Since we started DataTrek back in October, we’ve been positive on US stocks. That’s been the right call, and we’re sticking with it.
Our basic argument: corporate earnings are high and still rising, long-term interest rates remain low and stable, and both US and global economies continue to grow. That’s the recipe for higher stock prices.
At the same time, we spend considerable time every day thinking about where we could be wrong.
Let’s face it: an 18x price earnings market based on pretty aggressive future estimates isn’t particularly tolerant of unforeseen negative shocks. Put another way, at 2,600 the S&P is essentially working without a net. Which is fine, until its not.
Some seemingly scary headlines don’t actually worry us too much.
#1 President Trump/Russia/Mueller. We’ll be the first to say that the Mr. Trump’s election last year had a positive effect on US stocks. As we’ve highlighted in past notes, not only have asset prices gone up but also correlations have declined. The latter happened only after Election Day 2016, which points to equity investors making more sector and stock specific investments after that date. Stock markets are finally acting the way they should – allocating capital on a case by case basis, not in aggregate.
No matter what comes from Robert Mueller’s investigation, Republicans will still drive to complete tax reform and push deregulation for the remainder of the current Congress. Simply put, markets don’t care if mail addressed to the White House bears the name “Trump” or “Pence”.
#2 Bitcoin/Crypto Speculative Excess. Take the market cap of all crypto currencies and you have $350 billion. That is right around 0.3% of world GDP. Bitcoin could go away tomorrow and it would mean very little to global economies and financial markets.
#3 North Korea. Growing up in the US in the 1960s and 1970s, the threat of nuclear war is not new to us. Equity markets managed long advances in the 1950s and 1960s even as the Cold War between the US and Soviet Union was at its worst.
Yes, at first blush this would seem to be a conundrum. Our only explanation is that “End of the world” trades only happen once, and no one would be around to profit from them anyway. Asset prices therefore do not incorporate truly cataclysmic scenarios. Because, well, what’s the point?
Now, here’s what does worry us…
#1 All the new faces at the Federal Reserve next year. Not only do we have a new Fed Chair in Jay Powell, but a new Vice Chair for Supervision (Randy Quarles), a fresh New York Fed president (not yet announced), and several open Fed governor spots.
Markets have a way of testing new policymakers. The US equity market crashed a few weeks after Alan Greenspan became Chair in 1987. Twenty-four months after Ben Bernanke took over, he faced the Financial Crisis. Will Chair Powell have some of Janet Yellen’s luck and avoid a meaningful crisis early in his tenure? Only time will tell.
#2 The final shape of Congressional tax reform package. Everyone from New Yorker cartoonists to the Twitter-sphere is mocking the hand-written pages of the Senate tax reform bill. But in that humor lies a real question: what will the final bill (presumably typed this time) actually hold?
The most important question for markets: will corporate tax rates decline in 2018 (versus a one year deferral)? If yes, good news. If not, it leaves open the possibility that political wrangling will endanger those reductions.
Remember that the famous Reagan tax cuts in the 1980s were a three-step process. The first round was in 1981, with changes in 1982 and a follow up in 1986. Bottom line: taxes are complicated. An 18x PE market may not want to hear that, but they are…
#3 Oil price spikes. Our vote for most-neglected but important news of the day goes to the killing of former Yemeni President Saleh outside of Sanaa and the takeover of the capital by Houthi militias. The conflict here is essentially a proxy war between Saudi Arabia and Iran, and the Saudis are losing. The world has thus far not been very interested in this conflict, even as it creates a humanitarian crisis. That may change.
From a capital markets standpoint, the slow burn of Middle East tensions is clearly their largest blind spot. A glance at history (1973, 1979, 1990, 2001) shows that the most reliable way to derail an equity bull market is for oil prices to spike. The Middle East teapot hasn’t boiled over yet, but no one seems to be turning down the heat either.
Our bottom line from this quick checklist: we remain bullish based on fundamentals. Nervous, but bullish.