For the third time in six months, markets reacted opposite to expectations. First, it was Brexit. Markets swooned after the unexpected vote. That lasted for two days before markets shook off the surprise and headed higher. Last month, when Trump won, the swoon lasted a whole 9 hours, and the tantrum ended just prior to the opening of U.S. markets. On Sunday, December 4th, when Italy voted “no” on PM Renzi’s constitutional reform, a potential Italian banking crisis was anticipated, as markets were expected to reject the capital offering of Banca Monte dei Paschi di Siena (BMPS), the poster child of Italian bank under-capitalization. But, surprise, surprise – markets opened higher and BMPS’s capital offering continued as if nothing had occurred.
Market exuberance has been confined mainly to three sectors, energy, financials, and industrials. The rise in interest rates has hurt real estate and utility stocks, and health care, and tech, two sectors with a lot of locked-up overseas earnings, have not performed well either despite the promise of earnings repatriation.
• Energy (+7% post-election): It is expected that Trump will reverse Obama’s EPA regulations that have all but strangled carbon based energy and pipeline construction;
• The Financial Sector (+13%): Suffering under thousand pages of regulations since the Recession, it was the one sector that was not over-valued in the pre-election market. With fewer such regulations promised, those companies should earn more;
• The Industrial Sector (+7%): The rise in market prices here makes less sense. Defense stocks have risen on the promise of a rebuilt military, but those companies in the construction industry seem to be way ahead of the curve. Infrastructure spending is still a distant cloud of dust.
The promises of tax cuts and deregulation are being taken seriously by the markets. Unfortunately, the forward PE ratio now stands at 18.8x, two standard deviations above its historic mean. Assuming corporate tax rates are reduced, and assuming that the lower rates increase after-tax earnings by 10% (a big “if”), then the forward PE ratio is still 17x+, more than a standard deviation above the historic mean. Also keep in mind that market participants may be waiting to take profits until 2017, when they hope that capital gains tax rates will be lower.
Now let’s examine some underlying data:
• A disconcerting development is the significant rise in delinquencies in the sub-prime auto sector. Not that this is going to have any substantive impact on the financial sector (the repo of a car is a piece of cake relative to the foreclosure of a house), but it is a sign that the U.S. consumer may be approaching tapped-out status – holiday sales will tell us more on this count;
• In the new car market, it has now become clear that deep discounts are needed to produce that monthly 17 million unit (seasonally adjusted annual rate) sales level. Such discounting always pulls demand forward, so look for some leaner months in early 2017;
• The reduction in the unemployment rate (U3) to a surprising 4.6% from the 4.9% caused a lot of hoopla and high-fives. Not that the number of new jobs created (178,000) was lackluster, but the drop in the rate came from 446,000 able bodied people leaving the labor force (i.e., technically, not counted in the U3 calculation). And, of those 446,000, only 73,000 were retirees. The hoopla and high-fives were probably not in order. It appears that there is still a lot of slack in the labor markets;
• For those believing that Mr. Trump will magically make inflation reappear, as the bond market seems to think, a look at core inflation shows that it has been flat for throughout most of 2016, and the slack in the labor market makes it unlikely that we will see wages grow more rapidly than they have in the recent past. Ask yourself this: “if inflation is truly around the corner, then why have gold prices fallen in the post-election period?”
• While the ISM Manufacturing (53.2) and Non-Manufacturing (57.2) Indexes were quite strong in November and may support a Q4 real GDP growth rate of 3%, we haven’t seen the impacts to the economy of a stronger dollar and the rapid rise in the 10 year Treasury yield. The dollar is likely to get even stronger as the European Central Bank just extended the period of Quantitative. With the impending Fed rate hike, dollar strength will only increase. Exports already took it on the chin in October, and that was before the dollar’s post-election strength. They will likely weaken further going forward. Rising mortgage rates may increase home sales in the next couple of months as consumers react in anticipation of even higher rates. But, ultimately, rising rates are not good for housing.
Conclusions
• PE ratios are in nosebleed territory;
• A stronger dollar bodes ill for exports and manufacturing;
• Demand appears to have been pulled forward in autos and housing;
• Growth in Q4 may be near 3%, but conditions entering Q1 and Q2 appear less than ideal.
Enjoy the Trump rally while it lasts because profit taking is likely to occur in early 2017. In addition, if underlying economic data show weakness early next year, the markets could be in for something more than just a bout of profit taking.
