Anti-Bubble and The Economy

 

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Year to date the stock market continues to reach new record highs.  The reasons are anticipation of tax reform by Congress; earnings growth of public corporations; low interest rates from bonds; low inflation; and the perception of an improving economy.

For the first three quarters, the Dow is up 15.45%, the S&P 500 up 14.24% and the NASDAQ up 21.67% lead by technology stocks such as Facebook, Amazon, Netflix and Google (Alphabet).  Growth stocks continue to outperform value stocks by approximately 12.8% year to date.  Information Technology was up 27.36%, Healthcare up 20.31%, Materials up 15.82%, and Industrials up 14.13%.  The worst performing sector was Energy, which was down 6.63%, but was up in the third quarter.  Interest rates in the 10-year Treasury bond have ranged from 2.20% - 2.38%.

Anti Bubble

Powerful bull markets like this one, the second longest in American history, can test value investors’ resolve.  The father of “value investing” was Benjamin Graham, who has been quoted for decades and revered by investment professionals.  One of his disciples is the highly respected co-founder and chief investment strategist at Grantham, Mayo, Van Otterloo (GMO) & Co., Jeremy Grantham.  As written in an article entitled “The Lion In Summer” from the August 2017 edition of Financial Advisor:

[Mr.] Grantham sent clients a quarterly letter that proved more controversial than most of his provocative missives. Titled “This Time Seems Very, Very Different,” Grantham’s letter immediately grabbed the value investing community’s attention. The piece pointed out that equity prices have spent the last two decades oscillating at multiples 65% to 70% above their 1935-1995 norms on a remarkably consistent basis.

The two decades since 1995 have seen two violent bear markets and two very different bull markets. But Grantham identified other, equally significant trends. Notably, the Shiller CAPE (cyclically adjusted price-earnings) ratio had only reverted to its pre-1996 mean for a brief six months during the 2008-2009 financial crisis.

On the surface, his arguments appear grounded in cold, statistical reality. Yet to some value apostles, Grantham’s letter sounded as though he were capitulating to a bubble-like roaring bull market that has bedeviled value investors.

Some people, like Jim Grant, publisher of Grant’s Interest Rate Observer, called the letter an apostasy. “The world is bullish and a bear’s got to eat,” Grant wrote.

Turning the tables on Grantham, Grant argued the 78-year-old was violating the cardinal sin of money management—career risk. Loosely defined, career risk occurs when a money manager decides to run with the crowd and willingly make the same mistake as other mainstream asset managers, secure in the knowledge that he can’t get fired, even if he is wrong,because there are simply too many other lemmings afflicted by the same pandemic of groupthink.

Grant’s accusation amused the British-born Grantham, who believes some members of the value cult need to look at the facts. Furthermore, Grantham doesn’t think the world is bullish at all. Quite the opposite.

Historically, he has reveled in challenging the conventional wisdom of Wall Street’s optimists, so his explanation about why equity prices remained persistently high blindsided the value crowd. After penning his May letter, Grantham discovered another factoid about trailing-12-month PE multiples, which peaked at 21 times earnings in 1929 and never reached that figure again until late 1997. “The entire block of 20 years I’m obsessed with”—1997 to 2017—“has an average PE higher than 1929. Don’t tell me that things aren’t different,” he retorts.

So why is this time really so different, as Grantham argues? “This is not a bubble” as it is completely lacking in “all the psychological stuff you saw in 1999, 1929 and the 2007 housing market,” he says.

To Grantham, today’s equity market feels cold-blooded and bureaucratic. “Almost everything is going up in a boring way,” he explains. “It’s not the nature of a bubble; it’s almost an anti-bubble.”

Grantham sees no euphoria or craziness.

“This market has been characterized by nervous investors” and virtually no public interest, he says. “In June, stocks hit two new highs in one week and it didn’t make the paper.”

Three years ago, he began to discern that there was a lot of positive machinery that supported the persistence of high stock prices. This, despite the fact that some of GMO’s traditional metrics pointed to the S&P 500 being overvalued by 30% or 40%.

Roughly half the level of excess valuation came from record corporate profit margins, which appeared unsustainable, with the other half coming from the PE multiples themselves. Profit margins were once about the most reliably “mean-reverting” data series in finance. But Grantham surmised that, with corporate America’s huge increase in power over the last 40 years, hefty margins might be sustainable, even if it continued to widen income inequality since more GDP is going to corporate profits than labor.

Other powerful factors were also at play. A student of the presidential election cycle’s impact on stock market swings, he suspected that U.S. equities would stay strong through the 2016 election.

In the slow GDP growth environment pervasive in the post-2000 world, a different variant of the career risk syndrome has appeared in the CEO suite. Caution among CEOs is particularly pronounced since the financial crisis.

One upshot is that risk-averse CEOs, when given the choice, are likely to take the easy route, increase dividends and repurchase shares to drive up their stocks so they can exercise their options and ride off into the sunset. Most CEOs face a tenure of less than eight years. In today’s unforgiving world, the odds of initiating a bold venture entailing up-front losses, then failing and yet still surviving are small indeed.

Another reason is a global savings imbalance. People in China and many emerging markets are over-saving, while those in the developed world are aging and playing catch-up because they haven’t saved enough. Opposite though these trends may be, both drive demand for financial assets.

Monetary policy and low inflation are other obvious factors. Former Fed chairmen Alan Greenspan and Ben Bernanke both possessed outsized faith in the magic of cheap money. “Bernanke had great faith that monetary policy could stimulate growth,” Grantham says. “It’s a delusion. Since Greenspan [became Fed chairman in 1987], we tripled our debt and growth has slowed noticeably.” From his recent remarks, Greenspan appears to believe low productivity and growth are the new normal.

Grantham believes these rates are likely to remain subdued for some time. Moreover, no one knows what will trigger the next 15% or 20% correction. None of the megatrends, such as demographics, income inequality, huge corporate profit margins or low interest rates, appears likely to disappear anytime soon. That’s why Grantham thinks equities could remain expensive long enough to drive more value investors to hit the hard stuff.

Hoisington Investment Management Company

The following commentary is from the Hoisington Investment Management Company “Quarterly Review and Outlook Third Quarter 2017”:

The worst economic recovery of the post-war period will continue to be restrained by a consumer sector burdened by paltry income growth, a low and falling saving rate and an increasingly restrictive Federal Reserve policy.  Additionally, with the extremely high level of U.S. government debt and deteriorating fiscal situation, the economy is unlikely to benefit from any debt-financed tax changes.  Finally, from a longer-term perspective, the recent natural disasters are an additional constraint on economic growth.

Consumer

The Nominal GDP has expanded by $712 billion over the past four quarters. Consumer spending, which was up $552 billion, represented 77% of this growth. For the past five years, consumers have accounted for about 68% of GDP, which is nearly identical to the average over the past 20 years. Clearly, consumer spending is a crucial component of maintaining growth in GDP. Consumer spending is funded either by income growth, more debt or some other reduction in saving. Recent trends in each of these categories, as outlined below, do not bode well for this critical sector of the U.S. economy.

First, in the past five years real disposable income growth (DPI) has averaged a disappointing 2%. DPI has risen a paltry 2.7% over the past year. Consumer spending, in contrast, has risen much faster over the past year, growing by 3.9%.

Second, in an effort to maintain their standard of living in the face of slowing income growth, consumers stepped up their borrowing and significantly reduced their savings. In national income accounting, personal saving is calculated by subtracting personal outlays, including interest and transfer payments, from disposable personal income. As an example, in the past month personal income was $14.4 trillion (SAAR), with personal outlays of $13.9 trillion, resulting in total personal saving of $523 billion, or 3.6% of income. That is about three-fifths less than the 8.5% saving rate level that has existed since 1900. As recently as five years ago the saving rate was 7.6%. An increase in borrowing was the major factor behind the recent slide in the saving rate.

Historically there has been an important relationship between the saving rate and economic growth. A high initial saving rate has been associated with subsequently stronger economic growth, while a low saving rate produces a lower growth pattern. Considering that the present 3.6% saving rate is lower than all of the initial starting points of economic contractions since 1900, the outlook for ebullient growth is problematic particularly in the context of slow and diminishing income growth.

Fed Tightening

The prospect for stronger economic growth in the economy is clouded further by restrictive actions previously taken by the Federal Reserve (the effects of which are still being felt) along with the promise of further rate hikes, and by the coming reduction in the Fed balance sheet, or quantitative tightening (QT).

The probabilities are high that QT will not be sustained for the duration of 2018, or that substantial offsetting purchases of securities (repo or outright) will be necessary to offset the existing maturities.

Tax Cuts

Negative existing federal fiscal conditions strongly suggest that any benefit of the proposed debt-financed tax cut is likely to be very muted, if it is positive at all. The U.S. budget deficit, according to the non-partisan Congressional Budget Office (CBO), surged to an estimated $693 billion in the fiscal year that ended September 2017, up from $585 billion and $438 billion, respectively, in fiscal 2016 and 2015. Deterioration in the budget deficit of this magnitude is unprecedented in a late-stage business cycle expansion. In the late-stage expansions of both the 1990s and early 2000s, the deficit was reduced significantly. Indeed, late in the 1990s’ expansion, budget surpluses were registered.

Unfortunately, the deficit doesn’t capture an accurate picture of the federal financial situation. An increasing number of items have been taken off the expenditure accounts and re-categorized as “investments.” This accounting gimmickry has artificially reduced deficits for the past three fiscal years relative to the actual amount of debt that was incurred. For example, the increase in federal debt for the three years ending September 30, 2017 totaled $3.2 trillion, or almost twice the $1.7 trillion cumulative deficit for these three years.

It appears that gross U.S. government debt will very shortly reach a new record of 110% of GDP. At the end of calendar 2016, this ratio was 106.1% of GDP. Econometric studies indicate that such high levels of U.S. debt reduce the trend rate of growth in economic activity and quite possibly at a non-linear pace. One major study found that when this debt ratio exceeds 90% for five consecutive years, the economy loses one-third of its trend rate of growth. The U.S. government debt ratio has exceeded 100% for each of the past six years.

When the 1981 Reagan and 2001 Bush tax cuts were implemented, U.S. government debt was 32% and 55%, respectively, of GDP. Further, the Reagan and Bush tax cuts were supported by a sharply falling federal funds rate, much stronger monetary growth and significantly higher level of money velocity. In the first three years of the 1981 and 2001 tax cuts the federal funds rate fell by 960 and 500 basis points, respectively. Since the federal funds rate is currently 1.00% to 1.25% and rising, such previous rate reductions are in sharp contrast to today’s monetary environment. A host of other critical initial conditions - including favorable demographics, debt and productivity - were also much more supportive of economic growth then than now. Therefore, the combination of existing large deficits and record debt levels with a restrictive Federal Reserve will mean any tax cuts will have only a muted impact at best on economic growth.

Natural Disasters

The recent natural disasters have been viewed as providing a potential boost to economic activity. This is an incorrect assessment. If a natural disaster destroys viable homes, businesses and infrastructure, then more of current household and corporate saving (income less spending) will be diverted from normal spending to disaster spending. Hence, disaster recovery spending will benefit some while hurting others. For example, funds would likely be diverted from new business ventures, research and development or household formation and various other consumer/ government goods and services.

The unseen or unintended consequence of a natural disaster is to weaken an economy over the course of time. U.S. government action to cover the losses of a disaster leads to larger budget deficits and additional debt financing, but the increased expenditure financed in this manner results in a decline in private expenditures that is greater than the increase in debt financing. The action may be socially responsible and politically necessary, but at the end of the day the economy’s growth trend will be reduced, regardless of the possible short-term effect of additional deficit financing. For state and local governments that typically lack the option of additional deficit spending, the trade offs are serious and direct. If a state or local government raises taxes to cover disaster relief, this may cause firms to shift operations elsewhere in the state or to some other state entirely. In short, the opportunity cost of natural disasters is far larger than any immediate benefit that accrues from a short-term rebuilding effect on GDP, resulting in another drag on future growth.

Treasury Bonds

With monetary restraint continuing to weigh on economic growth for the remainder of 2017 and 2018, inflation, which receded sharply this year (PCE is up 1.2% year-to-date and 1.4% year-over-year), will continue on a downward path. Coupled with extreme over-indebtedness, these factors are the dominant factors causing both cyclical and secular growth to weaken. Additionally, these negative impulses are presently being reinforced by the problems of poor demographics and productivity. Population growth in 2016 was the slowest since 1936-37 - roughly half of the post-war average - and the fertility rate in 2016 was the lowest on record. These trends have contributed to the declining growth of household formation, which is now less than one-half the rate of increase that has been experienced since 1960. Productivity in the eight years of this expansion was the lowest for any eight-year period since the end of World War II.

These existing circumstances indicate that a Fed policy of QT and an indicated December hike in the federal funds rate will put upward pressure on the short-term interest rates. At the same time, lower inflation and the resultant decline in inflationary expectations will place downward pressure on long Treasury bond yields, thus causing the yield to curve to flatten. Continuation of QT deep into 2018 would probably cause the yield curve to invert. Short-term interest rates are determined by the intersection of the demand and supply of credit that the Fed largely controls by shifting the monetary base and interest rates. Changes in long-term Treasury bond yields are primarily determined by inflationary expectations. Inflationary expectations will ratchet downward in this environment, pushing the long Treasury bond yields lower.

 

Jamison Monroe
Chairman & CEO
Director of Consulting