Summer Dreams


“And what is so rare as a day in June?” – James Russell Lowell

In a see-saw week made up mostly of events overseas and more administration weirdness, the Federal Reserve’s monetary policy committee (FOMC) met and raised the federal funds rate, as expected, to a range of 1%-1.25%. This has left the yield curve somewhat impressively flat, with current one-month Treasury rates just over 80 basis points (0.8%) and 30-year bonds yielding only 2.87%. What? Only 2% more to give you the money for another 30 years? Yes. Recent times have been absolutely wonderful for selling long-term bonds, with the reasons including a low inflationary environment that slowly seduces the crowd into forgetting about inflation entirely, a bond market that believes hard data about the economy rather than heavily-massaged, heavily-qualified earnings chatter, and the ever-present (since the Fed cut rates to zero in the wake of the 2008 crash), increasingly desperate search for yield.

The other day I took note of the fact that the Shiller P/E ratio – a measure that compares equity valuations with long-term inflation-adjusted earnings – is now sniffing at the 30 level. That makes this the third-most expensive market in modern times, ahead of 2007 and just barely behind the 1929 peak that preceded the Black Tuesday crash (the endpoint of a black week) by a couple of months. With a little more true belief or some bad earnings luck, the little market that could (“I think I can, I think I can!”) can catch the 1929 peak of about 32.

In order to reach that lofty level, a little more magic is needed. One path would be the appearance (or even reality) of Washington progress towards the GOP ultimate prize of massive tax cuts. The precise make-up of said cuts is a thorny issue, making predictions about timing problematic, but any progress that makes them look imminent could send equities on another tear. We only need another 10% or so to put us over the top. It could be quite reasonably argued that the market has already amply rallied on tax cut hopes, but I have seen markets rally multiple times on a golden hope in the past. Whether it’s a real trader or an automated one, stock markets hate to give up on riding the bull until it’s dead, dead, dead.

Another possibility would be a path that more closely resembles the 1929 one – not shoeshine boys handing out stock tips, to be sure, but a market that keeps rising on optimism as the economy and earnings ease. The latter scenario is quite possible, despite the perennial stock market belief that economic downturns, while theoretically possible, are always in some far-off distant future – right up until the time the smoke from the wreckage has filled the room.

I also read an article the other day that noted the impossibility of market timing, with the specific conclusion that one should always keep buying, even when stocks appear to be quite expensive. It too mentioned the loftiness of the Shiller P/E ratio, but wisely concluded that it alone did not lend itself to a simple rule of when to buy and sell stocks. Well, duh.

Valuation alone doesn’t make stock prices go up or down, nor is it a timing tool. It just tells you how much room they have to run to regress to the long-term average, which (as a class) they always do. Had you practiced a rule of always selling stocks when the Shiller P/E hits 30 – which it may do by the time you read this – you would have missed the 1929 crash, but also have missed the 1999 bubble. Of course you would also have missed the 2000-2002 bear market, but let’s not split hairs. Suppose instead that you adopted a rule of selling out at a P/E of 28, instead. Then you’d have missed the 2008 crash, but then you’d have missed the Trump rally, so that can’t be right, right? Right. Maybe we’ll get to 60x again!

That kind of logic is at the core of the “there is no bubble” argument – since stocks aren’t as extended as 1999, then we can’t be in a bubble. By that definition, we only have had one bubble ever, and the 1929 bubble was just a hiccup. There was no “nifty fifty.” 1987 and 2007? Bumps in the road. Or you could ignore the foolish 1999 comparisons and realize that if you’re old enough to understand this article, absent a dramatic change in the mortality tables, you’re not going to see another 1999 in your lifetime.

If you’re 25 years old with $3000 in your 401k account, all of the above really doesn’t matter. Nor does overpaying 20% for a house that you plan to live in for the next 30 years. In the end, it will work out well enough not to be that noticeable. What timing critics never point out, though, is that not everyone has time to recover. If you were 63 years old during the tech bubble and didn’t take your money out, then you either didn’t retire for another ten years or you started drawing down from a much-diminished account – and those withdrawals mean you never get back to even. So if you’re not going to need your equity portfolio for another 20 or more years, forget about it and concentrate on other things. If you’re planning on retiring or otherwise using the money in less than ten years, than I’m here to tell that you are an idiot if you put more money into this market. Do the math – it won’t work.

The Economic Beat

The report of the week was the May retail sales report, which produced a surprise downturn of (-0.3%) in seasonally adjusted (SA) sales. However, excluding autos and gasoline sales, adjusted sales were unchanged.

On an unadjusted basis, sales looked better. Year-over-year sales are up an estimated 5.2%, and the trailing-twelve-month (TTM) growth rate moved from 3.2% to 3.5%. However, much of this may be due to higher, but soon-to-be-lower gasoline prices: the TTM growth rate for ex-auto, ex-gas sales moved from 3.35% to 3.48%, so the report might indeed be showing weakness.

May industrial production also disappointed with an initial estimate of no change versus expectations for growth of 0.2%. However, the year-year rate, led by oil, moved up smartly to 2.2% SA and 2.3% NSA (“mining,” which includes oil extraction, was up 1.6% on the month and is up 8.3% y/y). Manufacturing, however, suffered a 0.4% SA monthly decline, making for a year-year rate of 1.4%.

Despite these desultory results, Econoday bragged up the “unrelenting acceleration” in the Philadelphia Fed survey, which eased from 38.8 last month to the current (and still solid) reading of 27.6. The Philadelphia survey hasn’t really translated into real activity yet, with most industrial production gains coming from oil production. The May New York survey may have been more representative last month with a reading of (-1.0), but it leapt up this month to a reading of 19.8. New order readings were strong in both surveys, so perhaps June will show an uptick – though oil prices are in the midst of a plunge to nine-month lows.

Housing also seemed to slow, with the homebuilder sentiment index slowing to a still-elevated 67 (from an original 70, revised downward to 69). Housing starts did indeed show some softness the next day, with both the starts (-5.5% SA) and permits (-4.9%) rates falling from the previous month. It was the second consecutive month of negative comps for starts, with the year-to-date growth rate dropping to 3.4% overall. Single family growth remained solid at 7.2%, though that is down from the levels of the last two years.

Price inflation is moving back down along with oil prices. Producer prices were unchanged overall with the year-year rate easing from 2.5% to 2.4%. Excluding energy, prices were up 0.3%, 2.1% year-on-year. Consumer prices fell by 0.1% in the initial estimate, taking the year-year CPI growth rate down to 1.9% from 2.2%. Excluding food and energy, y/y price growth went from 1.9% to 1.7%. Import prices fell 0.3% and the year-year rate tumbled from 3.6% (revised downward from 4.1%) to 2.1%. Export prices fell a hefty 0.7%, dropping its y/y rate to 1.4% from 3.2%.

All of the foregoing led to downward GDP revisions and a more inflation-indifferent Fed statement. The NY Fed dropped its Q2 forecast to 1.9% from 2.2%, while the Atlanta Fed (which tends to start high and finish low) went to 2.9% from 3.2%. The Fed now expects inflation to remain below 2% “over the near term.” In concrete terms, this meant a drop in the expected PCE (personal consumption expenditures, the Fed’s favorite inflation measure) to 1.6% from 1.9%, a substantial move. The bank also lowered its unemployment rate forecast to 4.3% from 4.5%, and raised its 2017 GDP forecast from 2.1% to 2.2%. The NY Fed is currently expecting a 1.5% rate in Q3, so something is amiss somewhere. The central bank also left its long-run growth forecast of 1.8% intact.

Oh yes, the Fed also raised the target on the short-term funds rate to 1%-1.25%. That’s now a full hundred basis points above the ZIRP rate that prevailed through most of the expansion, and to add to it the Fed has announced that it is finally going to start trimming its balance sheet, starting off with the slow wind-down of its policy of reinvesting maturing securities. That alone will take some significant bidding out of the market. I though that the Fed should have started this policy more than a year ago – and I also thought that the Fed might not ever get back up to 1% on the funds rate in this cycle. The so-called Trump rally has made financial conditions marvelously untroubled, allowing the central bank to do a stealthy catch-up while largely indifferent markets sleep with visions of sugar-plum tax cuts in their heads.

The coming week is slated to be a quiet one, made up mostly of existing-home sales (Tuesday) and new-home sales (Friday).