Don’t Compare Stocks to GDP

 

Economics – the Dismal Science – is hard for most people. It’s even hard for economists who rarely agree on anything. But here’s an argument from Brian Wesbury of First Trust who thinks that the stock market is till under-valued.

The bull market in U.S. stocks, which started on March 9, 2009, gets little respect. Those who have been bullish, and right, are mocked as “perma-bulls,” while “perma-bears,” who have been repeatedly wrong, are quoted endlessly.

We don’t have enough fingers and toes to count the number of times a recession has been predicted. Brexit, Grexit, adjustable rate mortgages, student loans, the election of Donald Trump, tapering, rate hikes, a 3% ten-year Treasury yield, Hindenberg Omens, Death Crosses, and two fiscal cliffs are just a few of the seemingly endless list of things that were going to end the bull market. (And the pouting pundits of pessimism are never held accountable for erroneously spreading fear.)

One staple of the bearish argument, and the one we want to discuss today, is that corporate profits have grown faster than GDP. This, the bears have claimed for years, can’t last. The argument is that there will be a reversion to the mean, profit growth will slow sharply and an overvalued market will be exposed. A close cousin to this argument is that stock market capitalization has climbed above GDP, signaling over-valuation.

Both of these arguments make fundamental mistakes: first, about the relationship between GDP and profits; second, about the correct measurement of GDP.

The economy is a combination of the public sector and the private sector. Most people think direct government purchases of goods and services, which were 17.2% of GDP last quarter, represents the full impact of government on the economy. But total Federal, State and Local spending (which adds in entitlement spending, welfare, and government salaries), as well as the cost of complying with government regulations, raises the number to 45% of GDP. And because the private sector pays for every penny of government spending, resources directed by the government are significantly larger than just purchases.

There is little doubt that the growth rate of productivity in the private sector is much stronger than in the public sector. In fact, it is probably true that productivity growth in the public sector is negative – directly, and indirectly – through the burden of regulatory costs. If 55% of the economy (private spending) experiences strong productivity, but 45% of the economy (the public sector) experiences negative productivity, overall GDP and productivity statistics are dragged down.

In other words, secular stagnation is a figment of the average – government has grown too big and is a drain on the economy. Yes, private sector growth (and profits) can grow faster than GDP. It’s not a bubble, it only looks like a bubble when looking up from the hole government has created.

The second important point is that GDP is a flawed measure of economic activity. It tracks final sales, but not “total” economic activity. A new car may cost $42,000, but the total amount of economic activity to build and sell that car (the total of all the checks written between businesses and consumers) is significantly more than the final cost of the car. Much business-to-business activity is not captured directly in GDP.

Mark Skousen has pushed for years for the Bureau of Economic Analysis to publish “Gross Output (GO),” which includes all economic activity. And in Q4-2017 GO was $34.5 trillion, nearly double the $19.7 trillion reading for GDP.

If you really want to compare the market cap of U.S. corporations to the correct measure of economic output, it is much more logical to compare it to Gross Output, not GDP. By that measure the market cap of the U.S. stock market is still well below overall economic activity.

The real issue here is that investors should care little about GDP. No one buys shares of GDP. Investors buy shares of companies, and profits are proof that productivity is strong in the private sector. Government distorts the picture, showing both a secular stagnation and “bubble” that don’t really exist.

 

 

 

3% – Why It Doesn’t Matter

The stock market reacted negatively when the yield on the 10-year U.S. Government bond reached 3%.  There was a major one-day sell-off the first time that benchmark was reached.  Here’s what Brian Wesbury, Chief Economist at First Trust has to say.

Just a few weeks ago, the Pouting Pundits of Pessimism were freaked out over the potential for the yield curve to invert. They’ve now completely reversed course and are freaked out over a 3% 10-year Treasury note yield.

All this gnashing of teeth is driven by a belief that low interest rates and QE have “distorted” markets, created a “mirage,” a “sugar high” – a “bubble.”

These fears are overblown. Faster growth and inflation are pushing long-term yields up – a good sign. And, yes, the Fed is normalizing its extraordinarily easy monetary policy, but that policy never distorted markets as much as many people suspect. Quantitative Easing created excess reserves in the banking system but never caused a true acceleration in the money supply. That’s why hyper-inflation never happened and both real GDP and inflation remained subdued. Profits, not QE, lifted stocks.

And our models show that low interest rates were never priced into equity values, either. We measure the fair value of equities by using a capitalized profits model. Simply put, we divide economy-wide corporate profits by the 10-year Treasury yield and compare these “capitalized profits” to stock prices over time. In other words, we compare profits, interest rates, and equity values and determine fair value given historical relationships. The lower the 10-year yield, the higher the model pushes the fair value of stocks.

Because the Fed held short-term rates so low, and gave forward guidance that they would stay low, they pulled long-term rates down, too. As a result, over the past nine years, artificially low 10-year yields have caused our model to show that stocks were, on average, 55% undervalued.

In other words, stocks never priced in artificially low interest rates. If they had, stock prices would have been significantly higher, and in danger of falling when interest rates went up.

But we have consistently adjusted our model by using a 3.5% 10-year yield. Using that yield today, along with profits from the fourth quarter, we show the stock market 15% undervalued. In other words, we’ve anticipated yields rising and still believe stocks are undervalued. A 3% 10-year yield does not change our belief that stocks can rise further this year, especially with our expectation that profits will rise by 15-20% in 2018.

The yield curve will not invert until the Fed becomes too tight and that won’t happen until the funds rate is above the growth rate of nominal GDP growth. Stay bullish.

How interest rates are determined

From our favorite economist – Brian Wesbury:

An entire generation of investors has been misled about interest rates: where they come from, what they mean, how they’re determined.

Lots of this confusion has to do with the role of central banks. Many think central banks, like the Fed, control all interest rates. This isn’t true. They can only control short-term rates. It’s true these can have an impact on other rates, but it doesn’t mean they control the entire yield curve.

Ultimately, an interest rate is simply the cost of transferring consumption over time. If someone wants to save (spend less than they earn today) in order to consume more in the future, they must find someone else who wants to spend more today than they earn, and then repay in the future.

Savers (lenders) want to be compensated by maintaining – or improving – their future purchasing power, which means they need payment for three things: inflation, credit risk, and taxes.

Lenders deserve compensation for inflation. Credit risk – the chance a loan will not be repaid – is also part of any interest rate. And, of course, those who earn interest owe taxes on that income. After taxes, investors deserve a positive return. In other words, interest rates that naturally occur in a competitive marketplace should include these three factors.

So, why haven’t they? In July 2012, the 10-year Treasury yield averaged just 1.53%. But since then, the consumer price index alone is up 1.5% per year. An investor who paid a tax rate of 25% would owe roughly 0.375% of the 1.53% yield in taxes. In other words, after inflation and taxes (and without even thinking about credit risk, which on a Treasury is essentially nil), someone who bought a 10-year bond in July 2012 has lost 0.35% of purchasing power each year, in addition to capital losses as bond prices have declined.

Something is off. The bond market has not been compensating investors for saving, it has been punishing them.

Some blame Quantitative Easing. The theory is that when the Fed buys bonds, yields fall. It’s simply supply and demand. But this is a mistake. Bonds aren’t like commodities, where if someone buys up all the steel, the price will move higher. A bond is a bond, no matter how many exist. Just because Apple has more bonds outstanding than a small cap company doesn’t mean Apple pays a higher interest rate.

If the Fed bought every 10-year Treasury in existence except for a single $10,000 Note, why would its yield be less than the current yield on the 10-year note (putting aside artificial government rules that goad banks into buying Treasury securities)? It’s the same issuer, same inflation rate, same tax rate, same credit risk, and the same maturity and coupon. It should have the same yield. It didn’t become a collector’s item; it still faces competition from a wide array of other investments. It’s still the same bond.

The real reason interest rates have remained so low is because many think the Fed will keep holding short-term rates down below fundamental levels well into the future. If the Fed promises to hold the overnight rate at zero for 2-years then the 2-year Treasury will also be close to zero. And since the 10-year note is made up of five continuous 2-year notes, then Fed policy can influence (but not control) longer-term yields as well. The Fed’s zero percent interest rate policy artificially held down longer-term Treasury yields, not Quantitative Easing. That’s why longer-term yields have risen as the Fed has hiked rates.

And they will continue to rise. Why? Because the Fed has held short-term rates too low for too long. Interest rates are below inflation and well below nominal GDP growth. The Fed has gotten away with this for quite some time because they over-regulated banks, making it hard to lend and grow. Those days are ending and low rates now are becoming dangerous.

With inflation and growth rising, and regulation on the decline, interest rates must go higher. It’s true the Fed is unwinding QE, but that’s not why rates are going up. They’re going up because the economy is telling savers that they should demand higher rates.

Does Volatility Make You Nervous?

One of our favorite economists, Brian Wesbury, has some comments on recent volatility and the economy.

When Volatility is Just Volatility

Stock market volatility scares people. But, volatility itself isn’t necessarily bad. Only if there are fundamental economic problems, something that could cause a recession, would we think volatility itself is a warning sign.

So, we watch the Four Pillars. These Pillars – monetary policy, tax policy, spending & regulatory policy, and trade policy – are the real threats to prosperity. Right now, these Pillars suggest that economic fundamentals remain sound.

Monetary Policy: We’re astounded some analysts interpreted last Wednesday’s pronouncements from the Federal Reserve as dovish. The Fed upgraded its forecasts for economic growth, projected a lower unemployment rate through 2020 and also expects inflation to temporarily exceed its long-term inflation target of 2.0% in 2020.

As recently as December, only four of sixteen Fed policymakers projected four or more rate hikes this year; now, seven of fifteen are in the more aggressive camp. Some analysts dwell on the fact that the “median” policymaker still expects only three hikes in 2018, ignoring the trend toward a more aggressive Fed.

But all of this misses the real point. Monetary policy will still be loose at the end of 2018, whether the Fed raises rates three or four times this year. The federal funds rate is about 120 basis points below the yield on the 10-year Treasury (which will rise as the Fed hikes), and is also well below the trend in nominal GDP growth. Meanwhile, the banking system still holds about $2 trillion in excess reserves. Monetary policy is a tailwind for growth, not a headwind.

Taxes: The tax cut passed last year is the most pro-growth tax cut since the early 1980s, particularly on the corporate side. Some analysts argue that the money is just going to be used for share buybacks, but we find that hard to believe. A lower tax rate means companies have more of an incentive to pursue business ideas that they were on the fence about.

And there is a big difference between who cuts a check to the government and who truly bears the burden of a tax, what economists call the “incidence of a tax.”

Cutting the tax rate on Corporate America will lift the demand for labor, meaning workers and managers share the benefits with shareholders. Yes, some of the tax cut will be used for share buybacks, but that’s OK with us; it means shareholders get money to reinvest in other companies. Buybacks also move capital away from corporate managers who might otherwise squander the money on “empire building,” pursuing acquisitions for the sake of growth, when returning it to shareholders is more efficient.

Spending & Regulation: This pillar is a little shaky. On regulation, Washington has moved aggressively to reduce red tape rather than expand it. That’s good. But, Congress can’t keep a lid on spending. That’s bad.

Back in June, the Congressional Budget Office was projecting that discretionary spending in Fiscal Year 2018 would be $1.222 trillion. (Discretionary spending doesn’t include entitlements like Social Security, Medicare, or Medicaid, or net interest on the federal debt.) Now, the CBO says that’ll reach $1.309 trillion, a gain of 7.1% in just nine months.

Assuming the CBO got it right back in June on entitlements and interest, that would put this year’s federal spending at 20.9% of GDP, a tick higher than last year at 20.8% – despite faster economic growth. This extra spending represents a shift in resources from the private sector to the government. The more the government spends, the slower the economy grows.

Trade: Trade wars are not good for growth. And the US move to put tariffs in place creates the potential for a trade war. We aren’t dismissing this threat, but a “full blown” trade war remains a low probability event.

The bottom line: taxes, regulation and monetary policy are a plus for growth, spending and new tariffs are threats. Things aren’t perfect, but, in no way do the fundamentals signal major economic problems ahead. The current volatility in markets is not a warning, it’s just volatility.

 

Ten for 2018

1. It’s going to get complicated. The global economy is strengthening but there are crosscurrent including rising interest rates and changes on the way trade issues are addressed.
2. Central banks are winding down unprecedented levels of monetary stimulus. At the same time government policy and spending are stimulative.
3. The geopolitical climate remains unsettled. Elections are being held throughout the world and the electorate is looking at new faces.
4. China has confirmed that leader Xi will be in office as long as he wishes. His rule will impact China’s economic development and foreign policy.
5. The search for income will continue as the Federal Reserve has far to go before fixed income investment becomes appealing for the retail investor.
6. Current low default rates may change as public pension plans come under increased pressure as the elderly begin to outnumber the young.
7. Two-way markets return following the post-election bounce that saw a smoothly rising market with no meaningful interruptions.
8. Active management set to recover its value as some of the components of popular indexes become significantly overpriced.
9. Finding opportunities and avoiding “torpedo stocks” becomes a challenge for individual investors and fund managers.
10. Planning becomes critical as an aging population will be spending decades in retirement even as pensions and social security come under pressure.

If these issues trouble you, getting professional assistance and creating a financial plan may help you navigate the uncertainty of 2018.

 

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Stay Invested: Economy Looks Good

One of our favorite economists, Brian Wesbury, Chief Economist of First Trust, offers this advice:

The current recovery started in June 2009, 105 months ago, making it the third longest recovery in U.S. history.

The longest – a 120-month recovery in the 1990s – saw real GDP expand an annual average of 3.6%. The current recovery has experienced just a 2.2% average annual growth rate – what we have referred to as “plow horse” economic growth.

That’s changing. In particular, the labor market is gathering strength. In February, nonfarm payrolls rose 313,000, while civilian employment, an alternative measure of jobs that includes small-business start-ups, rose 785,000.

Hourly wages rose a tepid 0.1% in February, but in the past six months, average hourly earnings are up at a 2.7% annual rate while the total number of hours worked is up at a 2.6% annual rate. Total earnings are up at 5.4% annual rate in the past six months, which is faster than the trend in nominal GDP growth the past few years.

New orders for “core” capital goods, which are capital goods excluding defense and aircraft, were up 6.3% in the year ending in January, while shipments of these capital goods were up 8.7%. Sales of heavy trucks – trucks that are more than seven tons – are up 17.4% from a year ago.

The pace of home building is set to grow in the year ahead, in spite of higher interest rates or the new tax law limiting mortgage and property tax deductions. In the fourth quarter of 2017, there were 1.306 million new housing permits issued, the highest quarterly total since 2007.

A better economy also means higher interest rates, but this doesn’t spell doom. Housing has been strong despite rising mortgage rates many times in history. In fact, both new and existing home sales were higher in 2017 than they were in 2016 in spite of higher mortgage rates.

Yes, the new tax law will be a headwind for homebuyers and builders in high-tax states, but it’s going to be a tailwind for construction in low tax states like Texas, Florida, and Nevada. Housing starts have increased eight years in a row. Look for 2018 to be the ninth.

In the past two months, both ISM surveys – for Manufacturing and Services – have beaten consensus expectations. The US economy is not going to grow at a 3.0% pace every quarter, but all this data suggests that our forecast for an average pace of 3% growth this year is on steady ground.

The bottom line is that the U.S. economy is accelerating, not decelerating, and the potential for any near-term recession is basically zero. Corporate earnings growth, and forecasts of future earnings, have accelerated, and our 2018 year-end forecast for Dow 28,500 and S&P 500 3,100 remain intact. Even with higher interest rates! Stay invested.

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Why unwinding QE is not a threat to the bull market.

Brian Wesbury has a new Monday Morning Outlook out that is worth considering.

On March 9, 2018, the bull market in U.S. stocks will celebrate its ninth anniversary. And, what we find most amazing is how few people truly understand it. To this day, in spite of massive increases in corporate earnings, many still think the market is one big “sugar high” – a bubble built on a sea of Quantitative Easing and government spending.

While passing mention is given to earnings (because they are impossible to ignore), conventional wisdom has clung to the mistaken story that QE, TARP, and government spending saved the economy from the abyss back in 2008-09.

A review of the facts shows the narrative that “Wall Street” – meaning capitalism and free markets – failed and government came to the rescue is simply not true.

Wall Street was not the driving force behind subprime mortgages. In his fabulous book, Hidden in Plain Sight, Peter Wallison showed that by 2008 Fannie Mae, Freddie Mac and other government programs had sponsored 76% of all subprime debt – not “Wall Street.” Everyone was playing with rattlesnakes and government was telling them it was OK to do so. But, when the snakes started biting, government blamed the private sector, capitalism and free markets.

At the same time, Wall Street did not cause the market and economy to collapse; it was overly strict mark-to-market accounting. Yes, leverage in the financial system was high, but mark-to-market accounting forced banks to write down many performing assets to illiquid market prices that had zero relationship to true value. Mark-to-market destroyed capital.

QE started in September 2008, TARP in October 2008, but the market didn’t bottom until March 9, 2009, five months later. On that day in March, former U.S. Representative Barney Frank, of all people, promised to hold a hearing with the accounting board and SEC to force a change to the ill-advised accounting rule. The rule was changed and the stock market reversed course, with a return to economic growth not far behind.

Yes, the Fed did QE and, yes, the stock market went up while bond yields fell, but correlation is not causation. Stock markets fell after QE started, and rose after QE ended. Bond yields often rose during QE, fell when the Fed wasn’t buying, and have increased since the Fed tapered and ended QE.

A preponderance of QE ended up as “excess reserves” in the banking system, which means it never turned into real money growth. That’s why inflation never took off. Long-term bond yields fell, but this wasn’t because the Fed was buying. Bond yields fell because the Fed promised to hold short-term rates down for a very long time. And as long-term rates are just a series of short-term rates, long term rates were pushed lower as well.

We know this is a very short explanation of what happened, but we bring it up because there are many who are now trying to use the stock market “correction” to revisit the wrongly-held narrative that the economy is one big QE-driven bubble. Or, they use the correction to cover their past support of QE and TARP. If the unwinding of QE actually hurts, then they can argue that QE helped in the first place.

So, they argue that rising bond yields are due to the Fed now selling bonds. But the Fed began its QE-unwind strategy months ago, and sticking to its plans hasn’t changed a thing.

The key inflection point for bond yields wasn’t when the Fed announced the unwinding of QE; it was Election Day 2016, when the 10-year yield ended the day at 1.9% while assuming the status quo, which meant more years of Plow Horse growth ahead. Since then, we’ve seen a series of policy changes, including tax cuts and deregulation, which have raised expectations for economic growth and inflation. As a result, yields have moved up.

Corporate earnings are rising rapidly, too, and the S&P 500 is now trading at roughly 17.5 times 2018 expected earnings. This is not a bubble, not even close. Earnings are up because technology is booming in a more politically-friendly environment for capitalism. And while it is hard to see productivity rising in the overall macro data, it is clear that profits and margins are up because productivity is rising rapidly in the private sector.

The sad thing about the story that QE saved the economy is that it undermines faith in free markets. Those who argue that unwinding QE is hurting the economy are, in unwitting fashion, supporting the view that capitalism is fragile, prone to bubbles and mistakes, and in need of government’s guiding hand. This argument is now being made by both those who believe in big government and those who supposedly believe in free markets. No wonder investors are confused and fearful.

The good news is that QE did not lift the economy. Markets, technology and innovation did. And this realization is the key to understanding why unwinding QE is not a threat to the bull market.

 

Clear Skies Ahead

Brian Wesbury of First Trust:

You know the old saying about every cloud having a silver lining? Well, if you listen to some of the financial press, you’d think their motto was that clear skies are just clouds in disguise.

Friday’s GDP report showed the economy grew 2.5% in 2017, an acceleration from the average rate of 2.2% from the start of the recovery in mid-2009 through the end of 2016. Notably, what we call “core” GDP – inflation-adjusted GDP growth excluding government purchases, inventories, and international trade – grew at a 4.6% annual rate in the fourth quarter and was up 3.3% in 2017.

However, some pessimistic analysts were calling attention to a drop in the personal saving rate to 2.6% in the fourth quarter, the lowest level since 2005. The pessimists’ theory is that if the personal savings rate is so low, consumers must be in over their heads again, so watch out below!

But this superficial take on the saving rate leaves out some very important points.

First, consumers don’t just get purchasing power from their income; they also get it from the value of their assets. And asset values soared in 2017 as investors (correctly) anticipated better economic policies. The market cap of the S&P 500 rose $3.7 trillion, while owner-occupied real estate looks like it increased about $1.5 trillion. That could be a problem if we thought stock market or real estate was overvalued, but our capitalized profits approach says the stock market is still undervalued and the price-to-rent ratio for residential real estate is near the long-term norm, not wildly overvalued like in 2005.

Second, the tax cut that’s taking effect is going to raise after-tax income. According to congressional budget scorekeepers, the tax cut on individuals should reduce tax payments by $189 billion in 2019, which is equal to 1.3% of last year’s after-tax income. So, consumers are going to be able to save more in the next few years, even if we don’t include the extra income that should be generated by extra economic growth.

Third, the personal saving rate doesn’t include withdrawals from 401Ks and IRAs, many of which are swollen with capital gains. So, let’s say a worker contributed $5,000 of their income into a 401K at the end of 1988 and kept that money in the S&P 500 ever since. Today they can withdraw more than $97,000 and spend it. When calculating the saving rate, the government counts every penny of that spending while not counting a penny of it as income. As the population ages and spends down wealth they’ve already made, the saving rate tells us less and less about the saving habits of today’s workers.

Sometimes good news is really just good news. Unfortunately, some analysts can’t look at clear skies without imagining clouds.

 

 

Market Shakeout

Following a virtual non-stop rally in the stock market since the beginning of 2017, we are not particularly surprised that the stock market should stop and take a breather. What many people find disconcerting about this sudden drop is it’s steepness and breadth. We have not been exposed to a decline this steep for quite a while.

Some commentators actually blame good economic news for the market drop, claiming that a robust economy has triggered renewed inflation fears, which they assert will lead the Federal Reserve to raise interest rates faster than expected.

Our view is that there is nothing fundamentally wrong with the economy, or with an increase in interest rates which has been widely anticipated. Long-time market observers have seen this movie before, it’s just been a long time since we last saw it. From what we have been reading, some large institutions are employing trading systems that trigger large sell orders at certain levels in the market, which in turn causes a cascading series of further drops.

On a fundamental level, the stock market responds to the economy, and we see no indications that anything has changed since the start of the year. Hiring is up, wages are rising, and millions of people are getting bonuses that they haven’t seen in years. Take-home pay will go up for millions more Americans beginning this month. Lower corporate tax rates should lead to higher corporate profits which should lead to higher stock prices. Still other corporations that have billions of dollars parked overseas, like Apple, are bringing a lot of that money home and are promising to invest it in the U.S. economy.

While the recent free-fall in the Dow has been spectacular, the markets have been abnormally placid for about eight years now. A healthy market sees run-ups and pull-backs, and in recent memory the pull-backs have been on the maximum order of maybe 3% total. While we certainly prefer the markets always go up, the reality of long-term market history is that to have corrections on the order of 5% – 10% in the midst of a bull market isn’t unprecedented or even that unusual. We don’t think this pull-back signals the end of the bull market run, but rather that we might be getting back to a more historical norm.

No More Plow Horse

Brian Wesbury, Chief Economist of First Trust gives his take on the economy under the Trump Administration.

We’ve called the slow, plodding economic recovery from mid-2009 through early 2017 a Plow Horse. It wasn’t a thoroughbred, but it wasn’t going to keel over and die either. Growth trudged along at a sluggish – but steady – 2.1% average annual rate.

Thanks to improved policy out of Washington, the Plow Horse has picked up its gait. Under new management, real GDP grew at a 3.1% annualized rate in the second quarter of 2017 and 3.2% in the third quarter. There were two straight quarters of 3%+ growth in 2013 and 2014, but then growth petered out. Now, it looks like Q4 clocked in at a 3.3% annual rate, which would make it the first time we’ve had three straight quarters of 3%+ growth since 2004-5.

Some say a government shutdown would make it tough to get another 3% quarter to start 2018, but we disagree. Yes, some “nonessential” government workers might pull back on their spending temporarily, but there’s no historical link between government shutdowns and economic growth.

The economy grew at a 2.8% annual rate in late 1995 and early 1996 during the two quarters that include the prolonged standoff under President Clinton. That’s essentially no different than the 2.7% pace the economy grew in the year before the shutdowns. The last time we had a prolonged standoff was in late 2013, under President Obama. The economy grew at a 4% rate that quarter, one of the fastest of his presidency.

Right now, taxes are falling, regulations are being reduced, and monetary policy remains loose. With these tailwinds, the acceleration of growth in 2017 should continue into 2018.