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posted on 21 January 2018

It's A Shutdown

Written by , Clarity Financial

I am traveling this weekend but wanted to put out a short update on the market.

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On Friday, the Senate failed to reach a comprise necessary to pass a 30-day "continuing resolution," or "C.R." in order to keep the Government funded.

Let me clarify something about "continuing resolutions."

The government has been operating without a budget since 2009. Instead of passing a budget, Congress has opted to forgo the silly process of legislative procedure to effectively just operate the government with a "blank check."


Over the past 9-years, the Government has gone from passing "C.R.'s" that would fund the Government for the remaining fiscal year, or longer, to just 30-days currently.

So, if Congress is engaged in partisan conflict every 30-days to keep the Government funded, exactly how are you supposed to move other legislative agenda forward?

But here is what you probably don't know about "C.R.'s." While it is TRUE that each C.R. passed maintains the current level of spending from the last "budget" that was passed; the level of spending is "automatically" increased by 8% annually.

So, yes, while the Government will claim they are spending the same amount as they did in 2009, it is actually double that level due to the automatic increases. Of course, given that spending has continued to increase unabated, it is not surprising the U.S. continues to carry a rather large deficit between income and expenditures which is projected to get markedly worse.

But therein lies a problem.

As I discussed previously with the Chairman of the Financial Ways & Means Committee, Congressman Kevin Brady, while tax reform is expected to benefit the U.S. economy, tax reform without reductions in government spending will effectively nullify the reform effort from an economic growth perspective.

Congressman Brady is correct as there is absolutely NO historical evidence that cutting taxes, without offsetting cuts to spending, leads to stronger economic growth.

As debt continues to mount, the reduction in tax revenues from tax reform will lead to greater deficits which ultimately impedes economic growth.

The spending problem is potentially grossly compounded if interest rates do actually rise as the amount of interest paid on the debt rises sharply. Currently, the Government pays about $525 billion a year in interest payments on its debt - each 1% rise in interest rates adds $210 Billion to that payment.

While the "Shutdown" will be very short-lived, as they always are, the reality is that whatever "C.R." comes out it will only further increase our spending and, ultimately, our debt and deficits.

What Does This Have To Do With The Markets?

Nothing at the moment.

But it eventually will.

Over the last week, the run-up in the financial markets continued as Wall Street rapidly ratcheted earnings estimates for 2018 and 2019 based on the expected benefit from the recently passed tax reform legislation.

Currently, the only thing that matters to the market is the boost to earnings from tax reform in the coming year.

Just remember, that boost to earnings is only good for the 1st year.

More importantly, even if the current level of estimates are hit for the end of 2018, the current price advance in the market still remains well elevated above historic norms.

Only at current levels does valuation get reduced as the "E" catches up with the "P." If investors continue to push asset prices higher, and faster than the rate of earnings growth currently, valuations remain elevated at historically high levels.

As I addressed last week in "Has Tax Reform Been Priced In," at 2800 on the S&P 500, the improvement of earnings has already been priced in. Therefore, any disappointment in earnings growth will send valuations even further into "bubble" territory. Since Wall Street has a long history of always "over-estimating" earnings growth by 33%, the risk of disappointment to investors is very high.

Notice that already the expected benefit of tax reform is already being reduced in just the first two-weeks of this year. While year-end 2018 reamins elevated, estimates for front-end quarters are already being reigned in. "Hope floats."

Given that over the long-term there is a direct correlation between earnings and economic growth, further downward adjustments to estimates should be expected. This only makes sense since the companies that make up the stock market are a reflection of economic activity.

In 2019 Wall Street will once again begin comparing expected earnings growth to 2018. Immediately, earnings growth will revert to a reflection of expected economic growth. Given the lack of offsets by Congress to reduce the current expansion of debt, the small bump to economic growth in 2018 will likely recede back to longer-term trends of 2.1-2.3% annually.

Ultimately, investors will care about valuations.

For now, it is hoped that historically high levels of stock valuations will be reduced by an explosion in underlying earnings growth due to the impact of tax reform.

While exuberance is currently "off the charts" bullish, and our portfolios remain inherently long in the meantime, we are extremely cognizant of the risk of something "breaking."

It is what always happens.

Yes, currently, everything is absolutely, positively, optimistic. Economic growth has picked up over the last couple of quarters due to an unprecedented level of natural disasters, oil prices have risen boosting production and corporate earnings, and employment is at historically high levels if you don't count those out of the labor force.

The positive backdrop for stocks could not be currently better.

Just remember, "bull markets" don't die of pessimism - they die from excess optimism.

Currently, investors are more optimistic than at virtually any other point in history.

See you next week.

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