Markety Stragey: Don't pop your own balloon

Erica Szczech - Oct 30, 2017
Like everyone else on the planet, we keep looking for indications for what could go wrong. Sorry folks, but the only thing we can come up with is – there is nothing we can come up with. We keep looking for any significant signs that credit is deterio

Like everyone else on the planet, we keep looking for indications for what could go wrong. Sorry folks, but the only thing we can come up with is – there is nothing we can come up with. We keep looking for any significant signs that credit is deteriorating, or inflation is spiking, or the global economy is slowing, or the domestic economy is faltering, or the internals of the market are deteriorating, or etc., etc. At this point, we see no fundamental or tactical reason to de-emphasize our 2018 S&P 500 (SPX) 2800 target, with an emphasis on the “pro-growth” sectors. Literally, we are thinking the same thing you are – such a statement is a classic sign that something is about to go incredibly wrong fast. The only problem is that has been true since early this year.

History shows political discord doesn’t drive equities – fundamentals do. The 1980s had Reagan with Iran-Contra, the 1990’s had Clinton with Whitewater, other indiscretions and an impeachment, the 2000s had the Bush wars, and the 2010s had Obama’s ramp in regulation and anti-business sentiment. Now we have Trump. Yet during all those prior periods of political upheaval, any correction was temporary until there was an identifiable recession in sight (the market peaks on average 7.2 months prior to recession). The good news is the leading indications of each recession over the past 50+ years are consistent and not at all evident in the current environment:

 

1.     The Real Fed Funds Rate (RFFR) moves well above zero (Figure 1). While the RFFR has started to trend higher signaling the entry into the second half of the economic cycle, it is still far from any level that suggested recession in the past 60+ years.

2.     The U.S. Treasury Yield Curve inverts (Figure 2). It really doesn’t matter which measure of the U.S. Treasury Yield Curve you favor, no measure is anywhere near negative. As our Asset Class Strategist Brian Reynolds points out, the flatter the yield curve gets, the more intense the credit boom becomes as investors need returns. History has shown that only an inversion can kickstart the end of the credit cycle that drives the economy into recession. Again, using the current Fed Dot Plot and assuming the long end stays near current levels, the curve won’t invert until Q3/18, and the mean inversion lasts 15 months. That means no recession until 2020, or “the” peak until mid-2019.

3.     Banking, shadow banking, and credit market stresses emerge (Figure 3). We use the Chicago Fed National Financial sub-indices that aggregates 105 banking, shadow banking and credit market stress indicators into three indices. Although stress can happen fast, there are simply no signs of it now.

 

The tailwind of fiscal reform appears to be picking up steam. Regulatory reform and the potential for corporate tax cuts have kept Consumer and Small Business Confidence near historically high levels (Figures 4&5). Indeed, our friends at Thomson Reuters I/BE/S found that if the corporate tax rate drops to 20%, it would cause the current 2018 S&P 500 (SPX) operating EPS estimate to rise 10.5% from the current $145 view (please reply if you would like a copy of the study). In other words, our SPX 2800 target could prove to be overly conservative by a couple hundred points. The counter to that kind of thinking is that as the Fed raises rates, the market multiple may contract. The last year has shown that isn’t true this cycle.

 

If you need assistance, we can put you in contact with experts who can support you in this important process. We would be happy to help you. You can contact us at 604-643-7023