And just like that, 2019 is half-way over. Next week will give me the ability to more exhaustively evaluate what 2019 has had to offer so far (hint: it’s all positive for investors) and to look into the second half of the year and what may make sense as we prepare for what lies ahead. But for now, I can say that this was the strongest month of June for stocks since the 1930s (barring some unforeseen disaster as the month ends on Friday), and it represents a V-shaped recovery to how markets performed under the trade pressures of May.
This week’s trek into the Dividend Cafe looks at the state of the trade war, handicaps some expectations around the China talks this weekend, and offers a more logical take on that idea of “the market being at an all-time high.” We look at the Democratic debates of this week and what they may mean for investors, we peak under the hood of Europe’s economy, we evaluate the health of the bull market, and we discuss the state of U.S. oil markets. We have charts. We have analysis. And we have fun. So jump on into the Dividend Cafe.
A tale of two trade wars
It was pointed out to me in a research paper this week that last spring (2018) when "Trade War 1.0" was launched by President Trump, the U.S. dollar rallied higher, emerging markets rolled over badly, gold tanked, bond yields stayed flat, the Fed was extremely hawkish, and U.S. tech stocks led the market.
This spring, when "Trade War 2.0" was launched via Twitter, the response has been different in all categories. The Fed has been extremely dovish. U.S. bond yields have collapsed. Emerging Markets have done very well. The dollar has dropped. Gold has gone higher. And tech stocks are lagging, not leading, the market.
Ultimately, the Fed's change of posture is more a cause of some of the other changes than an effect. I also believe that emerging markets were more logical to sell off a year ago on a valuation basis than they are now. I have long given up on speculating on why gold does what it does (I recommend you do the same). Essentially, I think the various complexities around the trade war are more developed than they were a year ago, and the entire environment around monetary policy is categorically different (for good or for bad).
Was the latest market rally Fed-driven or trade-driven?
I think both factors are at play throughout all aspects of markets right now, so the answer is not mutually exclusive of the other option. That said, it does appear that market sentiment has been more impacted in recent weeks by the signaling of monetary accommodation than the idea of an imminent trade deal. Stocks with more direct exposure to the trade war (semiconductors, emerging markets, etc.) are all up in this market rally but not as much as the broad market itself (indicating more Fed causation than trade war).
China Trade War Saga
President Trump's meeting with President Xi is expected for this Friday and Saturday in Osaka, Japan, at the G20 meeting. By Wednesday morning this week Secretary Mnuchin was telling us that "the trade deal with China is 90% complete." What isn't clear in that declaration is whether or not the 10% gap is fixable, at a stalemate, or somewhere in between.
China's leverage has largely been considered to be (a) their dominant market share in rare earth exports, a leverage point that is far more bark than bite (it can be changed in a moment if it needed to be); (b) their heavy ownership of U.S. Treasury debt, a non-leverage point unless China wants to tank their own economy as I wrote about several weeks ago - see "What If China Goes Nuclear?"; (c) Play hardball with U.S. tech companies doing business in China (this is pretty legit); and (d) Devalue their currency (this is the go-to move, and it works, to a point).
At press time, the latest news on this front is that President Xi has a set of terms he will present to the President to bring this matter to a conclusion. The loose indications of those demands did not appear constructive in terms of being something President Trump would agree to, but the early reports were unverified and lacking specificity. We will know more in the days ahead ...
Remind me why I care?
Where do we see the trade war most impacting the real economy? Business confidence, the precursor to business investment, the precursor to productivity, the lifeblood of needed economic growth ... This drop in the business confidence index last month tells the story.
That familiar refrain: "Oh no! We're at an all-time high!"
One of the most interesting things about my job is hearing investors say when things are distressed in the equity market, "Shouldn't we lay off of stocks - things seem weak?" - and then when things make highs, the same voices say, "Shouldn't we lay off of stocks - things seem strong?" I actually am not criticizing such a contradictory message, for as I write every weak in the Dividend Cafe, an intimate understanding of human nature is paramount for the competent financial advisor. And it is perfectly within the logic of human nature that one would find a different, if not contradictory, rationale for their human fear in different circumstances.
I will write until I am blue in the face of this simple fact: An "all-time high" in price is a meaningless data point, as every price ever achieved was, at one point the all-time high. Rather, it is valuations that matter, interest rates, comparative returns, sentiment, and all sorts of things. And even valuations are awful timing indicators as assets spend the vast majority of their time being "over-valued" or "under-valued" - not "perfectly valued."
Thank God for the focus of dividend growth, that keeps one's eye on the ball of investing, and not the snack bar.
Well, where are valuations?
The S&P closed last week trading at 17.3x the expected earnings of full-year 2019 (just slightly above historical P/E ratio averages)
It is trading at 16.5x the expected earnings of 2020, a worthless measure, and I mean worthless, as those earnings face inevitable revisions as circumstances play out in the 6-18 months ahead.
Price-to-Sales is about 2.1x, and Price-to-Book is about 3.4x (both above past averages for a variety of reasons).
These valuations apply to the broad S&P 500 - and of course, have to be measured against a 2% treasury yield on the 10-year bond. In other words, the relative valuation measures that matter all reflect cheaper valuations, since for most of history the multiple paid for earnings was against a comparable "safe rate" that was more than double what it is now ...
Speaking of all-time highs, guess what it isn't
If one's process for investing capital was to deploy capital when something was cheap, and lay off when it was not cheap, then such a process would be backing the truck up around Energy right now, purely in terms of Energy...
I ran away from Iran?
With all the talk about China and the U.S. earnings environment it would be easy to ignore the situation in Iran and where its market implications may be hiding. The fact of the matter is that, for now, the hubbub with Iran last week and the retaliatory strike that the President decided against last minute is more of a political story than a market story. But that could change in a second. Should a real military conflict escalate, there obviously would be ramifications in world oil markets, the U.S. dollar and more. We see the likelihood of a prolonged military project there as highly unlikely, but certainly, a "tail risk" that must be acknowledged. Like most of geopolitics, there is little investors can do to prepare for tail risks that do not represent a larger cost than the undesirable outcome one is concerned about, to begin with.
What does the Fed do now?
The market is saying a rate cut is coming. The market is really confident that two cuts are coming (in the next few months). And the market says the odds are greater than half that even three cuts could be coming ... That latter point is not baked in, but at this point, the market is expecting monetary accommodation to the level of 50 basis point relief from present fed funds rate levels.
The Fed is using the decline in inflation expectations to rationalize the need for rate cuts. And that is fine, as these things go, for a rather cerebral conversation around models and inflation data is what central bankers are basically there to do. But the fact of the matter is that it is all about credit markets. The market trumped the Fed's models, and the market was responding to tightening credit (and fear of tightening credit). A 2.5% cap in the Fed Funds rate may be with us for a long, long time. The rate cuts that are coming may or may not prove stimulative in short term economic activity, but if I am right that we are now set with a very low cap on how high the Fed can go for years and years to come, we have really taken a significant tool off the table for future Fed response to recessionary conditions.
A different version of the same
Last week in the Chart of the Week I laid out the "Bear Market Watch" list from Strategas Research, and how the various past "bubble indicators" of 2000 and 2007 looked in the present environment (hint: it was 0-for-9). This week I offer a different version reflecting a pretty similar conclusion, for now.
Is Europe running out of options?
Mario Draghi has spent the last seven years doing "whatever it takes" (his words, not mine) to save the Euro. A couple trillion Euros later of "quantitative easing," and Europe remains in a deflationary spiral. The central bank would gladly cut rates further if they were not already, ummmmm, negative. Draghi will leave his position later this year pleading with member countries to take on the burden of their economies with greater fiscal stimulus, not continuing the dependency on aggressive monetary action. I am following the succession possibilities at the ECB, but the reality is that whoever inherits the position of Draghi's replacement will have limited ammo available (unless they are to use the Outright Monetary Transactions Facility which would literally let the ECB directly buy debt from a failing country). A coordinated fiscal response is what they will turn to next in Europe, and that means getting 10-20 countries of competing economic agendas to agree on a policy response. The failure of the shared currency experiment grow starker by the day.
Politics & Money: Beltway Bulls and Bears
- The Democratic Party held one debate Wednesday night and another debate Thursday night this week, and as of press time I am only able to comment on the Wednesday night festivities. It was not an encouraging night for those hoping to hear some sort of market-friendly, investor-friendly, or even free enterprise-friendly positions. The second night may go differently.
- I will plan on a special Dividend Cafe podcast next week to really analyze the lay of the land in the Democratic primary as it pertains to investors and the economy at large.
- One thing, though, that will get attention sooner than the aforementioned podcast aspiration, is that Bernie Sanders has proposed a .5% transaction tax on all stock, bond, and fund transactions to pay for the forgiveness of $1.6 trillion of student loan debt. There was a time where such a proposal could be dismissed as just disingenuous political nonsense. Those were the good old days. Now, the policy proposal is actually serious.
- A looming need for a deal in spending caps and the federal debt ceiling is closer, but not yet finalized. The White House has already said if a deal is not achieved they will support a one-year continuing resolution to get it done.
Chart of the Week
I really hope this week's chart needs little to no commentary to put a smile on your face, both as an investor, and an American.
Quote of the Week
“Continuous improvement beats delayed perfection.”
-- Mark Twain