Conviction


“Men in general judge more from appearances than from reality.” – Niccolo Machiavelli

As we finally get down to real business in 2017, keep some things in mind. One is that there is a sizable contingent of people in the business and investment world who are more or less convinced that nirvana is just around the corner. Despite the historical record of the Bush and Reagan administrations – when markets rallied on the prospect of tax cuts that proved unable to head off the end of the business cycle and recession – conviction abounds that all we have to do is give corporations more money and the world will be a much better place. Oh, and more equal, too.

Make no mistake about it, the market is dying to go higher. It wants tax cuts next week and regulations to disappear by Friday. Maybe that won’t work in the long run, but hey in the meantime earnings are going to soar so you might as well get on the bandwagon now, bub. Aren’t they?

For the moment, even some corporate executives have urged a bit more caution about what might happen. No CEO is going to get on an earnings call and say that tax cuts won’t help earnings, but most reasonable projections say that they are six months away. I personally wouldn’t make book on that, as a rush of hubris may speed the process, but there is an awful lot of sausage to be made. The stock market is gambling heavily on both tax cuts and massive infrastructure spending, but how this is ever going to get paid for without sending the deficit skyrocketing has yet to be answered. Will a GOP that has bitterly lamented the deficit these last eight years want to get on board for a doubling and tripling? They may or may not (it is folly to predict policy outcomes), but I think that there is going to be some fighting along the way. I suspect many on the right are counting on some combination of cuts to social spending (midnight session stuff, no doubt) and “dynamic scoring” (i.e., the myth that cutting taxes automatically produces more tax revenue) to come through and pay for it all. Sure it will.

Weekly claims are at their lowest levels in 40 years, yet many are running around talking about how job growth is finally going to take off. The business cycle will complete eight years this summer, but there is considerable talk on the Street is as if it is only about to begin.

We are going to see a rude awakening from all of this, but I don’t know when that will be. Stock market valuations are very rich indeed, with the fourth quarter of 2016 estimated to bring in four to five percent earnings growth overall and “the end of the earnings recession,” meaning of course that earnings are poised to take off again. On what, job growth? Why no, on eliminating taxes and regulations, of course. Just look at how well it’s worked in Somalia.

Underlying the will to believe is an element of fear, and that element is precisely why many are currently trading long. The thinking is that with many market participants on edge in varying degrees as to what the new President might say or do, every day that he doesn’t say something catastrophic is another reason to go higher and squeeze the shorts. It works until it doesn’t, but history has not been kind to this investing strategy. It’s a short-term trade and will only benefit those who get out in time – a number always far, far smaller than claimed. Until then, beware the overwhelming market consensus, for it is usually dead wrong.

The Economic Beat

A quiet week for data had the contradiction between manufacturing surveys and manufacturing activity data at its heart. The New York Fed manufacturing survey on Tuesday had a reading of 6.5, down slightly from a revised figure of 7.6 (originally 9.0) the month before, where zero is neutral. New orders were also in the positive, at 3.1, with the report overall showing muted but decent conditions. The Philadelphia Fed survey a couple of days later was much stronger, rising from a downwardly revised 19.6 to 23.6. The six-month outlook rose to a very high 56.6 (60 is about as high as it gets), and historically that has been an excellent contrarian indicator.

As has been the case since the election, activity data tell a different story. The December industrial production report did show a monthly increase of 0.8% (seasonally adjusted), but most of that was due to a weather-related spike in utility output (+6.6%); manufacturing only rose 0.2%, the same as the year-over-year increase. It was not much of a rebound from the sector’s November’s 0.1% decline, a decline not seen in most of the surveys. I suspect tax cuts and no regulations are being taken to the bank long before anything arrives in the mail. Capacity utilization for manufacturing at 74.8% is below the July figure of 75.1%, in truth mostly unchanged as it fluctuates in a narrow range of 74.7%-75%. Revisions can and do happen to the industrial data, but it would take a real outlier to make this picture look better. In a similar vein, the Fed’s Beige Book reported the same levels of modest-to-moderate growth, but a sharp increase in the outlook. I am very unconvinced that this is anything but the usual post-election fervor.

In housing, the homebuilder sentiment index declined a bit to 67 from 69, still a very optimistic reading. There was a decline in single-family housing starts, which finished the year with a 9.3% year-year increase over 2015 (not adjusted). Multi-family units were the star of 2015 but not in 2016, though December went out with a big jump that pulled the overall total up 11% in the month. Total starts were up 4.9% unadjusted for the year.

Weekly claims remain at very low levels, but retail sales have dropped off sharply from December. Next week’s focus will be on earnings, sort of, as the Trump tweets have really drowned out the season this month. The biggest economic reports will be Friday’s initial estimate of fourth-quarter GDP (consensus is about 2.1%) and December durable goods orders. The question is whether the growth in sentiment has started to translate into an increase in real orders, or simply more projected ones somewhere down the road.

Housing reports its main monthly slate of data, with existing-home sales Tuesday and new-home sales on Thursday. International goods trade is Thursday, and of course there should be interesting announcements coming out of Washington and Trump Tower.

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