I came across an article from the Washington
Post regarding President Trump’s comments on Russian President Vladimir
Putin. The article talks about President Trump’s upcoming interview tonight
with Fox News Bill O’Reilly. They quote,
“In an interview with Fox News's Bill
O'Reilly, which will air ahead of the Super Bowl on Sunday, Trump doubled down
on his “respect” for Putin — even in the face of accusations that Putin and his
associates have murdered journalists and dissidents in Russia.
“I do respect him.
Well, I respect a lot of people, but that doesn’t mean I’ll get along with
them,” Trump told O'Reilly.
O'Reilly pressed on,
declaring to the president that “Putin is a killer.”
Unfazed, Trump didn't
back away, but rather compared Putin's reputation for extrajudicial killings
with the United States'.
“There are a lot of
killers. We have a lot of killers,” Trump said. “Well, you think our country is
so innocent?””
I suppose comments like that is the draw of many Americans
that have supported his rise to the most powerful position in the world. Nevertheless,
it reflects his shoot from the hip approach towards elaborating on his policies
that could pose problems in the future, specifically as it relates to the
equity and capital markets.
Further, his mixed message on border taxes has raised several
questions. From Business
Insider, “Everyone seems to be
talking about a border tax these days — but few people seem to know what
they’re talking about.
One reason is the
neophyte US president’s own mixed message. As he has done on multiple
occasions, President Trump has taken both sides of this particular issue at
various times.
On January 16, Trump
said he was hesitant to impose a border tax on imported goods as part of his
anti-trade push: “Anytime I hear border adjustment, I don't love it,” he
said at the time. It’s “too complicated,” Trump added.
Days later, the
president had changed his mind. "If you go to another country and you
decide that you're going to close and get rid of 2,000 people or 5,000 people
... we are going to be imposing a very major border tax on the product when it
comes in," Trump warned during a meeting with CEOs.”
Additional taxes and tariffs with the potential to start
trade wars is not perceived as a pro-growth benefit for the economy or the
stock market.
In our opinion it just may be a matter of time before
President Trump turns his twitter rants towards a stock market that he himself
deemed a bubble. Jesse Felder from The Felder
Report summed it up nicely, “With
economic optimism soaring since the election, rising risks to the economy and
financial markets have fallen off Mr. Market’s radar. However, there are a
number of reasons to believe Donald Trump and his advisers are well aware of
these risks and have already made plans to address them sooner rather than
later.
To this point, Mark
Spitznagel recently wrote, “The ‘big, fat, ugly bubble’ in the stock
market that President-elect Donald J. Trump so astutely identified
during his campaign now becomes one of the greatest potential liabilities of
his presidency.” From a political standpoint, the sooner Trump and his
administration deal with these risks the easier it will be to blame on the
prior administration. Allowing them to fester for any period of time increases
the likelihood they will take the blame for the bubble’s bursting.”
“Interestingly, Trump
recently named Carl Icahn as a special advisor to his new administration. You
may remember that Icahn recently warned of “Danger Ahead” for risk markets:
“I’ve seem this before
a number of times. I been around a long time and I saw it ’69, ’74, ’79, ’87
and then 2000 wasn’t pretty. A time is coming that might make some of those
times look pretty good… The public, they got screwed in ’08. They’re gonna get
screwed again. I think it was Santayana that said, “those who do not learn from
history are doomed to repeat it,” and I am afraid we’re going down that road.”
So Trump is clearly
not running away from his famous “big, fat, ugly bubble” comment. Just the
opposite. In fact, it was probably Icahn who helped him to fully appreciate
just how dangerous the current situation is. In naming Icahn to his special
advisory position he is demonstrating that he takes the risks currently posed
by the financial markets very seriously.
In a
recent interview on CNBC, Icahn echoed his concerns once again:
Most telling is how
Icahn ended the interview, unprompted. “If you’re asking me am I concerned
about the market on the short term. Yeah I’m concerned about it,” he said. “You
can look at so many factors here that you have to worry about. Obviously, if
you get into a trade war with China, sooner or later, I think we’re going to
have to come to grips with that, maybe it’s better to do it sooner…”
It sounds like Icahn
may be counseling the president that it’s in everyone’s best interest to deal
with the glaring “dangers” posed by the financial markets to both the economy
and to Trump’s presidency “sooner” rather than later. For these reasons, I
wouldn’t be surprised to see the administration make, in Spitznagels words,
‘encouraging asset prices and investments to correct themselves,’
its first order of business after the inauguration today.”
Rubber Meets the Road
We have commented in past writings that “animal spirts” and
market sentiment has skyrocketed since the election. That said, there is going
to come a time where actions need to justify the rhetoric. Take Fridays jobs
report for instance. The headline number appears very strong and Donald Trump
was very quick to take credit for and hype the figure. He was quoted as
praising the headline figure saying, “227,000
jobs, great spirit in the country right now, I think it's going to continue,
big league.”
Yet during the campaign he was much more pessimistic towards
how the unemployment figures were calculated. Quoting from The
New York Times, “But Mr. Trump made
amply clear in his campaign that he doesn’t care for the way that government
agencies and mainstream economists summarize the state of the job market. The
unemployment rate, he said in December, is “totally fiction.” He claimed at one
point during the campaign that the real jobless rate was not the number below 5
percent widely cited by economists, but something like 42 percent.”
I know…I know…the New York Times and President Trump are at
war. That said it is quite clear that Mr. Trump was bashing the conclusions of
the survey not that long ago, except when the headline number confirmed his
bias. Regardless of the fact that much of this report was conducted while
President Obama still held office and a deeper look at the numbers wasn’t all
that impressive, Mr. Trump still went out of his way to praise the survey
results.
According to Business
Insider, “The release from the Bureau
of Labor Statistics showed that the US economy added 227,000 jobs in the month
of January. Wage growth disappointed, however, and the unemployment rate ticked
up slightly to 4.8%.”
Scott Grannis of Calafia
Beach Pundit went further in his analysis. He writes, “Job gains in January beat expectations by a significant margin (+227K
vs. +180K), but from a big-picture perspective, nothing much has changed
over the past six months or so. Private sector jobs (the ones that really
count) are growing at a modest 1.8% rate, the rate which has prevailed since
last summer. We've seen an uptick in animal spirits (e.g., consumer confidence,
small business optimism, equity prices), but it hasn't yet translated into
anything substantial on the employment front.”
“As the chart above
shows, monthly changes in private sector jobs can be, and typically are, quite
volatile. You can't draw strong inferences from one month's numbers.”
“The chart above looks
at the rate of change in private sector jobs over the past six and twelve
months. This has been roughly 1.8% since last summer, and that is a relatively
slow pace even for this relatively tepid recovery. We'd have to see a few more
months of job gains like January's before getting excited. I'm not saying this
won't happen, just that it's premature to declare that the pace of economic
growth has accelerated.”
There has come a time where the actual economic figures
lives up to the hype that is currently baked into the market valuation. Lance
Roberts of Real
Investment Advice pointed out the dichotomy between expectations and
reality. He comments, “We can see this
more real time by looking at the Chicago Fed National Activity Index (CFNAI)
which is arguably one of the more important economic indicators. The index
is a composite made up of 85 subcomponents which give a broad overview of
overall economic activity in the U.S. However, unlike backward-looking
statistics like GDP, the CFNAI is a forward-looking metric that gives some
indication of how the economy is likely to look in the coming months.
Importantly, understanding the message the index is designed to deliver
is critical. From the Chicago Fed website:
“The Chicago Fed
National Activity Index (CFNAI) is a monthly index designed to gauge overall
economic activity and related inflationary pressure. A zero value for the
index indicates that the national economy is expanding at its historical trend
rate of growth; negative values indicate below-average growth, and positive
values indicate above-average growth. “
The overall index is
broken down into four major sub-categories which cover:
Production &
Income
Employment,
Unemployment & Hours
Personal Consumption
& Housing
Sales, Orders &
Inventories
Here is my point.
While “exuberance” in terms of “attitudes” is surging, actual activity remains
quite subdued. The first chart compares my combined consumer confidence composite
to the CFNAI.”
“The next chart is the
dispersion of the components of the CFNAI also compared to consumer
“confidence.””
“In both instances
there is a wide deviation between “attitude” and “activity.” More importantly, “attitudes” have
typically reverted back to “activity” rather than the other way around.
This potentially
leaves the market set up for disappointment in the months ahead. Be careful.”
In our previous blog post, Investment Thesis for 2017 we wrote, “We believe that the US equity markets are
chugging higher more on investor sentiment than underlying fundamentals. Should
we get confirmation that expectations are becoming a reality then we could see
the next leg higher in the stock market. This will most likely happen as the
economy experiences a “sugar high” from continually accommodative monetary
policy and a burst of fiscal stimulus.”
We certainly understand the underlying risks to our bullish
2017 investment thesis rides on market perception becoming a reality.
Hints of Skepticism
We’re coming across reports that are starting to doubt
President Trumps ability to live up to the fanfare surrounding his election.
This stems from the campaign promises of fiscal stimulus, deregulation and tax
reform. All of these measures are considered pro-growth policies as judged by
the market reaction but thus far into his presidency he has decided to tackle
the more controversial issues. Namely his policy stance on trade has many nervous
about the direction that his administration is likely to take.
From Business
Insider, “So far Deutsche Bank has
been horribly wrong about the "defining feature of Trump's economic
approach." It hasn't been deregulation and an "expansionary fiscal
policy" (fancy words for stimulus); it has been trade (or rather
opposition to it).
And, everything Trump
said about trade on the campaign trail — which he is now forcing us all to take
quite literally — happens to be terrible for business. Deutsche Bank gave this
a passing acknowledgment in its note, saying simply: "Uncertainty about
the Trump administration's policies is still large, as is the reaction of those
impacted by these policies."
Well now we know more
about the policies and we know more about the reactions. Neither has been
great. Trump wants to rip up bilateral trade deals and renegotiate them one by
one.
In an interview with
Business Insider, trade policy expert and Carnegie Mellon economics professor
Lee Branstetter told us this may not be the best idea.
"That is an
incredibly expensive time-consuming way to recreate what you already
have," he said.
Last week Trump
described how he'd be doing that: basically handing countries a list of
demands, giving them 30 days to respond, and then, if they do not comply, hitting
them with tariffs. Making demands is an excellent way to upset a country, as we
learned last week when Mexican President Enrique Peña Nieto canceled a meeting
with Trump after Trump demanded in a badly timed tweet that Mexico pay for a
wall along the US's southern border.
This is the kind of
manic communication that insults nations and starts trade wars. If Trump keeps
insulting countries like Mexico and China, they can retaliate and put thousands
of American jobs at risk.
Branstetter told us
that if you know anything about the Chinese, you should know they're ready to
retaliate if they feel as if they've been hit first. Hit doesn't even mean only
economically. In an interview with NBC, China's Foreign Ministry spokesman said
the US's One China policy — the recognition that Taiwan is a part of China —
was not up for debate. Violating that would be grounds for retaliation, and
Trump has already tested it by taking a call from the president of Taiwan.”
Expectational
Exuberance?
Will it be possible for President Trump to live up the
expectational exuberance that has entered the mindset of market participants?
In the Pragmatic
Capitalism blog writings, they state, “When
Obama was coming into office the public was so euphoric about change that the
approval numbers were unsustainably high. At the same time, the cyclical trend
in the economy was so bad that there was a high probability of some mean
reversion and recovery. The public’s overall sentiment was better captured in
President Bush’s low approval rating of 35% at the end of his second term and
the consumer confidence figures which bottomed in 2009. In other words,
President Obama was becoming President at an extremely fortunate time. And
although he probably underperformed his stratospheric expectations he did
better than most probably expected.
And here’s the
interesting part about Trump’s Presidency – how much room is left in this
balloon? For instance, how much higher can consumer confidence go?”
“Or, how much more
employment can you pull out of an economy plumbing very low levels of
unemployment?”
“This looks like a
balloon that is much closer to its max capacity than vice versa. And while I
certainly think there’s room to grow you have to wonder if we aren’t seeing the
exact opposite reaction to Trump that we saw to Obama. In other words, are
Trump’s approval figures too low and are his expectations for economic growth
unrealistically high? I don’t know the answer and I certainly don’t know
the timing of the end of economic cycles, but this balloon looks a lot closer
to full expansion than the economy that Barack Obama inherited. And so the
smart betting man to has think that the potential for greater instability is
higher today than the economy that was so unstable at the start of Barack
Obama’s term.”
Perhaps a better analogy is a comparison to market activity
at the onset of President Reagan. Similar to the start of President Obama’s
first term, economic conditions at the start of President Reagan’s first term
surely was starting from a bar that was set much lower.
From the AB
blog, “Investors excited by the boost
the US election gave to US stocks should recall that starting conditions
matter. This is not 1981, the beginning of the Reagan era.
When Ronald Reagan
took office 36 years ago, the US economy was in a deep recession induced by
extremely high interest rates intended to wring out inflation. Back then, the
S&P 500 was trading at around nine times depressed forward earnings, as the
Display below shows.
When Donald Trump took
office, the S&P 500 was trading at about 18 times forward earnings—and
earnings were close to all-time highs. Yet, the fed funds rate was around 0.5%,
and the 10-year Treasury rate, about 2.5%. While both interest rates are higher
than a few months ago, they remain close to all-time lows, and are poised to go
higher.”
The folks at Alliance Bernstein are not expecting capital
market returns to be anywhere near the returns found in the Reagan or Obama
first term presidencies.
“Stock returns are
also likely to be subpar: Our central case calls for US stock market returns of
less than 6% annually over the next five years, below their nearly 8% average
over the past two decades. Even if the new administration and Congress agree on
policies that boost GDP growth and extend the economic cycle, earnings growth
is likely to be limited and much slower than in the early years of the recovery.
Why? Profit margins are close to record highs and could be hurt by
protectionist trade policies.
A reduction in US
corporate tax rates could add to after-tax earnings for some companies,
however. This is an area where research-based stock selection will be critical.
Overall, we expect modest gains from earnings growth and dividends to be
somewhat offset by valuation contraction.”
This past week John Hussman of Hussman Funds
lambasted President Trump, albeit in a cordial and polite way. “From my perspective, the problem isn’t
politics. A civil society can work out those differences. The immediate
problem, and the danger, is the mode of leadership itself. A leader can call
forth either the “better angels of our nature” or the worst ones. I am troubled
for our nation and for the world because of the example of coarse incivility,
mean-spirited treatment of others, disingenuous speech, thin temperament,
self-aggrandizing vanity, puerile character, overbearing arrogance, habitual
provocation, and broad disrespect toward other nations, races, and religions
that is now on display as our country’s model of leadership. Despotism reveals
itself through a reliance on threat, intimidation, bullying, coercion, and a
chilling instinct to address problems through forms of termination, such as the
killing of enemies and the exclusion and dismissal of adversaries. I am equally
troubled by emerging risk, discussed below, to the Constitutional separation of
powers.”
He goes on to write about potentially misguided policies and
how these policies would negatively impact an already overvalued stock market
and a lackluster economy. “While
references for many of the foregoing observations are easily available, the
basis for a few of the economic and financial comments is provided below. For
data and evidence regarding labor market demographics and the components of GDP
growth, see my December 12, 2016 comment Economic Fancies and Basic Arithmetic.
On the relationship
between the trade deficit and U.S. gross domestic investment, the following
chart shows data since 1947, and captures the inverse relationship. Think of it
this way: Whenever we import a dollar of goods and services, we export a dollar
of “stuff” in return. That “stuff” can either be goods and services, or
securities. So by definition, when the U.S. is a net exporter of securities to
foreign investors, it must also be running a trade deficit in goods and
services. That’s just an accounting identity.
Investment and savings
must be equal in equilibrium (this is also an accounting identity). From a
financial perspective, an export of U.S. securities is an import of foreign
savings. Putting this all together, booms in U.S. gross domestic investment
(factories, capital goods, equipment, housing) are typically financed by an
import of foreign savings and corresponding “deterioration” in the trade
deficit. Conversely, “improvement” in the trade deficit is systematically
related to deterioration in U.S. gross domestic investment.”
“The result of all
this is that U.S. investment booms are typically associated with a widening,
not a narrowing, of the U.S. trade deficit. If you really want a collapse in
U.S. gross domestic investment, cannibalize national savings by expanding the
U.S. budget deficit through massive spending projects and lower taxes, and simultaneously
limit the import of foreign saving by provoking a trade war aimed at
“improving” the U.S. trade deficit. That’s precisely the direction this
administration is heading. It seems we’ve forgotten the consequences of the
Smoot-Hawley Tariff, which was passed in June 1930, at the outset of the Great
Depression.”
“To offer a sense of
what’s likely to unfold, the following chart shows the ratio of nonfinancial
market capitalization to corporate gross value added (MarketCap/GVA), which is
more strongly correlated with actual subsequent S&P 500 total returns than
any alternative measure we’ve studied over time. In the chart below,
MarketCap/GVA is shown on an inverted log scale in blue. The red line is the
actual subsequent S&P 500 nominal total return over the following 12-year
period. At present, we project a likely market loss over the coming decade,
with S&P 500 total returns averaging just 1% annually over the coming 12
years. Those aren't much different than the awful market outcomes I projected
in real-time at the 2000 market peak. In that instance, the S&P 500 lost
half of its value over the completion of the market cycle, with negative total
returns for a buy-and-hold approach from March 2000 all the way out to November
2011. Every investment strategy has its season. My sense is that passive,
value-insensitive investors are now facing another long, hard winter.
Meanwhile, flexible, value-conscious investors are approaching the first day of
spring.”
“The following chart
shows some of the most reliable valuation measures we identify in terms of
their percentage deviations from historical norms. These measures are currently
125% to 150% above (2.25 to 2.50 times) norms that have regularly been
approached or breached over the completion of market cycles across history. At
the 2000 and 2007 peaks, we correctly projected the probable extent of the
losses that passive investors faced over the completion of the market cycle.
Presently, we estimate that this speculative cycle will be completed by market
loss in the S&P 500 in the range of 50-60%.
Bottom Line: Our
bullish call for 2017 makes several assumptions about monetary and fiscal
policy, economic growth and corporate profits. While valuations are certainly stretched
by historical standards, we understand that the stock market can be driven for
months and years by extreme levels of euphoric sentiment. We believe this to be
the case today.
We believe there
exists one more leg higher that could be called the “blow-off top” before
underlying market fundamentals start to drive prices lower.
The risk to our
thesis is a sudden deceleration in economic fortunes but more importantly a
negative change in sentiment from this point.
Joseph S. Kalinowski, CFA
Email: joe@squaredconcept.net
Twitter: @jskalinowski
Facebook: https://www.facebook.com/JoeKalinowskiCFA/
Blog: http://squaredconcept.blogspot.com/
No part of this report may be reproduced in any manner
without the expressed written permission of Squared Concept Asset Management,
LLC. Any information presented in this report is for informational
purposes only. All opinions expressed in this report are subject to
change without notice. Squared Concept Asset Management, LLC is a
Registered Investment Advisory and consulting company. These entities may have
had in the past or may have in the present or future long or short positions,
or own options on the companies discussed. In some cases, these positions
may have been established prior to the writing of the report.
The above information should not be construed as a
solicitation to buy or sell the securities discussed herein. The
publisher of this report cannot verify the accuracy of this information.
The owners of Squared Concept Asset Management, LLC and its affiliated
companies may also be conducting trades based on the firm’s research
ideas. They also may hold positions contrary to the ideas presented in
the research as market conditions may warrant.
This analysis should not be considered investment advice and
may not be suitable for the readers’ portfolio. This analysis has been written
without consideration to the readers’ risk and return profile nor has the
readers’ liquidity needs, time horizon, tax circumstances or unique preferences
been considered. Any purchase or sale activity in any securities or other
instrument should be based upon the readers’ own analysis and conclusions. Past
performance is not indicative of future results.
