Tag Archives: President Trump

Ignorance in action

The last time I posted on the climate change debate was here in November 2014 on the release of the synthesis reports on the IPCC’s 5th assessment. The post asked whether the debate would now move on, away from the climate change deniers, given the weight of scientific opinion. Well, that was before Mr Trump. In his inane rationale for withdrawing from the (nonbinding) Paris climate agreement, Trump has provided a classic illustration of Johann Wolfgang von Goethe’s quote that “there is nothing more frightful than ignorance in action”.

The Paris agreement is far from perfect. It does not however contain hard emissions targets but rather gives a framework for voluntary reductions. Admittingly previous voluntary reductions promised by many countries have been missed but even a flawed agreement is better than nothing. Recent declines in the growth in coal use in China and India were positive initial signs.

Maybe Mr Trump’s delusional thinking is that his masterful negotiations skills mean he can negotiate a global agreement with hard emission targets! More likely, he is acting politically to shore up his mid America coal loving support given the danger that some of his core support may just be realising that his healthcare and fiscal policies are not that favourable to those at lower incomes.

I recently came across this statement from January 1954 by the Tobacco Industry Research Committee, a tobacco firm group representatives, in reaction to some of the initial medical research showing that smoking was linked to lung cancer. The group stated that “we believe the products we make are not injurious to health”. My favorite bit is the arguments cited by “distinguished authorities” below countering the emerging scientific evidence:

  1. That medical research of recent years indicates many possible causes of lung cancer.
  2. That there is no agreement among the authorities regarding what the cause is.
  3. That there is no proof that cigarette smoking is one of the causes.
  4. That statistics purporting to link cigarette smoking with the disease could apply with equal force to any one of many other aspects of modern life. Indeed the validity of the statistics themselves is questioned by numerous scientists.

Don’t these arguments sound familiar?

Still Dancing

The latest market wobble this week comes under the guise of the endless Trump soap opera and the first widespread use of the impeachment word. I doubt it will be the last time we hear that word! The bookies are now offering even odds of impeachment. My guess is that Trump’s biggest stumble will come over some business conflict of interest and/or a re-emergence of proof of his caveman behaviour towards woman. The prospect of a President Pence is unlikely to deeply upset (the non-crazy) republicans or the market. The issue is likely “when not if” and the impact will depend upon whether the republicans still control Congress.

Despite the week’s wobble, the S&P500 is still up over 6% this year. May is always a good month to assess market valuation and revisit the on-going debate on whether historical metrics or forward looking metrics are valid in this low interest rate/elevated profit margin world. Examples of recent posts on this topic include this post one highlighted McKinsey’s work on the changing nature of earnings and this post looked at the impact of technology on profit profiles.

The hedge fund guru Paul Tudor Jones recently stated that a chart of the market’s value relative to US GDP, sometimes called the Buffet indicator as below, should be “terrifying” to central bankers and an indicator that investors are unrealistically valuing future growth in the economy.

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Other historical indicators such as the S&P500 trailing 12 month PE or the PE10 (aka Shiller CAPE) suggest the market is 60% to 75% overvalued (this old post outlines some of the on-going arguments around CAPE).

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So, it was fascinating to see a value investor as respected as Jeremy Grantham of GMO recently issue a piece called “This time seems very very different” stating that “the single largest input to higher margins, though, is likely to be the existence of much lower real interest rates since 1997 combined with higher leverage” and that “pre-1997 real rates averaged 200 bps higher than now and leverage was 25% lower”. Graham argues that low interest rates, relative to historical levels, are here for some time to come due to structural reasons including income inequality and aging populations resulting in more aged savers and less younger spenders. Increased monopoly, political, and brand power in modern business models have, according to Graham, reduced the normal competitive pressures and created a new stickiness in profits that has sustained higher margins.

The ever-cautious John Hussman is disgusted that such a person as Jeremy Grantham would dare join the “this time it’s different” crowd. In a rebuttal piece, Hussman discounts interest rates as the reason for elevated profits (he points out that debt of U.S. corporations as a ratio to revenues is more than double its historical median) and firmly puts the reason down to declining labour compensation as a share of output prices, as illustrated by the Hussman graph below.

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Hussman argues that labour costs and profit margins are in the process of being normalised as the labour market tightens. Bloomberg had an interesting article recently on wage growth and whether the Phillips Curve is still valid. Hussman states that “valuations are now so obscenely elevated that even an outcome that fluctuates modestly about some new, higher average [profit margin] would easily take the S&P 500 35-40% lower over the completion of the current market cycle”. Hussman favoured valuation metric of the ratio of nonfinancial market capitalization to corporate gross value-added (including estimated foreign revenues), shown below, predicts a rocky road ahead.

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The bulls point to a growing economy and ongoing earnings growth, as illustrated by the S&P figures below on operating EPS projections, particularly in the technology, industrials, energy, healthcare and consumer sectors.

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Taking operating earnings as a valid valuation metric, the S&P figures show that EPS estimates for 2017 and 2018 (with a small haircut increasing in time to discount the consistent over optimism of analyst forward estimates) support the bull argument that current valuations will be justified by earnings growth over the coming quarters, as shown below.

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The IMF Global Financial Stability report from April contains some interesting stuff on risks facing the corporate sector. They highlight that financial risk taking (defined as purchases of financial assets, M&A and shareholder pay-outs) has averaged $940 billion a year over the past three years for S&P 500 firms representing more than half of free corporate cash flow, with the health care and information technology sectors being the biggest culprits. The IMF point to elevated leverage levels, as seen in the graph below, reflective of a mature credit cycle which could end badly if interest rates rise above the historical low levels of recent times.

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The report highlights that debt levels are uneven with particularly exposed sectors being energy, real estate and utilities, as can be seen below.

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The IMF looked beyond the S&P500 to a broader set of nearly 4,000 US firms to show a similar rise in leverage and capability to service debt, as illustrated below.

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Another graph I found interesting from the IMF report was the one below on the level of historical capital expenditure relative to total assets, as below. A possible explanation is the growth in technology driven business models which don’t require large plant & property investments. The IMF report does point out that tax cuts or offshore tax holidays will, based upon past examples, likely result in more financial risk taking actions rather than increased investment.

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I also found a paper referenced in the report on pensions (“Pension Fund Asset Allocation and Liability Discount Rates” by Aleksandar Andonov, Rob Bauer and Martijn Cremers) interesting as I had suspected that low interest rates have encouraged baby boomers to be over-invested in equities relative to historical fixed income allocations. The paper defines risky assets as investments in public equity, alternative assets, and high-yield bonds. The authors state that “a 10% increase in the percentage of retired members of U.S. public pension funds is associated with a 5.93% increase in their allocation to risky assets” and for all other funds “a 10% increase in the percentage of retired members is associated with a 1.67% lower allocation to risky assets”.  The graph below shows public pension higher allocation to risky assets up to 2012. It would be fascinating to see if this trend has continued to today.

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They further conclude that “this increased risk-taking enables more mature U.S. public funds to use higher discount rates, as a 10% increase in their percentage of retired members is associated with a 75 basis point increase in their discount rate” and that “our regulatory incentives hypothesis argues that the GASB guidelines give U.S. public funds an incentive to increase their allocation to risky assets with higher expected returns in order to justify a higher discount rate and report a lower value of liabilities”. The graph below illustrates the stark difference between the US and Europe.

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So, in conclusion, unless Mr Trump does something really stupid (currently around 50:50 in my opinion) like start a war, current valuations can be justified within a +/- 10% range by bulls assuming the possibility of fiscal stimulus and/or tax cuts is still on the table. However, there are cracks in the system and as interest rates start to increase over the medium term, I suspect vulnerabilities will be exposed in the current bull argument. I am happy to take some profits here and have reduced by equity exposure to around 35% of my portfolio to see how things go over the summer (sell in May and go away if you like). The ability of Trump to deliver tax cuts and/or fiscal stimulus has to be question given his erratic behaviour.

Anecdotally my impression is that aging investors are more exposed to equities than historically or than prudent risk management would dictate, even in this interest rate environment, and this is a contributing factor behind current sunny valuations. Any serious or sudden wobble in equity markets may be magnified by a stampede of such investors trying to protect their savings and the mammoth gains of the 8 year old bull market. For the moment through, to misquote Chuck Price, as long as the music is playing investors are still dancing.

Farewell, dissonant 2016.

Many things will be written about the events of 2016.

The populist victories in the US election and the UK Brexit vote will no doubt have some of the biggest impacts amongst the developed world. Dissatisfaction amongst the middle class across the developed world at their declining fortunes and prospects, aligned with the usual disparate minorities of malcontent, has forced a radical shift in support away from the perceived wisdom of the elite on issues such as globalisation. The strength of the political and institutional systems in the US and the UK will surely adapt to the 2016 rebuff over time.

The more fundamental worry for 2017 is that the European institutions are not strong enough to withstand any populist curveball, particularly the Euro. With 2017 European elections due in France, Germany, Netherlands and maybe in Italy, the possibility of further populist upset remains, albeit unlikely (isn’t that what we said about Trump or Brexit 12 months ago!).

The 5% rise in the S&P 500 since Trump’s election, accounting for approx half of the overall increase in 2016, has made the market even more expensive with the S&P 500 currently over 60% of its historical average based upon the 12 month trailing PE and the Shiller CAPE (cyclically adjusted price to earnings ratio, also referred to as the PE10). A recent paper by Valentin Dimitrov and Prem C. Jain argues that stocks outperform 10-year U.S. Treasuries regardless of CAPE except when CAPE is very high (the current CAPE is just above the “very high” reference point of 27.6 in the paper) and that a high CAPE is an indicator of future stock market volatility. Bears argue that the President elect’s tax and expansionary fiscal policies will likely lead to higher interest rates and inflation in 2017 which will further strengthen the dollar, both of which will pressure corporate earnings.

Critics of historical PE measures like CAPE, such as Jeremy Siegel in this paper (previous posts on this topic are here and here), highlight the failings of using GAAP earnings and point to alternative metrics such as NIPA (national income and product account) after-tax corporate profits which indicate current valuations are more reasonable, albeit still elevated above the long term average by 20%-30%. The graph below from a Yardeni report illustrates the difference in the earnings metrics.

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Bulls further point to strong earnings growth in 2017 complemented by economic stimulus and corporate tax giveaways under President Trump. Goldman Sachs expects corporations to repatriate approx $200 billion of overseas cash and to spend a lot of it buying back stock rather than making capital expenditures (see graph below) although the political pressure to invest in the US may impact the balance.

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The consensus amongst analysts predict EPS growth in 2017 in the high single digits, with many highlighting further upside depending upon the extent of the corporate tax cuts that Trump can get past the Republican congress. Bulls argue that the resulting forward PE ratio for the S&P 500 of approx 17 only represents a 20% premium to the longer term average. Predictions for the S&P 500 for 2017 by a selection of analysts can be seen below (the prize for best 2016 prediction goes to Deutsche Bank and UBS). It is interesting that the average prediction is for a 4% rise in the S&P500 by YE 2017, hardly a stellar year given their EPS growth projections!

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My best guess is that the market optimism resulting from Trump’s victory continues into 2017 until such time as the realities of governing and the limitations of Trump’s brusque approach becomes apparent. Volatility is likely to be ever present and actual earnings growth will be key to the market story in 2017 and maintaining high valuation multiples. After all, a low or high PE ratio doesn’t mean much if the earnings outlook weakens; they simply indicate how far the market could fall!

Absent any significant event in the early days of Trump’s presidency (eh, hello, Mr Trump’s skeleton cupboard), the investing adage about going away in May sounds like a potentially pertinent one today. Initial indications of Trump’s reign, based upon his cabinet selections, indicate sensible enough domestic economy policies (relatively) compared with an erratic foreign policy agenda. I suspect Trump first big foreign climb down will come at the hands of the Chinese, although his bromance with Putin also looks doomed to failure.

How Brexit develops in 2017 looks to be much more worrying prospect. After watching her actions carefully, I am fast coming to the conclusion that Theresa May is clueless about how to minimise the financial damage from Brexit. Article 50 will be triggered in early 2017 and a hard Brexit now seems inevitable, absent a political shock in Europe which results in an existential threat to the EU and/or the Euro.

The economic realities of Brexit will only become apparent to the UK and its people, in my view, after Article 50 is triggered and chunks of industry begin the slow process of moving substantial parts of their operation to the continent. This post illustrates the point in relation to London’s insurance market. The sugar high provided by the sterling devaluation after Brexit is fading and the real challenge of extracting the UK from the institutions of the EU are becoming ever apparent.

Prime Minister May should be leading her people by arguing for the need for a sensible transition period to ensure a Brexit logistical tangle resulting in unnecessary economic damage is avoided. Instead, she acts like a rabbit stuck in the headlights. Political turmoil seems inevitable as the year develops given the current state of the UK’s fractured political system and lack of sensible leadership. The failure of a coherent pro-Europe political alternative to emerge in the UK following the Brexit vote, as speculated upon in this post, is increasingly looking like a tragedy for the UK.

Of course, Trump and Brexit are not the only issues facing the world in 2017. China, the Middle East, Russia, climate change, terrorism and cyber risks are just but a few of the issues that seem ever present in any end of year review and all will likely be listed as such in 12 months time. For me, further instability in Europe in 2017 is the most frightening potential addition to the list.

As one ages, it becoming increasingly understandable why people think their generation has the best icons. That said, the loss of genuine icons like Muhammad Ali and David Bowie (eh, sorry George Michael fans) does put the reality of the ageing (as highlighted in posts here and here) of the baby boomer generation in focus. On a personal note, 2016 will always be remembered by me for the loss of an icon in my life and emphasizes the need to appreciate the present including all of those we love.

So on that note, I’d like to wish all of my readers a prosperous, happy and healthy 2017. It looks like there will be plenty to write about in 2017…..