Market Commentary April 2017
The market is overvalued on a fundamental basis, and it continues to be a challenge to screen securities that are of reasonable value. Macro headwinds continue to persist, while mainstream financial networks fail to acknowledge any negative developments. Last commentary I highlighted how the S&P 500 was struggling to break above the 2200 level, and that there was buying exhaustion at this level. That was true until the election of Donald J. Trump. Since then, the S&P 500 has increased 8.5% to 2350.
The idea of a corporate friendly Presidential administration has created exuberance, and in turn, the stock market has seen an influx of money. The mainstream financial networks and their featured guests create whimsical “future projections”; the most prevailing is the health of corporate earnings. While it is true corporate earnings broke out of recession, they are more or less flat, and in no way keeping up with the gains in the market indices.
As you can see from the chart below the S&P 500 continues to expand a spread between itself and its underlying operating earnings. Historically you can see what happens when the spread becomes too large. Earnings will need to take off in the short to medium-term to justify the spread. For the red line to reach 700, and close the spread, corporate earnings would need to grow 12% over the next 3 years, furthermore the S&P 500 would also need to remain flat over those 3 years to see normal valuations.
Many believe the earnings growth will manifest out of tax and regulation reform. While these policies would be beneficial over the long run I believe the market is overly optimistic on the immediate changes, and are especially not considering the possibility of compressed US profit margins.
Financial models cannot be viewed in a vacuum. The financial system is very dynamic, and one variable change will lead to other ramifications. Many market participants are missing that the Trump policies will help the economy, but actually simultaneously hurt corporate profits. The Trump campaign struck a nerve with part of the population who were left out of the economic resurgence over the past 7 years. As the chart below illustrates, those with financial assets have done very well, while those whose spending power is primarily dictated by their earned wage have not benefited at the same rate.
Policies that will come out of the Trump administration can help the economy, while hurting financial assets, plus at the same time the Federal Reserve has decided after 8 years it is a good time to raise interest rates. Corporate profits margins will get squeezed due to an appreciating dollar, higher labor expenses, and higher financing costs. Let’s take a look at a few policy ramifications:
On face value lowering the corporate tax rate will increase profitability of corporations by paying less in taxes, enabling more reinvestment opportunities and an increase in capital return to investors from tax expense savings. All good, but one must take the next step. As the US market adopts a more competitive tax policy more money from around the world will flow into US capital markets. US investments must be purchased with US dollars, and if the demand for dollars increases, while the supply of dollars is stable, the dollar will increase in value over other currencies. An appreciating dollar instantly decreases revenue for US companies with large multinational business operations as the money earned overseas is worth less.
Repatriation of cash is when US based companies take currency earned in foreign countries and convert it back into US dollars. Currently US corporations will not repatriate because the tax is too high. For example, if Apple sells an iPhone in China they are taxed by the Chinese on the income, then if Apple decides to repatriate the cash Uncle Sam wants to tax Apple again (at the highest corporate tax rate). It would be imprudent for a corporation to handle investors capital in this manner, so they leave the income in the currency it was made. Getting rid of that tax, and having the cash flow back into the US would be great for the economy. These companies could invest and disperse more money here in the US, but again, this will increase the demand of US dollars and will increase the value of the dollar, eroding the the bottom line of US corporations.
Immigration control will limit the supply of workers within the country. Creating incentives for companies to produce products made in America will increase the demand for US workers. If demand for workers increases and the supply of workers is lessened there is only one direction for wages to go. Up. Higher wages are great for the workers, but will squeeze profit margins of the corporations.
The Federal Reserve has indicated they will be raising their target rate throughout the year and begin unwinding their balance sheet which will lead to higher interest rates. As I discussed in my previous commentary, leverage levels of US corporations are at an all time high. Furthermore, many of these corporations will not be able to pay off their bond obligations at the end of the bond’s term, and will need to refinance. They will be refinancing at higher interest rates and therefore higher interest payments, further squeezing corporate profits. Higher interest rates will not only affect corporations. Debt levels for individuals and governments are at historic levels as well. Debt repayment throughout the world will produce deflationary headwinds on growth. The illustration below illustrates the many factors “throwing shade” on our growth aspirations.
These are just a few of the many possibilities, but it highlights that one cannot simply subtract out tax expense savings for US corporations to model future profits.
Lastly, when we experience a selloff in the market I believe a normal correction could get disorderly quickly. The market structure, because the proliferation of ETF’s and the short term success of passive investing, has created a highly crowded market, and places no value on fundamentals.
In 2005, Vanguard owned over 5% equity in only 3 companies of the S&P 500. Today they own over 5% equity in 496 companies of the S&P 500. Passive investing through ETF’s has created crowding. To understand the problem we will look at crowding on a micro level.
Chevron, ticker symbol CVX, has 1.89 billion shares outstanding in the market. If you take the 3 largest holders of CVX; Vanguard, BlackRock, and State Street, who are not surprisingly the largest ETF providers, own approximately 335 million shares of CVX. 18% of the outstanding shares. ETF’s do not have fund managers making decisions. The money is just blanketed into stock of the companies which are part of the indices the ETF is tracking. In other words, it could be said that at least 18% of the stockholders are not investing based on merit, but rather just because it is part of the index. Could this be part of the reason why CVX’s stock price is at the same level with oil prices at $48 a barrel as it was with $120 a barrel? It seems to me that even the simplest fundamentals do not matter.
When investors eventually come to terms that they have overpaid for stocks they will soon realize the exits are too tight as well. Unfortunately some will be trapped. Take the three assets managers I highlighted earlier who own 335 million shares of CVX, then look at CVX’s past 3 month average trading volume per day: 6.5 million shares. If investors in only those 3 funds decided to liquidate it would take over 51 days. This means if the EFT sell orders come quickly, the stock of CVX could develop illiquidity issues, and illiquidity issues sometimes create market crashes. I’m highlighting CVX here, but this is true for almost every large cap company I look at.
A critic would say, “Well, all of those shares are held by individuals who would sell at different times or may not sell at all.” My response would be that in a normal market structure there would be decisions made on which individual companies to sell. Person A would sell Chevron while Person B might sell McDonalds. Selling would be spread out between companies, but that is not how the EFT market is setup. The ETF market has created the biggest “sell all” button the world has ever seen. Millions of CVX shares are held in Dow Jones EFT’s, S&P 500 EFT’s, and Energy specific ETF’s. When the market turns everyone is going to hit the sell button at once. Everything gets sold at once, as I noted in Market Jujitsu.
The market is overpriced, it is too exuberant about the effects of lower taxes and lower regulation on corporate profits, global debt is out of control, and we have stuffed everybody in the same investment vehicle. Watching the market go higher when you are not fully invested can develop a serious case of FOMO (“fear of missing out” for the older generation), but you cannot let that emotion drag you into bad investment decisions. Patience is the toughest psychological test for any investor. I continue to believe the greater risk is a market drawdown rather than risking missing out on the upside.
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