Indications of a Bear Market, or Something Else?
Dear Valued Clients and Friends –
Near the end of this week’s Dividend Café you will see our most recent updated analysis of various indicators about the dreaded “bear market territory,” and you can determine for yourself what the data appears to be suggesting. We think this week’s issue covers the gamut of truly pertinent issues, from the potential changes in the works at the European Central Bank, to the Senate action or inaction on repealing ObamaCare, to the path towards tax reform, to the significance of the high yield bond market in evaluating all sorts of things, all the way to a quick birthday greeting for my daughter … It’s a really full Dividend Café ending with some birthday wishes for my baby girl – all worth reading. Let’s get into it …
Pulled up and down by simple math
The market dropped 100 points on Tuesday but rallied 150 points on Wednesday, and as is often the case when very normal volatility excites the markets, talking heads go searching for a reason. A commonly uttered explanation but easily debunked one making the rounds mid-week was that the announcement on Tuesday by the GOP Senate that they were deferring on their ObamaCare repeal/replace vote for a couple of weeks caused the market to decline, and that rumors things were coming together caused the rebound Wednesday. We think this is highly dubious on both counts. In reality, the market was far more moved by the Draghi sentiments regarding European Central Bank monetary policy than the political gamesmanship around this bill. Fundamentally, the market believes some form of a Senate bill will come together, and very little of that is needle-moving to earnings. But the bigger issue which could impact markets is whether or not the easy and divergent policy in Europe turns the other way, giving the Fed a green light to tighten at an even more aggressive pace.
Well what are those Europeans up to?
I listened attentively to Mario Draghi’s speech, then read all of the analysis about what it meant, and I felt like I was in a totally different universe from what I was reading about the speech. It did not sound to me like all of a sudden they are planning to aggressively reverse years of hyper-accommodative monetary policy. Rather, it was a very nuanced message around very complicated topics. We really shouldn’t need Mario Draghi to tell us that the monetary approach Europe will take will be different at 2% annual economic growth than it was at 0% annual growth. That zero-bound economic emergency has dissipated, and with a climate of economic conditions that can at least be called “better than prior catastrophic levels,” their unprecedented aggressive posture towards monetary policy warrants adjustment. We think, though, that like our own Fed, the “new normal” for central banks is “lower for longer,” and “error on the side of easy vs. tight.” The key most are missing is that the market acts on expectations, not news. The expectation is now that the ECB will be moving towards some form of unwinding of their insane quantitative easing and interest rate compression – at some point, in some way – and that is why the Euro is hitting new one-year highs.
And we care why?
I have argued for at least two years that the single biggest thing holding U.S. interest rates lower both from a market standpoint and a central bank policy standpoint was Europe (and to a lesser extent, Japan). There was and is a ceiling in place for how high Treasury rates could go when our European counterparts were sitting at negative rates, or “zero-ish” rates. Any reacceleration in European growth lifts the ceiling for our own bond/rate market, and therefore means this drop in yields we have seen the last few months is likely closer to an end than beginning. We still believe global growth is fragile enough, both in real life, and in the perceptions of policymakers, that they are not about to be overly aggressive any time soon. But overall, we at least see the “floor” coming higher for bond yields as Europe (and the U.S.) get more harmonized around the idea of a pick-up in growth and modest movement towards respective normalization. This matters to our bond positioning and expectations for sector performance in the stock market.
Repeal and replace on hold, for now
The GOP Senate did announce this week their desire to defer their vote on the bill until after the Fourth of July, maybe a couple weeks after the holiday break. Senate Majority Leader, Mitch McConnell acknowledged they are a bit short on the votes and meetings continue with the Trump White House and within Senate conference for areas that can be tweaked to get a bill passed. The bill that finally does repeal/replace ObamaCare is unlikely to appease the conservative right or the moderate centrists, but it is likely to represent a symbolic momentum boost for the Trump agenda (if it happens).
Pax around Tax
No, we don’t believe there will actually be peace between both parties as it pertains to tax policy any time soon, but we do believe a path towards tax reform is definitely becoming clearer. Getting the health care bill addressed first provides a lot of political and numerical cover. The major issue politically is getting a budget resolution done to open a reconciliation window, which would change the votes needed to avoid a filibuster threat from 60 down to just simple majority of 51. As we have been writing for quite some time, the great threat of the Border Adjustment Tax (not only as bad policy but due to political toxicity) seems largely removed, as the few advocates the idea did have do seem to have thrown in the towel. We still expect some knobs to be turned on the final reform package, and we expect more political twists and turns, but we do see a bill getting passed by Q1 of next year.
What is the brass tax about tax?
Our thesis has been for some time that this has been an earnings acceleration rally in the market – that markets have moved higher because the growth rate of corporate profits has moved higher. One of the reasons tax reform matters so much is that much of the hoped for/expected earnings growth for 2017 and 2018 has become consensus (the earnings growth we have seen the last six months was NOT expected, and therefore a material catalyst for higher stock prices). However, the robust and impressive but consensus expectation for earnings over the next 12-18 months do NOT – I repeat, DO NOT – factor in the impact of tax cuts. Should we get the kind of reform in the business and individual tax code we expect, there becomes a further opportunity for earnings growth in the quarters ahead. See also our Chart of the Week for more color on the importance to the economy.
A new angle
For those interested in the political machinations that matter to potential tax reform achievement: As we have explained above, to get this done with a simple majority vs. a filibuster-proof sixty votes, the Senate must use what is called reconciliation, but reconciliation rules state that any bill which will add to the deficit outside a ten-year window must be set to expire. This is why President Bush’s tax cuts of 2001 had all those famous sunset provisions in 2010. The House and Senate GOP believe their tax reform will not be deficit-enhancing with the dynamic growth in the economy the tax cuts and tax reform will create, but procedurally, it becomes tricky. Sen. Pat Toomey of Pennsylvania is looking at expanding that window to 20 or 30 years, which is a very do-able way to allow the full dynamic pro-growth aspect of business investment and business confidence to be monetized.
Does High Yield matter to my stocks?
I talk below about what the rationale is behind our bearishness on the high yield bond asset class based on present spreads and valuations. I do believe non-high yield investors should care about the high yield asset class for two reasons: (1) (the one I talk about the most) – There is a general reflection overall risk sentiment often embedded in High Yield bond spreads, whether reflective of too much apathy or too much fear; and (2) What they say about corporate balance sheets. The present level of low spreads (see below) do indicate to us a problem for the future returns of High Yield, but do not necessarily indicate systemic apathy, as there continues to be ample other indicators showing investor skepticism about risk and equities. However, from a balance sheet standpoint, we have a very simple theory around debt – namely, that much of it (high yield and investment grade) has been used to buy back stock. This does compress Return on Equity, which is really more of a cosmetic than substantive event. However, and this is key, it reflects a strong bias against equity and towards debt in corporate capital structure. As we wrote at Market Epicurean a few weeks back, this may be the time to be addressing one’s balance sheet in the exact opposite way!
But buying back stock is good for me, right?
It may be from one day to the next or one quarter to the next. “Earnings per share” go up when there are less shares. And as big dividend growth investors, we applaud attempts to return capital to shareholders so that shareholders can monetize their successful investments. Stock buybacks are allegedly a different category of the same objective – returning cash to shareholders. However, and this is so, so, so important – we believe with every ounce of breath in our body that the reason stock buybacks are so high and business investment so low is that companies do not have confidence in what economists call “price discovery” – in what the data tells them about Return on Investment possibilities for various capital expenditures – because of the artificially low interest rate. And this distortion prevents needed long term business investment, and promotes short term behaviors like stock buybacks. It is something that we watch carefully – what needs to happen structurally for businesses to increase their investment into the long term growth and innovation and equipment and inventory and facilities needed to accelerate growth. There are glimmers of that willingness coming back, but we are confident it has been monetary policy keeping it from proceeding.
Give me one good reason not to throw in the towel
When sentiment and investor flows get this negative in MLP’s (oil and gas pipelines trading as publicly-held partnerships), it can only mean one thing … $200 million of retail money has exited the space in the last month alone, with over $80 million of it being last week (as MLP’s and oil prices were hitting yearly lows). Capitulation can be a wonderful thing for patient and long-term investors, but capitulation is not always evident until one has a rear-view mirror.
It is worth noting, by the way, that at $638 billion, the ENTIRE MLP UNIVERSE is 15% smaller than just Apple.
If only we had some indicator of what to expect?
For the rest of our lives as risk asset investors, we will face the same ironic reality: When something like High Yield bond spreads are extremely wide, sentiment will be extremely negative in the space, and subsequent returns are likely to be very good; and inversely, when something like high yield bond spreads are very tight, sentiment in the space will be quite positive, and subsequent returns will be disappointing. We are using High Yield bonds as a mere example because we just so happened to have recently acted on this very thing, but the principle is true of any risk asset class which has a valuation measurement embedded in it. High Yield spreads recently hit ludicrously tight levels, and we responded by tactically exiting the asset class. We note here the historical correlation between low spreads (i.e. a small difference what a High Yield investor is getting in income vs. a Treasury bond investor) and subsequent disappointing returns. This does NOT refer to “pending defaults” in the space, necessarily; just lagging returns.
Is the next bear market around the corner?
There are dozens of criteria that one may use to try and forecast the end of an equity bull market. As we have shown in the past, our friends at Strategas Research have used nine items in their checklist, and all nine items in this checklist were present as the 2000 bull market violently ended and again when the 2007 bull market ended. Not a single one of these nine items are present now. Of course, anything can change at any time, but this monitoring work and understanding of history is an important part of what we do.
Chart of the Week
Why do we believe corporate (business) tax reform is so needed for the U.S. economy and U.S. investing markets? Simply put, our present code is just not competitive with the rest of the world. It possesses too many loopholes for select businesses, has too much complexity, and uses rates that are far too high, all incenting anti-growth behavior. The chart below puts it all into perspective to see the gravity of what we are up against, and why improved competitiveness in the corporate tax code is so important for investors.
Quote of the Week
Liberty is not the power of doing what we like, but the right of being able to do what we ought.
– Lord Acton
Originally published on Dividend Cafe.
Trending on Affluent Investor
Sorry. No data so far.