Written by Jim Welsh
Macro Tides Monthly Report 06 September 2018
U.S. Economy Set to Slow Modestly
On August 28 the Bureau of Economic Analysis released its second estimate for second quarter GDP and revised it up from 4.1% to 4.2%. This is splitting hairs but the reasons for the upward revision were slightly negative and were due to fewer imports and a smaller reduction in inventories, while consumption was lowered to 3.8% from 4.0%.
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The upward revision suggests consumer demand was a little less strong and inventory building in the third and fourth quarters may be less, which will subtract from future growth. The bottom line is that growth in the second quarter was the strongest since 2014. How much of that strength will roll into the third quarter is open to conjecture, which is clear when the Atlanta Fed’s GDPNow estimate is compared to the New York Fed’s Nowcast. The Atlanta Fed’s estimate is 4.4% as of September 4 for Q3, while the Nowcast forecast is for growth of 2.0% as of August 31. There is a good chance that splitting the difference will be closer than either of these estimates.
The economy will continue to be supported into the end of 2018 by fiscal policy before it gradually fades throughout 2019. After a Merry Holiday season consumers paid down credit card debt in the first quarter, and then ramped up their spending in the second quarter as the full benefit of the tax cut boosted their take home pay. My guess is that consumers will cut back a little in the third quarter in part due to the impact of inflation on wages. The Consumer Price Index (CPI) was up 2.9% in July while wage growth was 2.7% from a year ago. Real wage growth was a negative -0.2% from July 2017, so the cost of living is eating up most of the increase in worker’s pay. Companies have increased business investment in response to the write-off incentives in the tax reform bill that allows companies to expense 100% of an investment.
The minutes from the August 1 FOMC meeting reflected feedback to members from companies in their district. The uncertainty surrounding the trade negotiations is leading some companies to pull back on their investments until more clarity emerges. This suggests business investment may not be as strong in coming months. The Dollar has rallied by more than 8% since February and is likely to curb future export growth. Monetary policy works with a lag of 6 to 12 months. The cumulative drag from higher interest rates on several trillion dollars of loans tied to various Libor rates is increasing from the 3 rate hikes in 2017 and 2 in 2018. Housing activity has been slowing for months and further slowing is likely. Auto sales have stagnated and are unlikely to perk up anytime soon.
For perspective let’s remember that GDP growth averaged 2.1% during the first 8 years of the current recovery. In that light, a ‘slowdown’ to 3.0% or so looks pretty good. More importantly, the risk of a recession developing in the next six months remains quite low. Based on the Chicago Fed’s National Activity Index, the real federal funds rate, and the yield curve, the odds of a recession is 18%.
Federal Reserve
The federal funds rate will rise to 2.16% after the Federal Reserve increases it .25% at their September 26 meeting. The headline CPI was 2.9% in July and the core CPI was 2.3%. The real federal funds rate will still be negative, which means monetary policy will remain accommodative after the September hike. Historically, the federal funds rate has had a real return of 2.0%.
The Fed’s preferred inflation measure is the core Personal Consumption Expenditures (PCE) index and is the basis for its 2.0% inflation target. This suggests that the terminal rate for the federal funds rate in a normal cycle would be 3.75% – 4.0%, which is double the current level of 1.92%. This, as we all know, has been anything but a ‘normal’ cycle, and the demographic drag of baby boomers retiring has lowered the growth potential going forward compared to prior World War II recoveries. After the fiscal stimulus that is goosing growth in 2018 and 2019 wears off, the Fed estimates the long run growth potential of the U.S. economy is 1.9%. The terminal rate for the federal funds will be lower than in the past cycles due to demographics and the amount of debt that has built up since 1982.
Total debt as a percent of GDP has soared from $1.65 for $1.00 of GDP in 1982 to $3.55. Total debt includes household, corporate, and government debt. The dip after the peak in 2008 was due to the wave of mortgage defaults. This growing debt burden is why the federal funds rate has made lower peaks at the end of each business cycle since 1981, and why it has required progressively more stimulus via a lower federal funds rate to resuscitate growth after each recession. The Federal Reserve wants to get the federal funds rate up to a level that doesn’t impede growth in the short run, but is high enough that after the federal funds rate is lowered it can stimulate the economy when the next recession appears. Even if the Fed is able to lift the federal funds rate to 3.75% to 4.0% prior to the onset of the next recession, lowering it to near 0% is unlikely to provide enough monetary stimulus to spark a subsequent economic recovery. This is why another round of Quantitative Easing is likely when the next recession appears.
In the next six months the Fed will attempt to identify the neutral level for the federal funds rate. The neutral interest rate is the rate at which monetary policy is neither accommodative nor restrictive, and where growth and inflation are both at their natural rate on a stable basis. Once the majority of FOMC members believe the neutral rate has been reached, the Fed will remove the word accommodative from the post FOMC meeting statement. My guess is the FOMC is more likely to determine that the neutral rate has been reached after two more rate increases, rather than at the September meeting. After the Fed removes the word accommodative from its statement, any additional rate increases will indicate that monetary policy is becoming progressively restrictive.
Yield Curve Inversion Angst
After the January employment report Treasury yields jumped which caused the spread between the 2- year Treasury note and 10-year Treasury bond to widen to 0.75%. The spread narrowed to 0.21% at the end of August which was the lowest month-end level since it closed at 0.16% in June 2007. The narrowing developed as the 2-year yield rose to 2.64% after the Federal Reserve increased the federal funds rate twice, and the 10-year yield fell from 3.115% in mid May to 2.85% on August 31. If the 10-year yield holds near 2.85%, the yield curve could invert after the Fed increases the funds rate at its September 26 meeting.
Whenever the yield curve inverts, it is likely to spur a torrent of articles and TV commentary on top of the deluge that has already emerged. Part of the attention is justified since a 2-10 inversion has been a good predictor of recession during the last 50 years. The minutes from the August 1 FOMC meeting indicate that members discussed what an inversion might mean in the current environment with some more worried than others:
“Several participants cited statistical evidence for the United States that inversions of the yield curve have often preceded recessions. They suggested that policymakers should pay close attention to the slope of the yield curve in assessing the economic and policy outlook. Other participants emphasized that inferring economic causality from statistical correlations was not appropriate. A number of global factors were seen as contributing to downward pressure on term premiums, including central bank asset purchase programs and the strong worldwide demand for safe assets. In such an environment, an inversion of the yield curve might not have the significance that the historical record would suggest.”
The historical record shows that an inversion has occurred on average 19 months before the onset of a recession and 24 months prior to the 2008 crisis.
While the yield curve is important it really doesn’t provide much insight as to what is happening with liquidity. The economy is far more at risk once liquidity begins to deteriorate since it means companies and consumers are losing access to money. Bank lending standards are a great barometer of whether liquidity is improving or drying up, since banks are the source of liquidity. A lowering of lending standards indicates that banks are confident in economic growth and willing to lend more. The Federal Reserve conducts a quarterly survey of large banks to determine if they are easing or raising lending standards for large and small companies. The Fed also asks if banks are increasing or lowering the spread between their cost of funds and loan rates. The spread tends to contract when the economy is good and banks are competing for loans, and widens when banks become more cautious and less aggressive.
Banks have been easing lending standard for small and large companies, after oil prices stabilized in the first half of 2016. As the economy improved in 2017 and 2018, the spread narrowed as banks competed for business and offered more attractive terms. The July Senior Loan Survey indicates that the amount of liquidity flowing out of the banking system for lending is plentiful, even though the 2-year minus the 10-year Treasury yield curve has narrowed significantly since February.
As you can see lending standards and spreads increased dramatically starting in early 2007, which was an important clue to the housing troubles to come as I discussed in March 2007 commentary:
“The January 2007 Senior Loan Survey by the Fed found that more institutions had increased lending standards than at any time since 1991. Even though the Fed has kept rates unchanged for months, monetary policy has been effectively tightened by many lending institutions. Lending standards are not just being raised for sub-prime borrowers, but for borrowers across the board. In the short run, higher lending standards will curb demand, even as foreclosures increase. It is hard to believe that less demand and more supply will not depress home values more than we’ve already seen.”
The Senior Loan Survey is superior to the yield curve in quantifying when liquidity is becoming more positive or negative, and provides more insight to economic turning points. If the yield curve inverts and lending standards are increased, we’ll know that the expansion is on borrowed time.
In contrast to the yield curve, the Conference Board’s Leading Economic Indicator (LEI) has proved timely. The LEI has an average lead time of 12 months and a median of 10 months, which is why I closely track it. (Chart compliments of Doug Short and Advisor Perspectives) In July the LEI posted a new high so it hasn’t even turned lower yet, so the odds of a recession is at least 7 months away based on the shortest lead time since 1969.
Corporate Debt, This Cycle’s Excess
In every extended economic cycle excesses build up that are usually recognized in hindsight as the excesses are unwound, create instability, and negatively impact the economy. The Federal Reserve has played a role in every recession by tightening policy too much leading to a recession that exposes the most leveraged and vulnerable sectors, often leading to a crisis of some magnitude. In the late 1980’s the Savings and Loan crisis wiped out 1,043 of the country’s 3,243 S&L’s at a cost of $160 billion of which taxpayers paid $132 billion.
Regulatory changes in 1983 allowed S&L’s to lend up to 100% of a homes’ appraised value from the prior limit of 75%, and encouraged S&L’s to increase commercial real estate loans up to 40% of their assets. Real estate developers saw an opportunity, bought S&L’s, and then lent too much money to projects they were developing that led to overbuilding in some regions. When depreciation and “passive loss” rules were tightened by Congress in 1986, commercial real estate values subsequently declined exposing many S&L’s to loan losses.
The Reagan economic boom certainly fed the hubris in the commercial real estate market and the willingness to take on risk. Although the S&L crisis didn’t cause the 1990 – 1991 recession, it did make the economy vulnerable to a spike in oil prices after Iraq invaded Kuwait in July 1990. The record economic expansion in the 1990’s produced the internet and the dot.com bubble, as risk taking was exponentially rewarded in the New Paradigm until technology stocks crashed. In the wake of the orgy in risk taking a number of high profile companies collapsed in 2001, after it was discovered they engaged in fraudulent accounting including Enron, Arthur Anderson, WorldCom, and Adelphia Communications in 2002.
In 2007 the housing bubble burst after too many Americans indulged in the real estate gravy train funded by the Federal Reserve and enabled by Wall Street firms willing to extend a mortgage to anyone with a pulse. Similar to the S&L crisis, lending standards were lowered by a government agency (Housing and Urban Development HUD), and in 2004 the S.E.C. allowed the five major investment firms to increase their leverage from 12 to 1 to 30 to 1. Securitization of subprime and low quality mortgage loans allowed institutions globally to bathe in the cesspool of excessive risk taking by everyone involved.
The U.S. economy is unlikely to fall into a recession until mid 2019 or later based on the Leading Economic Indicators and the additional fiscal stimulus that will continue to support growth. As we all know, at some point the good times will come to an end, and when the current business cycle ends the corporate bond market will likely provide some unpleasant surprises.
According to the most recent Federal Reserve data, total U.S. corporate debt stood at 45.2% of gross domestic product at the end of the first quarter. That is down a tick from 45.3% six months earlier but still matches the highest level it reached during the financial crisis and is higher than at the end of the dot.com era. It is higher now than at prior periods of economic duress.
A better evaluation of how levered corporations are is to determine how much cash flow they have relative to their debt, since corporations will service their debt from cash flow. Net cash flow is earnings before adjustments for interest, taxes, depreciation and amortization (EBITDA). The ratio of debt to EBITDA illustrates how much cash flow a company has to service its debt and the amount of leverage.
The more levered corporations are the more difficult it will be for them to service their debt, especially during a recession. Although the debt to EBITDA ratio has dipped slightly, it is significantly higher than it was before the financial crisis, and higher than before the shallow recessions in 1991 and 2001. The ratio will spike higher in the next recession, just as it has in every recession in the past 100 years. The fact that it is higher now than before the last three recessions suggests that the default rate for speculative corporate debt may approach the 12% level it reached during the 2008 financial crisis.
The default rate for Investment Grade corporate bonds was a miniscule 0.42% in 2009 and 0.33% in 2010. It will likely be higher during the next recession, even if it’s less severe since almost half of Investment Grade corporate bonds are rated BBB the lowest possible Investment Grade rating. During the next recession a greater percentage of these ‘almost junk’ bonds will default compared to prior recessions, when far fewer Investment Grade bonds were rated BBB. The percent of BBB bonds rated Investment Grade has increased by more than 50% since 2009.
As long as the outlook for economic growth remains healthy, investors have been comfortable taking on more risk for the extra yield provided by high yield bonds. In the short term ignoring the high level of corporate debt as a percent of GDP won’t be a problem. The spread between the Bank of AmericaMerrill Lynch High-Yield Spread, which tracks the spread between all U.S. dollar-denominated corporate bonds below investment grade and a spot U.S. Treasury curve, is quite small. This reflects investor’s willingness to reach for yield and their confidence in the economy.
A sign that confidence is waning will occur when the spread begins to increase meaningfully, as it has prior to previous recessions. In 2016 the spread widened as the decline in oil prices resulted in more defaults in energy related bonds, so the increase was more sector specific driven than broad based.
The Leveraged loan market has doubled since 2012 reaching $1.06 trillion in July. Leveraged loans are floating rate which tend to hold up well in a rising rate environment. After the Federal Reserve’s December 2016 rate hike, interest in Leveraged loans jumped as investors expected the Fed to continue to increase interest rates. According to Lipper, assets in U.S. Leveraged loan funds hit a record of $176 billion in July up from $110 billion in 2016.
The real risk to investors is the lack of protection provided by Leveraged loans, as the percentage of covenant-lite loans set a record for the 15th straight month in July. Of the $1.06 trillion in Leveraged loans outstanding, 77.8% are covenant-lite according to LCD. In 2018 82% of all Leveraged loans issued have been covenant-lite, which is why the overall percentage continues to rise and set records. Covenant-lite loans have no financial maintenance restrictions and they give borrowers lots of flexibility to issue more debt, pay out dividends to shareholders, and even pull collateral out from under lenders.
Historically, investors in leveraged loans have recovered 70 cents to 80 cents on the dollar in defaults. According to Derek Gluckman, senior covenant officer for Moody’s Investor Services:
“As investor demand continues to be strong, the terms for Leveraged loans keep softening. We have never seen weaker loan covenants.”
In the next recession, Leveraged loan investors may be lucky to receive $.70 on the dollar when an issuer defaults.
Last February in its semiannual report to Congress, the Fed said:
“Leverage in the nonfinancial business sector remains high, with net issuance of risky debt climbing in recent months.”
S&P estimates that about $4.4 trillion of corporate debt is scheduled to mature through 2022, including $1.3 trillion of junk bonds issued by risky companies. Moody’s estimates that high-leverage companies have $424 billion of debt coming due between 2018 and 2022. The Tax Cuts and Jobs Act was signed into law on December 22, 2017 and limits the net interest expense deduction for most businesses to 30 percent of adjusted taxable income (ATI). If interest expense climbs to 40% of ATI during a recession, the company will not be able to write any interest expense above 30%, and will negatively impact cash flow. According to Moody’s:
“As earnings decline in a downturn, the new tax rules will exacerbate any reduction in cash flow and could lead to a higher default rate.”
During the next recession, just as it’s getting bad, it’s going to get worse.
How Well Will Small Cap Stocks Fare When the Good Times Are Over?
Whenever the economy falters, Small Cap stocks may be vulnerable to a significant shakeout that could prove painful for those exposed to small cap stocks. As discussed previously, the ratio of debt to EBITDA illustrates how much cash flow a company has to service its debt and the amount of leverage. The more levered corporations are the more difficult it will be for them to service their debt, especially during a recession. Small Cap companies are significantly more levered than they were before the financial crisis, and the shallow recessions in 1991 and 2001. The ratio of debt to EBITDA will spike higher in the next recession.
The interest coverage ratio for the median Small Cap firm is down significantly from a healthy level in 2012 and really strong levels in 2005 and 1997. It is now hovering just above where it was at the depth of the 2009 recession. This is extraordinary in the ninth year of an economic expansion.
Compared to the non-financials in the S&P 500, Small Cap companies are sick puppies. The U.S. economy is enjoying the second longest business expansion in history. Amazingly, 27% of the companies in the Russell 2000 are not profitable. This level of unprofitability has only been seen during recessions or just prior to a recession, when small companies were feeling the effects of the oncoming contraction before large companies.
Small Cap companies have a lot of debt and the quality is poor, as 60% of their debt is below investment grade compared to just 10% for companies in the S&P 500. With so much debt rated so low, the rating agencies are indicating to investors that the risk of default during a recession is high. Compared to large companies, more of the debt issued by Small Cap companies is vulnerable to higher interest rates. More than 50% of Small Cap debt is floating rate, while only 27% of the debt used by Large Cap firms is floating rate.
Why Are Small Cap Stocks Being Recommended Now?
Conventional Wisdom has provided a number of reasons why Small Cap stocks have been in favor in recent months. Since they get less of their revenue (21%) from international sales than S&P 500 companies, which derive 43.6% of their sales outside the U.S., Small Cap stocks are more immune to a number of negative influences. Lower exposure to the global economy has been a plus as global growth slowed in the first half of 2018, while growth in the U.S. ramped higher. When the Dollar appreciates significantly in a short period of time, it makes U.S. multi-national companies less competitive with their foreign competitors, since a higher Dollar increases the price of U.S. goods and services. Since recording a low in February the Dollar has risen more than 9% in the past six months.
Small companies are not completely insulated from the impact of tariffs (just ask any small company that imports steel or aluminum). But they typically do not have the long supply chains that many large multi-national companies rely upon that could become disrupted or break down if a trade war erupts. According to Conventional Wisdom Small Caps have had a trifecta of tailwinds in recent months that are expected to continue, which is why so many strategists are recommending Small Caps.
As is usually the case there is always a kernel of truth and a big dose of logic embedded in a piece of Conventional Wisdom. This is why it’s so easy for the majority of investors to buy hook, line, and sinker the ‘story’. It’s true that small cap companies only get 21% of their revenue from overseas, according to Bank of America Merrill Lynch. According to S&P Dow Jones Indexes, international sales in 2017 for the average company in the S&P 500 were 43.6% of total revenue, up from 43.2% in 2016, but down from 44.3% in 2015 and an 11-year record high 47.8% in 2014.
A stronger Dollar does raise the prices of American products so it seems logical that small cap companies would be less affected when the value of the Dollar rises. The threat of tariffs should be another plus for small companies since they are less exposed to the global economy. The bias toward small cap stocks seems logical since the degree of uncertainty surrounding trade talks with China continues to escalate.
Based on Conventional Wisdom an investor has a number of good reasons to expect small cap stocks to outperform in coming months. U.S. growth is widely expected to remain strong, interest rate hikes by the Fed should lift the Dollar further, and trade discussions with China and the European Union have yet to produce anything so uncertainty rules. There is no such thing as a sure thing, but what could possibly go wrong?
While international sales are a small percent of total sales, many small companies have large U.S. multinationals as customers. If Boeing gets hurt by tariffs, the pain is going to flow downhill to small companies that provide parts for Boeing. There are probably a handful of small companies that are quite dependent on Boeing for a high percentage of their total sales, so those small companies could be severely affected. Boeing is just one example of many major U.S. corporations that derive 40% or more of their sales overseas that could be forced reduce purchases from small suppliers. To offset higher costs from tariffs or a stronger Dollar, large companies would likely squeeze small companies to lower their selling prices, which would adversely affect small company profit margins. While it may seem logical that small companies would be less affected by tariffs and an appreciating Dollar, the reality could easily be far different for many public small companies.
The chart below illustrates the relative strength of the Russell 2000 to the S&P 500. The black line is the relative strength of the Russell 2000 and the blue and red lines are moving averages of the relative strength line. The direction of the relative strength line doesn’t necessarily indicate if the Russell 2000 and the S&P 500 were rising or falling. For instance, in the third quarter of 2011 both averages declined, but the Russell 2000 was significantly weaker. When the line is rising, the Russell 2000 is outperforming the S&P 500, and falls when the S&P 500 is doing better. According to Conventional Wisdom, when the Dollar is rising, the Russell 2000 should outperform the S&P 500. Now let’s look at how the Dollar performed and determine how much of an influence it has had on the Russell 2000 since 2010.
The Dollar topped in June 2010 and declined by more than 17% by May 2011. In theory the relative strength of the Russell 2000 should have weakened along with the Dollar, but in fact it improved materially until May 2011. The Dollar rallied by 15% from May 2011 into July 2012, but the relative strength of the Russell 2000 fell from May 2011 until November 2012. From May of 2013 until March 2014 the Dollar shed 6.7% of its value, but the relative strength of the Russell 2000 improved continuously during this 10 month window. In the spring of 2014 the Dollar bottomed just below 80.0 and then rallied 20% by mid January 2015 and 25% into March 2015.
As the Dollar was rising between April 2014 and November 2014, the relative strength of the Russell 2000 was doing the opposite of what Conventional wisdom suggested it should. The Russell’s relative strength peaked in March 2014 and weakened until November 2014. The improvement in the Russell 2000’s relative strength between November 2014 and June 2015 occurred while the Dollar was basically trending sideways, after its huge rally from the spring of 2014 into March 2015.
The Russell 2000’s relative strength then rebounded into June 2015, after which it declined again until April 2016. The improvement after April 2016 got a big boost after the election in November 2016, when the Dollar rallied and the Russell 2000’s relative strength improved. The Dollar peaked on January 3, 2017 and fell for 13 months until it recorded a low in February 2018. Even though the Russell 2000 rose in absolute terms during this period, its relative strength to the S&P 500 trended lower until March 2018. The Russell’s relative strength has trended higher as the Dollar rallied by almost 10%.
This analysis shows that from June 2010 until mid 2016 the relationship between the Dollar and the relative strength of the Russell 2000 was virtually the opposite of the relationship promulgated by Conventional Wisdom. Since the election in November 2016, the relative strength of the Russell 2000 and the direction of the Dollar have moved together. This is why Conventional Wisdom is now espousing this relationship as gospel, even though over the most of the last 8 years it did not hold up.
Clearly, there have likely been other factors that outweighed the Dollar in influencing the Russell’s relative strength to the S&P 500. Rather than relying on inconsistent fundamental factors to determine whether the Russell 2000 is likely to outperform the S&P 500, it is better to use the analysis presented here to simply measure when the relative strength of the Russell 2000 is improving or weakening irrespective of why it is changing.
Measuring the relative strength of the Russell 2000 to the S&P 500 can help identify when it may pay to overweight the allocation to Small Caps and when it is better to overweight Large Caps as measured by the S&P 500. As noted earlier, the direction of the relative strength line doesn’t necessarily indicate if the Russell 2000 and the S&P 500 were rising or falling.
For instance, in the third quarter of 2011 both averages declined, but the Russell 2000 was significantly weaker. A more extreme example occurred in 2008 when the Russell 2000 performed significantly better than the S&P 500 from May 2008 through September 2008. The Major Trend Indicator (which is presented each week in the Weekly Technical Review) generated a bear market signal on September 4, 2008 which called for the liquidation of all longs and the establishment of a short position in the S&P 500. The Russell 2000 subsequently broke below its chart support in early October 2008 and its relative strength to the S&P 500 weakened considerably.
The black line is the relative strength of the Russell 2000 and the blue (longer term) and red (short term) lines are moving averages of the relative strength line. The black relative strength line closed above the short term trend line on April 13, 2009 and remained above it until October 23, 2009. During this six month window, the Russell 2000 rose by 28.4% compared to an increase of 25.7% for the S&P 500. The relative strength of the Russell 2000 was stronger from December 28, 2009 until July 1, 2010. Although the Russell 2000 fell -4.6% during this period, the S&P 500 lost -8.9%. From October 5, 2010 through June 10, 2011, the Russell’s relative strength was stronger and the Russell rose 13.1% compared to the S&P 500’s gain of 9.5%.
During 2018 the relative strength of the Russell 2000 crossed above the red short term moving average on March 14 and fell below it on July 31. The Russell 2000 gained 5.45% compared to 2.4% for the S&P 500 during this period. The Russell 2000 continues to post higher highs and higher lows so the trend is clearly up, even though the Russell’s relative strength to the S&P 500 has weakened. This analysis suggests that the Russell 2000 may underperform the S&P 500 despite all the fundamental reasons promoted by strategists.
Stocks
The Tax Cut and Jobs Act prohibited repatriated funds to be used for stock buybacks or dividend increases, just as the 2004 Homeland Investment Act stipulated. A 2010 study by academics at Harvard University, the University of Chicago, and the Massachusetts Institute of Technology estimated that for every $1.00 that was repatriated, stock buy backs increased by $.79. This study verified the results of the 2009 NBER paper which found that buybacks represented a $.79 increase in share repurchases and $.15 increase in dividends. As noted in the December 2016 issue of Macro Tides:
“Money is fungible and corporations are likely to circumvent whatever restrictions that are put into place, just as they did after bringing $300 billion in overseas profits home in 2005.”
Since the beginning of 2018 the amount of stock buybacks has almost doubled and will likely exceed $1 trillion by the end of this year.
Total NYSE Volume has been trending down since it spiked during the sharp sell-off in early February. The increase in the dollar value of stock buybacks has thus become a greater percentage of the total dollar value of all stocks traded. The growing impact of buybacks has arrested declines and contributed to the outperformance of FAAMNG stocks (Facebook, Apple, Amazon, Microsoft, Netflix, Google), as these companies have been big buyers of their stocks in 2018.
The six FAAMNG stocks represent 15.0% of the S&P 500 and 49.1% of the Nasdaq 100. Since these averages are capitalization weighted, the FAAMG stocks have a greater impact. Through August 17, the FAAMNG stocks were up 28.4% in 2018 compared to a gain of 5.42% for the S&P 500, and a loss of more than 8.0% for the All-World Index, after the six FAAMNG stocks were removed. The spread between the FAAMNG stocks and the rest of the stocks around the world is remarkable.
According to research by New York University, at the end of 2017 the 10% wealthiest of households owned 84% of all stocks in pension plans, 401(k)’s, individual IRA’s, trust funds, mutual funds, and 529 plans. What matters most to the other 90% is wage growth.
Prior to the passage of the Tax Cut and Jobs Act, the Council of Economic Advisers (CEA) released a white paper in October 2017 stating that reducing the top corporate tax rate from 35% to 20% would boost middle-class incomes substantially. CEA Chairman Kevin Hassett said:
“I would expect to see an immediate jump in wage growth.”
The average household brought home $83,143 in income last year, and Hassett said it would increase by $4,000 to $9,000 a year from reducing business tax rates alone. Middle class workers have seen their net pay rise due to the tax cut, but Kevin Hassett was referring to gross pay. In December Average Hourly Earnings were up 2.6% from December 2016 and increased to show an annual increase of 2.7% in July 2018. In June the Employment Cost Index, which accounts for 70% of all employment costs, was up 2.8% from 2017. So far, the immediate jump in wage growth has been miniscule and hardly compares to the rhetoric used to promote the tax cut.
The market is overly dependent on a small number of stocks that sport huge capitalizations, with Apple and Amazon poised for at least a bout of profit taking that may contribute to a modest correction of less than 5% in the S&P 500.
Gold – Major Bottom Forming
The positioning in Gold is extreme and sentiment is outright bearish. Looking out over the next 6 to 12 months and longer, Gold is likely forming a major bottom as this process extends in time. The only question is how much additional pain there will be in the short term. Gold could fall to $1123 which is the December 2016 low, although the odds of that are small given how constructive positioning and sentiment already are.
The key is Gold holding above $1173. The longer it holds the more likely a decline to $1123 will not occur. It would be a further sign that a bottom is in place if Gold climbs above last week’s high of $1214.10. Longer term, Gold is likely to trade above $1300 before the end of 2018 and above $1400 sometime in 2019.
Dollar
A pullback to 93.20 to 93.75 in the Dollar Index is likely in coming weeks. Given the positioning and sentiment this target may prove conservative.
Treasury Yields
Positioning in Treasury futures suggests that Treasury yields are more likely to fall than rise in coming months. As previously noted, the 10-year Treasury yield could test the March low of 2.715% and possibly the 2017 high of 2.63% in coming months. The 30-year Treasury may fall below the July 6 low of 2.925%. If it does, it would complete the potential Head and Shoulders top that has been forming since the February high at 3.221% and allow for a decline to 2.66%. (Head 3.24% – Neckline at 2.95% = 0.29% subtracted from the Neckline at 2.95%)
