Per Stirling Capital Outlook – February 2017
Winston Churchill sarcastically said that “democracy is the worst form of government except for all those other forms that have been tried from time to time.” Right about now, there is probably about 50% of the American voting public that is prepared to take Churchill quite literally. However, it is not just that they feel disheartened that they are going to live the next portion of their lives in a political environment that they disagree with.
After all, that is nothing new. Such disappointments, for one side or the other, are an inevitable by-product of every election. However, this time there is a very important difference.
It is normal for different sides of the political aisle to disagree on the correct course of action, but to share an understanding of the most likely outcome of the policies being discussed. However, it is something quite different when, as is the case today, the collective economic expectations for each side are at polar opposites from one another, and a person’s outlook for the U.S. economy and capital markets is almost perfectly correlated to who they voted for in the November elections.
This was borne out this month by The University of Michigan Consumer Sentiment Indexes, which soared to their highest levels since March of 2004 on the backs of self-identified independent voters who appear willing to give “Trumponomics” a chance, and who posted an impressive sentiment reading of 89.2.
On the other hand, the survey included what the University’s Chief Economist, Richard Curtin, called “an unprecedented partisan divergence, with Democrats expecting recession and Republicans expecting robust growth.” It should therefore be no surprise that self-described Republicans posted a stratospheric sentiment reading of 120.1 (since 1952, the overall sentiment index has never topped 112), while self-described Democrats posted a very pessimistic reading of only 55.5 (the worst reading since the depths of the financial crisis). Put another way, Republicans are expecting to see the best economy in the post-World War II era, while Democrats expect another economic calamity.
A just-published Gallup survey reinforced these findings. Prior to the elections, 46% more Republicans were negative about the economy than were positive. However, in a complete reversal, Republican economic optimists now exceed economic pessimists by a noteworthy 27% (a 73% swing!). Over the same period, the economic confidence amongst Democrats plunged by 23%. To illustrate just how extraordinary this swing is: when President Obama was first elected, economic confidence amongst Democrats only gained by 13%, while Republican confidence declined by a surprisingly small 6%.
Even the anecdotal evidence suggests that many Democrats are so despondent that President Trump won the election, and are so distrustful of his policies, that they are simply ignoring the extraordinarily pro-business and equity-market-friendly aspects of the Trump platform, and are staying away from risk assets.
In contrast, Republicans seem so enamored by the prospects of tax reform, deregulation, profit repatriation, and fiscal stimulus that they seem oblivious to the potentially very dangerous political tactics being employed by the White House, and the risk that some elements of the Trump platform could create unwanted levels of inflation, and potentially destabilizing currency volatility.
Indeed, uncertainty abounds, as can be seen in both media news coverage and Federal Reserve commentary, and yet investors seem to simply be ignoring it. You can see this in the VIX Index, which is a measure of the price that investors are willing to pay for protective options (the price of which goes up and down in conjunction with the levels of investor fear and perceived risk)… at least normally.
However, in the current environment, investors appear remarkably fearless and complacent, as shown by the fact that this VIX “Fear Index” (gold line) is trading near historic lows, while the level of perceived global uncertainty (blue line) is soaring to one of the highest levels since the trough of the global financial crisis.
In summary, Republicans seem drunk on “animal spirits”, while Democrats seem to be virtually devoid of them. This historic divergence in expectations is manifesting itself in a number of very unique ways, and to such an extent as to even distort traditional inter-market relationships.
Indeed, one of the great ironies is that, while the election of Donald Trump was expected by many to catalyze a global markets collapse, the period since his election has featured some of the strongest equity market returns, the lowest equity market volatility, and the lowest levels of fear, in the modern history of both the domestic capital markets and the business community at large. Indeed, the broad U.S. market has now gone an unprecedented 90 plus days without experiencing as much as a single 1% down day.
While that fact may, at first glance, be considered by some as an indication that the equity markets are destined for a smooth ride higher, the lesson from history is quite the opposite. Periods of extremely low volatility are normally followed by periods of extraordinarily high volatility, and periods of extraordinarily low fear and high investor complacency have often proven to be very dangerous periods for equity investors. In other words, fearful markets tend to react much less violently to negative news, because investors are already on the lookout for (and therefore are already prepared for) a negative catalyst. In contrast, it is normally complacent markets, where everything is already priced for perfection, and where investors are not on the alert for bad news, that are almost always the most susceptible to significant declines. As was noted by famed value investor Sir John Templeton, “Bull markets are born on pessimism, grown on skepticism, mature on optimism and die on euphoria.”
For a tangible example of this phenomenon, one needs to look no further than December of 1999 (three years after Federal Reserve Chairman Alan Greenspan’s “irrational exuberance” speech), when a poll of equity investor sentiment revealed expectation for a 26% average annual return over the next ten years. Instead, a bruising bear market in domestic equities started within just a matter of weeks.
While sentiment is very ebullient, we should emphasize that valuation has historically been a very poor market timing tool, and instead serves better as a gauge of potential downside risk. Further, we really don’t see signs of overconfidence or complacency that are anywhere as extreme as they were in 1999. Indeed, if you talk to the “man on the street” or read most media stories, you start to wonder if they are only polling Republicans, or if the VIX fear numbers do not reflect the angst being experienced by the Democratic portion of our population for the simple reason that they are not using protective options to hedge their long equity positions because they have virtually no long equity positions to hedge.
If anything, the saving grace for equities may be that much of the country is so scared of President Trump’s agenda that they have largely remained on the sidelines (at least, until the last week or so, when money finally started trickling into equity mutual funds from smaller, individual investors). However, it is far too early to even consider that an emerging trend, and we know from history that bull markets rarely end until there is very broad public participation in equities, and an air of investor hubris, overconfidence end even invincibility… and, in theory, that must also include the Democrats. Until that time, their sideline cash should remain as a potential support under equity market prices.
That is not to suggest that the equity markets are not vastly overdue for a decline that is sufficiently large to restore some level of investor fear. At the same time, we just do not see any evidence that the conditions exist to bring about an end to the longer-term uptrend in equity market prices. In particular, we perceive virtually none of those hubristic elements in the Democratic half of the population.
Despite our continued longer-term optimism, the domestic equity markets are confronting not only complacency and over-confidence, but also the prospect of higher interest rates (as soon as March) and historically high equity valuations. Forward-looking price-to-earnings multiples are now 18 times, whereas they were 15.5 times a year ago. Further, according to the latest Investors’ Intelligence Survey, bullish sentiment is approaching a 13-year high.
Further, Market Vane bullish sentiment is now 66%, as opposed to 47% a year ago and, according to Barron’s Magazine, 76% of the world’s stock markets are now overvalued, whereas 89% of markets were undervalued a year ago.
Despite the Barron’s comment, much of that change in global valuations (the global price-to-earnings multiple is currently 22.1 times versus 19.3 times two years ago), is attributable to the U.S. markets. Indeed, the U.S. equity markets now trade at 2.8 times their book value, whereas the rest of the world trades at a book value of 1.7 times. Further, while the domestic equity markets are hitting all-time highs, the rest of the world is still 25% below their all-time highs reached in 2007 and 11% below the most recent highs set in 2015.
However, even the lofty valuations of the domestic equity markets should look much more reasonable if President Trump can get his corporate tax cuts through Congress, because that alone is expected to boost domestic earnings by as much as 20%, and ratios would be brought further back in line as profits are boosted by the slow unwinding of many of the onerous regulations that were imposed in the days since the start of the financial crisis.
From our perspective, the bottom line is that the domestic equity markets have already priced in tax reform and regulatory reform, and that they will likely sell off if it looks like those expectations for tax reform in particular will not be met. At present, the prospects for tax reform are relying on the passage of a poorly understood and critically important new type of tax called a border adjustment tax.
Whereas the current system taxes revenue based upon where the goods and services of that company are produced, a border adjustment tax is based upon where a company’s products and services are ultimately consumed, with domestic consumption being taxed and exports remaining untaxed.
As such, the winners under the new system would likely be companies that are very export-oriented (and particularly those that manufacture in the U.S.). The losers would likely be companies that cater to a primarily domestic consumer, and that would include primarily smaller and mid-sized companies.
Such a tax looks appealing at first glance, as it favors domestic production and foreign consumption, thus increasing America’s wealth and promoting American industry. It should also raise revenues to help pay for tax cuts. However, it would be financed on the back of the American consumer, as retailers would simply pass through the cost of the consumption tax. This proposed tax system is also being promoted as a means of leveling the playing field for U.S. exporters against unfair foreign competition. While that may sound good, it is a bit misguided. In fact, a recent report from Goldman Sachs states that only 2.5% of all job losses over the past decade were attributable to globalization. On the negative side, such a tax would also be quite experimental and have consequences that would be very hard to predict.
To start with, the currency markets should, in theory, very quickly offset the trade flow benefits of such a tax. Put another way, the dollar should appreciate in value by the amount of the tax, so that the post-tax price of a good to American consumers would be the same after the tax as it was before the tax was implemented. As such, if such a tax were implemented, then the American dollar could soar by as much as 20% or so, which would be very destabilizing to the global financial system. Alternatively, the dollar could adjust higher by less than the amount of the tax, in which case the tax would start importing potentially unhealthy levels of inflation into the economy.
At present, this revenue-raiser is not expected to pass the Senate, but it bears close watching from an equity allocation perspective, as its passage would likely benefit big multi-national companies while penalizing mid-sized and smaller companies.
The passage of such a tax structure would thus challenge our existing premise that the Trump agenda should favor small and mid-sized companies over their larger brethren, because they serve a primarily domestic consumer and would thus be less susceptible to Trump’s protectionism and threats of trade conflicts. However, any introduction of a “border adjustment tax” would likely shift investor preferences towards multinationals. In the meantime, it will pay to keep one eye on Wall Street and one eye on Washington.Alan Greenspanborder adjustment taxbullishcomplacencycorporate taxcurrency marketsDemocraticdomestic consumptiondomestic equity marketsglobal uncertaintyglobalizationinflationObamaoptimismoverconfidenceovervaluedpessimismregulationsregulatory reformRepublicantaxtax reformtradeTrumpTrumponomicsundervaluedVIX