Trump Stock Market Rally Staring Down Formidable Opponent: Valuation

With the U.S. stock market having rallied 5% since Election Day, many investors are very enthusiastic about President-Elect Trump’s clear agenda of filling his Cabinet with wealthy business people who will be tasked with creating an optimal business environment for American companies. Slashing regulations, cutting corporate tax rates, and incentivizing profits earned overseas to be repatriated back to the U.S. will certainly put a jolt into Corporate America. Perhaps even more crucial to the recent stock market rally is the fact that infrastructure spending and corporate tax cuts are likely to be funded with additional borrowings by the federal government. As a result, we have seen a steep increase in interest rates over the last month, which has led many traders to sell bonds and reallocate that capital into stocks.

But after that asset reallocation is over, then what? Count me as skeptical that this market rally will continue for the next four years. I see two main headwinds that are likely to creep into the picture beginning in 2017; lofty legislative expectations for the Republican-controlled Congress and elevated stock market valuations.

First, there is likely to be a gap between what legislation is actually passed in 2017 and the “best-case scenario” that stocks seem to be banking on today. Dreams of a $1 trillion infrastructure spending program coupled with large personal tax cuts, as well as a reduction in the corporate tax rate from 35% all the way down to 15%, will cost a lot of money. As in trillions of dollars. Where does this money come from?

President Obama has been able to reduce the federal government’s annual budget deficit by more than 50% since he took office, but the U.S. is still spending more than half a trillion dollars more each year than it is bringing in from taxes. There are likely many Republicans who are concerned enough about our country’s finances that they would be unwilling to vote for a material increase in the budget deficit. In that scenario, $1 trillion of spend on infrastructure spending does not work. Corporate tax rates fall to 20-25% instead of 15%, and large personal tax cuts become quite small (remember George W Bush’s $300 per person tax cut in 2001?). A more subdued legislative result would limit the rush of cash into personal and corporate pockets that many are hoping for. Simply put, expectations might be too high.

Even more concerning for the stock market are current valuations. Right now the S&P 500 index trades for roughly 20.5 times estimated earnings for calendar year 2016. The average trailing 12 month price-earnings multiple over the last 50 years is 16 times. Market bulls are quick to point out that interest rates are sitting at below average levels, so stocks deserve to trade at above-average prices. That may be true, but interest rates are on the rise and over the last five years, as interest rates reached record low levels, the S&P 500 index traded between 15 and 20 times trailing earnings. As interest rates rise, stock valuation multiples should go down, not up.

This chart shows year-end price-earnings ratios for the S&P 500 index going back more than 50 years. To smooth out the downward volatility seen during recessions, I used “peak earnings” (highest ever recorded) as opposed to “current earnings” (trailing 12 months). The consensus for 2016 earnings is to get within ~3% of the profit peak, which was in 2014 before oil’s big drop.

Simply put, price-earnings ratios are likely to trend downward over the next few years. In order for stock prices to continue their march higher, corporate profits would really need to grow quickly. If legislative action on that front disappoints in 2017, the current market optimism could very well die down quickly. Normally, Trump’s election could very well have marked the beginning of a prolonged bull market in stocks, due to his desire to put business leaders in powerful positions (the underlying assumption being that these folks will be more friendly to business than any other constituency). The big headwind to that theory this time around is that during President Obama’s two terms in office, the Dow Jones Industrial Average has soared from below 8,000 to over 19,000. As a result, the old adage that “trees don’t grow to the sky” seems particularly relevant, no matter the legislative agenda.

That is not to say that markets are going to reverse course and move dramatically lower. I think a more likely outcome is that P/E ratios move from 20-21x to 16-18x and corporate profits grow at a 5-10% annual clip. In that scenario (7.5% annual profit growth and a 17x P/E), the S&P 500 index in four years would be trading around 2,475, or roughly 10% above current levels. Not a terrible outcome, but hardly robust either.

2016 Election: Thoughts The Day After

It is reasonable to expect that the financial markets will see an increase in volatility over the coming months as folks try to decipher exactly how a Trump presidency will look, feel, and sound. I thought I would share some initial thoughts, both on the election result and how U.S. policy might evolve in 2017.

  • The conventional wisdom as people digest the election results is likely to be that Trump had a unique ability to connect with a set of voters that might not have been regular voters in past cycles and were sick and tired of the political status quo (high turnout), whereas Clinton had a last name and a resume that defined that very persona (low turnout). I doubt it will get much airtime, but it turns out that only one of those scenarios played out. Below is a summary of the popular vote totals from the last four elections. I think it is quite striking and explains the result this year.popvote
  • From a business and financial market perspective, there are several issues that are likely to be addressed in 2017 now that Republicans will control the executive and legislative branches of government. They have both positive and negative aspects, which means that the exact details will be very important. Several come immediately to mind:
    • Overseas cash repatriation
    • Corporate tax reductions
    • Personal income tax reductions
    • Infrastructure spending
  • In every case, the core question will be how/if the tax cuts/spending increases are paid for
  • If not, more borrowing will increase the deficit and debt, which would exacerbate an existing problem
  • If they are paid for, it will be important to see which segment of the country takes the brunt of the cuts. We have seen in the past that cutting services for the working class to pay for lower taxes for the wealthy and corporations doesn’t work so well, so the ideal scenario would be relatively equal benefits for everyone
  • Bringing foreign cash back to the U.S. should be a no-brainer no matter your political affiliation. There is no doubt that it benefits the wealthy more than others, but it makes no sense for trillions of dollars to be idling in foreign bank accounts in perpetuity
  • Lower corporate taxes would definitely boost the stock market and it would be a very rational response. Again, the key is how they would be paid for (if at all) and whether cuts elsewhere would offset the benefits. Again, wealthier people have more assets invested in the markets, but higher stock prices help the value of retirement accounts no matter the size
  • Starting in 2017 it should be abundantly clear what the priorities of the new administration are and how they will approach legislating them. Only then will we have a sense for whether economic optimism is warranted or not.

U.S. Stock Market Post-Brexit: The Beat Goes On

Friday’s somewhat surprising Brexit vote (given that the polls showed both sides neck in neck, I cannot agree with the media that a 52-48 vote was a “shock”) reminds me a lot of the financial market turmoil that was brought on by Greece’s tumult several years ago. The fear was always about a European contagion rather than a huge impact from the main event. As I reminded people back then, Greece is roughly the size of Ohio and therefore we could extrapolate its ultimate impact on the rest of the world to have its limits. The U.K. is definitely larger in population than Greece (about the size of California and Texas combined), but it remains a small sliver of the globe.

As was the case then, the Brexit vote is going to have its biggest impact locally as the U.K. tries to figure out exactly what it means and how to tread slowly in order to minimize economic disruption. Companies doing business in Europe will have to contemplate their next steps, but by and large it should be business as usual for most players in the region. The stock market reaction has been interesting because one can point to obvious losers where substantial market devaluations seem warranted (U.K. banks, for instance), but also many that seem to be painted with the guilt by association brush. Anheuser Busch InBev (based in Belgium) and Shire (based in Ireland) each fell by 5-10% on Friday despite the fact that sales of beer and pharmaceuticals should be unaffected (in fact, perhaps alcohol consumption in the region sees a tick upwards in coming months). Those types of investment scenarios might be ripe for picking.

Other areas are worth watching too. U.S. commercial and investment banks are actually very healthy these days after taking dramatic capital raising measures post-housing crisis. If one was looking for a chance to buy well-run firms such as JP Morgan or Goldman Sachs on sale, the current drops might look quite appealing. For those brave souls who want to scour the U.K. for riskier options (not a task I plan on undertaking, simply due to my lack of knowledge of the region), there will not be a shortage of opportunities to ponder. After all, British Telecom has lost 25% of its value over the last two days, despite operating a business traditionally seen as fairly defensive in nature. A bank it is not.

With the U.S. market only down about 6% from its all-time high, I think it is too early to be either overly worried or overly eager to gobble up stock bargains. Consider that the crash of 1987 was a 500 point decline that equated to 23% of the market’s value. Friday’s 600 point drop was a little more than 3%.

U.S. Unemployment Rate Drops To Historical Average in January

Since the political party in power will always try to spin economic data postively, while the opposing party tries to convince you the country is still in the doldrums, sometimes it’s nice to put metrics like the U.S. unemployment rate in perspective by showing historical data without political interference. Accordingly, below is a chart of the unemployment rate over the last 40 years. As you can see we are back down to “average” today (the 40-year mean is the red line), so things are neither great nor terrible. That’s surely not what you’ll hear as the mid-term elections get into full swing this year, but that’s yet another reason why politics and investment strategies shouldn’t be mixed. Investing is far more dependent on reality than politics.

40Year-US-UE-Rate-1975-2014

Part Time Workers, Consumer Spending, And The Affordable Care Act

Don’t worry, no political arguments will be made here. That is not worth the effort for the author or the readers of this blog. However, since we are focused on stock picking as investors, it is a valuable exercise to dig into the data and determine if there will be a material impact on U.S. corporate profits because of the Affordable Care Act. After all, if consumers’ pockets are squeezed from fewer hours worked each week and/or the need to start buying health insurance for the first time, that would definitely impact the sales and earnings of the companies we are invested in. And that could hurt our portfolios.

Since the September jobs report came out this week I decided to take a look and see if the trend than many people fear as a result of the new healthcare law — employers shifting full-time workers to part-time status in order to be exempt from being required to provide them with health insurance — has actually started to take hold. Many people have already argued one way or the other, but most of them have political motivations and rely on a small subset of anecdotal reporting without actually looking at the numbers and reporting the truth.

The good news for our investment portfolio is that this trend has yet to materialize. It certainly could in the future, so we should continue to monitor the situation, but so far so good. Last month there were 27, 335,000 part-time workers, out of a total employed pool of 144,303,000. That comes out to 18.6% of all employed people working part-time (defined as less than 35 hours per week). That compares with 26,893,000 part-time employees during the same month last year, which equated to 19.1% of the 142,974,000 employed persons. Interestingly, part-time workers are actually going down in both absolute terms and relative to full-time workers. These numbers will fluctuate month-to-month, but it clearly has not happened as of yet.

The other potential problem with the Affordable Care Act, and more specifically the requirement that everyone buy health insurance, is that discretionary consumer spending could fall as more of one’s after-tax income goes towards insurance and is not spent on discretionary items. We should remember of course that consumer spending counts the same in the GDP calculation regardless of whether or not we buy insurance or other things, so there is no overall economic impact. But, we should expect to see consumers allocate their funds differently, which could impact specific areas of the economy (vacationing, for instance).

But just how much of an impact will this have? Will it be large enough to materially hurt the earnings of many public companies? To gauge the overall potential for that we need to dig into more numbers.

About 15% of the U.S. population does not have health insurance. Let’s assume 100% compliance with the Affordable Care Act (either via the purchase of insurance or the payment of the penalty for not doing so). Let’s further assume that the net negative financial impact of such compliance comes to 5% of one’s income (not an unfair assumption based on insurance premiums). That means that approximately 0.75% of consumer spending (5% x 15%) would be reallocated to healthcare and away from other areas. While that is not a big shift, it would be real.

However, the analysis can’t end there. We can’t simply conclude that approximately 1% of non-healthcare consumer spending will be lost due to the new law. Why not? Because that would assume that every American earns the same income. In reality, those impacted by the Affordable Care Act (the uninsured), are skewed towards lower and middle income folks. Most wealthier people get health insurance through their full-time jobs and will continue to do so.

Now, the bottom 50% of Americans only make 15% of the income earned nationwide. If we factor that point into the equation, then the overall impact on consumer spending goes from quite small (0.75% per year) to fairly immaterial. In fact, it comes out to something around 0.2% of overall consumer spending per year if we assume that the average uninsured person falls into the 25th percentile of total income.

So what is my conclusion from all of this? Well, I own a lot of shares in consumer-related companies both personally and for my clients, and I am not concerned about the Affordable Care Act taking a meaningful bite out of the profits that those companies are going to generate in the future.

CBO Projects U.S. Budget Problem Solved For Now

It’s amazing what some tax hikes coupled with spending cuts can do for a $1.1 trillion annual budget deficit (just kidding… actually, it’s pretty logical). The Congressional Budget Office (CBO), the leading group of nonpartisan budget number-crunchers, now projects that the U.S. federal budget deficit will shrink by an astounding 41% this year, from $1.087 trillion to $642 billion. The reason? Tax receipts are rising faster than expected. Couple that with budget cuts and the result is a huge dent in the annual funding gap for the federal government.

Even more important than a one-year annual decline is the trend CBO sees for the next decade. Here is a chart of their annual deficit projections through 2023:

deficitsbillions

As you can see, the deficit hits bottom in 2015, so this (falling deficits) is not a one-time 2013 event. Now, you may look at the rest of that chart and conclude that the good times will be short-lived, as the deficit climbs back to about $900 billion by 2022. If you are just looking at the absolute numbers alone, that would be concerning. However, we need to remember that the deficit as a percentage of GDP is what matters. Somebody making a $1 million a year, for instance, can afford a $10,000 per month mortgage payment. Somebody making $50,000 a year cannot. The ability to carry debt and service it adequately depends on how much money you have to work with, making the absolute numbers meaningless without context.

So what do the above numbers look like if we look at the deficit as a percentage of annual U.S. GDP? Here is that chart:

deficitspctgdp

The key number here is the last bar, which shows that the average deficit over the last 40 years (1973-2012) has been 3.1% of GDP. All of the sudden those later years don’t look so scary, even though from 2015 to 2022 the deficit nearly doubles on percentage terms.

Now, it is certainly true that if we do nothing to adjust the long-term Social Security or Medicare payments we are scheduled to make, then the deficit will become a huge problem again down the road. However, it is very important to understand from an investing perspective (and possibly from a political one as well), that over the next decade we really will not have a debt problem as long as current law remains in effect and the CBO’s baseline assumptions about the economy are close to accurate. Although plenty of people hated the tax hikes and/or the budget cuts that took effect this year, they are doing wonders for our debt problem. Personally, I’ll take longer term gains with shorter term pains anytime, if the alternative is the exact opposite.

Would Going Over The Fiscal Cliff Really Be That Bad?

Easily the most frustrating thing about being a long-term investor nowadays is how short-term focused Wall Street has become in recent years (or more accurately, the last two decades). Quarterly earnings reports and whether companies slightly beat or slightly miss estimates made by a bunch of number-crunchers in New York result in huge share price volatility. Owners of real businesses would be the first to tell you that small quarter-to-quarterly fluctuations in sales and profits are far less important than the long-term strength, viability, and competitive position of their companies.

Political leaders have the same problem; they are obsessed with the short term because they are up for reelection so frequently. If you listen to the media, or your elected representatives, you would think going over the fiscal cliff would be absolute catastrophe. But is that actually true? Well, it depends on whether you care about the short term or long term outlook for the finances of the United States.

The Congressional Budget Office (CBO), the non-partisan fiscal accountant for Congress, projects that the U.S. would fall into a mild recession if we went over the fiscal cliff, and that the unemployment rate would rise from 8% to 9% in 2013 as a result. In 2014, the economy would return to growth, much like we have today. That is the short-term impact. And yes, that is a bad outcome for politicians currently holding office.

But what about the long-term view? Are there any positive effects that might make it worth it to have a short, mild economic downturn in 2013? This is a question the media and politicians rarely speak about. For instance, did you know that without any actions to blunt the impact of going over the fiscal cliff, the U.S. budget deficit ($1.1 trillion in fiscal year 2012) would fall 43% from 2012 to 2013. In 2014 it would fall another 40%. In 2015 it would fall another 45% (all figures are current CBO estimates). At that point, the U.S. federal budget would essentially be balanced. The deficit problem would vanish within three years, and that is if we do absolutely nothing! Congress could actually accomplish something important by not passing a single piece of legislation!

One could easily argue that the best long-term outcome for the U.S. economy would be to have a balanced budget within three years, even if it meant taking some short-term pain in 2013 as tax rates reset to Bill Clinton-era levels. But nobody is taking a longer term view. Everyone is acting as if they are on Wall Street and care only about the immediate future. There is absolutely no chance that our country’s leaders do nothing and balance the budget, even though they would all agree that $1 trillion annual deficits are unsustainable and are easily the biggest problem the U.S. faces in the intermediate term.

Instead, we should expect that politicians will opt to extend most of the Bush tax cuts and postpone or eliminate most of the planned spending cuts. Such a plan would do nothing to reduce our deficits and sets us up for much bigger problems a few years down the road. What people don’t seem to understand is that the debt crisis that will arise from $1 trillion annual deficits year after year is many times worse than the relatively mild 2013 recession that inaction on the fiscal cliff would cause. Don’t believe that? Just ask Greece or Spain, where unemployment rates are over 25%.

Consumer Debt Paydown Crimps GDP Growth

It’s election season so both candidates would love for you to think that the POTUS has a lot of control over economic growth, but this week we got a report that sheds light on one of the major reasons the U. S. economy is growing at around 2%, down from its long-term average of around 3% per year. The New York Federal Reserve reported that credit card debt balances last quarter dropped a $672 billion, a level not seen since 2002. It also marks a 22.4% decline from the peak we saw in the fourth quarter of 2008.

So how exactly has this de-leveraging trend negatively impacted GDP growth? Well, consumer spending represents about 70% of GDP, so a drop in credit card balances of $200 billion over the last few years represents a lot of money that was sent off to pay bills, not spent on goods and services. Toss in another $100 billion of spending that would normally be incremental over that time period due to overall growth in the underlying economy, and you can see that about $300 billion of consumer spending has been absent from the system, compared to what would have been normal.

With annual U.S. GDP at around $15 trillion, this consumer credit card de-leveraging represents about 2% of GDP growth lost. Over 3-4 years, that comes out to about 0.5% GDP impact per year. In a world where GDP growth has dropped a full percentage point from its long-term normalized level, consumer debt repayments account for a major portion of that slowdown. You aren’t likely to hear much about that on the campaign trail, but politicians rarely deal with facts and truths when it comes to hot-button issues like the economy.

The Obama Bull Market Continues

Below are some pretty surprising statistics, regardless of which political party you side with. With today’s stock market rally, thanks to another strong employment report, the S&P 500 index has now risen more than 20% per year since President Obama moved into the Oval Office, besting even Bill Clinton’s best term as Commander in Chief. This could certainly play a role in the 2012 campaign, but it is also important to note that although the U.S. unemployment rate has fallen from a peak of 10.0% down to 8.3%, it is a still above the 7.3% level from January 2009, the month Obama took office.

Let’s Face It, Given All That Has Happened Lately, A Market Correction Makes Sense

In a few short days I leave town for a two-week vacation (interesting timing I know, but it has been planned for months and therefore not market-related) but before I leave these volatile markets behind for some refreshing time away I think a few comments are in order. As I write this the Dow is down 400 points to below 11,500 and the S&P 500 index has now dropped 11% from its 2011 high. In the days of computer-driven trading stock market moves are more pronounced and happen faster than ever before, so it is important to keep things in perspective.

First, given everything that has happened in Europe this year, coupled with our own ugly debt ceiling political debate in Washington DC, it is completely reasonable to have a stock market correction. I would even go a step further and say it was a bit odd that the market held up so well prior to last week’s debt ceiling dealings. Historically the U.S. stock market has corrected (by 10% or more) about once per year. The last one we had was a 17% drop in 2010 during the initial Greece debt woes. That we have another one now in 2011 is not only predictable based on history, but especially when we factor in everything going on lately financially, economically, and politically. Let’s keep the market swoon of the last week or two in context.

From an economic standpoint, investors need to realize we really are in a new paradigm. The U.S. economy was goosed up by debt, both at the consumer level (credit bubble) and at the government level (tax cuts along with increased spending). As a result, we have to see both groups de-lever their balance sheets. Consumers are reducing debt and saving more, and many don’t have jobs. The government is now beginning to cut back as well. Consumer spending represents 70% of U.S. GDP and government spending, at $3.6 trillion per year, makes up another 25%. Corporations are the only bright spot in today’s landscape, with record earnings and stellar balance sheets, but their spending is only the remaining 5% of GDP. With both consumers and government agencies cutting back, a slowing economy and lackluster job growth are all but assured.

So are we headed back into a late 2008, early 2009 situation for both the economy and financial markets? While anything is possible, we probably should not make such an assumption. A slowing economy (say, 1-2% GDP growth) is far better than what we had at the depths of the financial crisis with 700,000 jobs being lost per month, negative GDP of several percentage points, and runs on the country’s largest banks. The 2008-2009 time period did not reflect a normal recession (which would last 6-9 months and be relatively mild). It was far worse this time and those events typically only happen once per generation, not once every few years.

The best case scenario short term is that the markets calm down and we meander along with 1-2% growth. Not good, but not horrific either. Could we slip back into a garden-variety recession due to government cutbacks, 9% unemployment, and a deteriorating economy in Europe? Sure, but that would likely result in a more typical 20% stock market decline over several quarters, not a 50-60% drubbing. And keep in mind we are already down 11% in a few short trading sessions.

What does this mean for the stock market longer term? Well, believe it or not, there are reasons for optimism once investors calm down and we really get a sense of what we are dealing with. With slow economic growth interest rates are going to stay near all-time lows. Buyers of government bonds today are accepting 2.5% per year in interest for a 10-year bond. Savings accounts pay 1% if you are lucky. The S&P 500 stock index pays a 2% dividend and many stocks pay 3% or more. Given the financial backdrop for U.S. corporations relative to the U.S. government, which do you think is a better investment; lending the government money for 10 years at 2.5% or buying McDonalds stock and collecting a 2.9% annual dividend? Investment capital will find its way to the best opportunities and even with slow growth along with the possibility of a double-dip recession, U.S. stocks will look attractive relative to other asset classes.

As a result, I think there are reasons to believe the current market correction is going to wind up being much more normal than the 2008-2009 period. With interest rates and government finances where they are, equity prices can easily justify a 12-14 P/E ratio. Maybe stock market players before the last week or two were just hoping we could escape all of this unscathed, despite the fact that market history shows that is rarely the case. In any event, while I am looking forward to spending some time away from the markets, I am not overly concerned about this week’s market action, especially in the context of global events lately. My hope is that by the time I return markets have calmed down and we can revisit how to play the upcoming 2012 presidential election cycle, even though that thought alone makes me want to take far more than two weeks off. 🙂