NOVEMBER 20, 2016
IS THE BULL MARKET REBORN?
Dear IntelligentValue Reader,
Over the last two weeks, stocks logged very strong gains. The S&P 500 shot almost 100 points (4.63%) higher while the Russell 2000 small-cap index recorded an amazing run of 13.72% since its low on November 3. Was this rally the result of investor's enthusiasm over the election of Donald Trump to be the next president of the US, and most importantly, will the rally continue? We'll answer those questions and more in this issue of the Intelligent Value Alert.
Raging since March 2009, the longest bull market in history has shot sharply higher with the certainty
that has come following the most bizarre
election in US history. Is the bull revived for another leg higher?
DID PRESIDENT-ELECT TRUMP SPARK THE RALLY?
On November 8, the world witnessed the culmination of what was possibly the most bizarre presidential campaign in the history of America. However, by the early morning hours of November 9 the Clinton campaign conceded and Donald J. Trump was crowned the victor of the 2016 presidential election. Trump's victory shocked virtually everyone since all polling, and even the political-wagering sites (which historically have been very accurate) favored a Clinton victory over Trump by an 87% to 13% margin.
Based on statements made during his campaign, when President-Elect Trump takes office next January 20, the future of free trade, interest rates, and government spending could be radically re-arranged. Also, with Trump embracing Russia's Putin throughout his campaign, a new world order may be established. The big risk is that violent aggression occurs as various countries experiment with their newfound positioning.
One thing is certain: As has happened with many other new US presidents, shortly after he takes office Trump will likely be tested to see how long a leash he will allow. For example, will he let Russia aggressively expand its borders and invade Ukraine or other Eastern European countries? The biggest question for investors: how will Trump respond to the coming challenges and opportunities? The answer to that question will make all the difference to the markets.
The consensus of market forecasters was a -10% to -20% downturn in stocks over coming weeks because of the uncertainty inherent in a Trump administration. The old adage is that investors abhor uncertainty. In fact, it appeared that a selloff was coming because, in the early morning hours of November 9, the Dow Industrial futures were down more than -800 points.
However, as seasoned contrarians might have guessed, markets responded in the opposite way of what most pundits predicted following a Trump victory. In fact, virtually everything forecast about Trump has been wrong from the beginning. Instead, over the last two weeks, stocks logged very strong gains. The S&P 500 shot almost 100 points (4.63%) higher while the Russell 2000 small-cap index recorded an amazing run of 13.72% since its low on November 3. Investors apparently embraced the fact that there now is certainty about which sectors and industries are likely to benefit under a Trump andministration versus a very different direction from a Clinton administration.
In his first statement after the election, Trump said that job creation from infrastructure spending would be at the top of his list of priorities once he took office. Investors apparently realized that Republicans will control of all three branches of government starting in 2017, and many now expect a major infrastructure spending program to pass (what happened to deficits and debt being evil?).
While it's true that we won't know what policies will get through Congress until well after Trump takes office in two months, in the interim there will be speculation and positioning to invest in those companies that are likely to have the most to gain. For this reason, markets could climb throughout the seasonally favorable period through next April.
The vast majority of market gurus are attributing the rally over the last two weeks to the election of Trump, but did his election and the prospect of massive, increased government spending really spark the powerful two-week rally? Well, Trump's election may be boosted the rally, but it did not spark it.
As mentioned earlier, stocks started rising on November 3 – four full sessions before the election results were known. In fact, we believe markets would be climbing regardless of who won the election. Perhaps any result was enough to eliminate much of the uncertainty. At least now investors know where to put their money, and that has spurred a massive rotation of money out of some investment and into others.
But HAS the Longest Bull Market CreateD a "Big, Fat, Ugly Bubble?"
We analyzed historical market data going back to 1871 and found the longest instance the market climbed without a bear period (generally defined as a downturn greater than -20%) was the seven years from 1982 to 1989. A new record has been set because the current bull run beats that period by a sizable margin.
The stock market has gone up without a decline of more than -20% for the last 7.6 years (since March 2009). Most bull markets die out after four to five years (average is 4.7 years). So what has caused the current market to set the record as the longest bull run in history?
In a rambling rant about the economy during his first debate with Secretary Clinton, Trump insisted that an increasingly “political” Federal Reserve was holding interest rates low to help Democrats, driving up a bubble that will pop when the central bank raises rates.
“Believe me, we’re in a bubble right now. The only thing that looks good right now is the stock market, and if you raise interest rates even a little bit, that’s going to come crashing down. We are in a big, fat, ugly bubble.“
—Donald J. Trump
SECOND HIGHEST PE RATIO IN HISTORY
When we consider the facts, Trump's statement is credible. IntelligentValue has been pounding the table about the extremely rich stock valuations since early 2015, and those valuations have only increased since then.
Since the 1880s, stocks have historically ranged between an average or "fair" Price/Earnings level of 15 (dotted blue line), an "undervalued" PE level of 10 (dotted green), or an "overvalued" PE level of 20 as shown in Chart 1 below.
Chart 1: S&P 500 prices
are currently 23.99 times earnings, or about 67% above an historically "fairly valued" PE ratio of 15.
At the end of 2014, stocks had reached that "overvalued" level of 20, but then as earnings began a six-quarter, -20% decline, stock prices first dropped from August 2015 to January 2016, then rallied beginning in February 2016. Today, stock prices are 66.77% above the average or "fair" PE ratio of 15, which is historically the second highest (only to the 87.67% peak reached in 2000).
FEDERAL RESERVE SPURRED 60% OF STOCK'S GAINS
Trump is also correct is saying that the Federal Reserve is the key player in causing stocks to be so richly priced. In an op-ed written in The Wall Street Journal following the debate, Morgan Stanley chief economist, Ruchir Sharma, says, Trump’s bubblicious depiction of the state of equities isn’t off base, given the degree to which the Federal Reserve is propping up stocks by maintaining ultra-low interest rates. Sharma says about 60% of the gains from the stock market since the dovish monetary policy was enacted in the wake of the 2008 financial crisis can be attributed to central-bank support. According to Sharma:
Leave the conspiracy theory aside and look at the facts: Since the Fed began aggressive monetary easing in 2008, my calculations show that nearly 60% of stock market gains have come on those days, once every six weeks, that the Federal Open Market Committee announces its policy decisions.
Put another way, the S&P 500 index has gained 699 points since January 2008, and 422 of those points came on the 70 Fed announcement days. The average gain on announcement days was 0.49%, or roughly 50 times higher than the average gain of 0.01% on other days.
–Morgan Stanley chief economist, Ruchir Sharma
Chart 2 below shows the correlation between the three Federal Reserve asset purchase programs (Quantitative Easing or 'QE') and the Russell 3000 Total Stock Market Index. Notice that when the Fed terminated each of the three quantitative easing programs in 2010, 2011-2012, and since December 2014, the stock market went into sideways/downward, highly volatile periods. Since the end of QE3 in December 2014, stocks have inched up only a few percent spanning nearly two full years. Click chart to enlarge.
Chart 2: This chart of Federal Reserve QE asset purchases relative to the Russell 3000 Total Market Index shows the strong correlation between the two. Source: St. Louis Federal Reserve Bank (Click to enlarge)
While quantitative easing coming out of the Great Recession provided support for the stock market and restored the "wealth effect," it did not facilitate robust economic growth as hoped. The primary reason for this is that a politically-motivated block of fiscal stimulus programs prevented the economic growth that America might have had otherwise.
Economists believe that very severe, credit-based recessions (as occurred in 2007–2009) require both monetary stimulus (low interest rates and QE from the Federal Reserve) and fiscal stimulus (government spending on domestic programs) to make up for the utter lack of consumer spending following this rare type of extreme financial contraction.
However, in the politically motivated travails following President Obama's victory, Republicans blocked all efforts at domestic fiscal stimulus and sentenced the US economy to a muddle-through mode. The reason? So they could claim that Obama and Democrat's economic policies had failed and the country needed change (back to Republican control). That's exactly what they got eight years later! Depending on whether or not you support Machiavellian political strategies, you are either cursing or praising the plan Republicans created to win back all three branches of government. It was undeniably successful!
Investors apparently believe (at least for now) that a Trump administration and the coming Republican domination of all branches of government will ease the political loggerheads. Many expect money to finally begin flowing into domestic fiscal stimulus programs, which will, in turn, spark long pent-up economic demand.
ARE EARNINGS FINALLY TURNING HIGHER?
In what could be the biggest twist of political fate in a very bizarre election, it appears that there may be another factor favoring the economy when Donald Trump takes office in two months. We have documented in past Value Alert Newsletters that earnings have declined for six straight quarters since their peak at the end of 2014.
Chart 3 below shows the S&P 500 Trailing Twelve Months Earnings Available to Common Shares (TTMIACS, shown in red) from 1999 to present. This red line clearly shows the ebb-and-flow of economic growth and contraction over the last 17 years, as represented by corporate America's profits. The S&P 500 Index is shown in the background in blue.
Chart 3: The S&P 500 Trailing Twelve Months Earnings (red) has now moved above its 20-week Moving Average (green).
Notice how the rise and fall of stock prices coincided with rising and falling earnings levels. One key to timing the market with earnings is not their absolute level, but turning points in their trajectories. This is best tracked by overlaying a 20-week moving average (green). When earnings fall below the green 20-week moving average, an earnings recession may be near. When earnings (red) rise above their moving average (green), an imminent earnings recovery is likely.
As the most recent earnings season (third quarter-2016) has progressed, it became clear that earnings had initially flattened and then gradually began to improve with the last quarter.
Chart 4 below shows a closer view of the S&P 500 TTMIACS earnings (red), the 20-week moving average of those earnings (green), and the S&P 500 Index in the background (blue) from October 2014 to present. Notice that earnings first rose above the green moving average in August and recently spiked even higher. Are these the first glowing embers of an incipient earnings recovery? Perhaps the market seems to think so, anticipating the turn by a full nine months with the lift-off last February.
Chart 4: A zoom into the S&P 500 TTMIACS
(red) shows that that it first started to rise above its 20-week moving average (green) in August.
A NEW LEG UP FOR THE BULL MARKET?
This positive change in the trajectory of earnings may explain the previously confounding rise in stock prices that started in February. The market discounts the future by about six months, and much of that anticipation is driven by insiders who know the prospects for their companies in the months ahead. Big money managers take their cue from the insiders (or get it through the 'grapevine') and stock prices move higher. It is certainly possible that we may be beginning a new leg up in a bull market that has already lasted for seven-and-a-half years.
As discussed in the section above, the Fed created the bull market up to this point by adding $4.4 trillion to their balance sheet and keeping interest rates low. If fiscal stimulus in the form of a (rumored) two-trillion-dollar infrastructure boom is added on top of that base, we certainly could see a new leg up in the bull market that started in March 2009.
However, unless corporate earnings increase dramatically, that extremely high PE ratio discussed above is going to keep a lid on stock prices. Fortunately, if the infrastructure program actually comes to fruition, that money will trickle into almost all parts of the economy and not just construction-related firms. The key word in that last sentence is "if."
Nevertheless, with the intense sector rotation occurring within the market now, there are a completely new set of undervalued stocks to evaluate. Portfolio returns are greatly enhanced by selecting companies in those well-performing sectors. That gives IntelligentValue the chance to reload our portfolios and continue reaping gains.
OUR PLAN FOR THIS WEEK
Members can view our plan for the coming week in that section of our November 20 Intelligent Market Risk Analysis (IMRA) by clicking here. Portfolio updates and new undervalued stock selections can be accessed here.
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Best Wishes for Another Week of Intelligent Value Investing,
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