Outside the Box

Is Mr. Market Playing the Role of Pavlov’s Dog?

March 15, 2017

David Rosenberg is one of the most respected voices in the investing world. His Breakfast with Dave goes out to thousands of appreciative subscribers nearly every business morning. He has also been the leadoff hitter at my Strategic Investment Conference every year for several years running – and this year will be no exception. He is always one of our top-rated speakers, and his energy gets the conference up and rolling.

To everyone’s surprise, Rosie turned bullish in a big way at SIC six years ago. Now he’s cautious – in a big way – as you’re about to see. Rosie is the Data Meister, and in today’s Outside the Box he runs the numbers on today’s economy and markets and comes off as downright incredulous:

It is amazing, I have to say, to see Mr. Market respond to the same [“Trump rally”] language over and over and over. It is a present-day version of Pavlov’s Dog.

More discussion of tax cuts, deregulation and infrastructure, and again, the market soars on what really is old news by now. Or should be.

The fact that this is all still rhetoric, with no details or timetable provided, should be a bit worrisome.

Where will Rosie be – where will we all be – in May? Join us at SIC 2017 and find out.

The 2017 Strategic Investment Conference - Register Now

I am in a very cold New Jersey surrounded by lots of snow, but the roads are clear. Dallas shuts down with a few inches of snow, but NJ is up and going the next day. Even the park across the street has shoveled all its sidewalks. Not that I will be taking a stroll in 20 degrees with 30-mph winds.

I am here doing three speaking events in two days to what I am told will be packed rooms. Lots of Q and A, which really gets me going as there is just so much to talk about.

And between sessions life is filled with meetings, research, and writing. Always writing. O, deadline, where is thy sting?

I note with sadness the recent passing of two of the older stalwarts and longtime friends in the investment writing world, Bill Donoghue and Larry Edelson. Bill was the money market guy back when money market funds paid 15% and then segued into mutual funds. Jazz aficionado and wine expert, he once asked me to spend an afternoon consulting with him. My price was a visit to his cellar, where I chose the wines we had for dinner. One of my better trades. He will be missed. And Larry was the lead writer for fellow publisher Weiss Research. He was a writing machine, cranking out enormous amounts of marketing copy and writing five monthly letters on a wide variety of topics as well as weekly columns. He was based in Bangkok for years, where we had some great times. His emails were always on target.

You have a great week.

Your trying to stay inside analyst,

John Mauldin, Editor
Outside the Box

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Is Mr. Market Playing the Role of Pavlov’s Dog?

By David Rosenberg, Chief Economist & Strategist, Gluskin Sheff

If you mix your politics with your investment decisions, you’re making a big mistake. 

– Warren Buffett, February 27th, 2017

Sage words indeed, and likely true.

After all, Herbert Hoover had the biggest honeymoon of all and look what happened down the pike.

The markets tripled under two “socialist presidents” (Bill Clinton and Barack Obama) and slid 35% under the “pro-business” George W. Bush administration.

Even Ronald Reagan’s first two years in Office were rocked by a 25% plunge in the stock market after a brief though powerful bounce following the November 1980 election.

What you see isn’t always what you get, and it is likely a mistake to extrapolate today’s market performance into the future.

Admittedly, the charts, momentum and fund flows are all very positive (U.S. equity exchange-traded funds took in a huge $22 billion of net inflows last month).

But some aspects of the technical picture have become muddled – the share of NYSE stocks trading above their 200-day moving average is at the highest level in nearly four years (a sign of overextension).

Sentiment is wildly bullish, and while it has been such for weeks now, we have hit some pretty extreme levels.

The Investors Intelligence poll now shows there to be 63.2% bulls, up from 61.2% a week ago, and the highest since January 1987 (i.e. when we last saw the Dow on a 12-day winning streak).

The bear share fell a point to 16.5%, the lowest since July 2015 (and the correction camp is down to 20% – one in five see at least a 5% correction coming even though the declines roughly of this magnitude have happened at least once per year for 88 of the last 89). 

The bull-to-bear spread is now in proverbial danger-zone at 46.6 percentage points, up from 43.7 and just took out the 45.5 nearby high in February 2015. That is an ominous sign, even if not yet apparent amidst the euphoria. 

As per Bob Farrell’s Rule #9, in reference to the herd mentality:

When all the experts and forecasts agree – something else is going to happen.

Just because it hasn’t happened yet, doesn’t mean it is not going to.

And of course, that then leads to Rule #4, which also has to do with excessive manic behavior:

Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways.

They do not correct by going sideways!

And lurking in the background is the Federal Reserve, which is poised to raise rates sooner rather than later.

Monetary policy is profoundly more important to the markets and the economy than is the case with fiscal policy, though all the Fed is doing now is removing accommodation. 

A little bit of history – there have been 13 Fed rate hike cycles in the post-WWII era, and 10 landed the economy in recession.

Soft landings are rare and when they have occurred, they have come in the third year of the expansion, not the eighth.

And valuations don’t matter until they do matter, and we have a market priced for perfection right now – the S&P 500 is trading at 18.5x forward earnings per share, up a full point since Inauguration Day, and only 20% in the past were valuations as expensive as is the case today. 

So momentum, charts and fund flows are positives; valuation, technicals and sentiment are warning signs.

Take your pick, but as you do, take some profits as well.

While Warren Buffet likely is prescient, this continues to be labelled the “Trump Rally”.

Once again, the headlines are filled with the same old thing – tax cuts, deregulation, and infrastructure.

These were the Trump campaign planks and so when he got elected, the S&P 500 rallied 6.2% right through to Inauguration Day.

He then talked about these same themes, and investors (more likely algorithmic traders), thinking they were hearing something new, bid up the stock market by 4.1% right through to the State of the Union speech the other night. 

And then, one day past the address to Congress, the S&P 500 tacks on an extra 1.4%.

It is amazing, I have to say, to see Mr. Market respond to the same language over and over and over. It is a present-day version of Pavlov’s Dog.

More discussion of tax cuts, deregulation and infrastructure, and again, the market soars on what really is old news by now. Or should be.

The fact that this is all still rhetoric, with no details or timetable provided, should be a bit worrisome.

What if all this wonderful stuff doesn’t take place until 2018 (or later)?

Tax reform is no easy task; it took Reagan four years.

Relying on private-public funding for infrastructure has all sorts of question marks in front of it logistically, and take Canada as an example of how long the gestation period is – long.

And Trump did seem to tip his hat in favor of the border-adjustment tax, which would benefit exporters to be sure and over time incentivize production to relocate to the U.S., but the initial impact will be to boost import prices, impair household spending power, and risk a consumer-led recession as was the case in Canada when the goods & services tax (GST) was introduced in 1991.

The good news is that the speech was less sinister and dark than on Trump’s Inauguration address, though the protectionist themes were still quite evident even if emphasized less in this latest go-around.

The ISM manufacturing index really whipped up the markets even more yesterday which is almost like a case of double-counting since the one thing they both have in common is being measures of confidence.

The headline ISM manufacturing index spiked 1.7 points to 57.7 in February, with 17 of 18 industries reporting growth, and most components rising smartly (like new orders jumping 4.7 points to 65.1, the best since December 2013; backlogs jumping 7.5 points to 57.0; supplier delivery delays up 1.2 point to 54.8 – these are old Greenspan favourites and he may well have tightened intermeeting in the old days based on numbers like these).

The prices-paid component also was elevated at 68.0, though off from 69.0 in January, it compares to 65.5 in December and 53.0 in September.

The pre-“Great Recession” Fed would have had little trouble tightening policy right away based on this set of data.

But there are just a few nagging concerns. 

The first is that the rival Markit manufacturing PMI did not corroborate these ISM results. That diffusion measure actually dipped to 54.2 in February from 55.0 in January.

Second, all these recent juicy ISM manufacturing releases have only managed to squeeze a string of 0.2% MoM gains in manufacturing output. Okay, but short of stellar. 

Third, we know that the last time we had such a strong ISM manufacturing print (back in the summer of 2014), it actually coincided with a 5% annualized growth rate in real GDP.

We also know that this is hardly the case this time around, as an epic gap has opened up between the survey data and the actual hard data. Sentiment is nice, but it does not feed into GDP.

And so despite all the exuberance, the Atlanta Fed just cut its estimate for Q1 real GDP growth to 1.8% from the 2.5% projection it had with near consistency since the middle of February.

[Note from John: The Atlanta Fed relowered its Q1 GDP estimate to 0.9% from 1.2% after seeing the BLS report Friday and consumer spending and CPI today. Hat tip: Peter Boockvar.]

I see many forecasters as low as 1.5% and my old shop (BAML) is calling for 1.3% current quarter growth.

There was a time this cycle when such stall-speed was met with investor euphoria because it meant the Fed was going to ease policy further and liquidity is like a drug for the stock market.

But here we have the Fed poised to tighten into an actual economic slowdown.

The fiscal stimulus hope is just that – hope. Size, details and timing are still open for debate, but what is not, is that growth is slipping again.

As in:

  • Real consumer spending declining nearly 0.3% MoM in January (baking into the cake little better than 1% real PCE growth for this quarter; and this follows the soft tone to core capital goods shipments in January which has led to downwardly revised capex estimates).
  • Real disposable income slipping 0.2% MoM. The vagaries of a 0.4% spike in consumer prices cutting into real spending power.
  • Construction spending falling 1.0% MoM in January after a flattish December.

We know that the consumer is tapped out and there is no more such thing as pent-up demand.

Autos and housing have peaked and spending intentions for both have rolled off their cycle highs. 

Not even another month of blowout incentives and discounting could manage to take auto sales north of 17½ million annualized units in February (actually a tad below the 18 million annualized units in Q4, even in the face of the widespread price breaks – one sure sign of a market suffering from consumer fatigue).

The dollar will constrain exports, to be sure.

Government is not a factor. 

Commercial real estate is in its own mini-bubble and rising vacancy rates suggest that the impetus from this sector will wane.

So we are left with capital spending as the necessary lynchpin which is why Congress and the White House should be in a hurry to pass tax reform and engage in pro-growth deregulation.

Standing in the way of a boom, mind you, is the ample spare capacity underscored by a 75% industry capacity utilization rate.

Plus, with there already being $3 trillion of liquid assets sitting on the balance sheets of U.S. businesses, it’s not as if Corporate America was ever that cash-constrained to embark on at least a mild capital spending cycle. 

The arithmetic is daunting. 

Between net exports, consumer spending, government, housing and commercial construction, together they are unlikely to add more than 1% to growth this year and next.

This means that to get to the Trump vision of 3% growth, arithmetically we would need capital spending to begin to surge at a 20% annual rate or more, the sort of thing we have never seen happen before (at least over the past 70 years). 

So good luck with that. 

At best, look for 10% capex growth and that will then give us a 2% GDP trend, in line with what we have already seen this cycle (and believe me, I am being very generous here because even seeing 10% growth in capital spending in any given year is less than a one-in-five event). 

In other words, nothing will really change.

It’s one thing to have fiscal stimulus when there is pent-up demand, we are early in the cycle, and the Fed is accommodating the largesse (as it did with FDR, with Reagan and with Obama, and did not with Eisenhower and Bush Sr.). 

It is quite another story at this late stage of the cycle, following another debt-financed consumer spending expansion (as in sub-prime autos, credit cards), and with the Fed openly signalling its intent to lean against the wind. 

So we may get stimulus and a lot of it on the fiscal side, but much will be saved, not spent, as economic agents (us!) look into the future and realize that at a near-80% starting point on the net federal debt-to-GDP ratio, today’s largesse equals tomorrow’s tax liability. As I have recommended before, look up “Ricardian Equivalence”.

With headline PCE inflation gapping up from 1.6% YoY in December to 1.9% in January (as well as the 0.3% MoM bump in the core PCE index, which was the largest monthly increase in a decade), it is reasonably safe to say that we are starting to see some late-cycle inflation pressures emerge (while the core inflation rate remained at 1.7% YoY, the three and six month trends are quickly heading towards 2%).

This, however, remains in the context of secular disinflation, and inflation is a classic lagging indicator.

But it is creating a slowdown in the real (price-adjusted) data and undoubtedly will raise eyebrows among the FOMC hawks who are looking at this in the context of a prolonged sub-5% unemployment rate backdrop.

Fed Chair Janet Yellen herself is probably not too fussed by the inflation numbers, but her recent commentary has been “hawkish” for her (what happened to running a “high pressure” economy?) as she ostensibly fears the Fed is behind the curve and may have to do more tightening down the road (having waited so long to rekindle the rate-raising process that was started 15 months ago).

Just wait to see what happens if we get the fiscal boost and the Fed raises its growth projections, keeping in mind that as a group, it sees 3% in the fed funds rate as neutral (and we are still 225 basis points away from that mark). 

But take it from me, even getting to 2% this cycle is going to end up feeling a lot like 5.25% did in 2007 and 6.5% back in 2000.

In poker parlance, we have a pair of twos on hand to contend with by year-end – 2% growth (stuck) and a 2% fed funds rate (five hikes is not out of the realm of possibilities).

I started with Warren Buffett so it is probably appropriate that I leave you with three of his most pertinent pieces of advice, all the more relevant given today’s runaway market valuation:

Most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.

Long ago, Ben Graham taught me that “price is what you pay; value is what you get.” Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.

Be fearful when others are greedy and greedy only when others are fearful.

 

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Comments

Jeffrey Braden

March 17, 5:58 p.m.

We’ve had nearly a generation of monetarist policies. Both Bush 43 and Obama administrations were monetarist. They apparently believed more money created meant more growth… even after the Great Recession. Hence, the Dick Cheney comment deficits don’t matter. Fed Chairman Bernanke professed dropping money from helicopters. We now have a President who believes Fiscal Policy (incentives) matter. Money is meaningless (not put to work) if it can’t be productively invested in projects that yield a return. Hence the need for Fiscal reforms and real investment in infrastructure.

The question becomes, will incentives overcome the public and private debt overhanging the economy? Provided key tax and regulatory burdens are removed, will “animal spirits” jump start the economy and the beleaguered velocity of money?

In a Honeywell International brief to JP Morgan Aviation Transportation & Industrials Conference the company’s brief projected a three fold increase in global M&A activity and share repurchases with the anticipated tax reform. Their projections were for $6B without tax reform and $18B with tax reform. Yes, it is anecdotal. But, is exemplary of what could happen if/when taxes are reduced. What will happen if/when the regulatory shackles are removed? Particularly those stunting small businesses.

Jeff Braden