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Q1 2017 Commentary: Hope, or Hope Deferred

by Albert Meyer

We started the year with high hopes of major tax cuts. We argued that these cuts should not be delayed as the current mood of optimism and the recent stock market gains are predicated on Congress delivering. As much as tax cuts will spur economic growth, a resumption of entanglements in regime-change wars will undermine public confidence, and we can kiss our hopes goodbye. More so as nuclear powers, Russia and China, have legitimate security interests in the regions that are currently being targeted by a president who six months ago presented himself as a “peacenik.” How will this all unfold?

Tax Cuts ASAP We have heard the saying: the wheels of justice turn slowly. It is no different in Washington. The promised corporate tax cuts will have a hugely positive impact on stock prices, as well as on the broader economy. Yet, for various reasons, legislators can’t juggle two balls at once. We are being told, first healthcare reform and then the tax cuts. Some pundits are now predicting that we might have to wait until 2018 for any changes in the corporate tax code, which, if true, is bitterly disappointing.

Nothing will play a bigger role in the stock market’s performance than the implementation of Donald Trump’s 15% corporate tax rate and the repatriation of trillions of dollars of corporate profits from abroad. We have harped on this in the past, but we are not seeing much in the form of common sense analysis on this score. In Washington, great ideas are clubbed to death by the political process in an “us vs. them” contest.

Politics notwithstanding, corporate taxes only raised $292.561 billion in fiscal 2016, ended September 30, according to the Tax Policy Center. Some economists who pontificate on these matters argue that lower taxes yield more revenues, and they have data to back this assertion. Under the scenario of a 90% corporate tax rate, most corporations would flee the country. Under a 35% tax rate, many corporations have transferred some of their profits to lower tax jurisdictions, which explains the more than $2 trillion in ready cash stored abroad.

Using approximations for the sake of brevity, a more than 50% cut in the corporate tax rate (from 35% to 15%) could cost the Treasury close to $150 billion, which equates to 4% of government expenditures in fiscal 2016. (The government spent $28 trillion during the Obama Administration.)

This is where politicians come in and spoil the party, especially those who argue that the tax cuts will have to be funded by so-called border adjustment taxes, or other silly suggestions. Recall that they were quite happy to borrow trillions of dollars for wars, but now balk at funding a $150 billion shortfall in corporate tax revenues through short-term borrowing. We say “short-term borrowing” because the retention of $150 billion in the hands of corporations, the engines of economic growth and job creation, will cause tax revenues to rise considerably and make the shortfall a redundant issue.

Besides, trimming a $3.540 trillion budget by $150 billion is hardly an insurmountable task. Shutting down the Department of Education (only established in 1980), a needless duplication of functions already taken care of at state capitols, will eliminate $80 billion of the shortfall. Back in 2012, Rick Perry, our new energy czar, promised to rid the federal government of the Department of Energy should we elect him as president. Nothing is stopping him now, but don’t hold your breath. Gene Epstein at Barron’s (Kill the Border Tax, March 20, 2017) made a list of easy-to-accomplish budget savings amounting to $200 billion.

Under a static analysis, the proposed tax cut would lower the oft-quoted 22.5 P/E on the S&P 500 to approximately 19.5. The impact of the restatement of the aggregate deferred tax liabilities carried by S&P 500 corporations (consider it a one-time tax forgiveness) will increase their net book value (shareholders’ equity). The repatriation of foreign profits will have a further beneficial impact on the growth prospects of corporations. Our rough guess is that a speedy implementation of these tax reforms/cuts could lower the said P/E to 15.0, assuming the S&P 500 index remains at current levels. However, the prospects of higher profits in future years, in the light of the cut in the corporate tax rate, could propel the index another +10% higher to the 2,600 level in the short term.

Governors and city leaders should be lining up in Washington pleading for the tax cut. On August 25, 2016, CNBC reported that in 2015, state pension funds faced a $934 billion shortfall in pension assets compared to unfunded liabilities. These funds own assets (investments) of more than $2.5 trillion. Assume half are invested in the stock market. Not counting 2016’s gains of about +10%, the introduction of the tax cuts could increase the value of the stock portfolio by more than $700 billion, measured from 2015, effectively taking care of 75% of the projected shortfall. The same argument can be made for pension funds held by city administrators. Private pensions funds would also benefit. The S&P 500 corporations have more than 26 million employees. It is fallacious reasoning, as some know-nothing politicians argue, that corporate tax cuts would only benefit the rich. A drastic cut in corporate taxes would have a phenomenal impact on the health and welfare of the US population. It could change the way we think about corporate taxes, as well as the size of government for decades to come.

At current levels, the market continues to anticipate the realization of these tax cuts, but optimism is fading fast. For the sake of the whole country, because there is hardly a worker not exposed in some way to the vicissitudes of the stock market, let us hope that the obtrusive media and the establishment politicians, renowned for their lack of critical thinking, don’t quash our expectations and derail the stock market rally. We are facing a once in a lifetime opportunity to effect a profound change in the corporate tax structure that will reverberate throughout the economy, for the good of all.

Stock Market Compared to recent years, the first quarter of 2017 was a standout, with the S&P 500 gaining +5.4%, while the tech-heavy Nasdaq surged +11.7%. The +2% gain of the small-cap Russell 2000 index looks positively miserable. A +5% year-over-year (Y/Y) increase in Q4 2016 earnings, with expectations of a +9% Y/Y increase in Q1 2017 helped propel stocks higher.

The Technology (+12.4%), Consumer Discretionary (+8.2%), HealthCare (+8.0%), and Consumer Staples (+5.9%) sectors performed better than the S&P 500 (+5.7%), while Telecommunications Services (-4.8%) and Energy (-7.2%) were the poorest performing sectors.

The first quarter of 2017 has been the least volatile in recent memory. The S&P 500 and the Dow each saw only a single -1% daily decline, which occurred on March 21. Both the S&P 500 and the Dow gained on average +0.3% per day, which was the smallest average daily move since the mid-to late-1960s.

Goldman Sachs has been tracking a basket of stocks that should gain if Trump’s promise of significantly lower corporate taxes comes to fruition. These stocks are now trading below where they traded ahead of the election, illustrating that the market has lost faith in Washington’s ability to deliver.

Market Prediction On March 22, 2006, a Bank of America technical strategist argued that the S&P 500 could reach 3,000 by 2019. If the S&P 500 closes at 3,000 on December 31, 2019, it would translate into a +10.25% p.a. return over the next three years, which would not be too shabby, considering the low interest rate environment that still persists. It would appear that the 3,000 target is just a straight comparison between today’s value and 2019’s projected value, excluding the impact of dividends. The current dividend yield on the index is 1.82%. If we add 1.82% to the 10.25%, investors could earn +12.07% p.a. over the next three years. Many would argue that such hopes seem unrealistic.

We have asserted in the past that the 30-year period, beginning 1990 to end 2019, is an appropriate period over which to measure long-term returns. Immediately preceding and during this period, the Soviet Union disintegrated, East Germany and West Germany re-united, China liberalized its economy, important changes in accounting rules were mandated, the advent of the semiconductor and the coming of age of the internet significantly changed the economic landscape, and we experienced the Great Crash of 2008, among other notable events. Regrettably, we even had a few wars thrown in along the way.

For a longer historical perspective, consider that from 1889 to 1989, the S&P 500 returned +9.21% p.a. Measured from 1900, the return was +9.50% p.a. This rate increase to +10.71% p.a. if we measure from 1920, post WWI. The rate declined to +10.11% p.a. if measured from 1930. If our starting points are 1940, 1950, 1960 or 1970, the long-term annualized returns were +11.85%, +11.63%, +10.11% and +11.13%, respectively.

If the S&P 500 closes at 3,000 on December 31, 2019, the 30-year return would be +7.65% p.a. A 30-year return of +10% p.a. to +11% p.a. would be in tune with historical averages. If the S&P 500 closes at 3,500 at the end of 2019, the 30-year return would be +8.20% p.a. A 3,500 close would also mean a +16.06% p.a. return over the next three years. The historical averages favor predictions in line with a 3,000-plus value on the S&P 500 by the end of 2019.

A long-term stock chart of the Dow or the S&P 500 will show that through the peaks and troughs the stock market rises relentlessly. Fear drives markets down. However, attributes such as innovation, intellectual endeavor, reason rather than emotion, innovation and creativity in search of economic gains will always have the edge over apprehension, anxiety and trepidation. That is what the history of the stock market teaches us. Although the market always recovers, predicting the period of recovery remains an elusive target.

Since the year 2000, the average estimate of Wall Street strategists for yearly gains on the S&P 500 was +9.6%. Last year’s +5.5% projected gain for 2017 was surprisingly bearish. In 2016, strategists predicted the S&P would gain +8.4%. The actual gain was +9.5%. pretty close, considering that on average they are about 550 basis points (5.5%) points above the actual year-end change. Currently, the average strategist now projects a gain of +8.4% in the S&P 500 in 2017, i.e., an additional gain of +3.0% from the end of the first quarter.

Optimism JPMorgan Chase’s annual survey of business leaders closed the day of Trump’s inauguration. The results show a high level of optimism among the 1,400 respondents. Optimism is at its highest level over the past seven years and pessimism at its lowest level. In January and February, small business optimism reached its highest level in 43 years, according to the National Federation of Independent Business (NFIB).

The 235,000 new jobs added in February, accompanied by a moderate increase in wage growth, boosted confidence in future consumer spending. Hourly salaries and wages grew +2.8% year over year. Jay Timmons, CEO of the National Association of Manufacturers, commented in a statement on the February job numbers: “Today’s news is another strong indicator of the ‘Trump bump’ of positive economic activity. Across America, manufacturers’ confidence is high, and business optimism continues to soar, because of President Donald Trump’s laser focus on policies that will accelerate a jobs surge in America.”

Small business lending is up +8.5% in the first five months of this fiscal year compared to the previous year, according to the US Small Business Administration (SBA) in New York. The borrowed funds mean increased hiring, inventory and capital equipment purchases. According to a recent survey by Wells Fargo, optimism in the construction sector is also growing.

Optimism in the banking sector is high as they anticipate changes to the Dodd-Frank legislation that, not surprisingly, hit smaller banks disproportionately. Legislators take care of the big boys, the bullies, so to speak, who fund their campaigns. Regulations often push smaller competitors under, in a true school playground fashion. One of the complaints against the new healthcare bill was that the insurance industry insiders wrote the legislation.

The manufacturing sector added 28,000 jobs in February and 57,000 jobs over the past three months, according to Labor Department statistics. Scott Paul, president of the nonprofit Alliance for American Manufacturing, agrees that there is a guarded sense of optimism among manufacturers.

The Consumer Confidence report for the month of March shows that confidence levels are now comfortably above the highs seen during the prior expansion from 2003 through 2007.

The Federal Reserve’s confidence in the global economy was signaled by the recent interest rate increase and the promise of two more increases before year-end. For the first time since the financial crisis, signs of positive economic growth are broadly based.

The Business Roundtable is an association of chief executive officers of leading US companies working to promote a thriving economy and expanded opportunity for all Americans through sound public policy. The roundtable represents companies with over $6 trillion in annual sales and more than 15 million workers.

The Business Roundtable indicated recently that the outlook for the economy over the next six months posted its biggest increase since the end of 2009. The roundtable’s CEO outlook index leaped 19.1 points to 93.3 in the first quarter, marking the first time in almost two years that it exceeded the historic average of 79.8. Plans to hire and spend more on big investments surged.

GDP Real (inflation-adjusted) gross domestic product (GDP) increased at an annual rate of +2.1% in the fourth quarter of 2016, according to the third estimate released by the Bureau of Economic Analysis (BEA). In the third quarter, real GDP increased +3.5%. For the year, GDP growth was a tepid +1.9%. Currently, estimates of Q1 2017 GDP growth are at an uninspiring +1.0%. Global GDP grew +2.7% in the fourth quarter 2016, but expectations for Q1 2017 are modest.

If GDP growth had kept pace with the long-term average, per capita income would have been $64,502 and not the current $58,189. Not casting any aspersions, but GDP growth during the Obama Administration tracked well below the long-term average growth rate of +3.1% p.a. Consequently, our current level of GDP is about $3 trillion lower than it would have been under +3.1% p.a. growth rate over the past 8 years.

Corporate earnings fared better. The S&P 500 companies reported a +4.9% average increase in Q4 2016 earnings, which was the first time the S&P has seen earnings growth in back-to-back quarters since early 2015, according to FactSet. Sixty-five percent of S&P 500 companies also beat their mean earnings-per-share estimates.

The New York Fed’s currently projects Q1 GDP growth of +3.0% (as of March 24), which is up sharply from Q4’s and way better than what we have seen for the first quarter in recent years. On the other hand, The Wall Street Journal’s March survey of economists predict average growth of +1.9% for Q1 2017.

Glenn Hubbard, an economics professor at Columbia University and a former chairman of the Council of Economic Advisors in the George W. Bush administration, believes that “fundamental tax reform could raise US growth by half a percentage point.” We think the impact could be much greater if the cuts are deep and unaccompanied by border tax adjustments and other esoteric provisions that usually find their way into the tax code.

Stanford’s Professor John Taylor pins his hopes on deregulation. He claims that, “The regulatory constraints have been a big factor in the slower growth of the US economy.” – no doubt.

The risk of recession remains low.

Recession Watch Talking about recession. Even though economic data projects uninterrupted growth, ever so often some pundit pops up to warn that we are due for a recession. After all, the argument goes, the current expansion is now in its eight year. Irrelevant. Australia has not experienced a recession since 1991. Countries like Taiwan, Singapore, The Netherlands and Switzerland have also enjoyed prolonged periods of economic growth.

iMarketSignals, an economic research firm, compiles an index that it claims acts as a predictor of a looming recession. Currently, the firm’s Business Cycle Index (BCI) stands at 218.7, an improvement on the previous reading, and hence no recession is signaled.

Officially, the National Bureau of Economic (NBE) research announces the start and finish of a recession. Often, by the time the NBE confirms the existence of a recession, renewed growth has already set in.

The yield curve and interest rate spreads are very positive. Historically, most recessions in the US are preceded by a flattening of the yield curve, that is, a narrowing of the spread between the yield on the 10-year T-bond and the 3-month Treasury security. The opposite effect is noticeable months before the start of an economic recovery.

Currently (last updated April 4, 2017 using data through March) the “Yield Curve” model shows a 5.18% probability of a recession in the United States twelve months ahead.

The Labor Department reported that in March, the official unemployment rate hit 4.5%. The lowest in 10 years. Ironically, some pundits argue, this could be bad news. Since 1948, when the Bureau of Labor Statistics started reporting unemployment data, a rock-bottom unemployment rate has been an excellent indicator of upcoming recessions and a very good warning sign of corrections and bear markets ahead.

Since 1948, the unemployment rate hit a cyclical low on ten occasions. Each time, after the registering of such a cyclical low unemployment rate, it took one to 16 months for the economy to fall into a recession. The average gap between that cycle’s low unemployment rate and the onset of a recession was 9.2 months.

Bear markets also followed low unemployment rates regularly. On average, it took nearly 15 months for a bear market to follow a recession, according to Yardeni Research.

Economists find it particularly difficult to predict recessions (the NBER “calls” recessions only after they’ve begun), so it’s hard to know when the unemployment rate has actually bottomed until after it’s happened. And the low unemployment rates can continue for a long time. Unemployment fell below 4% in February 1966, but it took more than 2½ years for it to bottom at 3.4%, where it stayed for eight months. In 2006-2007, it hovered in the mid-4% range for more than a year even as a housing bust and financial crisis loomed.

Seismic shifts in the workplace also makes historical averages problematic. Automation and globalization have displaced millions of workers in their prime years. That and an aging population—10,000 baby boomers turn 65 every day—have dropped workforce participation to 63%, way down from a peak of 67.3% in February-March 2000, when unemployment bottomed at 3.8%.

Federal Reserve Chairwoman Janet Yellen said at the University of Michigan recently, “The unemployment rate itself might be a misleading indicator of the extent of slack in the labor market.” In other words, the unemployment rate would have to fall further than in the past before we hit what economists call “full employment.”

Trump’s Trade War Media pundits, no fans of President Trump, continue to warn that Trump’s trade war will end in tears. We are free traders ourselves, but are willing to consider for argument sake whether Trump has a point. The Financial Times reported that, “China’s car business is attractive to outsiders chasing sales growth, but rules protecting local companies dent profits of global auto giants and force them to share technology with potential rivals. The 25% tariff on vehicle imports makes US-built automobiles too expensive for most buyers in the world’s largest auto market.”

Eventually, Chinese officials plan to relax the auto sector’s joint ownership rules. Last year, Miao Wei, the minister of industry and information technology, said Beijing could ease regulations within eight years. We don’t think the Trump Administration can wait that long.

Martin Wolf, the chief economic columnist of the Financial Times, argues that a trade war between China and the US is fraught with unintended consequences. “Mr. Trump may declare ‘America first.’ The Chinese leadership may focus on the welfare of its own citizens. But neither will be able to deliver what they want without paying attention to the interests and views of others… It is astonishing that today the Chinese leadership seems to understand this better than that of the US…” according to Wolf.

Limiting imported goods supposedly protects domestic industries. (As an aside, if tariffs are such a great idea, why impose sanctions on, say, Iran and Russia? Aren’t sanctions tariffs in disguise? Domestic manufacturers in these countries must be celebrating Washington’s protective shield.)

An immediate effect of tariffs is that imported goods become far more expensive. Domestic producers may be able to deliver, but at a higher price as they lack the foreign suppliers’ cost advantages and economies of scale.

At present, Chinese (19%) and Mexican (12%) imports comprise close to a third of what US consumer buy. If the effect of tariffs is a price increase on a third of the goods we buy at stores, a substantial increase in the cost of living will not sit well with voters. Tariffs could also be expanded to cover imports from other countries. The folk in Washington might not care at first, as they rake in the additional revenues generated by tariffs.

And for those who long for a trade war with Mexico, Michael Pettis explained the folly of such a notion in his paper, “Mexico’s Positive Impact on The U.S. Trade Balance.” Space does not allow us to elaborate. Basically, trading with all and sundry, regardless of political and religious ideologies, makes us all winners.

In an article on Frederic Bastiat, Jeff Thomas quotes Bastiat, “Most tariffs are either abolished or at least lowered at some point. In the meantime, they’re like plaque in a body’s arteries, creating a sclerotic effect on the economy. Invariably, they’re a heavy price for a country to pay for a brief period of additional revenue that political leaders may squander.” Bastiat also described tariffs as “veritable icebergs of economic destruction.”

It was announced on April 4, 2017, that Boeing agreed to sell 30 jetliners to an Iranian airline valued at $3 billion, the second deal in the country in four months. Prior to this deal, the company reached an agreement in December to sell $16.6 billion in planes to Iran Air, the first pact of its kind since 1979. The agreements come after most international sanctions on Iran were lifted as part of its nuclear deal with world powers. These transactions would create or sustain about 18,000 US jobs, Boeing said, citing Commerce Department calculations.

Unfortunately, Boeing notes that it would have to obtain government approval, which only makes sense in Washington. Boeing’s last airplane deliveries to Iran were 747 jumbos that arrived in 1977. “We should be increasing sanctions significantly on Iranian and Russian interests that are helping Assad. In particular, this Boeing deal should be canceled,” Sen. Marco Rubio told George Stephanopoulos at ABC. This beggars belief.

Trump finds himself on the horns of dilemma. He has to please the warmongers in Congress who believe in the ridiculous notion that a country seven thousand miles from us, with no genuine military capability, is a threat to our security. On the other hand, he wants go around and boast of the many manufacturing jobs he has saved or created.

The issue is easily resolved by following the wisdom of Frederic Bastiat: “When goods cross borders, armies won’t.”

Finally, without going into the minutia, Daniel Griswold in “Plumbing America’s Balance of Trade,” a paper published for the Mercatus Center at George Mason University correctly argues that, “America’s commerce with the rest of the world must be and always is balanced when taking into account investment flows as well as the exchange of goods and services… One key insight for public policy is that the total outflow of dollars each year from the United States to the rest of the world is matched by an equal inflow of dollars from the rest of the world to the United States. There is no need to worry about a ‘leakage’ of dollars siphoning off demand from the domestic economy. Dollars spent on imported goods and services return to the United States, if not to buy US goods and services, then to buy US assets in the form of an inward flow of investment… When we account for all the dollars flowing into the United States, with an adjustment for the statistical discrepancy, it totals the exact same amount. The difference between dollars flowing out and dollars flowing in each year is zero.” Unfortunately, this kind of logic won’t win you any votes among the economically illiterate.

Trade Deficit According to a recent headline America is great again and no better proof than the fact that the trade deficit was down. On the contrary, when the economies of foreign countries grow faster than the US, our exports industries will benefit and thereby putting downward pressure on the trade deficit. However, slower growth in the US also causes a decline in imports, which shrinks the trade deficit; and that’s supposed to be a good thing? Moreover, a shrinking trade deficit also suggests a relative decline in foreign investment in the United States.

As noted above, trade deficits are funded by foreigners investing an equivalent amount of US dollars in real estate (e.g., track the property acquisitions by Chinese on the West Coast), US securities (stock and bonds) and the like. Trade deficits are only of statistical significance. Someone’s counting and getting paid to do so, but if politicians weren’t so inept at Economics 101 it would never be mentioned on the campaign trial. Protectionism is a quest for coerced special privileges and restraint of trade at the expense of efficient competitors and consumers.

Trade Policy We would argue for complete elimination of all restrictions on the importation and export of legal products. Give citizens the freedom to buy and sell all legal products anywhere in the world. To borrow from our Economics 101 textbooks, if the Portuguese are not good at making linen and the Irish particularly inept at making wine, the right of citizens of both countries to freely trade wine for linen creates maximum prosperity for both countries. Using trade restrictions to encourage the production of inferior wine in Ireland and sub-standard linen in Portugal is pure foolishness. The division of labor and resources is a natural, beneficial process that knows no international, political boundaries. Free trade results in the most efficient allocation of worldwide capital to produce the most goods and services for the benefit of all.

The US/Canadian softwood dispute is an interesting case study in international trade. For more details consult Wikipedia. Suffice to say that politicians in the US accused Canada of subsiding the country’s softwood exports to the US and thereby threatening the US softwood industry. The reciprocal tariffs that emanated from this dispute have caused Americans to pay more for softwoods, reducing their standard of living. Yes, the American softwood producers get higher prices for their product, but at the expense of their fellow countrymen. The US consumer suffers and capital is used in less productive ways than if the tariff were not in place. If Canadians are foolish enough to subsidize exports, the beneficiaries are Americans. Canadians are taxed so that Americans can enjoy cheaper softwoods, according to the Mises Institute.

The Mises Institute also argues that free trade is incompatible with managed trade as manifested in trade treaties, agreements, etc. If the purpose of a trade agreement is for a nation to open its doors to another nation’s products only if that nation reciprocates, then each nation is still pursuing the illogical and self-defeating precepts of a mercantilist trade policy. We say, scrap all such treaties and defund the associated government bureaucracies.

Taxation When European political leaders gathered in Malta in March to discuss the future of the European Union, German Chancellor Angela Merkel denounced any post-Brexit move on the part of the United Kingdom to lower corporate taxes. Merkel called any such move a “race to the bottom” – bring it on.

The bureaucrats in Europe view lowering taxes as retrograde and non-progressive thinking. German Finance Minister Wolfgang Schäuble noted that, “A truly global economy must think of global governance.”

A lower corporate tax rate in the UK will seriously undermine those who argued that businesses will flee the UK and move to Europe. There is no economic threat in the world that a lower corporate tax rate cannot diffuse.

Jamie Dimon, CEO of JPMorgan Chase, penned a 45-page annual letter to shareholders in which he pointed out that most other developed nations have cut their corporate tax rates in the past decade, leaving the US with the highest levels and causing “considerable damage.”

“Our corporate tax system is driving capital and brains overseas,” he wrote. Dimon asserts that American corporations are now better off investing capital outside the US, where they can earn higher returns. He cites a 2007 Treasury Department review, he argues that lowering taxes would improve wages.

He has a sobering assessment of the past 16 years: “Since the turn of the century, the US has dumped trillions of dollars into wars, piled huge debt onto students, forced legions of foreigners to leave after getting advanced degrees, driven millions of Americans out of the workplace with felonies for sometimes minor offenses and hobbled the housing market with hastily crafted layers of rules… Infrastructure planning and spending is so anemic that the U.S. hasn’t built a major airport in more than 20 years.”

Shiller and CAPE Among his many other accomplishments, Professor Robert Shiller is a Nobel Laureate and an economics professor at Yale. He is also famous for his CAPE ratio, a measure by which he assesses the intrinsic value of the S&P 500. It would not be disrespectful to say that based on the CAPE ratio at almost any point in time, the market seems to have been overvalued. Hence, the wrong conclusion would be to always sell when the CAPE ratio appears too high to one’s liking. Such a decision would have caused many an investor to miss huge market rallies.

Professor Shiller contends in an article in the New York Times that a bullish mood among investors “could be a self-fulfilling prophecy and lead to continuing gains for a while.” He admits, perhaps prompted by criticism, that his CAPE Ratio does not tell us “where the market is going tomorrow, but it suggests that some caution is advisable, and that returns over the next decade or so are likely to be constrained.”

Correctly in our view, Professor Jeremy Siegel, the Russell E. Palmer Professor of Finance at the Wharton School of the University of Pennsylvania, pointed out that continuous changes in accounting rules over the decades make earnings comparisons over these periods an apples-to-oranges comparison. This important point undermines the value of CAPE, as historical earnings are the nominator in the ratio.

Professor Shiller sees the CAPE ratio as a tool that forecasts stock returns “somewhat well in the stock market. That ‘somewhat’ is important because the ratio has its limits as a forecasting tool…. The current level of CAPE suggests a dim outlook for the American stock market over the next 10 years or so, but it does not tell us for sure nor does it say when to expect a decline. As I said, CAPE is useful, but it does not provide a clear guide to the future.”

On the other hand, Professor Shiller’s one-year confidence index is at a record high for institutional investors, and it is at the highest level since 2007 for individual investors. Professor Shiller writes that, “It is hard to reconcile these results. One possible interpretation might be that respondents perceive a stock market bubble: They think valuations are high and there is a non-negligible probability of a crash. At the same time, they are hanging in because they think the Trump boom will probably last for at least another year.”

Professor Shiller concludes that, “There is no clear message from all of this. Long-term investors shouldn’t be alarmed and shouldn’t avoid stocks altogether. But my bottom line is that the high pricing of the market — and the public perception that the market is indeed highly priced — are the most important factors for the current market outlook. And those factors are negative.”

Professor Shiller has always had a bearish bent. He receives most, if not all, of his publicity when he voices his market concerns. It would have been highly disadvantageous in the past for investors to have acted on these concerns by either selling out or remaining on the sidelines.

Clearly, buying stocks today is not as an attractive proposition as it was in February last year, but that does not mean one should liquidate today and wait for better days. It merely implies that one should be cautious. Even during periods when the market peaked, investors could have discovered stocks that had compelling value and bucked the down trend, or recovered really quickly after a market correction.

Of course, if the slowpokes in Congress surprise us all and cut the corporate tax rate to 15% any time soon, even the likes of Professor Shiller would look back at the current apparently overvalued market and admit that in retrospect it was fairly- to under-valued.

An Alternative to CAPE “After-tax profits adjusted for capital consumption allowances and inventory valuation” offers an alternative earnings measurement by which to judge equity valuations. Proponents of this measure argue that it represents the most consistent and contemporary measure of the true economic profits of corporate America. On this basis, the S&P 500 companies generated adjusted earnings, of $1.61 trillion, that is, if Q4 2016 earnings are annualized. Year-over-year, this represents a +15.7% increase. This was in no small measure attributable to the diminishing impact of the sharp drop in oil prices since the summer of 2014. From a historical perspective, the $1.61 trillion amount is unusually high when compared to GDP. It would be fair to conclude from these observations that equity valuations are not unduly overvalued, contrary to what S&P 500 GAAP earnings might imply.

Another proxy for corporate earnings is the most recent quarterly annualized rate of profits as calculated in the National Income and Products Accounts (NIPA), i.e., NIPA profits. Calculating a P/E based on NIPA profits yields a P/E that is marginally – in the 16-range – above the long-term average of 15. This also confirms that the market is not at nose-bleed levels, as some pundits, mainly writers of dubious newsletters, suggest.

What about the equity risk premium? The equity risk premium is the difference between the earnings yield on stock (the inverse of the P/E ratio) and the yield on 10-year Treasuries. The premium represents the additional yield investors require to compensate for the additional risk carried by equities.

In the past, during periods of excessive exuberance, the risk premium was negative, demonstrating investors willingness to own equities. This trend changed after the Great Recession with a consistently positive premium, reflecting investors’ reluctance to jump back into equities. An analyst pointed out that the current risk premium is about where it was in the late 1970s during the Carter years.

Optimism has been in short supply over the past 8 years. Consumers worked on reducing their debt, while government borrowed with gay abandon. Corporate profits were not reinvested in plant and equipment, but instead were allocated to stock repurchases. The reluctance to hire also meant that unemployment remained stubbornly high, and wages did not grow. Some referred to this as the emergence of feudal capitalism, where the corporate nobility, with compensation packages that would make the Royal family blush, ruled over the “peasant” class who gratefully clung to their jobs – an environment ripe for a surge in populism. Economist, Doug Short, echoes this view: “The absence of real income growth was undoubtedly a key contributor to the rise in populism that has become a major focus of contemporary journalism.”

Emotions in Check Consider the following: Since 1954, the S&P 500 has had years of positive returns 73% of the time (average gain + 16.2%); years with negative returns 27% of the time (average loss -13.1%); one year with a loss between -30% and -40% (2008); two years with losses between -20% and -30% (1974, 2002); four years with losses between -10% and -20% (1957, 1966, 1973, 2001); and two periods of meaningful back to back losses (1973 – 1974, 2001 – 2002).

It is natural to fear temporary selloffs. However, market corrections present an excellent buying opportunity, if one can keep one’s emotions in check. Since the November election, the market has experienced a series of all-time highs. Inevitably, the media rolls out the scaremongers predicting a major crash.

Sure, the market is not currently offering us stocks at bargain basement prices. As we noted above, there is no way of knowing for certain whether the current exuberance may not spark a further rally as those who missed out, join the party. After all, prices are determined by buyers and sellers. An influx of buyers will propel prices higher. That said, the probability of a decent correction before the end of summer is perhaps more than 50%.

A recent BlackRock report observes that, “Volatility is often the catalyst for poor decisions at inopportune times. Amidst difficult financial times, emotional instincts often drive investors to take actions that make no rational sense but make perfect emotional sense.”

The report highlights the fact that long-term investors build up large unrealized gains in their portfolios, which ensures that their initial capital investment is adequately protected against market corrections. The market gives and then it takes some away, only to recover. Over the long-term the market is a giver. Corrections outlast themselves, and then the upward trajectory continues.

In this context, Salil Mehta, a statistician and former director of analytics for the Treasury Department told MarketWatch that there was a 13% chance of a short-term bear market, or fall of at least -20% from a recent peak. He sees a more than one-in-three chance of a downturn of at least -10% or better, and a nearly three-out-of-four likelihood of a -5% drop.

It ultimately boils down to market tolerance. Those who can’t handle the occasional downdraft ought not to be in stocks. The mistake these investors invariably make is to resort to panic selling in an effort “to protect capital.” On the contrary, the worst time to panic is during a correction.

Outperformance Possible We continue to outperform the market. Bastiat’s composite portfolio, all client portfolios in the aggregate, Y/Y at the end of Q1 2017, returned +20.36% compared to 14.71% for the S&P 500. The Efficient Market Hypothesis (EMH) says that all available information will get priced into assets efficiently, hence outperformance is a virtual impossibility.

Information can broadly be defined as distinct or complex. Distinct or straightforward information is instantly impounded into the price of a stock. Complex information, on the other hand, like some of the obscure footnotes found in annual reports are not priced into the market unless it is discovered and widely-publicized.

One could argue that there are only a few investors or analysts who have the time and the expertise to rummage through this information, interpret it correctly and act on it. Accordingly, such information does not affect market prices, not in the short-term anyway. This is what creates market outperformance, or alpha as it is known in the industry.

The EMH simplistically assumes that all information is the same and everyone has the ability to fully understand it. On the contrary, those with unique skills and expertise, often the fruit of years of dedicated effort, will outperform their peers.

Economy Virtually all the major economic indicators and data points reflect economic growth. Space limits us to highlighting a few important indicators.

Leading economic indicators look promising. The Institute for Supply Management (ISM), which tracks US aggregate manufacturing activity, rose to 57.7 in February from 56.0 in January, exceeding analyst expectations. This reading declined slightly in March to 57.2, but the employment-index hit a six-year high.

ISM data showed on Monday April 3 that America’s factories experienced continued expansion in March after two challenging years. ISM’s diffusion index eased to 57.2 (matching median forecast) from February’s 57.7. Readings above 50 indicate growth.

The ISM measure of export orders climbed to the highest level since November 2013, indicating improving global demand. Inventories, now at second lowest level since July 2015, continued to contract in March, confirming that manufacturing growth will hold up after Federal Reserve factory output data showed the strongest back-to-back advances in almost three years. Manufacturers are adding workers to assembly lines to address the highest order backlogs since 2014. Seventeen of 18 manufacturing industries reported expansion in March, led by electrical equipment and appliances.

Housing starts, another indicator of economic expansion, increased +3.0 percent in February to an annual rate of 1.29 million units, the strongest reading in four months. Residential mortgages are up +5.0% Y/Y.

On the other hand, household spending, the biggest component of GDP, posted tepid gains in March. Based on Ford Motor and Fiat Chrysler’s auto sales in March, despite heavy incentives being offered, declined -7.2% and -4.6%, respectively. GM sales grew +1.6%.

The trade weighted US dollar (broad) is up +4% Y/Y and up +3.6% against major currencies. The US dollar appreciated about +20% between mid-2014 and mid-2015. It has gone sideways since then but ramped after the US presidential election.

Tax withholding was $187.6 billion for the first 17 days of March compared to $176.1 billion one year ago (Up +6.5% Y/Y).

Jobs Data on the jobs front continues to be positive. Non-seasonally adjusted jobless claims of 228,300 are at their lowest level for the comparative period of the year since 1973 and 94,000 below the average level of 322,400, again for the comparative period, dating back to 2000.

ADP’s Private Payrolls reports 263,500 new jobs for the month of March, marking the third straight month that the US economy has created more than 240,000 private sector jobs. We have not seen this since the late 2005/early 2006. February’s blockbuster number of 298,000 was revised down to 245,000. There has been a burst of employment growth in the manufacturing sector in recent months, which corroborates other reports showing strength in manufacturing.

A record 152.528 million Americans were employed in February, 447,000 more than in January, and the labor force participation rate went up. Sixty-three percent of Americans either held a job or actively looked for one in February, the highest participation rate in ten months.

The number of Americans not in the labor force continued to drop, to 94.190 million in February, 176,000 fewer than in January and well below the record of 95.102 million set in December 2016. The participation rate dropped to a 38-year low of 62.4% on President Obama’s watch, in September 2015.

So far in 2017 (January and February), the US has gained 39,000 manufacturing jobs and 25,000 government jobs. Nonetheless, in February, government jobs in the US outnumbered manufacturing jobs by 9.942 million. That is down from is down from the 9.956 million margin that government jobs had over manufacturing jobs in December 2016, according to the BLS numbers.

From February 2016 to February 2017, the US gained 194,000 government jobs, growing from 22.130 million to 22.324 million during that time.

The number of manufacturing jobs in the United States peaked at 19.533 million in June 1979. Since then, it has declined by 7.151 million to the 12.382 million as of this February. During the same time frame—from June 1979 to February 2017—the number of government jobs grew from 16.045 million to the current 22.324 million, an increase of 6.279 million.

Households Those who track the financial burdens of US households tell us that our household sector is on financially solid ground, more so than at any time in decades. Payments required to service mortgages, consumer debt (includes student debt), auto loans, rents, homeowner’s insurance and property taxes as a percentage of disposable income are at historical low levels. This has also been the case over the past five years. Total liabilities as percent of total assets are at a 30-year low. The ratio of total financial obligations to disposable income is currently at 15% and was as high as 18% in 2001 and 2008. The mortgage and consumer debt component, which includes student loans, stands at 9%, also at an all-time low.

According to Fed data, financial obligations are substantially less now than they were prior to the past three recessions. Households’ leverage has plunged by about one-third since the 2008 recession, and leverage is now back to levels last seen three decades ago.

The party poopers will be quick to point out that top tier households skew the numbers, etc. The naysayers are not to be dismissed out of hand. As one analyses the numbers, it becomes clear that since 2008, mortgage debt, home equity loans, credit card and other debt are down -8%, -33%, -10% and -8%, respectively. On the other hand, auto and student loans are up +46% and +105%, respectively. One could argue that graduates earn more and therefore should be able to service this debt, albeit at considerable financial hardship.

In addition, we cannot fault the argument that the Fed’s expansionary (low interest rates) monetary policy, pre-2008, led to a housing bubble with exploding mortgages and home equity loans that came to a sad end. Considering the government’s Cash for Clunkers program and other such auto-related subsidies, auto manufacturer bailouts and income-based student loan repayment programs, combined with the Fed’s near-zero interest rate and quantitative-easing policies, we should not be surprised to see a housing bubble that morphed into significant financial indebtedness related to autos and student loans. Accordingly, our friends at Mises Institute argue that expansionary monetary policy can only replace bubbles with new bubbles. Malinvestments are not totally liquidated, but shifted from one sector to another.

Government’s efforts on behalf of students, like most of government’s unconstitutional actions, have had their unintended consequences, that is, apart from burdening students with a trillion dollars of debt. A recent release by the NY Fed contains data on labor outcomes for college graduates versus all other laborers. Comparing September 2008 to September 2016, the unemployment rate for college graduates has increased while the unemployment rate for all other workers has decreased. The underemployment rate (the share of graduates working in jobs that typically do not require a college degree) for recent graduates has hovered around 45% since 2008. An indexed measure of job postings indicates that demand for laborers with a college degree has not increased as much as demand for laborers that do not need a college degree, though both reached a peak late 2015. On March 29, 2017, Bloomberg reported that, “The bachelor’s degree — long a ticket to middle-class comfort — is losing its luster in the US job market. Wages for college graduates across many majors have fallen since the 2007-09 recession, according to an unpublished analysis by the Georgetown University Center on Education and the Workforce in Washington using Census Bureau figures. Young job-seekers appear to be the biggest losers.”

So, for what it is worth, in the aggregate and compared to previous periods, household obligations are relatively more manageable today – encouraging to some and cold comfort to others.

Households now have more than $20 trillion of equity holdings, representing 38.5% of their total financial assets, which includes houses and other tangible properties.

War Drums We started this commentary by stating that nothing will play a bigger role in the stock market’s performance than the promised tax cuts for corporations. We close the commentary with the statement that nothing will undermine the short- to medium-term prospects for both the market and the economy than to start another war, or wars. Washington seems to have an insatiable appetite for regime-change related conflicts.

The conventional wisdom in Washington and its mainstream lapdogs is that Assad must go. This is supposedly in our vital interests, but for those wanting more detail on any of these regime-change initiatives, the answer is always: “not gonna to tell yah, it’s classified information.” The removal of Assad and his secular government will make way for a Sunni sharia-supremacist regime, most probably in coalition with Al Qaeda. If this pleasant outcome takes a bit of time to materialize, Syrians can seek commiseration from their far-flung relations in other failed-states like Afghanistan, Iraq, Libya, Yemen and Somalia.

We hope this peaceful and most sought after transition takes place while Putin and his cabinet are on a prolonged vacation. If not, the bravado in Washington will cost us all dearly. Those who voted for the “peacenik” candidate in November, on the basis of his promises to shun war in favor of diplomacy, has seen these sentiments evaporate within the first 100 days. There is a slight chance that Putin abandons Assad and uses the vacuum created by Washington’s obsession and preoccupation with Syria to change the map in Eastern Europe to Russia’s benefit. Washington is already fighting wars on multiple fronts. Opening another more terrifying one in Eastern Europe is hardly advisable, especially if North Korea is threatening a nuclear attack on the US – another fantastical threat concocted in Washington to make us all cower in fear and approve of another full-scale war. China might use the fall of Pyongyang as an opportunity to expand its territorial ambitions, which, if it includes Taiwan, could mean only one thing: WWIII. History has a way of repeating itself. The fall of Damascus might have the same unintended consequences as the assassination on June 28, 1914, of Archduke Franz Ferdinand in Sarajevo. The missile attack on Syria (in violation of the UN charter) came exactly 100 years after the US entered WWI. As we say, history has a way of repeating itself.

A congressman, we prefer not to name, told Carlson Tucker with a straight face that ISIS could not have delivered the chemical weapons because they don’t have fixed-wing aircraft, only to frighten us to death minutes later with the stern warning that ISIS is a serious threat to America. Next time we see a swarm of fixed-wing dragon flies, it might be wise to check if they carry any missiles painted with ISIS insignia. If so, flee for your life – so says a Congressman, Sadly, his views reflect the majority opinion in Congress.

We have a feeling that waging endless wars abroad is not making America—or the rest of the world—any safer, and it’s undeniably plunging us deeper and deeper into debt. Sen. Linsey Graham, when challenged by Tucker Carlson, about the cost of effecting a regime change in Syria admitted his total ignorance. Changing the regime is Syria, and the cost in blood and treasure, will not make “America great again,” but this quaint idea is more than 100 days old and November’s election promises are long forgotten.

The government has spent $4.8 trillion on wars abroad since 9/11. According to the Watson Institute for Public Affairs at Brown University, interest payments on what we’ve already borrowed for these failed wars could total over $7.9 trillion by 2053: That’s a tax burden of more than $16,000 per American. As the Atlantic points out, we’re fighting terrorism with a credit card.

As for the despot in North Korea who keeps sticking his belligerent tongue out at trigger-happy Washington, retired Col. David Hunt predicts that a military confrontation with Kim Jong-un has a 100% chance of ending in a nuclear conflagration. Col. David Hunt served in Korea on the DMZ. He told Eric Bolling at Fox that every war game simulating a war with North Korea has ended in a nuclear conflict.

Sixteen years ago, under the “Sunshine Policy,” South Korea’s then President Kim Dae-jung opened up talks with the North, and, in spite of US opposition, his successor traveled to the North, and met with Kim Jong-Il. Thousands of South Koreans followed suit, crossing over to visit long-lost relatives. Trade increased, but the thaw didn’t last long. Nixed by the Bush administration, and the coming to power in South Korea of right-winger Lee Myung Bak, the “Sunshine Policy” turned dark and the process of North-South reconciliation came to an abrupt end.

The leading candidate of the liberal opposition in South Korea, Moon Jae-in of the Democratic Party, opposes a preemptive strike. He said he would reopen negotiations with Pyongyang. War is not an option for South Koreans.

Conclusion There is so much potential for the US to enter an era of strong economic growth, growth that will impact the rest of the world. These promising prospects will come to naught, and great economic stress and unthinkable human suffering will ensue if Washington abandons free trade, shuns diplomatic avenues to promote peace (something President Trump extolled in his State of the Union address) and gives way to the warmongers in the media and Congress. We can only hope.


Keep Emotions in Check

by Albert Meyer

The first quarter of 2017 has been the least volatile in recent memory. The S&P 500 and the Dow each saw only a single -1% daily decline, which occurred on March 21. Both the S&P 500 and the Dow gained on average +0.3% per day, which was the smallest average daily move since the mid-to late-1960s. Since the November election, the market has experienced a series of all-time highs. Invariably, the media, playing on our emotions, have rolled out the scaremongers predicting a major crash.

Granted, this lack of volatility won’t last. Donald Trump and Paul Ryan seem to have conflicting ideas about how much and where to cut taxes. Ryan, the consummate politician, knows that the tax code provides ample opportunity for pandering to special interests. “Cut the corporate tax rate to 15% and be done with it” is far too simplistic. Ryan’s border adjustment tax pits the likes of GE (in favor) against the likes of Wal-Mart (opposes). Think: campaign contributions. The spoils go to the highest bidder. So, while the tax circus is in progress, the market will get antsy. Based on past experience, a market correction cannot be too far off.

It is natural to fear temporary selloffs. However, market corrections present an excellent buying opportunity, if one can keep one’s emotions in check. Sure, the market is not currently offering us stocks at bargain basement prices. There is no way of knowing for certain whether the current exuberance may not spark a further rally as those who missed out, join the party. After all, prices are determined by buyers and sellers. An influx of buyers will propel prices higher. That said, the probability of a correction before the end of summer is perhaps more than 50%.

A recent BlackRock report observes that, “Volatility is often the catalyst for poor decisions at inopportune times. Amidst difficult financial times, emotional instincts often drive investors to take actions that make no rational sense but make perfect emotional sense.”

The report highlights the fact that long-term investors build up large unrealized gains in their portfolios, which ensures that their initial capital investment is adequately protected against market corrections. The market gives and then it takes some away, only to recover. Over the long-term, the market is a giver. Corrections outlast themselves, and then the upward trajectory continues.

In this context, Salil Mehta, a statistician and former director of analytics for the Treasury Department told MarketWatch that there was a 13% chance of a short-term bear market, or fall of at least -20% from a recent peak. He sees a more than one-in-three chance of a downturn of at least -10% or better, and a nearly three-out-of-four likelihood of a -5% drop.

It ultimately boils down to market tolerance. Those who can’t handle the occasional downdraft ought not to be in stocks. The mistake these investors regularly make is to resort to panic selling in an effort “to protect capital.” On the contrary, the worst time to panic is during a correction.

Professor Robert Shiller, Nobel Laureate and an economics professor at Yale, has always had a bearish bent. He receives most, if not all, of his publicity when he voices his market concerns. It would have been highly disadvantageous in the past for investors to have acted on these concerns by either selling out or remaining on the sidelines. Shiller is also famous for his CAPE ratio, a measure by which he assesses the intrinsic value of the S&P 500. It would not be disrespectful to say that based on the CAPE ratio at almost any point in time, the market seems to have been overvalued. Hence, the wrong conclusion would be to sell when the CAPE ratio appears too high to one’s liking. Such a decision would have caused many an investor to miss huge market rallies.

Professor Shiller, in article in the New York Times, admits, perhaps prompted by criticism, that his CAPE Ratio does not tell us “where the market is going tomorrow, but it suggests that some caution is advisable, and that returns over the next decade or so are likely to be constrained.”

Professor Shiller concludes the said article with this advice: “Long-term investors shouldn’t be alarmed and shouldn’t avoid stocks altogether. But my bottom line is that the high pricing of the market — and the public perception that the market is indeed highly priced — are the most important factors for the current market outlook. And those factors are negative.”

Clearly, buying stocks today is not as an attractive proposition as it was in February last year, but that does not mean one should liquidate today and wait for better days. It merely implies that one should be cautious. Even during periods when the market peaked, investors could have discovered stocks that had compelling value and bucked the down trend, or recovered really quickly after a market correction.

Of course, if the slowpokes in Congress surprise us all and cut the corporate tax rate to 15% any time soon, even the likes of Professor Shiller would look back at the current apparently overvalued market and admit that in retrospect it was fairly- to under-valued.