No Protection in Protectionism: Investors, Immigration, and More
The month of January ended this week and stock investors are likely happy, certainly compared to how January went just one year ago, which was the worst January in stock market history! The political climate right now is certainly heated, and we want to get through a lot of the noise and evaluate the lay of the land for what actually matters to investors. There are a lot of charts this week, and we think we have some really interesting perspectives on it. So with all that said let’s get into it
As earnings go, so goes the stock market
Corporate profits are the mother’s milk of stock investing, and of course the same can be said to their efficacy in the entire broad economy. Profits drive capital expenditures. Profits drive wage growth. Profits drive business investment. And profits drive innovation. Corporate profits and S&P operating earnings nearly mirror each other (top chart below). But as you see from the bottom chart below, the GROWTH of earnings is the catalyst to stock market growth. The vicious bull market rally began eight years ago as earnings growth bottomed. The question in front of us now that I do not believe anyone knows the answer to is whether or not profit growth deceleration has ended, as Q3 suggested, or if the bulls have gotten ahead of themselves.
Building a wall around a border tax?
The American people are currently subject to a nearly daily grind of discussion around very complex concepts that very few of the people reporting on actually understand. There are a number of policy matters at play right now with the Trump administration and Mexico, that when intersected together, do have implications to investors. First, we know that President Trump campaigned on the idea of building a wall at the U.S./Mexico border as a means of controlling immigration and security better. He further campaigned on this happening with Mexico paying for it. Second, we know that President Trump campaigned on wanting to reduce trade deficits and see better terms in our trade deals, notably with China and Mexico. And third, we know that the Trump administration and the GOP House are looking for a “deficit neutral” tax plan which will lower tax rates without blowing away deficits. It would appear that through the noise, drama, and twitter of it all, one particular policy proposal may be at the epicenter of all three of these things simultaneously. This “border adjustment tax” being thrown around frequently would look to tax imports, but not exports, thereby giving an advantage to companies who export goods, giving revenue to the treasury from companies and countries looking to send products into America (such as Mexico), and giving Trump cover to claim that “Mexico paid for the wall” by saying this border adjustment tax generated the revenue for it. A Border Adjustment Tax is said to not be a tariff, because in theory the dollar appreciates to offset the benefit. However, given present dollar strength, it really is very tricky to calculate how that would play out. The Trump administration is wise to pursue a policy like this vs. an outright tariff which will hurt consumer prices, but the complexity of this in light of currency exchange rates is something we have to watch from an investment perspective!
February follies are not fun
What surprised me most about this chart below is that someone would look at it and conclude it says something indicative at all, let alone conclusive, about how stock markets do in the first month of a new President. What I see with my lyin’ eyes are four positive months, five negative months, and two flat months – soooooo, nothing at all to write home about. Now, the first February in George W. Bush’s first term and the first February in Barack Obama’s term were both quite negative, so there is recent history there. I will put the odds of a February drop in the market like this: There is a chance the market goes up, and a chance it goes down. I will apply those same odds to next month. And the month after, etc.
Eight is enough?
February 2017 will represent the 12th month of the eighth year of a bull market that began in March 2009, and has faced minimal interruption since. In spring of 2010 and particularly summer of 2011 there was some globally-driven disruption of note, but in both cases the market drop proved very short-lived. In August 2015 and January 2016 there was some downside volatility, but again, it was short-lived (really, really shortlived, actually). Now, from mid-2014 through mid-2016 there was a generally flat period, but the point is that the bull market that began eight years ago has continued without the onset of a bear market (a 20% drop in markets). Will “eight years be enough” for this bull, or is there more life in it? We believe that bear markets come about because of (a) Recessions, and (b) Valuation bubbles. The sort of “black swan” events that often become problematic for markets – awful events not easily predicted or foreseen – are usually recession-creating things, or news-oriented events. So the way we begin to protect against bear markets, things we believe are generally impossible to time, is to stay vigilant in looking for recessions (also hard to time), and valuation bubbles (easier to observe but not easy to time the moment that markets respond to the valuation distortions). We look at a plethora of indicators that are useful in evaluating the health of markets, and right now we would note that just one indicator is historically bearish for markets (rising interest rates). We do not see a blow-off top in valuations, we do not see heavy flows into equities (suggesting mass euphoria), we do not see an active IPO market (quite the contrary), and we do not see poor market breadth. Credit markets are even quite tame despite rising interest rates. Any number of things could tip us towards a recession, most of them located outside the U.S. (a trade war, weakening conditions in Europe or China, etc) but for now, the bull seems to have legs.
No protection from protectionism
The loudest response from the press and in the political sphere so far since the Trump inauguration has been centered around his executive order on immigration dealing with seven Middle Eastern countries. But perhaps the loudest impact in financial markets in the early innings of a Trump administration will center around trade policy, and the realities of a protectionist ideology that President Trump has never really made much of a secret. Many pundits, economists, and analysts, myself included, have believed (and frankly, hoped) that the anti-trade rhetoric would prove to be negotiating tactics, and that the real meat on the bone of a Trump economic policy would center around deregulation and tax reform. The latter is very much alive and at play, but we are becoming increasingly aware that hope is not a strategy, and merely hoping that Trump has been “posturing” is not good planning. He has thus far proven to be rather serious about many of the things he campaigned on, and that could be good or bad depending on your political outlook and policy aspirations. But from a market standpoint, we do not believe the market has fully priced in the realities of increased protectionism, and it certainly has not priced in a full-blown trade war (which we acknowledge is unlikely to happen). Without offering any political view of NAFTA (which I am happy to do off-line any time you want), I can only show the following chart to indicate the level of TWOWAY activity open trade deals have represented:
Everything is so good it feels miserable
The arguments some make about being cautious this month (because of February foibles) are not the arguments we would use in favor of being cautious. More than anything else we just fear the complacency in the markets. A very low VIX. A narrative that seems to leave out the path to some of Trump’s end-run legislation, and instead only focuses on the final conclusion. A persistent down-talking of alternatives as if noncorrelation, beta reduction, and diversification are not needed anymore. Now, this certainly isn’t the kind of euphoria we used to see back in the good ole days of the tech or real estate boom, where P/E ratios went through the roof, cash balances were minimal, and margin debt was stratospheric. But as a general rule, we don’t detect a lot of fear right now, and we like fear in others when we are buyers.
If you ever read one thing, read this
One of the most common but dangerous investment fallacies I have seen over the years comes from ideologically-oriented people who struggle with the difference between what is, and what ought to be (what we call the descriptive vs. the prescriptive). It would be literally impossible to calculate how much money has been lost by people trading their beliefs, even when they are right (“the Italian banks are all insolvent; they can’t be allowed to live – let’s short them!*” – a belief that is at worst still meritorious and at best completely spot on – and yet, the reality of policy levers, can-kicking, government action, central bank manipulation, and all sorts of other things can keep the belief from becoming investible for a long, long time). “China is in a bubble; their debt is going to roll over and create contagion*” – and yet, in a multi-trillion dollar economy we find that the imagination policymakers have to pull levers, buy time, shift things around, etc., often exceeds the imagination of a bearish investor. I guess what I am saying here is that getting a lot of premises right, and maybe even all the premises, is never enough to guarantee a cogent and investible conclusion. Forces exist that alter prima facie accurate narratives all the time; and in investing, being right “in the end” is not always enough. How we apply this logic and this reality on a case by case by case basis wouldn’t fit into Dividend Café, but it is a manner of thinking that is deeply ingrained into our philosophy.
Settling the dollar debate once and for all, or until next week
We do believe that the bulk of how capital markets will perform in the short term of 2017 will revolve around the behavior of the U.S. dollar, and this simply means (as a self-attesting fact) that interest rates, commodity prices, many earnings results, and capital flows are all in the loop of hinges by which the dollar turns. The bullish argument for a strong U.S. dollar is rather simple: Our central bank is tightening, or says they will be tightening; other central banks are not, or say they will not be. The counter-argument is that the new administration’s policy framework is very likely to be anti-dollar (they want U.S. exporters to have advantages, not disadvantages, for right or for wrong, and see a weak dollar as benefiting U.S. exporters/manufacturers). There is a crowded trade phenomena (most everyone is on the side of a strong dollar), and that doesn’t always end well.
It is fascinating to us when the very risky, volatile, commodity-heavy emerging markets stocks do much better than the consumer staples, telecom, and utilities names in those
domestic markets. The criticism of some of those more defensive sectors in the U.S. is that they don’t offer adequate return and growth. In many emerging markets, companies of those sectors offer robust return upside but with the defensive and quality risk characteristics you would expect from sectors that are “have to’s” in any society. We let the fundamentals do the talking and take relative movements up and down around riskier sentiments for what they are: Unsustainable.
Chart of the Week
There is nothing that indicates an excessive complacency about risk than brutally low high yield bond spreads. Re-stated in English, when the amount of return investors are willing to take from very questionable and risky corporate bonds becomes not much higher than what they could get from government-protected Treasury bonds, we have a culture – a capital markets environment – where bad decisions get made and where capital is misallocated. Spreads in the high yield bond market are low right now because treasury rates are just too low (even with their recent increase), and investor confidence in growing corporate health is very high. This chart is something we are watching very closely. We don’t find de-risking to be something easy to time, and spreads are not as low as some past problems that ended badly, but they could get there. That’s all we are saying. They could get there.
Quote of the Week
“The investor’s chief problem, even his worst enemy, is likely to be himself.”