Posts published in December 2016
“It is demonstrable that things cannot be otherwise than as they are; for as all things have been created for some end, they must necessarily be created for the best end.” Thus spake Dr. Pangloss in Voltaire’s satirical short story Candide. Stripping away the eighteenth century rhetorical flourishes, Pangloss’s philosophy can be read thus: “All things always happen for the best.” Satirizing that attitude was the French Enlightenment wit, Voltaire’s way of poking fun at the smug certainties of the popular mindset of his day.
Mr. Market and the Gradually Filling Glass
Voltaire seems an appropriate touchstone for this, our final commentary of the year 2016, as we have spent much of the past six weeks or so gently poking fun at the popular mindset of our day, at least as it pertains to sentiment in risk asset markets. Let’s step back, take a brief trip down memory lane (as one is wont to do at this time of year) and look at the larger picture.
2016 started off with Mr. Market viewing the glass as half empty. The Fed’s rate hike in December 2015, followed by some mildly disturbing news from China as the opening bell rung stocks into the New Year on January 2, served up our first technical correction (pullback of 10 percent or more) since 2011. The “Fed put” reliably arrived to contain the damage, and interest rates marked time. Stocks rebounded and settled into a corridor, with the S&P 500 mostly fluctuating between its May 2015 high of 2130 and an arbitrary magic-number floor of 2000.
Britain Leaves, Elephants Heave
Then along came Brexit, and the glass went from being half empty to half full. Stocks surged, crashing through the valuation ceiling to set a series of new highs in July before settling into another lackluster sideways trading pattern in August. In September, investors were on watch for some important policy events, but Mr. Market sailed through these with an air of insouciance.
Finally, in November, Republican candidate Donald Trump scraped together some 100,000-odd votes in the key battleground states of Pennsylvania, Michigan and Wisconsin to eke out a victory in the Electoral College that surprised just about everybody, including the Trump campaign team. Now the glass went from being half full to being full to the brim and sloshing over the sides onto the coffee table.
It is not entirely true to say that a new paradigm was born overnight. Financial stocks, the big winners of the last two months of the year, had been outperforming the market before the election as steadily improving wage data indicated a likely upswell of pressure on prices. But the election did catalyze two dominant themes: the “reflation-infrastructure” trade, based on expectations of a flood of new public works projects (and a corresponding spike in the deficit, interest rates and the dollar); and a sharply lower corporate tax rate that would flow straight to the bottom line and goose up corporate earnings per share.
Simply the Best, Better Than All the Rest
Enter Dr. Pangloss and the best of all possible worlds. Where the market is priced today (including market risk levels at multi-year lows alongside record high stock prices) seems to reflect a broad sentiment among investors that, of all the variables good and bad swirling around in the global economy and its policymaking centers of influence, only the good ones will actually happen. Infrastructure spending that translates to actual GDP growth? Check. Corporate tax reform that not only cuts the statutory rate but widens the base by getting rid of all the loophole goodies (through which most companies pay far less than the statutory rate today)? Yes, certainly! Debilitating trade war with China? No way! Geopolitical shock waves as long-standing alliances are called into question and traditional adversaries brazenly throw down the gauntlet to challenge them? Uh-uh, not gonna happen. All things were created for some end, and that must necessarily be the best end, said Pangloss.
To be perfectly clear, we, too, hope that 2017 will serve up more in the way of positive than negative developments. But our analysis is never based on hope. It is based on connecting the dots between disparate pieces of empirical evidence to arrive at a view on where assets appear priced relative to the value drivers and risk factors affecting them. As 2016 closes out we find ourselves still faced with large open spaces between as-yet unconnected dots. We will be coming back to work next week with our pencils sharpened, ready to crunch the numbers as they come in.
Meanwhile, we wish all our clients and friends the happiest of New Years, and a healthy and personally fulfilling start to 2017.
So here we are again, nearing one of those seminal milestones in stock market lore. The Dow Jones Industrial Average, comprised of thirty (mostly household name-y) large-cap stocks, is an index whose main claim to fame is that its life span as a barometer of market sentiment extends all the way back to 1896. The Dow is poised to break through 20,000, a number whose main claim to fame is that it contains four zeroes. “Dow 20,000” screamed the entire front cover of Barron’s magazine last week. At the round earth’s imagined corners, blow your trumpets angels!
For portfolio analysts toiling away in the data-dense world of relative value movements, 250-day rolling returns and the like, these periodic “magic number moments” are scarcely worth a second look. That is particularly true when the index in question is the Dow, a much less useful or significant gauge than, say, the S&P 500 or the Russell 3000. Rationally speaking, there is nothing whatsoever of importance in these periodic episodes.
But rationality only counts for so much. In the vulgate of the wider population of investors and kibitzers, “the Dow” and “the market” are virtually interchangeable, and a nice round number like 20,000 has all the cultural significance of a special calendar date like January 1 or July 4. As with much else in the market, perception often becomes reality. Indexes do exhibit somewhat distinct trading patterns around these magic number moments, however silly it may seem. Thus, attention shall be paid.
Uncage the Elephant
The present magic number moment happens to coincide with a period of animal spirits stampeding up and down Wall Street. The Dow is up nine percent since the post-election rally kicked off on November 9. While the index has not actually broken through the threshold as we write this, it is entirely plausible that it will be on the other side by the time we publish. Given the momentum that continues to feed off itself, counterfactuals be damned, it is more likely than not that the melt-up will carry stocks through to year-end. What then? Inquiring minds will want to know.
We have no crystal ball, of course, but we can supply a bit of historical perspective. As it turns out, the last time the Dow reached a four-zero magic moment, we were also in the middle of a market melt-up. Consider the chart below.
This chart tracks the performance of the Dow – with the tech-heavy NASDAQ shown for comparison – during the last gasp of the late-1990s tech bubble and the ensuing bear market. As the chart shows, the Dow (green line and left-hand y axis) broke through the magic number of 10,000 in late March of 1999. Dow 10,000! These round numbers often act as very tough resistance levels, but 1999’s animal spirits pushed through the barrier with relative ease and, for good measure, surged an additional 1,000 points before settling into a brief holding pattern.
Forks in the Road
One interesting feature of this end-game stage of the late-90s melt-up is the pronounced divergence between the Dow and the NASDAQ on several occasions. This observation may have some relevance in thinking about today’s environment. The last gasp of the tech bubble, when investors more or less indiscriminately bought anything that sounded tech-y and Internet-y regardless of valuation or other counterfactuals, started in late summer 1999 and topped out in March 2000. The NASDAQ, as a proxy for the tech rally, enjoyed about seven months of near-unidirectional upward momentum during this melt-up.
The Dow, conversely, fell more than 11 percent from August to October 1999, and experienced another, even more pronounced correction of minus 16 percent from January 17 to March 7, 2000. The trough for this Dow pullback, then, roughly coincided with the NASDAQ’s March 10 bubble peak of 5,048. And, in fact, the Dow proceeded to bounce up by 15 percent from March 14 to April 11, during which time the wheels came off the dot-coms and NASDAQ experienced the first of what would be a series of bone-jarring descents over the next twelve months.
Mass Movements Then…
Why did the Dow diverge so far away from the NASDAQ (and, to a somewhat lesser extent, from the S&P 500) over that last leg of the 1999-2000 melt-up, and what light may that shed on market movements in today’s environment?
The driving narrative of that late-era ‘90s rally was technology. Investors were less concerned about what individual stocks they owned, and more concerned about getting in on the general action. The ability to obtain broad exposure to the tech and Internet sector – either through one of the then-small number of nascent ETFs, a passive index fund or similar pooled vehicle structure – was more important than the relative merits of any given stock.
By contrast to the tech-dominated NASDAQ, the Dow had a relative scarcity of tech names; only IBM, in fact, at the beginning of 1999, with Intel and Microsoft somewhat latterly tossed into the mix in November of that year. The Dow’s pullbacks in late 1999 and early 2000 thus had almost nothing in common with prevailing attitudes about the tech sector, and plausibly much more to do with valuation-wary investors looking for ways to pare back equity holdings without risking their clients’ ire by dumping those beloved shares of Cisco and Pets.com.
…Mass Movements Now
This year’s post-November 8 environment is likewise largely driven by a couple top-down themes. This time, the blessings of the narrative have fallen disproportionately on a couple sectors, in particular financials, but so far the broad indexes continue to move fairly closely in lockstep.
The mass movement vehicle of choice today is the exchange traded fund. ETFs offer exposure to just about any equity or fixed income asset class, including all the major broad indexes. Complex (and not so complex) algorithms employ ETFs for quick and efficient exposure to thematic narratives, such as the reflation-infrastructure trade that has been dominant since November.
But not all indexes attract the same level of interest from the short-term money. Consider that the average daily trading volume of SPY, the SPDR S&P 500 ETF, is about 94 million shares. For XLF, SPDR’s financial sector offering, average daily volume is about 80 million shares, and for QQQ, the PowerShares NASDAQ 100 vehicle, it is a still-respectable 24 million shares.
How Now, Dow?
By contrast, the average daily volume for DIA, the BlackRock iShares ETF for the Dow Jones Industrial Average, is just around 3 million shares – less than five percent of the volume for SPY. This statistic underscores one of our opening observations in this paper: as much as the average investor equates “the Dow” with “the market,” professional investors have little use for this quaint artifact of U.S. stock market history. Since the Dow is really not a ready proxy for either a specific asset class or a wider market gauge, it doesn’t offer much of a compelling reason for use in those algorithm-driven strategies that dominate short-term trading volume.
Which, in turn, may make it worth keeping an eye on the Dow once that magic number moment of 20,000 has receded into the rear view mirror. If those thirty stocks diverge away from their broad index cousins – S&P, Russell, NASDAQ et al – they may again be the canary in the coal mine warning that the fundamentals are out of line with the still-giddy prevailing market narrative. Of course, there is no assurance that this scenario will play out, and we would advise against hanging one’s hat on this outcome. Good investing is about paying attention to lots of moving parts while maintaining the discipline not to rely unduly on one or two. But we will be keeping track of the Dow’s fortunes in the coming weeks, even after the Dow 20,000! hoopla has come and gone.
Fiscal policy is where all the cool kids hang out now, as we noted in last week’s commentary. But the monetary policy nerds at the Fed got at least a modicum of attention this week as the dots settled on the Fed funds plot chart Wednesday afternoon. As was widely expected, the meeting resulted in a 0.25 percent target rate hike and some meaningful, if subtle, changes to the 2017 outlook. Three policy actions are on tap for next year, and this time the market seems to take this outlook seriously. Chair Yellen & Co. expect the recently favorable trends in output growth and employment to continue, while expecting to see headline prices reach the two percent target by 2018. These observations appear to be largely irrespective of what does or does not happen with all the hyped-up fiscal policy that has been driving markets of late. Be well advised: monetary policy will still matter, quite a bit, in 2017. It will have an impact on many things, not least of which will be the opportunity set of fiscal policy choices.
Divergent Today, Insurgent Tomorrow
Market watchers on Wednesday made much of the (temporary, as it turns out) pullback in stock indexes in post-FOMC trading. But the real action, as has often been the case in the last six weeks, was in the bond market. The yield spike is noteworthy in absolute terms, but even more striking on a relative basis. Consider the chart below, showing the spread between the 2-year U.S. Treasury note and its German Bund counterpart.
Short-term U.S. rates are at 52-week highs while German rates are at their 2016 lows. The spread between the two is wider, at 2.07 percent, than it has been at any time since 2003. Remember divergence? That was the big theme in the discourse one year ago, when the Fed followed through on its 2015 policy action last December. The Eurozone and Bank of Japan were full steam ahead with their respective stimulus programs as the Fed prepared to zag in the other direction. Then markets hit a speed bump in January, the Fed backed off any further action and rates came back down. As the above chart shows, U.S. and German short-term rates followed a more or less similar trajectory for most of the year.
But divergence is back with vengeance. Holders of U.S. dollar-denominated assets will be pleased, as the euro gets pushed ever closer to parity. Policy divergence leads to dollar insurgence. On the negative side, that insurgence looks set to redouble the FX headwinds that have clipped corporate top line revenue growth for much of the past two years. That, in turn, will make it challenging to achieve the kind of double-digit earnings growth investors are banking on to justify another couple laps of the bull market.
Three Times the Charm?
What we took away from Chair Yellen’s post-meeting press conference was a sense that the Fed’s world view has changed only modestly amid all the hoopla of the post-election environment. She took pains to note that the outlook shift to three possible rate changes in 2017 does not reflect a seismic change in thinking among the dot-plotters, but an incremental shift reflecting a somewhat more positive take on the latest growth, employment and price data.
And fiscal policy? Yellen could hardly avoid the topic; it was the point of the vast majority of the questions she fielded from the press. Over the course of her tenure at the Fed she has spoken many times of the need for monetary and fiscal policy to complement each other at appropriate times in the business cycle. This, however, may not be one of those times. Consider her comment in response to one question: “So I would say at this point that fiscal policy is not obviously needed to help get us back to full employment.” For the moment, at least, and in the absence of any tangible data to suggest otherwise, the Fed does not appear to be giving undue attention to the fiscal variable.
As Location Is To Real Estate, Productivity Is to Growth
Chair Yellen did make a point of emphasizing what kind of fiscal policy she does like: namely, that which directly helps boost productivity. That’s a point you have heard us make in this space ad nauseum, so it was good to hear it from the Eccles Building. What kind of fiscal policy could that be? Education, jobs and skills training programs and improving the quality of installed capital used by American workers were specifically called out by the Fed chair. Of course, there is no clarity of any kind that such productivity-friendly programs will make it through the legislative sausage factory. One can always hope, though.
Happy (Fiscal) Holidays
Opinions among the politico-financial commentariat appear to be converging on the basic idea that “fiscal policy is the new monetary policy.” Out with the obsession over FOMC dot-plots, in with infrastructure! Does a more robust fiscal policy, if in fact implemented, presage a structural bump-up in GDP? The stock market seems to think so, with a strangely high degree of conviction, as illustrated in the chart below.
This chart, one of our periodic favorites, shows what we like to call the “risk gap” between stock prices (the solid blue line showing S&P 500 price performance for the past two years) and volatility (the green dotted line shows the CBOE VIX index, the market’s so-called “fear gauge”). The wider the risk gap, the more complacent the market. As of late the gap has turned into a chasm, with stock prices setting all-time highs on a near-daily basis while the fear gauge slumbers at or near recent lows, and well below the threshold of twenty indicating a high-risk environment.
The takeaway from the chart would appear to be this: not only are we absolutely, positively going to get a bracing jolt of stimulative fiscal policy in the near future, but that new policy is going to translate into higher GDP growth, higher wages and prices, and who knows what else. Maybe a groundbreaking new proof for Fermat’s last theorem?
If you kept your nerve during the seven day run-up to last month’s election (where you see that big stock price dip and brief spike in the VIX), then you are no doubt pleased as punch that Mr. Market decided to react thus. But you may also be concerned about whether this reaction is a rational assessment of the impact of future fiscal policy, or alternatively a sugar high that will leave in its wake a sensation not unlike overindulging in Krispy Kremes.
Three Pillars of Fiscal Wisdom
The fiscal policy measures being lobbed around Washington think tanks and spin rooms these days fall into three broad categories: taxes, regulations and infrastructure. Call them the Three Pillars of fiscal policy in Paul Ryan’s brave new world of one-party rule. As we noted above, the market’s near-immediate response to the prospect of the Three Pillars was ebullient optimism. This attitude is partly understandable. After all, we have had to endure eight years of gridlock in Washington during which very little got done. Central banks, which did all the heavy lifting during this time, are understandably receptive to the prospect of some burden-sharing.
But two questions pose themselves. First, how much of whatever comes out of the abstract Three Pillars and into actual policy will be stimulative? Second, as Fed Chair Yellen herself has asked, how much stimulus does the economy even need? Job growth is close to what economists typically regard as “full employment.” Moreover, despite a somewhat weaker wage figure in the last batch of jobs numbers, hourly earnings have trended above core and headline inflation for the last year. GDP in the third quarter was above expectations, and even the long-beleaguered, all-important productivity number beat expectations in Q3. These are not exactly conditions screaming out for a redoubling of stimulus (though, to the point made by many central bankers, when it does become time for more stimulus in the future, it would be preferable for the burden to be shared between monetary and fiscal sources).
Given that the economy is, in fact, not falling off a cliff, by nature austerity-loving Republicans in the House are likely to push back on initiatives that add significantly to the budget deficit. Tax cuts will always be a priority over new spending on the right-hand side of the Congressional aisle. Of the Three Pillars, tax cuts are probably the most likely to be first out of the gate. But even here, as we read the (admittedly confusing) tea leaves of current chatter, the outcome is not likely to be as simple as was the last batch of significant cuts under George Bush. Not only individual and corporate taxes are under consideration, but some kind of a value-added sales tax as well, as a partial offset measure. Strangely a VAT tax – generally considered regressive – seems to have a measure of Democratic support.
We will have quite a bit to say about the progress, or lack thereof, of the Three Pillars in forthcoming commentaries. Where we always want to take the discussion, though, is back to how these measures ultimately connect to anything that drives actual cash flows for publicly traded companies. Connecting these dots is what helps us understand whether there is anything fundamental behind temporal stock price movements or not.
Right now our assessment tends more towards the “not.” That “risk gap” illustration above strikes us as being unsustainable. Either volatility will pick up at some point – most likely as the pre-inauguration honeymoon winds down and the real business of governing looms large – or markets will resume the kind of drift patterns along a trading corridor such as we saw for much of 2015 and 2016.
A period of corridor drift could be preceded by a sizable pullback of five to ten percent, such as the ones we experienced in August 2015 and January 2016. We tend to think that such a pullback would more likely be the result of an external surprise – another plunge in the renminbi, say, or even a geopolitical shock from a global trouble-spot – rather than anything directly connected with the still-healthy U.S. economy. While we don’t see the makings of a sustained downturn ahead, it is worth remembering that stock price valuations remain at decade-plus highs.
Only a sharp upturn in corporate earnings in the coming quarters will supply the justification needed to be comfortable with those high valuations. That upturn, should it come, will be the result of continuing improvements in productivity and a revival of global demand. Not from a fiscal stimulus program that may or may not happen.
2016 has been a rough year for the predictive sciences. The two marquee debacles, of course, were the Brexit vote in June and then the U.S. presidential election in November. On both occasions, the polls said one thing – with varying but largely robust degrees of confidence – while the outcomes said another. “The polls failed us” went the refrain of a chorus of observers in the aftermath of June 23 and November 8.
But when we say that “predictions were the year’s biggest loser” do we necessarily mean the polls? Or, rather, was the real culprit the folly of those who use predictive data to make their own prognostications about event outcomes, and the likely ensuing market reactions? If you’re a long-time reader of our commentary, you probably know where we’re going with this. Event-driven investors were tripped up by predictive folly in 2016. If we were to make our own prediction it would be this: they will be tempted to trip up again in the year ahead. We hope the events of 2016 will be an incentive for fewer to bite at the tempting apple of predictions and odds.
The Law of Small Numbers
Predictions necessarily derive from sample sets – a (if done right) random subset of a larger population or process. Polls are one example of a sample set – a slice of the likely voting predilections of a larger population. Coin tosses are another sample set, with each toss representing a sliver of a larger process that generates a defined outcome of either heads or tails. Students of the science of probability and statistics learn certain rules about the handling of sample sets; unfortunately, those rules tend to get lost in the noise of media coverage of events with probabilistic outcomes. Look no further than those two headline events of Brexit and Trump, and the Law of Small Numbers.
Media outlets tend to present poll samplings as a probability-weighted outcome. When an article says that the likelihood of Britons voting to remain in the EU is about 90 percent, or that Hillary Clinton’s chances of winning the White House are 85 percent, those sound like pretty good odds, right? So when Britain decides to bail on Europe and Donald Trump scoops up more than 270 votes in the Electoral College – well, the polls failed, didn’t they?
Not so fast. Let’s revisit that notion of sample sets. A fair toss of a coin has a 50 percent chance of coming up heads or tails. If you toss a coin ten times you would expect to see five heads and five tails. But if you’ve ever tried this out, you know that any discrete sequence of ten coin tosses may show something wildly different: seven heads, or ten tails, or any other combination. If you tossed that coin 100,000 times you would almost certainly record a number of heads (or tails) vanishingly close to 50.0 percent. That’s called the Law of Large Numbers.
But within that sequence of 100,000 tosses will be smaller handfuls of ten heads in a row, or nine tails and one head, or something else. That’s called the Law of Small Numbers, which says that the connection between underlying probabilities and observed results is much weaker when the sample size is small.
Why should you care? Because the outcome of a single event, like a referendum or a presidential election, is roughly analogous to tossing a coin a small number of times. You’re more likely than not to see the expected outcome. But there is a meaningful probability that you will see a different outcome. If you could simulate the presidential election 100,000 times (heaven forbid), you would probably see a Clinton victory closely aligned with what the polling data predicted. But the real world only offered up one simulation, and that was the actual outcome on November 8.
If Not One, then Zero
The Law of Small Numbers is what drives us to consistently advise our clients against playing the odds with individual events. Think about what happened to bond yields, the U.S. dollar and industrial commodities immediately after the election: they all spiked. Granted, an inflation trade trend of sorts was already underway, but the outcome of the election amplified it. Had the election gone the other way, it is unlikely that we would have seen those hockey-stick charts for copper and the 10-year yield that we featured in our commentary a couple weeks ago.
In other words, these individual events have discrete, binary outcomes. Yes / no, one / zero, win / lose. And not just for referenda or elections. “Production freeze / no production freeze” was the event headlining this week, as a tortuously arrived-at thumbs-up for an OPEC deal sent crude prices soaring by nine percent on Wednesday (what would they have done if the deal had fallen through?). For just about every such macro event there are highly sophisticated futures markets predicting the odds. And there are plenty of willing investors lining up to bet on the action, misunderstanding the predictive science to believe that the likelihood of their being on the wrong side of the trade is vanishingly low. The odds, they believe, are ever in their favor.
If nothing else, we hope that the colossal predictive fails of 2016 will have the positive effect of dissuading more investors from parting with their money in this fashion.
Events Aplenty in 2017
We don’t even have to look ahead to 2017; just within the next seven days we will have a critically important referendum (on Sunday) in Italy, the outcome of which is likely to have an outsize directional impact on Italian (and regional Eurozone) financial stocks, and then the FOMC statement next Wednesday where a rate hike is expected. Next year there are elections in France and Germany. Not to mention, of course, decisions about U.S. economic policy that will either validate or not (we think not) the “reflation-infrastructure trade” so breathlessly covered by the financial media over the past three weeks.
As a matter of course, we necessarily pay attention to all these events as they get folded into the overall picture of the global economy and capital markets. But rather than taking predictive bets on any given outcome, we ask how that outcome impacts the larger, constant concerns of organic growth, profitability and asset quality that in the long run are the most important determinants of stock price performance. Truth be told, our assessment of trends in global supply and demand, based on consumer expenditures, business investment and the like, has not changed much over the course of the last several months.
We will have more to say about our views when we publish our annual market outlook in January. For now, though, we will stay diversified and resist the temptation to push the envelope too far in any one direction in response to – or in expectation of – individual event outcomes.