Markets in Minutes: December 2, 2017
S&P 500 Tax Cuts 10 Year Treasury Gold World Ex-US US Dollar Commodities US Economy Stock Market Valuation
Markets in Minutes is intended to give our client partners and subscribers a quick and easy understanding of current market conditions. This update covers November 1 – November 30, 2017
I’m also going to discuss the potential impact of the tax bill on corporate earnings and therefore the stock market in this update.
Investor Learning: “Risk never looks like risk when it’s generating a high return” Howard Marks
“Paradoxically, it is exactly then, when investors don’t see any risk in a market that it becomes the riskiest. But this is usually realized later.” Francois Rochon
S&P 500: +3.1% since October 30, +17.8%% year-to-date. The S&P 500 posted a solid November on the back of continued earnings growth for the quarter (approximately +5% vs. 2nd quarter), a raft of positive economic data, retail strength which seems to have somehow surprised most market watchers, and a mostly positive outlook on tax reform. Both the primary and intermediate uptrends are intact.
Tax Cuts: With tax cuts approved by both the House and Senate as of this morning, the bill now heads to chamber for reconciliation before being sent to the President. There will be tweaks, but the corporate tax break is going to come through. This is a major positive for stocks.
Some quick, back-of-the-napkin math to illustrate:
In the last 12 months, the S&P proxy SPY has delivered approximately $18.75 in equal weighted earnings (“EWE”). The average 10-year price-to-earnings ratio on an EWE basis is 11.3x. So, using one measure of fair value, the S&P should be at about $2119 (It closed at $2642.22 yesterday). So, prior to tax reform, the S&P is about 25% over-valued.
This is a simplified illustration, BUT with a 15% tax cut to corporate taxes, companies will now theoretically see after tax earnings rise to reflect those extra dollars now available for earnings.
CURRENT: $18.75 EWE (earnings) x 1.35% (current corp. tax rate) = $25.31 Pre-tax EWE (earnings).
IN CHAMBER: $25.31 EWE (earnings) x 20% (new corp. tax rate) = $5.06 per share tax = $20.25 EWE (earnings) .
$20.25 EWE x 11.3x (Avg. EWE Price-to-earnings ratio) = $2288 fair value for S&P. So, the market is now only about 15.5% over-valued. That’s a LOT better than 25% over.
Earnings are still growing; interest rates are still low. In short, the tax cuts are inarguably a good thing for a stock market that was starting to push valuations to uncomfortable heights.
Again, this is back-of-the-napkin stuff and there are other factors involved, but it makes the point.
Bonds: The 10-year treasury yield rose 1.7% for the 2nd month in a row. In between it fell to 2.32%. The 10-Year is up 2.1% Year-to-Date. I sound like a broken record, but yields are currently low enough that long duration bonds (more than 5 years) should be examined to make sure they are in your portfolio for a specific reason. It is still a good time to compare corporate bonds with highly rated municipal bonds in both the taxable and exempt spaces.
Gold: Basically unchanged at +0.3% for the month and in a technical consolidation following the failed breakout in September. Gold appears to have moved out of the counter trend rally it’s been in for a couple years and looks a lot like a range trade is setting up between $11.47 and $12.60. As before, if a spike occurs, $12.60 still looks like a good place to reduce bets on higher gold prices. If gold falls below $11.38 it’s likely the larger down trend will re-assume control of price.
Again the broken record, but a sudden large scale geopolitical event is likely to cause a rapid spike in price. In my view, that spike is likely to be temporary and a selling opportunity. For those interested, I use IAU as a proxy for Gold and the above is based on the ETF.
World Ex-US: +0.8% for the month, +21.9% year-to-date. It will be interesting to see if US tax cuts and the resulting reduction in US market valuations pull money from a less stable, less growth oriented Europe. I am not long term bullish on European/Asian/Emerging market stocks/economies due to the social/structural risks I see vs. the US. I may be wrong about this. I may wind up with egg on my face with this view, but I just don’t think any other market in the world compares with the risk/reward trade-off in US markets.
US Dollar: The Buck fell 2% in November (down -10% year-to-date). Continued dollar weakness into the quarter end would be another positive for stocks in that they support the earnings of large US based multi-nationals. From a near term technical perspective, it looks like the dollar is about equally likely to test the September low of $91.33 as take another run at $95. With tax cuts, we may see another run at $95 first.
Commodities: Oil was up +5.1% in November on the heels of a multi-month rally that tested $60 a barrel last week. Talks of production cuts by both OPEC producers and Russia as well as dollar weakness continue to support the rally, as does a still growing global economy. My range expectations for oil in 2017 are still intact ($40 – $60/$65) and while I think 2018 will see oil prices average higher than 2017, I don’t think oil will sustain prices above $55 until late spring, particularly given that US producers are increasing well counts again.
Copper futures fell by -1.4% in November in what appears to be a consolidation of the recent run. The economy is still moving forward, and the tax cuts are likely to give the economy a little more steam, adding to the argument that industrial expansion will continue to support copper prices.
Economy: Consumer prices rose 0.2% in October as housing costs rose. Prices excluding food and energy up about 1.8% in the last 12 months. This inflation rate is in-line with the Fed mandate and should help keep rate raises gradual. Industrial production fell slightly but is still solidly in growth mode with backlogs increasing.
Anecdotal commentary by CEO’s suggest that the typical 4th quarter slowdown isn’t as strong as normal. This supports my idea (below) that we may be heading for a record 4th quarter. The Non-Manufacturing Index hit a 2-year high, suggesting that 70% or so of the economy is clicking along nicely. The official unemployment rate fell again to 4.1% in September. Despite that, wage inflation remains below target at 2.5% at the last report.
The US continues to be a mostly sweet spot: moderate inflation, rising employment, low interest rates, rising GDP and corporate earnings.
Earnings: Q3 earnings are wrapping up and overall it looks like the S&P saw EWE earnings rise about 5%. The earnings expansion is still underway with the tax cuts likely to add some momentum coming into what may be a record 4th quarter in earnings.
Market Valuation: Valuations are less stretched than last week and value in both sectors and individual companies will get a reset in the wake of the tax cuts. Despite that, things were stretched enough that near term value will still be a difficult find. We are likely to see an interest rate raise in December, but rates are still very low. With lowered valuations, earnings holding up their end, and continued supportive interest rates, near term pullbacks and especially corrections are buying opportunities.
Recession Probability Indicator: The most recent reading on the RPI is 12, indicating we are not currently in recession and the investment environment is stable. The indicator will be updated for October somewhere between Nov. 5 and Nov. 10. If there is a meaningful change, I will update subscribers. CLICK HERE to learn more about the RPI.
S&P Technical Picture: The S&P is more overbought on weekly basis than we’ve seen in 10 years. This continues to suggest a near term top from a technical perspective, but corporate tax cuts combined with other positive economic data seem likely to overwhelm short term technical. In English, things seem like they might keep getting better (prices rise) before they get worse (prices fall). Overbought situations almost always result in either pullbacks or consolidations, but following tax cuts and a reset of stock valuations, we may see the technical aspects of what is happening overrun by the fundamentals.
Given all that is happening, I can’t help but consider the Rochon quote at the start of this update.
Fair Value has risen to $229.00 or so on the S&P proxy SPY, but I would not look for the index to fall that far should a correction ensue. Barring some truly nasty surprise, pullbacks more than 5% are probably buy opportunities, even in the face of geopolitical events. The intermediate term and primary trends are identified by the red arrows below, Fair Value by the thick blue line.
If you compare fair value with last month’s update, you can get a good idea of how much earnings and tax cuts are helping the market. Any of these points can present reasonable entry points for index investing from a technical, if not a purely fundamental, standpoint.
SPY Chart (S&P 500 Proxy)
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