On 12/31/17 the S&P 500 closed at 2674, resulting in a total return of 21.83% for the year. Spanning decades, the expected present value investment return of the S&P 500 is now only 4.74%, rather than our required return of around 8%. Investors should compare this expected stock return with the likely return of the 10 year treasury one or two years from now, around 4%. The actual realized return to short-term speculators will be – whatever.
In our December posting, we noted relatively persistent economic patterns relating unemployment and inflation, patterns that momentum investors or computers could exploit. Is this pattern relevant to value investors? In The Intelligent Investor, Benjamin Graham wrote that investors should consider themselves partners in real businesses; they should analyze their investments as businesses.
“Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes to you a little short of silly….If you are a prudent investor, or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise?”
Consistency is very important for investors in markets, thus the importance of an investment philosophy to guide you through the market’s complexities. But, there is also the issue of ownership. You are the ultimate owner of your portfolio, not Mr. Market.
Some of our readers may have spent decades of their careers amassing their net worth; certainly the investment of that net worth is worth some patience. A value investment philosophy would dictate, “Buy when prices are low, not high,” to preserve wealth. However, if some of our readers are just starting their careers, it is more important to consistently invest in the stock market at their comfort levels, and to invest their efforts in their day jobs, because a major portion of their net worth will accrue in the future. They will then continue to buy stock when the stock market is low and the expected returns of the market are higher. Readers at the midpoints of their careers might find it useful talking to a qualified investment advisor, avoiding complicated investments and being aware of the present historically low return of the U.S. stock market.
This is a website about the stock market, it is also about its political economy context - the organization of society to produce wealth. The present politics of the United States is very worrisome, because it is motivated not by the reasonable consequences of a certain course of action, but by the emotions of fear and anger. Recall school. You are rationally solving an algebra equation. Could you do so if you were overwhelmed by fear and anger? Likewise, we ask whether pandering to the electorate’s fear and anger will achieve anything like the present (albeit unbalanced) economic prosperity brought about by previous years of expert Fed management to recover.
Unfortunately, in a democracy, a way to get political power is to pander to the fear and anger of the voters, always blaming someone else: foreigners, immigrants, fake news, experts, the bureaucratic swamp in Washington, and the “deep state.” (This sounds like the Mideast.) A divisive president can’t govern, can’t convince; the next step is to blame domestic traitors for regime failures. The way to get out of this national nightmare is to realize that people are not powerless; that the 2018 elections do matter very, very much; and that the way to get out of a hole is to stop digging (to mix a metaphor) into a Pandora’s box containing the evils of the world. We would look to real concern * and the power of reason to navigate an increasing complex world created by globalization, demographic, climate and technological changes.
The 12/26/17 Washington Post contains an excellent article, “To beat President Trump, you have to learn to think like his supporters.” The author is a Madrid economist, Andrés Rondón, who grew up in authoritarian and now distressed Venezuela.
“(This is) how populism works. As long as Trump is still swinging back, scandals help him to polarize the country further. The scorn of his adversaries, in the eyes of his supporters, proves that he’s doing exactly what they voted him to do: dismantling a rigged (economic and ethical) system that they believe destroyed their hopes **….what can really win them over is not to prove you are right. It is to show them you care. Only then will they believe what you say….I believe (the solution to Trump) should rest on understanding and emphasizing with their grievances that brought Trump to power ‘(wage stagnation, cultural isolation, a depleted countryside, the opioid crisis)’. Trump’s solutions may be imaginary, but the problems are very real indeed. Populism is and has always been the daughter of political despair. Showing concern (by developing effective programs) is the only way to break the rhetorical (and political) polarization.”
The historian, Donald Kagan (1991), writes about the difficulties of maintaining a system of liberal democracy.
“The paradox inherent in democracy is that it must create and depend on citizens who are free, autonomous and self-reliant. Yet its success – its survival even – requires extraordinary leadership. It grants equal rights of participation of citizens of unequal training, knowledge, and wisdom, and it gives final power to the majority (who concern themselves with leading their lives rather than politics)…It gives free reign to a multiplicity of parties and factions, thereby encouraging division and vacillation rather than unity and steadiness. In antiquity, this led critics to ridicule democracy as ‘acknowledged foolishness’; in the modern world, it has been assailed as inefficient, purposeless, soft, and incompetent. Too often in this century its citizens have lost faith in times of hardship and danger and allowed their democracies to become tyrannies of either the right or the left.”
But why endure hardship and danger when it is easier to slide into the irresponsibility encouraged by a tyranny? The major moral virtue of democracy is responsible freedom, both to oneself and to others. It’s not, “Don’t Tread on Me.” -In Professor Kagan’s words, “(Pericles’) success and that of Athens rested on more than prosperity and rhetoric. He also had a vision for his city that offered…its citizens the opportunity to achieve, through common effort, personal dignity, honor, and the fulfillment of their highest needs.” The Athenian system of democratic self-rule survived for hundreds of years.
* This is not an article advocating gimlet-eyed rationality. This 12/29/17 NYT article discusses the importance of positive emotion to sustain your commitments, financial and otherwise.
* *Let these words sink in. More generally, the capitalist system considers labor but a factor of production like natural resources and capital equipment. Of course it isn’t just that. An economic system is supposed to benefit the country and its people at large, not just a deal oligarchy and shareholders, for a short time.
The Washington Post columnist, E.J. Dionne, concludes his new book, One Nation after Trump (2017), “…it is our shared commitment to republican institutions and democratic values that makes us one nation.”
As of 1/19/18 the S&P 500 has increased by 5.11% for the year to 2810, pricing the stock market way beyond its economic fundamentals. A crucial assumption being made is that inflation and interest rates will remain very low, supporting share prices by making fixed-income investments less attractive as an alternative to stock dividends. We make the opposite assumption because:
1) As our 12/1/17 posting suggested, the Philips curve describing a tradeoff between inflation and the low unemployment rate is starting to reappear.
2) The Congressional Budget Office projects that the tax bill just passed will increase the deficit by a 10 year average of $150 billion per year (not including macroeconomic effects; the 2018 baseline projected deficit without this tax bill is $563 billion). During more prosperous times, nations are supposed to increase their savings.
3) International economic growth and oil prices are increasing; the exchange rate of the dollar is decreasing.
We are closely tracking 10 year treasury yields, which we expect to increase.
add: We suggested above that the U.S. economy is primed to generate inflation in the excess of the moderate 2% expected by the Fed and by the market. On 2/14/18 the Labor Department reported that the January consumer price index jumped by 0.5%; excluding food and energy, the core inflation rate jumped by .3%. Whether 0.3% or 0.5%, this doesn’t look good. The yield on the ten year treasury jumped from 2.66% on 1/19/18 to 2.92% on 2/14/18. We think at a level of 3%, long-term interest rates will start to inflict even more pain on the stock market.
To further discuss the effect of monetary creation on the economy: In 2009, at the beginning of quantitative easing, some hedge fund managers expected higher inflation, which did not happen. The reason for this is that the excess bank reserves created remained bottled up in the banking system, held there by a low demand for funds, by the Fed policy of paying interest on these reserves, and by a Congress that had hobbled itself by spending caps and sequestration.
With the Republicans presently in control of all three branches of government, such restraints have disappeared. In the following, the Congressional Budget Office estimates the effect on the deficit of the most recent H.R. 1 Budget Conference Agreement between the House and the Senate; we add New Approved Spending and Infrastructure.
Effect on the Deficit of the H.R. I Budget Agreement & New Approved Spending
(billions of dollars)
2018 2019 2020 2021 2022 …..
Baseline Forecast -563 -689 -775 -879 -1,027
Effect of Tax Cuts -137 -286 -273 -244 - 208
New Spending -243 -153
Infrastructure Spending - 45 -20 - 20 - 20 - 20
Total Deficit -988 -1,148 -1,068 -1,143 -1,255 ….
Rather than starting in 2022, the trillion dollar deficits will essentially start this year, with the economy operating at full capacity, driving up interest rates. The trillion dollar deficits will never end; this analysis does not even take into account economic downturns. At around 5% of GDP, these deficits will add another 25% of GDP to the debt in five years. What does this mean for the future ability of the United States to borrow? Here are OECD comparisons of the 2015 Gross Government Debt /GDP ratios of selected countries:
United States 125% + 25% in 5 years
United Kingdom 112%
These figures show that the large and continuing U.S. deficits will begin to tempt fate very soon.
The $20 billion per year that the administration has allocated to infrastructure will probably be enough to improve all the hiking trails in the United States – we like hiking.
On January 20th, President Trump celebrated his first anniversary with a government shutdown. The major issue of contention was of his making, cancelling an Obama administration executive order that deferred deportation action for the Dreamers, undocumented immigrant children who have grown up in the United States and who are now contributing members to U.S. society. His handling of this issue subsequent to his order illustrates how he does deals. His deal style had resulted in the refusal of all the major banks in New York to do business with him, with the exception of the private banking (not the commercial banking) division of Deutsche Bank.
According to a NPR report, on January 20th, Senate Minority Leader Chuck Schumer related what happened when he spoke with President Trump:
“He’s rejected not one but two viable bipartisan deals...What’s even more frustrating than President Trump’s intransigence (after tasking Republican Graham and Democrat Durbin to reach an agreement, which they did) is the way he seems amenable to these compromises before completely switching positions and backing off (after then considering what his advisors say). Negotiating with President Trump is like negotiating with Jell-O.”
This is a telling comment, for it strikes at the President’s deal making ability, not addressing the separate issue of his intentions. From this comment, it seems that President Trump:
1) Did not exert leadership, pulling a deal together.
2) Doesn’t know what he really wants, being bereft of a political philosophy.
3) Can't govern. Before becoming President, he had run only a family business.
His presidency lacks coherence; its time for checks and balances.
On 2/16/18 Special Counsel Robert Mueller unsealed a detailed criminal indictment against sixteen Russian organizations and individuals, accusing them of having, “…a strategic goal to sow discord in the U.S. political system, including the 2016 U.S. presidential election. Defendants posted derogatory information about a number of candidates, and by early to mid-2016, Defendants’ operations included supporting the presidential campaign of then-candidate Donald J. Trump…and disparaging Hillary Clinton. Defendants made various expenditures (our note) to carry out those activities…and without revealing their Russian identities and ORGANIZATION affiliation, solicited and compensated real US. persons to promote or disparage candidates.
On 9/22/17, Donald Trump had tweeted, “The Russia hoax continues…What about the totally biased and dishonest media coverage in favor of Crooked Hillary?” On 2/16/18 he then tweeted, “Russian started their anti-US campaign in 2014, long before I announced that I would run for President…The Trump campaign did nothing wrong – no collusion.”
These tweets show that the major concern of the President is not securing the United States from future Russian interference. They show his major concern is to be shown to be innocent of Russian involvement in his election. In other words, the presidency is all about him, not about the future of the nation. Time for a rethink about enabling this President to do more damage described in all the above.
Due to the common sense of the American people and our redundant government system of checks and balances, the Republic will (just) survive, even this presidency. But, the economic forces of globalization and the resulting income inequalities are tearing away at the social fabric of liberal democracies around the world: in Britain, France, Italy and (here most notably) Poland.
According to a 1/22/18 WSJ article, “…a battle for Europe’s soul is once more being fought in Poland….(European populist) rebels say control of people’s lives has been given to elites, technocrats and courts, leaving voters with limited choices. They promise to return power to ordinary people. Similar frustrations…(include) the populist wave that helped carry Donald Trump into the White House….’For years we were subject to a kind of indoctrination,’ said Witold Waszczykowski,…Poland’s former foreign minister. ‘Traditional, religious, patriotic family values were not progressive enough, not European, not developed.’”
“The message appealed to socially conservative…Poles in small towns and villages. Many of them didn’t identify with the new, cosmopolitan Warsaw of sushi bars and Gay Pride marches. In the still-poor countryside, many felt the new Europe was more interested in cheap Polish labor than in the traditions that carried them through war and tyranny….The Law and Justice party drew on a broader sense of betrayal among Polish voters. Although the nation’s economy grew during the global downturn, salaries remained low, jobs were insecure and health are and public services were patchy. A cultural divide deepened: half of Poland looked at Europe with hope, the other half with suspicion.”
The world’s economic system is now highly integrated. We do not think it can be fractured without severe consequences. The founder of the Polish democratic revolution, Lech Walesa, says of the ruling party, “They diagnose well, but they cure badly (by acting out).” The socio-economic justification for the free trade system is that the winners compensate the disadvantaged. The failure to do so is the glaring deficiency of the globalized economic system; there is still time to correct.
On Feb. 27, Jerome Powell, Chairman of the Federal Reserve, testified before the House Committee on Financial Services. He expected more years of economic growth:
“The robust job market should continue to support growth in household incomes and consumer spending, solid economic growh should continue to support growth in household incomes and consumer spending, solid economic growth among our trading partners should lead to further gains in U.S. exports and upbeat business sentiment and among our trading partners should to further gains in U.S. exports, and upbeat business sentiment and strong sales growth will likely continue to boost business investment. Moreover, fiscal policy is becoming more stimulative. In this environment, we anticipate that inflation on a 12-month basis will move up this year and stabilize around the FOMC’s 2 percent objective over the medium term.”
But the S&P 500 then dropped 1.27%. Why? If you are .” How true. vested in short-term money market funds, you will finally be receiving some return on your cash. If you are invested in long-term financial assets, economic growth is beginning to cause losses. In the Keynesian portfolio adjustment process, if the return on cash increases due to a more restrictive monetary policy, so will the return on long-term financial assets and their prices will drop. The discussion now in the financial markets is whether the Fed will hike rates three or four times this year, and then more the year next (causing acute problems). Given the ability of a dysfunctional Republican controlled Congress to generate unending trillion dollar yearly deficits, not at the bottom of an economic cycle but at its likely peak, we consider four ¼% Fed policy rate increases this year to control inflation quite likely. If that does not happen, the bond markets will adjust at the long end to compensate investors for higher inflation. We also note that both the highly leveraged Fed (although it accounts for its assets at historical cost) and world economy, full of low interest rate debt, cannot let inflation get out of control.
Four more rate hikes this year will lift the Fed funds rate to 2.5%. That should, after some volatility, translate into a 10 year treasury of 4.5%, and a S&P 500 eventually priced to return investors 8% (our target) - 8.5% (including the likely equity risk premium) At a 2/28/18 closing level of 2714, the S&P 500 is priced to return only 4.67%.
Goldman Sachs’ most recent baseline interest rate forecast expects a year-end 10 year treasury rate of 3.25%, saying there is no immediate cause for concern. This is likely the Wall Street consensus. However, this graph series indicates that a low .75% spread between the fed funds rate and the 10 year treasury is unlikely, except in times of extreme financial market turbulence.
This stock market discussion illustrates that stocks can (and should) be priced off their alternatives, which are long-term bonds. This is also the best explanation for our readers.
On 3/1/18 President Trump announced he would impose a 25% tariff on steel imports and a 10% tariff on aluminum imports. The stock market dropped 1.33% to 2678. Now add the effects of tariffs, trade wars to the prospect of an overdriven economy...
This is a political economy website. We have really been trying not to write about the Administration; but then – something happens – illustrating some lack in presidential character and self-control, violating the norms, restraints and expertise that make us free – and therefore inevitably resulting in bad policy. Such a policy is a large tariff on imported steel and aluminum. The 3/2/18 Bloomberg writes:
”…the Trump administration’s focus on metal manufacturing misunderstands the nature of America’s trade with the world, where the (trade) deficit is not in raw materials, but in (more sophisticated) finished products. It’s cheaper for U.S. consumers to buy things abroad, and that’s what they’ve been doing for many years. Little wonder, then, that U.S. steelmakers have been reluctant to invest, showing some of the lowest rates of capital spending and R&D globally.
That refusal to spend now looks to have got its reward in the form of Washington’s new protectionist stance. But the more innovative automotive, machinery and aerospace manufacturers that consume American metal are the ones employing more workers and showing better prospects for the country’s economy. Lifting the materials costs they face by protecting inefficient local mills is only going to exacerbate their problems.”
On 3/22/18 the S&P 500 index dropped by 2.52% to 2,643, bringing to mind the late economist Rudiger Dornbusch’s quote, “The crisis takes a much longer in coming than you think, and then it happens much faster than you would have thought.” Almost ten years ago, on 9/1/08, the S&P 500 closed at 1283. During the Great Recession, it dropped by 46% to a low of 683 on March 5, 2009. In the September posting , we cited three main reasons for the vulnerability of that stock market.
1) A decrease in house prices.
2) Decreasing credit extended by banks.
3) An increasingly complicated financial infrastructure, acting as a vector of contagion that ultimately required the Fed’s rescue of the entire world’s financial system.
In globalized markets the catalysts (positive or negative) can differ widely. We cite the likely catalysts for this large market drop. (We apologize for mentioning Donald Trump again.)
1) An economically optimistic speech given by the new Fed chairman, Jerome Powell, that predicted (in a data dependent way) an increasing series of moderate but indefinite rate hikes, reaching a projected Fed policy rate of 2.9% by the end of 2019. (Needless to say at that normalized interest rate, a 4.67% long-term stock market return is decidedly unattractive.)
2) A data scandal at Facebook calling into question its business model of selling ads, targeted according to the behaviors of their users. Cambridge Analytica produced very misleading political ads and trafficked in disinformation. Steve Bannon was an executive of the company and ran Donald's Trump's political campaign. (Note Facebook's business problem. Commercial ads are ignorable, allowing "puffery." Politics is very serious. Social media facilitates the unchecked spread of rumor and untruths. Does the establishment of truth need the restraint of checks and balances? Who is to judge? How can the social media provide them? These are the classic problems of liberal society.)
3) Donald Trump’s announcement of a plan to slap large tariffs on at least $50 billion in Chinese imports, thus possibly initiating a global trade war. From perusing a summary of “The President’s Trade Policy Agenda,” we sense he means to follow up. What is further disturbing is the announcement of his appointment of John Bolton, a major advocate of the Iraq war, to be his third National Security Adviser. This new appointment, along with many others, signals that after a year of trying to live with the Washington establishment, “Donald is going to be Donald.”
Some things remain the same. We ended that posting with a quote from the Bard, “When sorrows come, they come not single spies but in battalions.” Our portfolio strategy remains risk control.