Green, Yellow And Red

We often talk about stock market indicators in terms of green light, yellow light and red light. Are earnings forecasts green, yellow or red? Are bond yield trends green, yellow or red? Are government policies green, yellow or red?

After eight years of mostly green indicators, we're seeing a lot more yellow right now. This does not mean that we are yanking money out of stocks. However it does mean that if you have a significant expense in the next year (i.e. a big trip, a home purchase or a renovation) it might be a good idea to raise the cash now.

Employment Numbers, Interest Rates And Corporate Earnings

At present, the US economy is expanding moderately with the best employment numbers since 2000 and reasonable economic growth of around 2.8%. The world economy in general is doing well: developed economies are growing around 2.5% and emerging economies are growing around 4.9%.

From December 2008 through December 2015 Fed Funds were 0%. Since 2015, the Fed raised short term rates 7 times to 1.75%. This is still low compared to the 5.25% at the peak of the previous economic cycle (2000-2008).

However, long term rates have barely moved, with the ten year yield rising less than 0.5% over the last year, squeezing the spread between long and short term rates. This condition, known as 'yield curve flattening', is often a precursor of recessions.

Looking At Stock Market Indicators: The S&P 500

The S&P 500 focuses on the large-cap sector of the market; however, since it includes a significant portion of the total value of the market, it also represents the market. Companies in the S&P 500 are considered leading companies in leading industries.

Robust corporate earnings have not translated into robust stock market gains. The 2017 tax cuts boosted earnings growth by 6-10% above trend. As a result, the overall earnings growth for 2018 is forecast at 19.7% vs. 11.8% in 2017. For 2019, the estimates fall sharply to 7.0%.

In 2017 the S&P 500 gained 21.8%. Through January 26th it gained 7.5% and then sold off sharply in February. After seesawing back and forth in March, April, May and June, the S&P is only up 2.6% on the year.

Why is the stock market doing poorly if earnings are doing so well? The stock market is a forecasting mechanism. Half of last year's gains were attributable to better corporate numbers after an 'earnings drought' in 2015 and 2016. The rest of the gain derived from the anticipation of the tax cuts. That euphoria prevailed until this administration started talking about trade tariffs.

The Effects Of Trade Tariffs

No reasonable economist, corporate strategist (not even most politicians) think that imposing trade tariffs is a good idea. But here we are, looking at a cost explosion for things we import and a price collapse for things we export.

Soybeans, for example, are down 20% since late March as Chinese buyers are shifting to other markets. Steel prices are up 35% since February.

Mid Continental Nails laid off 12% of its work force in mid June and 40% in July as orders fell by half. It announced it could be forced to close its doors by Labor Day. Volvo suspended plans to hire 4,000 employees at a new plant in South Carolina.

Last week, General Motors wrote that the trade tariffs would jeopardize jobs in the auto industry by raising auto prices by several thousand dollars. Harley Davidson announced plans to shift the production of bikes (destined for the European market) to Thailand, in order to avoid retaliatory tariffs. 

The US Chamber of Commerce concluded in May of this year that this President's trade policies would threaten a net 2.6 million US jobs. Unfortunately, that forecast appears to be conservative.

Political Mythology: Looking At The Numbers

In political mythology, Republicans are the sober stewards of the economy while Democrats are the reckless spendthrifts. We say mythology, because at least since 1992, that statement has been demonstrably false:

• Clinton raised taxes, balanced the budget and created the first surpluses since the 1950’s. Americans enjoyed a decade of robust income growth, real estate and stock market gains.
  

• George W. Bush’s tax cuts returned the US to deficit spending, particularly after spending trillions of dollars on the Afghanistan and Iraq wars. His failure to properly regulate financial services imploded the economy, led to the “Great Recession” and cost millions of Americans their jobs, their homes and their health. The national debt doubled from $5.8 trillion to $11.9 trillion.
  

• Obama received an economy in free fall, but deftly crafted a bail-out bill with Congress to save at least the banks and automakers (home owners were not saved; their equity evaporated as defaults soared). The national debt redoubled to $20.2 trillion as the economy limped to recovery, but by the end of Obama’s 8 years in office, the unemployment rate declined from an in initial 9.3% to 4.3%.
  

• Under President Trump, the unemployment rate declined by another 0.9% to 3.4%, matching the level last seen under Clinton in October 2000. Since October 2010, the US has enjoyed 94 consecutive months of jobs growth, 76 under Obama and 18 under Trump. The budget deficit was shrinking in the later years of the Obama administration but unfortunately, following the 2017 tax cuts it will expand. By 2028, the US national debt will be $33.8 trillion, so large that after spending for transfer payments such as Social Security, Medicare, Defense and debt service, there will be literally no money left over for discretionary spending such as infrastructure and highways, medical and scientific research.

The Next Recession And The Next Bear Market

By 2019 we expect US employment numbers to turn negative, US unemployment rate to start rising, GDP growth to stall, perhaps even turn negative, and consumer confidence to fall. 

Ironically, the Americans most likely to be harmed by President Trump's tariff policies are farmers and those employed in manufacturing, the very people who voted for him in 2016. At present, the President’s approval ratings fluctuate between 40 and 45% - poor, but possibly good enough to get him reelected in 2020 given that the Democrats have no viable alternative right now.

With the US economy possibly in recession by 2019, will US stocks follow in a bear market? We’re not sure about that. US stock prices are curiously disconnected from the US economy for two reasons:

• 60% of S&P 500 earnings come from overseas, so as long as the world economy does OK (with China picking up the slack as the US withdraws) US companies should do OK.
  

• The bulk of the corporate tax savings from the 2017 Act are simply being used to increase dividends and buy up stock. (Hire more people and start up more factories? How naïve!). If actual revenues are flat, but stock buy ups reduce the amount of stocks in circulation, earnings PER SHARE still increase. This financial engineering gives the illusion of financial health even if what the company is doing is “buying high” in their own stock price, and not creating value by providing products to new or expanding markets.

Our Recommendations

On this basis, stock prices can still drift higher. So right now we’re making the following recommendations:

• If you have a substantial financial expense coming up in the next year (like buying a home, taking an expensive trip), let us know now. We’ll take your money out of stocks and put it in bonds or even cash.
  

• If you have money to invest, or if you’re a new client, we’ll scale you in by half or even a third at a time. Either the markets will pull back and we’ll get you fully invested at lower prices, or the markets will continue to rise, but at least we’ll have the psychological cushion of some profits.
  

• For financial expenses that won't come up until at least 5 years in the future, we’re still confident about long term stock market returns. We would never “go to cash” and then re-invest in the stock market later. After paying taxes, transaction costs and market slippage, this is never a successful strategy.
  

• We’re using a modest 6.5% as an anticipated return net of fees in our financial planning model for the next 20 years.

Do you have questions?
Feel free to contact me.

David Edwards, President
DavidEdwards@HeronWealth.com
Direct: (347) 580-5281