tariff wars have already opened the door to Brazil in the soybean market, permanently damaging US farmers
–not a permanent issue but one that implies lack of planning: isn’t it weird to create large tax-cut stimulus but then until it wears off to launch a trade war that will cause contraction?
Then there are Trump’s intangibles–his white racism, his sadism, his constant 1984-ish prevarication, his disdain for honest civil servants, his orange face paint, the simulacrum he appears to inhabit much of the time, the influence of Vladimir Putin… None of these can be positives, either for stocks or for the country, even though it may not be clear how to quantify them. (A saving grace may be that the EU can’t seem to get its act together and both China and the UK appear to be governed by Trump clones.)
Two of them:
1.If you were thinking all this, how would you invest your money?
Unlike the case with 1980s Mexico, there’s no foreign stock market destination that’s clearly better. China through Hong Kong would be my first thought, except that Xi Jinping’s heavy-handed attempt to violate the 1984 handover treaty has deeply damaged the SAR. So we’re probably limited to US-traded equities.
What to buy?
–that are structural change beneficiaries
–whose main attraction is intellectual property, the rights to which are held outside the US,
–with minimum physical plant and equipment owned inside the US, and
–building new operating infrastructure outside the US, say, across the border in Canada.
As I see it, this is pretty much what’s going on.
2.What happens if Mr. Trump is not reelected?
A lot depends on who may take his place. But it could well mean that we return to a more “normal” economy, where the population increases, so too economic growth, corporate investment in the US resumes, domestic bricks-and-mortar firms do better–and some of the air comes out of the software companies’ stocks.
At first glance, the performance of the S&P 500 would seem to say yes–the S&P 500 is up by 47% since the first trading day of January 2017. That’s substantially better than Europe or Japan has done over the same time period. On the other hand, the US–which caused the global financial crisis–was first out of the blocks in repairing ailing banks.
Look a little closer, however, and the evidence from the S&P is not so clear. There are a number of factors involved:
–about half the earnings of the S&P come from outside the US
–major domestic industries like housing or autos have little representation in the S&P
–tech companies, which don’t employ a ton of people and many of which don’t need offices or showrooms, make up about a quarter of the index.
The Russell 2000, an index made up of mid-sized, mostly domestic firms, is–I think–a much better indicator of how things are going for the average American.
looking at US stocks
Russell 2000 = US-based, US-serving firms flat
S&P 500 = half US/half foreign earnings +3%
S&P 500 software = half US/half foreign earnings, no US plants needed +13%
Russell 2000 +8%
S&P 500 +22%
S&P 500 software +32%
Russell 2000 +23%
S&P 500 +47%
S&P 500 software +75%
What’s going on?
To state the obvious, investors are much more interested in betting on forces of structural change than on the administration’s efforts to pump life into traditional industries. It may also be that the market thinks, as I do, that the MAGA plan (if that’s the right word) will end up being a lot like Mr. Trump’s foray into Atlantic City gambling–where he profited personally but knew surprisingly little, with the result that the people who supported and trusted him lost almost everything.
What’s been running through my mind recently, though, is the resemblance between this US market and the Mexican bolsa in the 1980s.
I’ve just updated myKeeping Score page for January. weaker world economy = interest rates lower for longer = more buoyancy in stock markets
The Russell 2000, which is composed of medium-sized US-based firms serving mostly US customers is up by 4.5% over the past two years. This compares with +16.5% for the S&P 500 and +25.5% for the NASDAQ, which are far more globally oriented. (These are capital changes figures, which I plucked off Yahoo Finance.)
The latter two are 3.7x and 5.7x the return on the Russell 2000. Attention grabbing, yes, but not the right way to sum up the situation. More important is that these ratios happen because ex dividends the Russell has returned pretty close to zero.
The S&P 500 is trading at about 25x current earnings, with 10% eps growth in prospect, implying the market is trading at around 22.7x forward earnings. During my working career, which covers 40+ years, high multiple/lower growth has virtually always been an unfavorable combination for market bulls.
Could the growth figure be too low, on the idea that forecasters give themselves some wiggle room at the beginning of the year?
For the 50% or so of earnings that come from the US, probably not. This is partly due to the sheer length of the expansion since the recession of 2008-09 (pent up demand from the bad years has been satisfied, even in left-behind areas of the country–look at Walmart and dollar store sales). It’s also a function of shoot-yourself-in-the-foot Washington policies the have ended up retarding growth–tariff wars, suppression of labor force expansion, tax cuts for those least likely to consume, no infrastructure spending, no concern about education… So I find it hard to imagine positive surprises for most US-focused firms.
Prospects are probably better for the non-US half. How so? In the EU early signs are emerging that structural change is occurring, forced by a long period of stagnation. The region is also several years behind the US in recovering from the recession, so one would expect that the same uptick for ordinary citizens we’ve recently seen in the US. Firms seeking to relocate from the US and the UK are another possible plus. In addition, Mr. Trump’s life-long addiction to risky, superficially attractive but ultimately destructive, ventures (think: Atlantic City casinos) may finally achieve the weaker dollar he desires–implying the domestic currency value of foreign earnings may turn out to be higher than the consensus expects.
The biggest saving grace for stocks may be the relative unattractiveness of fixed income, the main investment alternative. The 10-year Treasury is yielding 1.81% as I’m writing this That’s 10 basis points below the dividend yield on the S&P 500, which sports an earnings yield (1/PE) of 4. I say “may” because, other than Japan, the world has little practical experience with the behavior of stocks while interest rates are ultra-low. In Japan, where rates have flirted with zero for several decades, PE ratios have declined from an initial 50 or so into the low 20s. Yes, Japan is also the prime example of the economic destructiveness of anti-immigration, anti-trade, defend-the-status-quo policies Washington is now espousing. On the other hand, it’s still a samurai-mentality (yearning for the pre-Black Ship past) culture, the population is much older than in the US and the national government is a voracious buyer of equities. So there are big differences. Still, if the analogy with Japan holds–that is, if the differences don’t matter so much in the short term–then PEs here would be bouncing along the bottom and should be stable unless the Fed Funds rate begins to rise.
That’s my best guess.
The consensus was of viewing last year for the S&P is that all the running was in American tech industries. Another way of looking at the results is that the big winners were multinational firms traded in the US but with worldwide markets and very small domestic manufacturing and distribution footprints. They are secular change beneficiaries located in a country whose national government is now adamantly opposing that change. In other words, the winners were bets on the company but against the country. Look at, for example, AMZN (+15%) vs. MSFT (+60%) over the past year.
The biggest issue I see with the 2019 winners is that on a PE to growth basis they seem expensive to me. Some, especially newer, smaller firms seem wildly so. But I don’t see the situation changing until rates begin to rise.
Having said that, low rates are an antidote to government dysfunction, so I don’t see them going up any time soon. So my practical bottom line ends up being one of the gallows humor conclusions that Wall Streeters seem to love: the more unhinged Mr. Trump talks and acts–the threat of bombing Iranian cultural sites, which other governments have politely pointed out would be a war crime, is a good example–the better the tech sector will do. As a citizen, I hope for a (new testament) road-to-Damascus event for him; as an investor, I know that would be a sell signal.