Since the election the financial markets have been trying to price in “Trumpflation.” This is the idea that the combination of infrastructure spending, tax cuts, rising deficits, immigration curbs and protectionist policies could reverse the disinflationary trends we have witnessed over the past few decades and more dramatically since the financial crisis. The selloff in the bond market amid surging interest rates might be the single most important piece of evidence in this regard.

Over the summer I noted we were likely witnessing the final blow-off stage of the bond bull market (see this and this). Since then the long bond has fallen nearly 15% leading many pundits to conclude it has already begun pricing in the prospect of Trumpflation. However, if you look at the data, it appears it’s just not pricing in as much deflation anymore. In fact, by some measures the yield 10-year treasury bond would still need to double in order to finish the job.

A simple model based on #inflation, #ISM and short-term rates suggests the 10-year US Treasury yield should be 4%! pic.twitter.com/FooVkNvQTt

— jeroen blokland (@jsblokland) November 12, 2016

And if inflation were to actually increase from where it stands currently, yields would need to rise much further than that in order to properly price this in. Think of it this way: If inflation is running at 3-4% and rising how much of a premium to this number should an investor be paid for tying up his money for 10 years? 1%? 2%? More? Perhaps this is why “bond king” Jeff Gundlach recently suggested the 10-year yield could rise to 6% after Trump’s first term in office.

This is a big deal not just for bonds but for asset classes of all kinds that have been priced in similar fashion over the better part of the last decade. Stocks now have more interest rate risk than they have had for many years, maybe ever. It might be wise to remember the 1994 bond market crash. Just like it has over the past few months, the long bond fell 15% back then before stocks took notice and fell a quick 10% of their own. Should bonds continue their current selloff, the parallels to 1987 might be more appropriate. The long bond fell 25% during that episode, the final phase of its decline coinciding with the stock market crash that fall.

Either way, the prospect of rising inflation is something the bond market is only beginning to grapple with. It may not even materialize. There’s a good chance Trump will run into a lot more resistance than most market participants currently believe when it comes to his dramatic policy shifts. But inflation does rear its ugly head again investors may be forced to reconsider the rampant enthusiasm for financial assets that has taken hold since the election.

Courtesy of TheFelderReport

With “Black Friday” here, the performance of retailers will be a focus for the markets. As of today, which retailers in the S&P 500 are projected to see the highest and lowest year-over-year earnings growth for the fourth quarter? Which retailers in the index have seen the largest upward and downward revisions to earnings estimates for Q4 over the past two months?

In terms of year-over-year earnings growth, seven of the 13 retail sub-industries in the S&P 500 are predicted to report growth in earnings for the fourth quarter, led by the Internet & Direct Marketing Retail (23.6%), Food Distributors (14.3%), and Home Improvement Retail (13.8%) sub-industries. On the other hand, six of the 13 retail sub-industries in the S&P 500 are predicted to report declines in earnings, led by the Home Furnishing Retail (-16.0%), Hypermarkets & Super Centers (-13.5%), and Food Retail (-9.8%) sub-industries.

Revisions to Estimates

In terms of upward revisions to earnings estimates, four sub-industries have recorded an increase in expected earnings growth since the start of the quarter, led by the Food Distributors (to 14.3% from 8.8%) and Computers & Electronics Retail (to 0.4% from -4.3%) sub-industries. In the Food Distributors sub-industry, Sysco (to $0.53 from $0.51) has recorded upward revisions to EPS estimates during this period. In the Computers & Electronics Retail sub-industry, Best Buy (to $1.66 from $1.58) has witnessed upward revisions to EPS estimates over this time frame.

In terms of downward revisions to earnings estimates, eight sub-industries have recorded a decrease in expected earnings growth since September 30, led by the Internet & Direct Marketing Retail (to 23.6% from 53.9%) and Drug Retail (to 6.1% from 12.9%) sub-industries. In the Internet & Direct Marketing Retail sub-industry, Amazon.com (to $1.45 from $2.13) has recorded the largest downward revisions to EPS estimates during this period. In the Drug Retail sub-industry, both CVS (to $1.67 from $1.79) and Walgreens Boots Alliance (to $1.11 from $1.17) have recorded downward revisions to EPS estimates over the past two months.

It is interesting to note that despite recording the largest decline in expected earnings growth over the past two months for all S&P 500 retail sub-industries, the Internet & Direct Marketing Retail sub-industry is still expected to report the highest earnings growth of all S&P 500 retail sub-industries at 23.6%.

Courtesy of FactSet

The giant international trade deal known as the Trans-Pacific Partnership died last week. It was supposed to be the largest regional trade deal in history.

The TPP itself was a massive 30-chapter lawbook that would have freed access to markets for things like car manufacturing, data storage, online commerce, intellectual property and medicines.

Hoards of technology and media companies supported the trade deal. Google was pro TPP. As was Microsoft, Apple and Facebook. The Motion Picture Association of America supported it too. The deal would have allowed them to make it easier to store user data across borders, offer stricter copyright protections and clamp down on digital pirating.

President-elect Donald Trump positioned his opposition to the trade deal as one of the defining issues of his campaign. He compared the TPP to the North American Free Trade Agreement of the 1990s that allowed U.S. manufacturers to move jobs to Mexico.

President Obama, on the other hand, was betting on the trade accord to be a part of his foreign policy legacy, refocusing the American economy toward Asian countries and hedging against China’s growing power. But after Trump’s unexpected win, there are no hopes for the Republican majority Congress to ratify it. China, meanwhile, has a trade deal of its own the country is hoping to pass in the wake of the TPP’s failure.

Now that deal is off the table, the large companies that supported it will have to go back to the foreign policy drawing board.

Here’s what American technology companies would have gotten had the deal been finalized.

• The TPP’s e-commerce chapter included the world’s first set of international trade rules that would have barred governments from blocking how companies share data across national borders. The internet works by freely moving data across the world. It’s how an artist in Mexico is able to have a fanbase in the U.K. just by posting a video on YouTube. Now governments can impose laws on how data is ferried outside of their country, potentially blocking content and balkanizing the internet. On the flip side, technology companies cooperate with digital surveillance operations across borders too, and the TPP would have muddled the way countries would have been able to pass national privacy laws.
• In many of the participating countries it is not currently illegal to break the digital rights management, a digital lock that technology companies can add to their products to prevent piracy, tinkering and repair. But DRM is easy to circumvent, and hackers as well as media pirates have found ways to break to digital locks to make pirated copies of movies and music. In the U.S., it’s illegal to break DRM under copyright law, and the TPP would have expanded that internationally. Several countries would have had to make bans for repairing or tinkering with software or devices if DRM was circumvented, which would have been a win for the digital music and movie industry’s battle against piracy, as well as device manufacturers.
• Six of the twelve participating countries would have expanded their copyright terms an additional 20 years. Under the TPP, it would have taken over 70 years for a copyrighted work to enter the public domain, which is what happens when a song or film is so old that it’s legal to access it for free.
• Tech companies also were in favor of the TPP’s ban on “forced localization,” or laws that require a company to keep its citizens’ user data stored within its borders. Technology companies oppose these statutes on the grounds that they inhibit their increasingly cloud-based business models. When a country requires that data generated in the country stay stored within its borders, tech companies are forced to build data centers there in order to do business. Forced localization could also open a technology company or website to being compelled to follow a country’s censorship laws by dint of operating servers there.

Courtesy of ReCode

The U.S. and global economy has reacted in mixed fashion since the election of Donald Trump as 45th President of the United States. One of the most significant potential fallouts though, is a trade war with China. Trump has spoken out against the current situation with China on a great number of occasions. Now he is in a position to potentially see through his pledges, some fear the emergence of a tit-for-tat trade war between the two countries. As the infographic below shows, the industries most endangered by any such war would be transportation and tech.

This chart shows the leading export categories of the United States to China in 2015.

You will find more statistics at Statista

As the market partied this week, believing that Obamacare would be smashed and their premiums would revert back to lower levels, I sat and chuckled.  You're already spending money you haven't received in terms of lower premiums but there's always a price. Always. Already the "costs" of repealing ACA are being calculated and surprise surprise, it won't be free or easy.  In fact QZ ponders it will cost "us" Billions but let's examine the possibilities.  From BuzzFeed:

In the wake of Donald Trump’s stunning victory Tuesday night, the only certainty for the American health care industry is the end of the Affordable Care Act, at least in its current form.

Everything else for the industry, however, is deeply uncertain. Supreme Court cases have jeopardized parts of Obamacare before, but with a Trump presidency, the industry is for the first time facing the real possibility of a drastic and abrupt repeal of the entire ACA — a scenario that some industry sources say insurance companies and hospitals are unprepared to deal with.

Though he has many ideological disagreements with Republican leaders, including on health care issues like Medicare subsidies, Trump and Congress are united in agreement that Obamacare must go, and quickly. Majority Leader Mitch McConnell told reporters on Wednesday that repeal of the law remained a top priority for the GOP-led Congress.

Many in the health care industry are hopeful that they can still have an influential seat at the table in the shaping of a new health care law — one that would allow them to preserve some of the key parts of the Affordable Care Act that they have spent six years building, and would give them enough time to craft new plans that will keep people insured.

But when the health care law was originally passed, Republicans raged against it for being a product of backroom deals with the insurance and pharmaceutical industries — the same kind of deals Trump consistently campaigned against.

So there remains a strong possibility that, in the face of enormous political pressure in the administration’s early days, Trump and Congress could pursue a sudden, complete repeal, or something resembling one. In that scenario, the most pressing concern would be the immediate defunding of state health care exchanges, which would potentially remove 20 million people from insurance rolls. Abruptly ending the individual insurance mandate, too — something Trump has said he will do — could cause millions of people to end their insurance.

For insurance companies that participated heavily in Obamacare, a full repeal early in Trump’s tenure would be a nightmare scenario, said the industry source, causing a sudden and dramatic loss of revenue.

“I’m not sure that they’re ready for the full repeal,” said a senior health care industry official of insurers like Blue Cross Blue Shield and Anthem, who have invested heavily in the ACA. “They totally changed their business model” for the ACA, the official said.

An ACA repeal would come with some substantial tax breaks for insurers and pharmaceutical companies, which have been paying into the ACA. And drug companies will likely be able to continue their practice of raising prices on drugs they own, something that was not likely to continue under a Clinton administration — a fact that sent pharmaceutical stocks rising sharply Wednesday in the wake of Trump’s election.

But a large number of people losing or leaving their insurance could also cost pharmaceutical companies revenue as people become unable to afford medications, and would drive up costs for hospitals.

Under the ACA, “more people were able to pay hospital bills through insurance,” said Benjamin Isgur, the leader of PwC’s Health Research Institute. “If people become uninsured and there’s no state funding to make up for that, you have hospitals providing services with no payment.”

As of now, Trump doesn’t have the congressional majority he would need in the Senate to quickly dispatch the entire ACA, and in the past, with the law under threat in the Supreme Court, Republicans have signaled some willingness to work on a slower transition that preserves some parts of the law.

Though the industry is “hyper-focused” on the possibility of an ACA repeal, Isgur said, “We don’t know exactly how repeal would be defined.”

But even the more muted scenario of a partial rollback — one where the dismantling of the health care law plays out over a matter of months, or years — could be troublesome for the industry.

“Even with all the problems with the ACA, there was still a fair amount of certainty baked in,” said the senior industry official. “When it comes to insurance companies, there’s a big question of what this practically means. That’s the thing that’s most concerning.”

Outside of declaring his intent to repeal the ACA, Trump has provided relatively few details about what health care would look like under his presidency. Many expect him to focus on “free market” reforms like more transparent pricing, creating health care savings accounts, and allowing the sale of insurance across state lines. But he has also said he intends to expand Medicaid to make up for a loss of coverage under the ACA, something that is deeply at odds with many conservatives’ viewpoints.

Health care stocks have been the worst-performing sector in the S&P 500 so far this year, facing huge uncertainty in the face of controversies over drug prices and troubles with Obamacare.

As technicians battle over whether our "hated" seven year rally still has legs, I continue to return and ask myself "has anything truly blown up?".  I do personally believe the US Dollar will continue it strength and that will continue to put pressure on commodities, dividend payers and discretionary.  Financials and insurers will push higher.  Can the rest of the boat survive?  Are earnings guidance showing a 'rosey' picture of the future?  Will Trump win?  Too many unknowns for me.  This post, using monthly charts, brings me back to earth.  While I have no need to catch the absolute top, it gives me specific areas which need to be defined.  I remain cautious and yes, have numerous short positions as well as longs.  That doesn't mean, however, that I'm willing to give up just yet.  I hope you enjoy-

While the technicians usually write about the short tem, I want to zoom out a little and use a monthly chart of the New York Composite ($NYA). For those who follow my webinars, we are following the charts very closely as the market conditions are frail in my opinion. We could rally from here, but the long term charts continue to disappoint in my work. This New York Composite chart ($NYA) shows the close Friday, November 4th, 2016.

While the October 31st close did not close below the 10-month Moving average or give a MACD sell signal, it only took a pullback of one more day (November 1) to generate a sell signal on both the MACD and the 10 month moving average. That is a fine detail on a monthly chart. These can be seen looking at the Zoombox on the far right. By the Friday close shown below, the picture was getting a little more difficult. Martin Pring's Monthly KST is below zero as well.

The note I wrote on this chart above back in August 2016 as the $SPX made it's high is extremely important now. We actually did cross above the signal line but so far this month we are below. We will need to wait for the November close and the level of 10414, but it is very important to realize how frail the market setup is. There were only 3 times on this chart that a monthly sell signal reversed higher. One was the coordinated central bank move in September 2012. The other was the brief rally in 1999 before the tech top. The current one is in play. If we close below 10414, we have an important signal.

Why is this so important? The real problem is understanding what has happened through the passage of time from the high on the MACD in 2014. As oil plummeted from June 2014 and the energy sector was decimated, it slowly affected other industries and sectors. By the spring of 2015, the $NYA chart above made marginal new highs over the 2014 level. As the industry dominoes started to fall, the market pulled back most of 2015 with a final low in January/February 2016 coinciding with Crude Oil's final low. As oil rallied, GDP numbers started to improve and recently we just had a GDP print of 2.9%.

My position is if energy (Oil, Natural Gas, Wind, Solar, Coal, Nuclear, Ethanol) fails to hold up, we could see more pressure on the economy. Since the market top of May 22,2015, three groups have gained meaningfully from that day, three are close to flat and three declined heavily.

However, zooming in on the markets for the last 3 months after the initial rally off the floor in February 2016, we have a different picture. While energy and financials are marginally positive, big sectors like consumer discretionary, industrials and materials are down. As well, Biotech within Healthcare has been crushed. Technology has been relatively flat, even with Apple, Google, Amazon, Facebook and Netflix.

In a nutshell, for my way of thinking, we need Energy to continue to rebound. If that doesn't happen, it is a global sector that slowed the MACD from the highs of 2014 to the very low levels we saw in the first chart. If Energy rolls over again, which it appears to be doing now, this could be the major derailment that gives our global markets negative momentum. The other sectors don't look strong enough to carry the economy forward in my mind. The monthly charts are warning us. It could break out to the upside, but I think it is important to understand what a sell signal in November and confirmation in December could mean for the longer term. We don't usually get two whipsaws on monthly charts.

Lastly, some of the webinars over the last two weeks have set the stage for how close this market is to a major reversal. If you are not aware of how fine that picture is, I would encourage you to watch Commodities Countdown 2016-10-27 and then the Commodities Countdown 2016-11-03. I have been bullish until late September so I am not quick to jump on the bear bandwagon. But when the time comes, keeping your capital becomes more important than making money.

Courtesy of StockCharts.com

When it comes to energy, there is one matter everyone agrees on. For the near future, at least, the world will need more of it—and how it is produced and used will be a critical factor in the future of the global economy, geopolitics, and the environment. With that in mind, McKinsey took a hard look at the data, modeling energy demand from the bottom up, by country, sector, and fuel mix, with an analysis of current conditions, historical data, and country-level assessments. On this basis, McKinsey’s Global Energy Insights team has put together a description of the global energy landscape to 2050.

It is important to remember that this is a business-as-usual scenario. That is, it does not anticipate big disruptions in either the production or use of energy. And, of course, predicting the future of anything is perilous. With those caveats in mind, here are four of the most interesting insights from this research.

Global energy demand will continue to grow. But growth will be slower—an average of about 0.7 percent a year through 2050 (versus an average of more than 2 percent from 2000 to 2015). The decline in the rate of growth is due to digitization, slower population and economic growth, greater efficiency, a decline in European and North American demand, and the global economic shift toward services, which use less energy than the production of goods. For example, in India, the percentage of GDP derived from services is expected to rise from 54 to 64 percent by 2035. And efficiency is a forthright good-news story. By 2035, McKinsey research expects that it will take almost 40 percent less fuel to propel a fossil-fueled car a mile than it does now. By 2050, global “energy intensity”—that is, how much energy is used to produce each unit of GDP—will be half what it was in 2013. That may sound optimistic, but it is based on recent history. From 1990 to 2015, global energy intensity improved by almost a third, and it is reasonable to expect the rate of progress to accelerate.

Demand for electricity will grow twice as fast as that for transport.

China and India will account for 71 percent of new capacity. By 2050, electricity will account for a quarter of all energy demand, compared with 18 percent now. How will that additional power be generated? More than three-quarters of new capacity (77 percent), according to the McKinsey research, will come from wind and solar, 13 percent from natural gas, and the rest from everything else. The share of nuclear and hydro is also expected to grow, albeit modestly.

What that means is that by 2050, nonhydro renewables will account for more than a third of global power generation—a huge increase from the 2014 level of 6 percent. To put it another way, between now and 2050, wind and solar are expected to grow four to five times faster than every other source of power.

Fossil fuels will dominate energy use through 2050. This is because of the massive investments that have already been made and because of the superior energy intensity and reliability of fossil fuels. The mix, however, will change. Gas will continue to grow quickly, but the global demand for coal will likely peak around 2025. Growth in the use of oil, which is predominantly used for transport, will slow down as vehicles get more efficient and more electric; here, peak demand could come as soon as 2030. By 2050, the research estimates that coal will be down to just 16 percent of global power generation (from 41 percent now) and fossil fuels to 38 percent (from 66 percent now). Overall, though, coal, oil, and, gas will continue to be 74 percent of primary energy demand, down from 82 percent now. After that, the rate of decline is likely to accelerate.

Energy-related greenhouse-gas emissions will rise 14 percent in the next 20 years. That is not what needs to happen to keep the planet from warming another two degrees, the goal of the 2015 Paris climate conference. Around 2035, though, emissions will flatten and then fall, for two main reasons. First, cars and trucks will be cleaner, due to more efficient engines and the deployment of electric vehicles. Second, there is the shift in the power industry toward gas and renewables discussed above. The countervailing trends are that there are likely to be some 1.5 billion more people by 2035, and global GDP will rise by about half over that period. All those people will need to eat and work, and that means more energy.

The world is full of unpredictable and sometimes wonderful surprises, so I accept that these numbers are unlikely to be perfect. As with any forecast, they are based on assumptions—about China and India, for example—as well as about oil prices and economic growth. Other sources see different outlooks. Concerted global action to reduce greenhouse-gas emissions, for example, could change the arc of these trends. Technological disruptions could also bend the curve.

For business and political leaders, though, the implications are clear. Given that global energy demand will grow, it is likely that prices will continue to be volatile. Better energy efficiency, then, is an important way to reduce related risks. Technology development is critical to ensuring that the world gets the energy it needs while mitigating environmental harm. This will require substantial new investments. Finally, to encourage the creation of the clean and reliable energy infrastructure that the world needs, energy producers will need to work with local, regional, national, and international regulators. Getting things right the first time is essential; there is extensive evidence to show that dramatic changes in policy act as a powerful deterrent to energy investments by producers. Given the scale of the new investments needed, this will be a factor of growing importance.

Courtesy of McKinsey

Election Day in the United States is, at last, almost here. Similar to any other major event, investors will be looking to what effect the presidential election will have on the stock market for the rest of the year and beyond. One way we can predict this movement is to analyze the historical price performance of the S&P 500 and the Dow Jones Industrial Average during past election cycles. Here we'll examine:

• How does the stock market perform in the final two months of presidential election years?
• What effect does the elected political party have on stock market performance in the years following the election?
• Which sectors are the top performers during election years and post-election?

S&P 500 and Dow Jones Industrial Average Underperform during Election Years

During presidential election years going back to 1928, the S&P 500 index has been in the positive 73% of the time (16 out of 22 years). The average price gain of the S&P 500 during election years was 7%, which trailed the 7.4% gain for the index during all years. When a Democrat was elected as President of the United States, the S&P 500 was up for the year 58% of the time (seven out of 12 years) and saw an average price increase of 3.3%. When a Republican was elected as President of the United States, the index was up for the year 90% of the time (nine out of 10 years) and posted an average price increase of 11.4%.

When performing this same analysis for the Dow Jones Industrial Average, we see a similar story. That is, the index tends to underperform during presidential election years when a Democrat is elected (compared to when a Republican is elected) and also underperforms during election years in general (compared to all years). This is shown in the two charts below.

What Does History Indicate about the Final Two Months of Election Years?

As of close on November 1, the S&P 500 is up 3.3% year-to-date. Looking at the final two months of presidential election years going back to 1928, the S&P 500 index gained in value 64% of the time (14 out of 22 years). The average price increase was 1.9%, which trailed the 2.1% average increase in the final two months of all years.

When a Democrat was elected as president, the S&P 500 posted an average price gain of 0.6% (during the final two months of election years), which was well-below the 3.6% average gain when a Republican was elected. When performing this same analysis for the Dow Jones Industrial Average, the average price increase in the final two months of election years actually exceeded the average gain in the final two months of all years by 0.3 percentage points. The effect that the elected political party had on the Dow’s price movement was consistent with that of the S&P 500 index.  

Post-Election Years: Third Year after the Election is a Charm

Looking at the first year after the presidential election (going back to 1928), the S&P 500 index has increased in value 55% of the time (12 out of 22 years), with the average price gain amounting to 5.1%. When a Democrat was elected president, the S&P 500 was in the positive during the first post-election year 75% of the time (nine out of 12 years), with the average price increase equaling 11.7%.

When a Republican was elected president, the index was in the positive only 30% of the time (three out of 10 years), with the average price change amounting to -2.8%. Keep in mind that this represents a stark contrast to the price change for the S&P 500 during election years, when a Democrat was elected versus a Republican. In election years, when a Democrat was elected as President of the United States, the S&P 500 underperformed (compared to when a Republican was elected) on average by 8.1 percentage points.

As shown in the chart below, the third post-election year experienced the largest price gain for the S&P 500 on average. During the third year after the presidential election, the S&P 500 increased 12.8% on average, which exceeded the 7.4% annual gain for all years (going back to 1928). No other post-election year logged an average percentage increase that beat the 7.4% watermark.

S&P 500 Favors Democrat to New Democrat President Transition over Democrat to Republican

From a political continuity perspective, a Hillary Clinton win would be better for the market in the first year after the election, based on history. On average, the S&P 500 index increased in value by 9.8% in the first post-election year when the political party of the president transitioned from a Democrat to a new Democrat. Keep in mind, though, that this has only occurred twice since 1928.

Contrastingly, the S&P 500 decreased in value by 10.2% on average in the first post-election year when the political party of the president shifted from a Democrat to a Republican. This has occurred four times since 1928. It is interesting to note that in the second and third years after the election, the Democrat to new Democrat transition underperformed the Democrat to Republican shift.

Consumer Discretionary has been Best Performing Sector in Post-Election Year

Looking at post-election years going back to 1992 (when all S&P 500 sector data is available), the S&P 500 index still performed best in the third year following the presidential election. At the sector level, the Financials group saw the largest price gain during election years, posting an 8.8% average jump. The Telecom, Information Technology, and Materials sectors were the only groups to log an average price decline during election years. 

In the first post-election year, all S&P 500 sectors saw an average price increase, with the Consumer Discretionary group leading the way (+19.9%).  The Information Technology sector led all groups in terms of price performance for the second and third years after Presidential elections.  Once again, all S&P 500 sectors posted a price gain on average during these years. 

Alphabet's investment arm, Google Capital, has quietly made an investment in Snapchat parent company, Snap Inc. 

The investment was only revealed after Google Capital rebranded itself to CapitalG on Friday and added the Snapchat logo to its portfolio page. Business Insider confirmed that it is a portfolio company of the growth equity arm of Alphabet. Snap Inc did not immediately respond to comment. 

The two companies have had a cozy relationship. In 2013, it was rumored that Google once tried to buy Snapchat for $4 billion after it turned down a Facebook acquisition. To this day, Snapchat remains one of the largest users of Google's cloud infrastructure, although it's recently brought a data center specialist in house. 

Before it renamed itself to Snap Inc in September, Snapchat had most recently raised $1.81 billion in a May 2016 round of funding. That funding round valued the company around $20 billion. 

Courtesy of BusinessInsider

The constant flow of goods from Asia to the United States was briefly interrupted last month after Hanjin, the South Korean shipping line, filed for bankruptcy, stranding several dozen of its cargo ships on the high seas.

It was a moment that made literal the stagnation of globalization.

The growth of trade among nations is among the most consequential and controversial economic developments of recent decades. Yet despite the noisy debates, which have reached new heights during this presidential campaign, it is a little-noticed fact that trade is no longer rising. The volume of global trade was flat in the first quarter of 2016, then fell by 0.8 percent in the second quarter, according to statisticians in the Netherlands, which happens to keep the best data.

The United States is no exception to the broader trend. The total value of American imports and exports fell by more than $200 billion last year. Through the first nine months of 2016, trade fell by an additional $470 billion.

It is the first time since World War II that trade with other nations has declined during a period of economic growth.

Sluggish global economic growth is both a cause and a result of the slowdown. In better times, prosperity increased trade and trade increased prosperity. Now the wheel is turning in the opposite direction. Reduced consumption and investment are dragging on trade, which is slowing growth.

But there are also signs that the slowdown is becoming structural. Developed nations appear to be backing away from globalization.

The World Trade Organization’s most recent round of global trade talks ended in failure last year. The Trans-Pacific Partnership, an attempt to forge a regional agreement among Pacific Rim nations, also is foundering. It is opposed by both major-party American presidential candidates. Meanwhile, new barriers are rising. Britain is leaving the European Union. The World Trade Organization said in July that its members had put in place more than 2,100 new restrictions on trade since 2008.

“Curbing free trade would be stalling an engine that has brought unprecedented welfare gains around the world over many decades,” Christine Lagarde, managing director of the International Monetary Fund, wrote in a recent call for nations to renew their commitment to trade.

Against the tide, the European Union and Canada signed a new trade deal on Sunday.

It may be hard, however, to muster public enthusiasm in the United States and other developed nations. The benefits of globalization have accrued disproportionately to the wealthy, while the costs have fallen on displaced workers, and governments have failed to ease their pain.

The Walmart revolution is over. During the 1990s, global trade grew more than twice as fast as the global economy. Europe united. China became a factory town. Tariffs came down. Transportation costs plummeted. It was the Walmart Era.

But those changes have played out. Europe is fraying around the edges; low tariffs and transportation costs cannot get much lower. And China’s role in the global economy is changing. The country is making more of what it consumes, and consuming more of what it makes. In addition, China’s maturing industrial sector increasingly makes its own parts. The International Monetary Fund reported last year that the share of imported components in products “Made in China” has fallen to 35 percent from 60 percent in the 1990s.

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The result: The I.M.F. study calculated that a 1 percent increase in global growth increased trade volumes by 2.5 percent in the 1990s, while in recent years, the same growth has increased trade by just 0.7 percent.

Hanjin, like other big shipping companies, bet that global trade would continue to expand rapidly. In 2009, the world’s cargo lines had enough room to carry 12.1 million of the standardized shipping containers that have played a crucial, if quiet, role in the rise of global trade. By last year, they had room for 19.9 million — much of it unneeded.

India is not China redux. Most trade flows among developed nations. The McKinsey Global Institute calculates that 15 countries account for roughly 63 percent of the global traffic in goods and services, and for an even larger share of financial investment.

China joined this club the old-fashioned way: It used factories to build a middle class. But the automation of factory work is making it harder for other nations to follow. Dani Rodrik, a Harvard economist, calculates that manufacturing employment in India and other developing nations has already peaked, a phenomenon he calls premature deindustrialization.

The weakness of the global economy is exacerbating the trend. Infrastructure investment by multinational corporations declined for the third straight year in 2015, according to the United Nations. It predicts a further decline this year. But even if growth rebounds, automation reduces the incentives to invest in the low-labor-cost developing world, and it reduces the benefits of such investments for the residents of developing countries.

The political reaction is global, too. The economist Branko Milanovic published a chart in 2012 that is sometimes called the elephant chart, because there is a certain resemblance. It shows real incomes rose significantly for most of the world’s population between 1988 and 2008, but not for most residents of the United States and other developed countries.

The chart is often presented as a depiction of the consequences of globalization. The reality is more complicated, but perception is undeniable. Voters in developed nations increasingly view themselves as the victims of trade with the developing world — and a backlash is brewing.

Donald J. Trump’s presidential campaign is an obvious manifestation, as is Hillary Clinton’s backing off from her support of the Trans-Pacific Partnership trade deal. A study published in April found that voters in congressional districts hit hardest by job losses are more likely to reject moderate candidates, turning instead to candidates who take more extreme positions.

Economic stagnation is turning European voters against trade, too.

Professor Rodrik said that proponents of free trade were guilty of overstating the benefits and understating the costs. “Because they failed to provide those distinctions and caveats, now trade gets tarred with all kinds of ills even when it’s not deserved,” he said. “If the demagogues and nativists making nonsensical claims about trade are getting a hearing, it is trade’s cheerleaders that deserve some of the blame.”

Courtesy of NYTimes

The stock market continues to weaken, as evidenced by these ETF charts.    If you zero in on a sector you wish to short, I would bear in mind that ETFs are comprised of market leaders.  I would look for names "outside" of the ETF components; consider them leaders and you want the weaklings to short.

The reasons for weakness are numerous. 

Consider the election weight (a Trump win would weigh on equities but Clinton weighs on pharma pricing).  Then there are flat-to-dropping sales.  Of course the USD movement (up will weigh on commodities and large caps with overseas exposure).  Then there's those who feel we are already at or above maximum value and they're not buying here.  They're hedged, short some and long financials ahead of the Fed rate hike.  Then there's that Fed hike itself.  High dividend is flushing down the toilet (SDY) in September.  Overseas weakness with China not helping boost confidence for demand.  And we also have more failure at the OPEC talks with no offer from outside countries to participate.  They've definitely lost their 'power' over us and crude should continue to weaken.

Consider however, that the weakness has been growing, sector by sector.  When you accept we have weakness in housing, some retail, some restaurants, small caps, mid caps, pharma, healthcare and now oil.  With energy being the second largest sector, this weighs heavily.  Banks can't do it all on their own.

Well here they go and there are many, many more out there; you'll see.  Possibly you can use one here and/or search for more.  Cover above the upper trend lines.  Targets are all equal to the high/low of the pattern with a partial taken along the way.  I usually leave a small piece on the table as well.  You never know where the markets heading next.  NOTE:  Most are daily views but there are a few weekly charts.  Take note.

You're welcome

(Click on any chart to enlarge)

In December of 1996, Greenspan was clearly beginning to worry about the economic fallout of a bursting asset bubble. Back then he had a front row seat and, in fact, a strong hand in creating the dotcom bubble, whether he admits it or not. He was so worried about the consequences of “irrational exuberance” that he declared these concerns “must be an integral part of the development of monetary policy.” And this was before he had even witnessed any of the actual economic consequences we have now lived with for two decades. Clearly, his worries were well founded but he wasn’t quite worried enough.

The financial well-being of entire generations has been permanently damaged. Think of the Baby Boomers whose retirement dreams turned to nightmares through two stock market crashes in less than a decade. Think of the Generation Xers whose dreams were shattered by the housing bubble and the mortgage crisis. As a group these latter folks, even though they are now entering their peak earnings years, are flat broke almost a decade after it all began. And the major media outlets wonder openly why the average American has next to nothing in savings. He was explicitly encouraged by the single most powerful institution on the planet to put his savings into great peril, time and again.

Now I should be clear that over the decade following this famous speech, while he remained Fed Chairman, he did nothing to incorporate these prescient concerns into Fed policy. Just the opposite. After the dotcom bubble burst he engineered the housing bubble to try to ameliorate the damage done by the first. It’s one thing to worry about the risks of financial bubbles you have a hand in creating; it’s something else to actually do something about them. So while we can admire his foresight we should not honor it by overlooking his cowardice in failing to do anything about it.

Since then, and with the benefit of witnessing the actual fallout of these epic busts, many at the Fed (and even more outside of it) have openly discussed this dilemma of directly addressing asset bubbles. Eric Rosengren, head of the Fed Bank of Boston, became the latest to openly echo Greenspan’s concerns regarding “irrational exuberance” in the financial markets. Robert Shiller won a Nobel Prize for work in this very area. Still, nothing has been done to actually address these massive economic risks. After 20 years and two bursting bubbles whose effects are still plaguing the economy it’s still nothing more than sporadic public hand wringing by the people with the power to do something about it.

In recent years the Fed has only doubled down on these policies by directly pursuing a “wealth effect.” Rather than give a boost to the broad economy, however, these central bankers have only accomplished an even greater and more pervasive financial asset perversion. Stocks, bonds and real estate have all become as overvalued as we have ever seen any one of them individually in this country. The end result of all of this money printing and interest rate manipulation is the worst economic expansion since the Great Depression and the greatest wealth inequality since that period, as well.

Someday, possibly soon, the public will finally decide it’s had enough of the escalating boom bust cycles the Fed has exacerbated, if not directly engineered, over the past couple of decades. Falling confidence in these technocrats and the resulting rising populism will serve as a clarion call for a new brand of Fed Chairman with the courage to finally address the glaring danger asset bubbles pose to financial stability and the long-term economic health of our nation. She will be the 21st century’s version of Paul Volcker. Rather than breaking the back of inflation in the traditional sense, she will break the cycle of unwarranted asset inflation at the direction of the Fed and all of its deleterious consequences. At least I hope it’s not irrational to believe so.

Courtesy of TheFelderReport

As U.K.-based banks wait to see what life will be like after Brexit, one word -- passporting -- will speak volumes. If Prime Minister Theresa May can maintain the passporting rights of City of London banks, the U.K. stands to retain its status as a hub of global finance. If not, hope isn’t lost, but the alternative to passporting requires an arduous approval process and provides no secure basis for long-term planning.

1. What is passporting, anyway?

Passporting refers to the right of companies authorized in one country of the European Economic Area -- currently comprising the 28 EU states plus Iceland, Liechtenstein and Norway -- to sell their products and services throughout the bloc, accessing a $19 trillion integrated economy with more than 500 million citizens. There is not one financial passport, but rather a series of sector-specific agreements covering everything from banking to insurance and asset management. It’s why global firms such as Goldman Sachs or Morgan Stanley canhave the overwhelming bulk of their staff in London, with only satellite offices in other capitals like Paris and Frankfurt. 

2. What banking activities are involved?

Passporting covers a range of activities, including deposit taking, derivatives trading, loan and bond underwriting, portfolio management, payment services, insurance and mortgage broking. A bank does not need a passport to conduct foreign exchange trading because that’s an unregulated activity.

3. What does passporting mean for U.K. banks?

London’s status as the world’s preeminent financial hub is due in no small part to the access companies based in the U.K. have to the EU’s single market. Eighty-seven percent of U.S. investment banks’ EU staff live in the U.K., which also boasts 78 percent of the region’s capital markets activity, according to New Financial, a research group. Consulting firm Oliver Wyman reckons around a fifth of the U.K.’s banking sector’s annual revenue -- between 23 billion pounds and 27 billion pounds -- is based on passporting access.

4. Is it just banks?

No. The EU is also an important market for U.K.-based insurance companies and asset managers. About 28 percent of insurance exports go to the bloc, according to Open Europe. The Investment Association estimates 21 percent of assets managed in the U.K. are connected to EU clients. Financial firms and associated businesses employ more than 2 million people nationwide and paid 66 billion pounds in tax last year, more than any other sector. The Financial Conduct Authority estimates about 5,500 U.K. firms use passporting to do business on the continent, and that 8,000 companies based in Europe use it to access the U.K. So the EU, too, has an incentive to strike a deal.

5. What would the loss of passporting mean?

Banks with their European headquarters in London say they would have to move thousands of employees to new subsidiary offices on the continent. "If we are outside the EU, and we do not have what would be a stable and long-term commitment that we would have access to the single market, we would have to do a lot of things that we do from London somewhere inside the EU27," said Rob Rooney, chief executive officer of Morgan Stanley International, the Wall Street firm’s most senior banker in Europe.

6. Who doesn’t benefit from passporting?

One example: A Hong Kong-based bank with no subsidiary office in the EU could not make use of the passporting system to do business within the European Union.

7. Will banks in the U.K. retain their passport?

It’s highly unlikely. Under current EU rules, the U.K. would have to become a member of the European Economic Area for British firms to retain unfettered access to the region’s single market. EEA membership comes at a price May might not be prepared to pay: contributing to the EU budget and following its rules, including the free movement of workers, while having no voice in making them.

8. What does the government say?

In July, Foreign Secretary Boris Johnson said he expected the U.K. would keep its passporting rights. May says she will seek "to give British companies the maximum freedom to trade with and operate in the single market, and let European businesses do the same here," though not if that means giving up "control of immigration." Prior to becoming chancellor of the exchequer, Philip Hammond said, “I know and understand the importance of passporting.” He’s since retreated to pledging to aim for the “best” deal.

9. Is there a Plan B?

Maybe. If passporting is off the table, the U.K. may have to fall back on regulatory “equivalence,” which allows companies based outside the EU privileged, if targeted, market access. It would require the European Commission to recognize that the U.K.’s rules and oversight of specific business lines are as tough as -- equivalent to -- its own. The EU utilizes equivalence to reduce overlaps and capital costs for EU companies that must comply with rules in other countries. Most EU financial-services acts contain provisions for equivalence, including the updated markets rules known as MiFID II, which come into effect in 2018. Equivalence is also possible for some purposes in the EU’s bank capital rules and in Solvency II, which governs the insurance industry.

10. How might equivalence work in practice?

Take the recent agreement the commission struck with the U.S. Commodity Futures Trading Commission on central counterparty clearing. EU law, in this case the European Market Infrastructure Regulation, allows companies based outside the bloc to provide clearing services in the EU on two main conditions. First, the commission has to determine that the country’s legal and supervisory systems are an “effective equivalent” to those in the EU; second, the companies must be recognized by the bloc’s markets regulator. The deal with the CFTC enabled companies such as Chicago-based CME Group Inc. to continue providing services to EU firms. Without it, traders would have faced higher EU capital requirements to clear swaps, futures and other derivatives in the U.S.

11. Why isn’t equivalence as good as passporting?

Passporting is a right, while equivalence is a privilege that can be unilaterally withdrawn by the European Commission at short notice. Also, equivalence doesn’t cover some core banking activities such as deposit taking and cross-border lending. Firms may have to endure a long period of uncertainty as the U.K. negotiates with the EU to have rules deemed equivalent. It took the EU four years to negotiate the CFTC deal.

12. Where does this leave the banks?

Facing an uncertain future with no clarity on what access they will have to the single market after Brexit, banks are lobbying May and EU leaders to strike an interim agreement which would allow them to continue to provide services across the EU from London beyond the end of the two-year negotiation period. In the meantime they are planning for the worst and accelerating plans to move thousands of employees and operations to the continent.

Courtesy of Bloomberg

A December Fed rate hike, uncertainty regarding the U.S. presidential elections, weak earnings growth, diminished buyback activity and concerns about European banks pose near-term risks to global equities.  Comments in italics are mine.

The summer rally has left equity valuations looking stretched. The median U.S. stock now trades at a higher P/E ratio than even at the 2000 peak. The Shiller P/E ratio stands at 27, but would be 37 if profit margins over the preceding ten years had been what they were in the 1990s. The fact that interest rates are low gives stocks some support, but with the Fed likely to hike rates in December, that tailwind will begin to fade.

Lackluster earnings growth remains another concern. S&P 500 and economy-wide profit margins have rolled over. Granted, the collapse in profits in the energy sector has been the major culprit, and this headwind should wane if oil prices edge higher over the next 12 months, as we expect. Nevertheless, faster wage growth and a firm U.S. dollar will limit any recovery in margins. A Trump victory could also trigger a trade war, while a Clinton triumph could mean higher taxes and increased regulatory burdens.  Let's not forget further spotlight on biotech and drug prices. Both will be headwinds for the corporate sector.  Let us also not ignore the "hard Brexit" tensions and $DB worries across the pond as well as China slowdown in exports.  When will they ever hit bottom?  It all makes you want to be long USD and short the Euro, GBP and CNY.  Oh btw, if the USD continues to benefit, what will that do to the energy sector which has been so hot in 2016?  Can OPEC's talk of holding production hold true when so many producing countries are not OPEC members?  What weight will that place on SPX?

Bottom Line: Our Global Investment Strategy service believes global equities are vulnerable to a near-term correction.

This does not mean we can't see individual stocks climb higher on news or their potential implied price targets however "bears" tend to choose their entry levels as I have.  Last Summers "breakout' in SPX did not exceed 4% of the prior level and is therefore suspect in my book.  I am short in certain names (LULU, BIDU, TSLA to name a few) and will establish more as needed.  I am still long some equity names at the same time; mostly anticipating higher rates.

Courtesy of BCA Research

This week’s EVA brings the second edition of our new Random Thoughts format. The goal with this approach is to cover several key, but often unrelated, topics in a quick overview fashion.

In this issue, we are looking at, once again, the powerful financial force known as credit spreads.   Fortunately, they are not indicating financial stress at this time. We are also examining the supposed truism that this is one of the most detested bull markets of all time. Then, we wrap up with a look at the Fed’s and Wall Street’s forecasting track record (hint:  both make a dart-board look good!).

As always, your feedback is welcomed and appreciated.

RANDOM THOUGHTS

When the spread isn’t the thing. One of the themes this newsletter has emphasized most heavily this year has been the importance of the spread—or difference—between government and corporate bond yields. As we have repeatedly cited, when that gap is widening in a pronounced way bad things tend to happen both to the economy and financial markets.

The most recent case in point was the summer of 2014 when spreads began to lift off from dangerously depressed levels. When the gap is quite tight, as it was then, it indicates investors are too cavalier about future risks, particularly when there are discernible threats looming. But it generally takes some kind of negative catalyst to precipitate the spread-widening cycle. In the fall of 2014, there were actually two triggers : the collapse in oil prices and the dollar doing a moon-shot. (By the way, Fed governor Lael Brainard recently articulated a thesis, relayed in past EVAs, that the dollar’s 2014/2015 spike was the equivalent to a 2%—200 basis points—monetary tightening.)

Yet, despite a little indigestion, the stock market—at least in the US—continued to rise until the summer of 2015. Then, in August of last year we had another flash crash with Dow tanking 1000 points in less than an hour. The market stabilized and rallied back to its high of around 2110 before succumbing to another blow-out in credit spreads in January of this year. This took the S&P down 12% in less than two months (admittedly, there were other factors at work such as plunging oil prices, China’s wobbling currency, and mounting US recession fears).

Fortuitously for all of our portfolios, spreads began to contract starting in early February which, as previously relayed in these pages, coincided with the rousing rally we’ve seen since then. This episode reflects the typical pattern: rising spreads give a hugely valuable heads-up of future trouble; then, when they start narrowing, stocks explode to the upside (assuming it has been a severe widening event). As we’ve noted before, credit spreads have been a far more accurate stock market influence than what our central bank is doing, calling into question the old Wall Street axiom, Don’t Fight the Fed (see Don’t Fight the Spread).

The reason I’m going back over what is familiar terrain to consistent EVA readers is to point out that spreads don’t always warn of turmoil ahead. This is notwithstanding the fact that they did accurately forewarn of the bear markets looming in 2000 and again in 2008. Moreover, we’ve looked back at 50 years of stock market history and found that nearly all significant spread widening phases lead to corrections, if not actual bear markets. Encouragingly, they presently reside at a non-threatening level.

CORPORATE BOND SPREADS OVER US TREASURIESSource: Evergreen Gavekal, Bloomberg

Yet, there are numerous times when spreads are unhelpful. 1987 was a classic example and, if you want to go way back, so was 1962. Sometimes markets are slammed by what academics call an exogenous shock (the rest of us might refer to these as a bolt from the blue). In this case, spreads are no better than a fortune cookie at forecasting when stocks are poised to fall out of bed. (A note on 1987: Spreads did begin widening materially in 1986 and into 1987, providing an early warning of the crash in October of that year. However, they began to recede immediately prior to that spectacular decline, primarily because government bond yields erupted from 7% in the summer of ’87 to over 10% on the eve of the crash. Those were the days to be a buyer of long-term bonds!)

The other reason I’m bringing this up is that we may have a set of circumstances today that could lead to one of those out-of-nowhere moments. Now, since these are by definition unforeseeable, it would be foolish of me (even more than usual) to try to identify the external shock. But what is identifiable is that, until very recently, there has been pervasive complacency among the investment community (low volatility equates to a lack of fear).

Source: Ned Davis Research 

This carefree attitude, combined with very elevated S&P 500 valuations and a surprising (at least to the consensus) erosion in recent US economic reports, are the types of backdrops that can cause a severe and sudden drop-back in stock prices.

We’ve also got two big votes coming up over the next 45 days or so: The US presidential election and a de facto vote by Italy on staying in the European Union. Either one going “the wrong way” from the market’s perspective could precipitate another air pocket in stocks.

But, as they say, bull markets climb walls of worry. Over the last seven and a half years, this seemingly eternal bull has hopped over more of those walls than I can possibly recount. Maybe, just maybe, it’s got one more leap left in it.

The Gets No Respect market? One of the sound-bites you regularly hear on CNBC is that this is “the most hated bull market ever”. As usual, there is an element of truth in this mantra. Certainly, there are many high profile billionaires and hedge-fund managers (often one and the same) who have been skeptical in the extreme about further appreciation. Actually, many of them continue to warn of a future day of reckoning when years of stock market gains will evaporate nearly overnight.

As one who has shared many of their concerns, I can empathize with their conclusions. Yet the worry-warts among us must admit that they have been highly premature, even if, as you can see below, the broad market has gone nowhere for years. (The NYSE Composite is considered a more comprehensive measure of the stock market.)

But sentiment is just that—a feeling. What really counts is how investors are actually positioned. Per the charts below, you can see that overall US household asset allocations are hardly reflecting fear and loathing toward equities. In reality, it’s cash that is near its lowest weightings of the past 30 years, while bonds are in the middle of their historic allocation range.

Source: Ned Davis Research

The cash chart also doesn’t take into account the extremely lofty level of margin debt (essentially, negative cash).  Though this has come down a bit, it remains among the highest readings of all-time.  This is why the following chart factoring in both cash and margin debit balances is close to where it was when the biggest US stock market bubble on record was in full swing back in 2000.

INVESTOR CREDIT BALANCE/MARGIN DEBT (%)
Source: Ned Davis Research

Further, as recently as last month, this is how the net speculative positioning looked on the Dow. Maybe it’s just me, but I don’t see a lot of hate in this chart.

Ergo, perhaps what we’ve got on our hands is a market that is quite late stage and very tired, propped up by trillions of central bank joy-juice.  Not to mention, one also supported by a lot of fully-invested bears.  If so, these folks might not be the stickiest holders of equities should events take a turn for the worse this autumn.
Downward Dog. First, let me admit right up front that my yoga involvement these days is limited to wearing a few Lululemon jackets and work-out pants. But I did enough of it a few years ago to know about one of its most famous poses.

Also, over the years we’ve had a couple of pooches in our home with a bit of bull dog in their blood. For some reason this breed loves to do what my wife and I have called the “bow-stretch”, more popularly known as the Downward-Facing Dog.
No, I’m not going Westminster Kennel Club on you. There is a relevance to things financial, as improbable as that may seem. What I’m referring to is the uncanny similarity of a wide-range of economic charts to the downward slope of that pose.

Random Thoughts EVAs are meant to be more visual and lighter on text, so in that spirit let me just show you what I mean.

PRODUCTIVITY DOING A MAJOR “BOW-STRETCH”
Source: Moody’s

DITTO WITH CAPACITY UTILIZATION**How much of the country’s productive resources are being utilized.

INDUSTRIAL PRODUCTION, IN A RELATED DOWNWARD DOGSource: Evergreen Gavekal, Bloomberg

…AS IS THE VERY IMPORTANT LEADING INDICATOR OF DURABLE GOODSSource: Ned Davis Research

RETAIL SALES ALSO BOWING DOWN…
Source: Hedgopia

…AS IS NOMINAL/GDP (REPRESENTING OVERALL ECONOMIC ACTIVITY)
Source: Ned Davis Research

THEN THERE ARE PROFIT MARGINS (PERHAPS BOTTOMING OUT)…Source: Evergreen Gavekal, Bloomberg

…AND FINALLY, PRIVATE NON-RESIDENTIAL INVESTMENT (CRUCIAL FOR FUTURE GROWTH AND PRODUCTIVITY IMPROVEMENT)Source: Wall Street Journal

Not a pretty set of poses, is it?  But then let’s look at this chart since it’s all most investors seem to care about (at least when it is in the upward-dog pose).

THE S&P 500—STILL STANDING TALLSource: Evergreen Gavekal, Bloomberg

The reason for this disconnect can be visually captured in the next graphic showing what has been happening to price/earnings (P/E) ratios in recent years.

TRAILING 12-MONTHS P/E RATIO FOR THE S&P 500Source: Evergreen Gavekal, Bloomberg

As you can see, P/Es have been rising consistently, meaning that investors are paying higher and higher multiples for what have turned out to be declining, not rising, earnings.

Never fear, there’s always next year.

Price/Yearnings ratio? The Fed has deservedly taken considerable heat for its inexcusably misguided GDP forecasts over the last decade, if not longer.

Source: Wall Street Journal

As you can see, it hasn’t been a situation of win some/lose some. The Fed has not only been embarrassingly wrong, it has consistently—with one exception—been wrong on the high side. In other words, the economy has almost always turned out weaker than it projected during this not very expansive expanison. And, as observed in prior EVAs, the Fed has predicted precisely zero of the recessions America has endured over the years. But it has some company in this regard.

Perhaps it’s because both the Fed and Wall Street have a vested interest in spreading happy-talk, but, whatever the reason, “The Street” has also been serially guilty of overly bullish profits forecasts. Again relying on the crack team at Ned Davis Research, analysts have overestimated annual earnings by an average of 11.4% per year since 1984 based on their forward four-quarter projections. (This is despite their well-known tendency to low-ball the upcoming quarter, creating the “beat” that can often pop stocks.) For the last 17 quarters, as you can see below, they have been too bullish on their next twelve months’ estimates in every instance, with the last three having been overly cheery in the extreme.

Source: Ned Davis Research 

About the only time that the analyst community is too negative on a next 12-month basis is during a recession. Therefore, what they are really good at is extrapolating current conditions into the future.  When profits are growing at a steady pace, they project more of the same. Conversely, when earnings have collapsed they become quite cautious, even though history shows profits tend to come roaring back after recessions.

Presently, there are some high-profile money managers, not just “sell-side” strategists, who are publicly endorsing an earnings number of around $127 for the S&P 500 next year. So far, with 2016 half in the bag, actual profits are approximately $50, meaning, on an annualized basis it would be near $100, about flat with last year (which, by the way, was estimated by Wall Street to be $137 as recently as April, 2014; talk about a whiff!). Thus, if $100 does turn out to be close to 2016’s full year S&P net income number, a $127 target for next year looks heroic indeed.

Yet “The Street” is actually even higher for 2017 at $132. Part of this is predicated on an anticipated stellar second half of this year, supposedly bringing earnings up to roughly $110 per S&P share when 2016 is in the history books versus annualizing the first half as I did above. But as you can see from my friend Paban Pandey, who runs the nifty website Hedgopia (you can subscribe to this free service by clicking here), the trend of downward S&P revisions in recent years has been relentless.*

Source: Hedgopia 

Who knows? Maybe we will see a second half earnings eruption. And maybe next year will bring a 20% surge on top of that, as Wall Street is forecasting. But given the preceding Downward Dog section, and a global economy that appears to be losing altitude, it is looking less and less probable.

Call me cynical, but given this history I’d prefer to value the stock market based on recent actual earnings rather than the yearnings of “Street” economists and strategists whose paychecks are based not on accuracy but on how supportive their views are of perpetuating this bull market. Such a behavior pattern directly relates to one of Charlie Munger’s favorite sayings: “Show me the incentives and I’ll show you the results.” (Mr. Munger is Warren Buffett’s sidekick and fellow billionaire.)

Looping back to the Fed, I’d like to end this issue of the Evergreen Virtual Adviser with this extremely random thought (at least it’s one I haven’t come across elsewhere): Perhaps the reason our central bank—despite its enormous computer capabilities and PhD-stuffed personnel roster—has such a sorry record of economic forecasting is because of its incentive structure. The Fed has a dual mandate based on inflation and unemployment. Yet, as every economist knows, inflation and unemployment are two of the most backward-looking (i.e., lagging) economic factors.

It’s true that incentives aren’t the same as objectives but they are closely aligned. And while it’s nice to have both low inflation and unemployment, typically those two are at odds with each other (rising joblessness generally pushes inflation down, though it’s been different in this latest cycle, as has been the case in so many ways). But, more to the point, with the Fed highly focused on those two lagging indicators, it means it is constantly looking in the rear-view mirror. That’s a terrible way to drive a car and it’s proving to be a less than optimal way to steer an economy as complex and dynamic as America’s.

It might be better for the overall economy if the Fed’s incentive structure was modified to encourage it to look at what’s up ahead—like how it can ever extricate itself, without causing a market riot, from the zero-interest rate prison it has been locked inside for the last eight years. Perhaps that is when it might realize it takes a proper cost of capital to make capitalism function properly. Who knew? Actually, the Fed should have.

*If you are wondering about the discrepancy between the Ned Davis analysis and that of Hedgopia, it is because the former uses earnings estimates from IBES while the latter is using S&P’s database. However, both reveal extreme overestimation of profits in recent years.

Courtesy of Evergreen Gavekal

This is one of the stranger things we've seen recently.

The research team at the San Francisco Fed earlier this week published a letter analyzing one startup's analysis of Fed communications.

Economist Fernanda Nechio and researcher Rebecca Regan looked at data from Prattle, a textual analysis specialist, as part of an examination of the Fed's communication strategy following the financial crisis.

The short of it is that Prattle was accurately able to predict what the Fed's infamous "dot plot" would look like upon its next release.

Since 2012, the Fed has released a Summary of Economic Projections (SEP) — which contains economic projections from meeting participants — after every other Federal Open Market Committee meeting. The SEP also includes the dot plot, which is an aggregated forecast of where Fed officials see interest rates at various points in the future.

Prattle's findings show that Fed communications ahead of SEP releases can indicate where the Fed's median expectation for interest rates is likely to fall.

This is significant, as the median rate projection is an important number and serves as a guide to the Federal Reserve's view on the future path of interest rates.

The chart below shows the medium-term projections for the policy rate two to three years ahead released between September 2013 and June 2014.

FRBSF

Prattle uses a machine-learning algorithm to give each Fed communication a score, with a positive score providing a hawkish sentiment, and a negative score a dovish sentiment. 

This chart shows Prattle scores for FOMC meeting participants’ speeches given in the weeks leading up to the FOMC meetings in September and December 2013 and March and June 2014. (Fed officials can't speak publicly for a week ahead of FOMC decisions.)

FRBSF

They look alike, right?

The San Francisco Fed also analyzed the median interest rate projection and the median sentiment score. The median score is especially important, as Fed officials have said this is the most accurate prediction of the path of the policy rate. Once again, Prattle's sentiment score was found to be pretty accurate.

"The figure shows a statistically reliable positive relationship between the median sentiment scores and the median medium-term SEP interest rate projections," the note said.

"This positive relationship suggests that, on average, speeches preceding the meeting that carry a more hawkish sentiment are associated with a higher projected level for the policy rate in the medium term."

Courtesy of BusinessInsider