Dragon “Restructuring”, More Elephant Dreams, A Setting Sun, The Music Picks Up Pace, The Bear Facts, The Old Man Striding Strong, and The Quickening Climb

“There are two feedback loops from the increases in real estate prices and stock prices to the rate of growth of national income. One link is from the increases in household wealth to the increases in household spending. Households have savings or wealth objectives; as their wealth increases from the surge in asset prices, households save less from earned income and their consumption spending increases. The second link is from the increase in stock prices to investment spending. When stock prices increase, firms can raise cash from existing and new investors at lower costs and can undertake new projects that would be less profitable. Thus, the ‘cost of capital’ to a firm varies inversely with the level of stock prices: the higher the stock prices relative to the earnings of these firms, the lower the cost of capital. The lower the cost of capital to firms, the larger their investments in plant and equipment, since higher stock prices mean that the firms can earn a lower rate of return and still be very profitable.”

Manias, Panics, and Crashes: A History of Financial Crises
Chapter 6: Euphoria and Economic Booms
By Charles P. Kindelberger and Robert Aliber, 1978

 

“In rich and powerful countries, where large capitals are invested in machinery, more distress will be experienced from a revulsion in trade, than in poorer countries where there is proportionately a much smaller amount of fixed, and a much larger amount of circulating capital, and where consequently more work is done by the labour of men. It is not so difficult to withdraw a circulating as a fixed capital, from any employment in which it may be engaged. It is often impossible to divert the machinery which may have been erected for one manufacture, to the purposes of another; but the clothing, the food, and the lodging of the labourer in one employment may be devoted to the support of the labourer in another; or the same labourer may receive the same food, clothing and lodging, whilst his employment is changed. This, however, is an evil to which a rich nation must submit; and it would not be more reasonable to complain of it, than it would be in a rich merchant to lament that his ship was exposed to the dangers of the sea, whilst his poor neighbour’s cottage was safe from all such hazard.”

On The Principles of Political Economy and Taxation
Chapter 19: On Sudden Changes in the Channels of Trade
David Ricardo, 1821

The Global Economy continues its cyclical upturn. Global Final Demand has accelerated driving corporate profits and, in response, global capital spending has accelerated. Thus, all portions of the system are working together to drive Global Growth to its best levels since the initial recovery from the Global Recession. This is reflected in the strong growth reported around the world, from Hungary to Malaysia to Korea to Sweden. Global Growth should continue on a strong path, until such time as Central Banks become serious about tightening measures that would slow the Global Economy.

The early stages of the inevitable restructuring of the global economic system have begun. China has started to ride herd on its massive overcapacity. This overcapacity has stressed industries around the world, as China sought global export market share over the past 17 years and used foreign markets as dumping grounds for the goods it could not consume at home, due to the massive overbuilding of industrial capacity to maintain its economic growth rate. As countries have begun to tariff or threaten to tariff select products over the past year, in industries such as aluminum and steel, China magically reined in its overcapacity in those industries, pushing domestic pricing to levels that no longer would justify exports. Thus, it assuaged its trading partners by taking actions to close factories it could blame, to the domestic populace, on foreign countries and, using its environmental laws, force the closure of the worst polluting plants allowing it to begin to address its massive environmental issues.

However, as the bible says, “The Lord has given and The Lord has taken way.” (Job 21:1) While China is reining in its overcapacity in many of its low value, commodity related industries, the country is building massive capacity across numerous high value or high technology manufacturing areas. These are part of China’s 13^th Five Year Plan which lays out explicit goals to continue to insource all value added products at the expense of foreign manufacturers to meet its Made in China 2025 goals and to dominate the industries of the future on a global basis. Several examples will make clear the actions the government plans to take under this plan. First, as part of this thrust, the Chinese government is spending $150 billion to build semiconductor plants and the associated supply chain in China. This way it can avoid buying chips and components from outside the country. Second, over the past year, the government contracted with Huawei and ZTE to develop and sell 5G Telephony modules and systems that it plans to roll out across the country over the next few years to have some of the first operational 5G systems in the world, with commercial launch in 2020. The country expects to spend $180 billion in capex from 2019 to 2025 to initially deploy this 5G system. It then plans to export these systems, with government subsidies, to the remainder of the globe, displacing American, Japanese, and European products in Asia, Eastern Europe, the Middle East, South America, and Africa. In addition to benefitting Chinese telecom equipment providers, the government expects the domestic rollout to undergird indigenous producers of the following products: fiber optic cable, 25 Gbps and higher optical modules, and optical access components such as DWDM/WDM, lasers, and filter components. Third, COMAC, the giant Chinese government controlled aerospace company, just flew its C919 on its third test flight. The company already has over 700 orders for its unproven plane from Chinese airlines as part of the government plan to displace Boeing and Airbus products with indigenous Chinese built planes as they become available. Fourth, with healthcare expected to grow at 14% per annum over the next decade, China formed national champions to manufacture its own medical equipment, displacing US and European companies. The government has specific goals for the national champions to control 80% – 90% of all low end medical equipment markets and over 50% of all value add in high end medical equipment by 2020. It is ensuring this orderly market share change by instructing the hospitals to purchase their equipment from the new Chinese companies instead of foreign entities. Fifth, in robotics, China plans for annual installations to reach 150,000 units per year by 2020 with local companies increasing their market share from 31% in 2015 to 50%+ by 2020. In addition to claiming local market share, China is planning to create extra capacity to export low end robots around the world. These various industry plans are in addition to the large markets already largely closed to foreigners such as low, medium, and high voltage transmission equipment, power generation boilers, railway equipment, forklifts, shipbuilding, and LEDs, or markets requiring local manufacturing in conjunction with a Chinese partner, such as electric vehicles. While China is technically “restructuring” a small part of the industrial economy, this Dragon “Restructuring” looks more and more like window dressing to hide its mercantilist actions across broad swathes of its economy and its overt goals of displacing foreign companies with domestic producers.

Across the Himalayas, India continues to wrestle with the fallout from its monetary changeover and its imposition of a Global Sales Tax (GST), similar to the VAT in Europe, across its economy. For the Indian government, these moves underpin its resolve to collect taxes from the large portion of its economy based on cash. This is reflected in the 45% growth in the number of taxpayers on the rolls over the past year. Unfortunately, these new taxpayers represent less than 0.1% of GDP, being mostly subsistence farmers and those at the lowest echelons of Indian society. The risk the government faces is that these taxpayers turn to alternative means of payment than the Indian currency, such as gold, which has a long historical role in India, and the US Dollar or other foreign currencies, which are accepted around the globe. This would be similar to what has occurred in other developing economies whereby the populace did not trust the government. They merely substituted an outside currency for the local one, limiting their use of the national paper. In addition to the dubious benefits of forcing this portion of the populace onto the tax rolls, the demonetization removed about 20% of the currency in circulation. The history of massive contractions in money is not one with happy results. Typically, it ends up causing significant economic stress. This one-two combination of blows knocked the Indian economy to the mat for a Standing 8 Count over the past year. While the economy has begun to recover, the new taxes and goal to eliminate the cash economy will likely act as a significant retardant in enabling the economy to return to its former level of economic growth in the near term. For a government determined to eliminate the underground economy, this likely represents More Elephant Dreams than the cool rationality of viewing the economy in the light of day. In some admission of this reality, the Indian government moved to recapitalize the banks, providing funding equivalent to 1.3% of GDP into the banking system. With the proper lag, this should act as a large stimulus program for the Indian economy, beginning to offset the negatives from the government’s actions over the past two years.

Japan, over the past month, resoundingly reelected Prime Minister Abe to another term. Under his leadership the focus has been pushing Japan’s exports around the globe, increasing government spending, and moving the country to defend itself against the rising threat from China. Reflective of these goals, the Current Account Surplus recently reached 5% of GDP in August and manufacturing profit margins achieved record levels. With profits so strong, the unemployment rate has fallen to 2.4%, the lowest since 1994, and the job-offers-to-applicants ratio stands at 1.51, the highest since February 1974. There should be little wonder, given these economic statistics, that Abe blew his opposition away. However, as with China, this economic strength stands on the shoulders of other countries. Japanese exports rose at a 7.8% rate in Q3 with the rate at 9.8% to Asia ex-China and 17.3% to the US. China limited Japan’s export aspirations to a measly 3.6% growth rate and the European Union (EU) shrank its imports from Japan at a 10.4% rate. Given China’s and Germany’s export oriented economies, coupled with the direct competition between the leading manufacturing companies in Germany and Japan, the skewed nature of Japan’s export growth should come as no surprise. While the export growth to Asia ex-China reflects machinery orders for Asia’s industrial base, the exports to the US reflect final consumer goods or portions of final goods, such as automobiles and auto parts.

While Trump and Abe may have shaken hands and posed for the camera, the Trump Administration is targeting the Balance of Trade deficit in goods that the US possesses with Japan, which will near a record $75 billion in 2017 and represents 30% of Japan’s current account surplus. (Japan’s economy will reach $4.9 trillion in 2017.) Should the US take action, as it did in the 1980s, to address this deficit, it would have serious repercussions for the Japanese economy. And given the closed nature of Japan’s markets, which make it difficult for foreign goods to compete, this would make an easy target. Additionally, with China moving to manufacture its own high value goods, including the machinery and robots for its factories, Japan’s exports to China will come under increasing pressure. Lastly, with the new manufacturing technologies that are coming to the fore, such as integrated industrial automation/ robotics and Additive (3D) Manufacturing, total cost considerations, that include logistics, would dictate moving manufacturing close to the source of demand as labor costs become a rounding error. In this type of environment, the economic policies that have benefitted Japan over the past five years likely will come under increasing pressure due to outside actions by other nations. Given this, we see A Setting Sun on what has been a very, very sunny day.

For the rest of EM Asia, growth has been strong, a product of accelerating global growth and becoming the locus of global manufacturing over the past 20 years. The strong industrial production growth, in turn, has led to accelerating investment and consumption, as reflected in Global Goods Demand. Indonesia, Malaysia, The Philippines, Vietnam, and Thailand are all expected to grow 5% to 7.5% this year. At the same time, these economies are seeing their FX Reserves grow as they accumulate US Dollars to prevent their currencies from appreciating and undermining their global competitive position. FX Reserves are now in excess of $2 trillion for the EM economies. These economies face the same dilemma that Japan does. Global rebalancing, led by the US, will likely make this state of affairs unsustainable. As it does, these economies will be forced to accept lower growth and to grow their consumption to absorb their goods production. It is unlikely that this will occur smoothly and without bumps along the way.

For Brazil, life if getting better. After a horrendous recession, that makes the 2008 – 2009 recession in the US look tame, underlying growth is accelerating. This is supported by an accommodating Central Bank that has cut interest rates from over 14% to less than 8% over the past year. Interest rates are expected to continue to drop to 6.5% or less over the next few months. With this massive dose of stimulus coupled with a depreciation of its currency by 50% over the last 4 years, the Brazilian economy is beginning to show real signs of life. Unemployment, which peaked at over 13% is almost down to 12% over the past few months. The Current Account deficit has collapsed at the same time as Foreign Direct Investment (FDI) remains strong at over 4% of GDP. Retail sales are accelerating and Industrial Production grew 4% year-over-year in August. In addition, with oil prices recovering, the country is benefitting from improving fundamentals in its important energy sector. With the economy entering a sustainable self-reinforcing economic recovery, the average Brazilian is hearing The Music move from a feint sound to a strong melody as it Picks Up Pace.

On the other side of the world, oil prices are helping another economy, Russia. While Russia is already benefitting from the turn in Western Europe and the knock-on effects from Central European growth, the turn in oil prices should accelerate an already strong recovery. Economic growth reached 2.5% in Q2 despite the drag from exploding imports as domestic consumption reaccelerated and capital investment rose more than 6% year-over-year. If it were not for the explosive growth in imports, economic growth would have reached almost 6% in Q2. With the Central Bank of Russia continuing to cut rates, an already self-reinforcing dynamic should get even better. And with oil prices recovering, tax revenues should grow strongly, enabling the government to increase spending, further aiding the growth impetus. With all The Bear Facts moving in Russia’s favor, the economy should see accelerating growth over the next few quarters, pushing its growth rate well above 3% year-over-year.

A little further West, Central and Western Europe are enjoying the fruits of the European Central Bank’s (ECB) continued QE (Quantitative Easing). Unlike the US Federal Reserve, the ECB plans to continue QE through most of next year. This should provide a floor under European growth, enabling the positive economic dynamic to continue for some time. For Central Europe, growth is strong as their undervalued currencies coupled with the EU’s economic aid programs push their economies along. The Czech Republic, Hungary, and Poland are each expected to grow 4% this year with Romania notching almost 6% growth. For these countries, this has led to accelerating levels of inflation. For example, the Czech Republic’s inflation rate reached 2.8% in September. Poland’s Consumer Prices rose 2.2%. Hungary’s CPI hit 2.5%. Despite this strong growth, increasing wage growth, and accelerating inflation, the Central Banks have held off raising rates. This is due to the fear their currencies will appreciate against the Euro, as the ECB continues its policy of QE. Already, with just talk of tightening, the Czech koruna has appreciated given the positive Balance of Trade. As a result, even though the Czech Central Bank plans to hike rates in 2018, it will have an eye focused on the currency as much as inflation.

For Western Europe, it is as good as it gets. Growth reached 2.5% year-over-year in Q3 and has accelerated in the Southern portions of the Continent. Industrial Production is growing anywhere from 4% to 7.5% depending on the country, underpinning real fundamental growth. Even Italy has seen IP growth accelerate to over 5%.  And reflective of this strength, European Car Registrations are at their strongest levels since 2009. Furthermore, despite the rise in the Euro, the EU Balance of Trade has only declined slightly. Within the EU, there have been some differing results on trade as the German trade surplus continues to grow. While not causing any intra-European strife yet, it could lead to some unpleasantness if Germany does not encourage consumption of its neighbors’ goods. As in Central Europe, wages have begun to grow in Western Europe and will likely grow at a faster rate in 2018. Germany is the focus of this as the IG Metall union requested a 6% wage increase and improvements in work rules. While the union is not likely to receive such a large increase, it likely will receive at least a 3% – 4% rise, setting the standard for wage negotiations in Germany and elsewhere. As in Central Europe, despite obvious signs of declining unemployment and accelerating inflation, the ECB has chosen to go slow in terms of raising interest rates. Given the slack in a number of Southern European countries, it wants to ensure political cover prior to raising interest rates. With these actions ensuring strong economic momentum headed into 2018, the Old Man is Striding Strong.

The United States stands juxtaposed to Europe in many ways. Unemployment has fallen to levels typical of cycle lows. Manufacturing is growing at a strong rate, as evidenced by the Purchasing Managers Index remaining near 60 and the New Orders component standing well in excess of 60. Equipment spending is rising as well as investments in research and development. Commercial Construction stands at new highs, with areas such as Multi-Family Construction at record levels. Home prices have recovered and stand at new records in many cities. New Home Construction is now mid-cycle, having moved up strongly from the multi-decade lows recorded in 2011. And raw material, chemical, and energy industries have bounced back from the commodity collapse of 2014 and 2015. The only areas that remain below trend are manufacturing investment, which has yet to recover this cycle, and Public Construction. With a tax bill pending in Congress that would lower corporate tax rates to competitive levels with the rest of the world, corporate spending on plant should pick up. However, for Public Construction, it is a A Tale of Two Cities, with federal and state actions standing in contrast. As the chart below demonstrates, overall Public Construction remains at very low levels relative to the economy:

 

In fact, it stands 14% below its peak in 2009 in nominal terms and over 30% below its peak in real terms. At the Federal level, there is no solution in sight, as Republicans have chosen not to increase public spending. However, at the state and local level, where voters have more direct impact, spending is beginning to ramp after its normal post-election year slump. (For some reason, local and state governments rush to spend money in Presidential election years and make up for it by lower spending the year after.) This is due to the voluminous number of bonds approved by the public and the normal 6 – 12 month minimum lag before the actual construction can begin. There are just now signs that actual spending is picking up. This should accelerate into 2018, which just happens to be another election year. And adding to all this growth impetus is a massive tax cut by the Federal government. This tax cut should add further stimulus to the economy, as the Federal deficit as a percent of GDP increases and the US Government adds to GDP growth significantly. We note, that the largest portions of the tax cut are targeted to 2019 and 2020 in the runup to the next Presidential election.

The only fly in the ointment is the Federal Reserve. The Fed has indicated that it will raise interest rates in December and at a more rapid pace in 2018. This is consistent with past history connected with the ascension of a new Chairperson at the Federal Reserve. Usually, the Fed sets up the new Chairperson, in this case Jerome Powell, to raise rates to prove their inflation fighting credentials. And given the leading indicators of inflation are flashing a bright yellow and turning to red, the new Chairman will possess plenty of data against which he can act. The most obvious is the accelerating wage data coupled with the rise in commodity prices. And, of the commodities that count the most, the large increase in oil prices should carry the most weight, as it will flow through all aspects of the economy. Furthermore, should China truly control the excess capacity in its economy beyond the few industries it has targeted, tightening up capacity around the world in numerous areas, a broad based inflationary environment could ensue as pricing power would be restored across the global economic supply chain. But even without this, Chairman Powell will have plenty of ammunition against which to prove his credentials. The risk, of course, is that he and the FOMC become too enthusiastic and choke off the economy. However, that is a late 2018 or, more likely, a 2019 issue as the lag between interest rate increases and their economic impact is anywhere from 6 – 12 months. Assuming the Fed does not choke things off, the US economy should see growth continue to accelerate and make The Quickening Climb. (Data from Bureau of Economic Analysis, Federal Reserve, public company reports, and public sources coupled with Green Drake Advisors analysis.)

What Is Good For GM Is Not Good For America: The Carrot and The Stick

“For years I thought that what was good for our country was good for General Motors, and vice versa. The difference did not exist. Our company is too big. It goes with the welfare of the country. Our contribution to the nation is considerable.”

Confirmation Hearings for Secretary of Defense

Senate Armed Services Committee

Alfred Sloan, Testimony

Former CEO of General Motors, 1952

 

For the past 25 years, since the implementation of NAFTA, US companies have followed a policy of moving domestic production overseas and sourcing component parts from other countries. This move to foreign markets accelerated with the entry of China into the WTO, as companies moved to position themselves in the Asian markets. In addition, with the domestic manufacturing requirements imposed by the Chinese government, large multi-nationals had little choice but to open plants overseas to gain access to China and its population. With operations established in markets with little environmental regulation and low levels of government regulation, it then made sense to manufacture components in these markets and ship them back to the US. This lowered costs and improved margins significantly. Thus, a positive cycle for corporate profits and executive compensation ensued over the next 25 years.   This cycle was further boosted as companies took advantage of lower tax countries in Europe to relocate their corporate operations and headquarters to tax-advantaged locations, further increasing the companies’ after-tax margins.

While this was good for corporate profits and executive stock options, it was not good for the United States. It led to whole industries closing capacity domestically and relocating overseas as well as the hollowing out of many industries. Additionally, with the entry of China into the WTO and the granting of permanent Most Favored Nation status, US Capital Formation collapsed once the unsustainable investment into Housing in 2005 – 2007 ended, as the following chart demonstrates:

Chart Courtesy of Federal Reserve Bank of St. Louis.

And, as Capital Formation is critical to Productivity Growth, its collapse predictably led to declining levels of Productivity in the economy and a decline in the US Economic Growth Potential. The following chart shows the 5 Year Average Productivity Growth for the economy:

As a result, for the US economy and for the average American, the move to NAFTA and the WTO has been a failure as economic growth fell to only 2% per annum from 2009 – 2016, capital formation collapsed, and living standards stagnated for 20 years.

With Americans fed up with this set-up of soaring corporate profits, but no benefits for the average American, they elected Donald Trump and a Republican Congress. In order to encourage investment in the US, the Republican Congress is in the process of drafting tax legislation that would lower corporate tax rates to be competitive with other jurisdictions around the world and create a territorial tax system. In addition, it would provide a window for corporations to repatriate monies held overseas at a very low tax rate. Large corporations have accumulated several trillion dollars in cash overseas, as bringing it back to the US would cost them a large amount in taxes. The idea behind the Congressional tax cuts and repatriation holiday is that corporations could now repatriate the monies and invest in building new plants in the US. It is highly likely some form of the legislation will pass sometime by the middle of 2018. This theoretically should lead to higher investment in the US. And this higher investment in the US should lead to higher productivity growth and, hence, long term growth. In effect it would restart the following virtuous circle:

And due to manufacturing’s large role in Research & Development (R&D), it would lead to the following virtuous circle also accelerating:

Unfortunately, the reality is likely to be quite different than the theory. The last time that the US provided a repatriation window was in 2004. Corporations were allowed to bring back cash at just a 5% corporate tax rate if they agreed to invest the money in plant and equipment in the United States. So, theoretically, the above series of events being used to justify the tax legislation should have applied then as well. What occurred was the exact opposite when looking at the actions of the Top 15 firms that repatriated money. Not only were the funds not used to build plants in the US, these large corporations closed plants in the US and cut US manufacturing jobs. In addition, they used the funds to buy back stock and increase executive compensation, two areas explicitly banned under the law.

While Congress has offered corporations the carrot in the proposed tax legislation, should companies act as in 2004 in the 2019 – 2020 time frame, it is likely the stick would come out next. This stick would likely appear with the 2020 Presidential election or 2022 Congressional election. It would mean a wholesale repudiation of a system that has benefitted large corporations and a very small portion of the population over the past 25 years. The following chart shows the income distribution of economic growth in 1980 compared to 2014:

This repudiation would likely look to accomplish the following. First, it would redistribute the fruits of economic growth in the economy away from the top 1% of the population to the rest of the population, where real income stands significantly below long term trend. It would, in essence, redistribute GDP over time. Second, it would require substantial levels of domestic content in all manufactured goods, moving the country towards policies followed by countries such as Japan, China, and Germany today. Third, it would move the country back to bilateral trade agreements similar to those that existed under the GATT and eliminate extraterritorial bodies’ ability to overrule the US government. Fourth, it would revive the use of traditional tariffs to protect the US from foreign targeting of high value and other key industries.

This would utilize existing laws such as the Trade Expansion Act of 1962 or the Trade Act of 1974. Fifth, it would force the redomestication of significant capacity in technology and traditional manufacturing for national security and defense purposes. This would merely return the country to its position held until the end of the Cold War under Ronald Reagan in the late 1980s. And Sixth, it would impose significant limitations on the export of manufacturing capabilities in key high tech industries. For example, the export of advanced 3D/Additive Manufacturing technology would be prohibited. There would likely be other policies that went along with this specifically related to the actions of public corporations, such as limiting stock repurchases, forcing boards to consider a wide a variety of criteria including top line growth and investment in executive compensation, … All of these policy actions could occur without legislation as the laws necessary for action by the Executive branch of the government are already on the books through Congressional actions over the past 75 years. They just have not been used or enforced since the mid-1990s.

Given the populist backdrop in the country, we see corporations at a crossroads. They can either take the monies and reinvest them into the US leaving behind the policies that would fall under the rubric What Is Good for GM Is Not Good For America. Or they can see the imposition of The Carrot and the Stick as the populace elects a very different looking Congress that more resembles that from the 1950s through the 1970s. While Congress is currently offering corporations the Carrot, should they not take it, the country likely will go down the road of imposing the Stick and all that goes with it. (Data from the Federal Reserve, MKM Partners, Bureau of Economic Analysis, Census Bureau, and corporate reports coupled with Green Drake Advisors analysis.)

The Markets: Partying Like Its 1999
“Lemme tel ya somethin’
If U didn’t come 2 party
Don’t bother knockin’ on my door
I got a lion in my pocket,
And baby he’s ready 2 roar
Yeah, everybody’s got a bomb,
We could all die one day
But before I’ll let that happen,
I’ll dance my life away
Oh, they say two thousand zero zero party over,
Oops out of time
We’re runnin’ outta time (Tonight I’m gonna)
So tonight we gonna (party like it’s 1999)
We gonna, oww.”

1999
By Prince Rogers Nelson
Album with Song Released in 1982 (Warner Bros. Records)

 

“The notion that the desirability of a common stock was entirely independent of its price seems incredibly absurd. Yet the new-era theory led directly to this thesis. If a public utility stock was selling at 35 times its maximum recorded earnings, instead of 10 times its average earnings, which was the preboom standard, the conclusion to be drawn was not that the stock was now too high but merely that the standard of value had been raised. Instead of judging the market price by established standards of value, the new era based its standards of value upon the market price. Hence all upper limits disappeared, not only upon the price at which a stock could sell, but even upon the price at which it would deserve to sell.   This fantastic reasoning led to the purchase for investment at $100 per share of common stocks earning $2.50 per share. The identical reasoning would support the purchase of these same shares at $200, at $1,000, or at any conceivable price.

An alluring corollary of this principle was that making money in the stock market was now the easiest thing in the world. It was only necessary to buy ‘good’ stocks, regardless of price, and then to let nature take her upward course. The results of such a doctrine could not fail to be tragic. Countless people asked themselves, ‘Why work for a living when a fortune can be made in Wall Street without working?’ The ensuing migration from business into the financial district resembled the famous gold rush to the Klondike, with the not unimportant difference that there really was gold in the Klondike.”

Security Analysis
Chapter XXVII: The Theory of Common Stock Investment
By Benjamin Graham and David Dodd, 1934

For the stock market, it has been a great run since Donald Trump was elected President. The S&P 500 has risen from just below 2100 to almost 2600 or over 23%. This return, when added to the prior four years, mean investors have earned a 5 Year 15%+ compound rate of return including dividends, bringing the 10 Year compound rate of return including dividends back to 9%, the long term average for the equity markets. This is truly a spectacular return considering that the market returned somewhere around 0% from 2007 to early 2013, merely recovering from the depths of the bear market. In fact, given the above average recent run, investors have turned optimistic, with 52% of investors expecting returns of more than 10% per year over the next five years, 32% expecting returns of 15% or more, and 20% expecting returns of 20% or more according to Schroders Global Investor Survey for a balanced portfolio of stocks and bonds.

While investors are feeling pretty good about themselves, given the market’s recent performance, there are a number of worrisome signs that are flashing yellow to red on a long term basis. In addition, it is quite clear that the massive Quantitative Easing, that Central Banks around the globe have followed for the past eight years, has led to significant distortions in the bond and real asset markets. These actions, combined, are producing an environment similar to that of the late 1990s, with many valuation measures returning to levels last seen then. For example, the Shiller CAPE has risen to new highs, taking it close to the peaks of 1929 and moving it towards the levels last seen in 1999 -2000:

In addition, the overall equity markets, as represented by the Wilshire 5000, are approaching the same peaks of overall valuation relative to GDP as occurred in 2000:

At the same time as valuation is running at historically high levels, corporations have piled significant debt onto their balance sheets to buy back large amounts of stock:

Unfortunately, whenever a downturn comes, unlike in the 1990s, they have not put in place additional productive assets that produce cash flow to service the debt. And with margins likely to take their typical pullback in a downturn, debt ratios for many companies will move from adequate to tight.

Other statistics paint a disquieting portrait of the market producing eerie parallels with the 1999 – 2000 period. One is Z Scores. This is a statistical measure that shows how far a measurement is from the mean. The following chart shows the Z Score for the S&P 500:

As the chart demonstrates, there was a significant opportunity at the bottom in 2009 similar to that in 1990. As the chart also makes clear, the S&P 500 has moved to a similar level above its mean as in 1999 – 2000. Other statistics are of similar ilk. Technology represents over 20% of the S&P 500, its highest weighting since the late 1990s. And the weightings for the Top Stocks are similarly skewed as they were back then:

 

With investors continuing to index, having added over $237 billion to Index Funds and ETFs in the first nine months and pulled $105 billion from actively managed funds, investors may not understand that they are buying a High P/E (price to earnings ratio) technology fund in purchasing the S&P 500 Index with almost 21% of the index in Technology and numerous companies in the Industrial arena trading at very high multiples of earnings. Amazon trades at over 100x its estimated earnings for 2018 based on its computation of earnings and, on a GAAP Earnings Basis, which takes into account costs that managements like to ignore such as stock options, the P/E for Amazon is over 140x. Nvidia, the artificial intelligence chip leader, is trading at 45x. Tesla will not have any earnings until 2020, but at an equity market capitalization of $54 billion, trades at the same value as GM or Honda.

The other way for investors to think about the public markets is to examine the overall valuations in the markets compared to the long term averages. Given the massive indexing occurring, this would help them to understand their downside over the medium turn or limits to their upside over the long term. The following table provides some estimates of today’s valuation compared to the long term averages for the S&P 500 using actual reported numbers and not the operating earnings Wall Street analysts like to use. Statistically, it can be shown that the market correlates to the actual earnings over the long term not the operating earnings:

While anything can happen in the short term, as the Z Scores demonstrate above, markets are mean reverting. So, over the next decade, investors can expect some form of mean reversion.

Furthermore, economic growth and inflation tend to be positively correlated. Thus, if the economy were to accelerate, which would be needed to raise real wages and to grow corporate profits at the same time over the next decade, given the starting point for corporate margins today, interest rates would move higher. Should inflation move back to its long term average of 3.2%, then long term interest rates would likely reach the 5% to 6% level. This compares to less than 2.4% on the 10 Year Treasury today and just 2.85% on the 30 Year Treasury. At those higher levels, it is hard to believe that P/Es would remain in the 20’s. It is likely they would gravitate back to the mid-point of their long term range of 14.5x – 15.5x earnings. A simple calculation demonstrates what this would mean for investors long term return:

As the table above demonstrates, a return to Normalized P/E’s would seriously impact long term returns. Assuming investors collected 2% in dividends along the way, the next decade could see returns of just 6% compound, assuming they had a tax free account and actually owned the indices. If they were taxable, returns would be lower. However, the big issue would really be inflation. In a 3.2% or higher inflation world, the long term average since 1912, investors real return would fall to under 3% compared to the 7% real return over the past decade and the 13% real return over the past 5 years.

While the long term numbers are quite clear, just as they were in 1998 and 1999, the party did not end until March, 2000 for the NASDAQ and September, 2000 for the S&P 500. With Congress forging ahead with its tax plan, there likely is one more major piece of good news ahead. But with valuations close to historic highs that have marked peaks in the past, it is clear the music will likely end sometime over the next two years. In the meantime, just like the Prince song, the market will be Partying Like Its 1999. (Data from S&P, McAlinden Research, Robert Shiller at Yale University, Federal Reserve and MKM Partners coupled with Green Drake Advisors analysis.)

The Open Road, Those Awesome Clouds, Cutting Edge, and Shop Till You Drop

Finally, we close with brief comments on The Open Road, Those Awesome Clouds, Cutting Edge, and Shop Till You Drop. First, consumers have returned to the RV market. According to the Recreational Vehicle Industry Association, RV shipments from manufacturers to dealers rose over 29% year-over-year in September. This continues a string of accelerating sales of RVs this year that show Americans are returning to The Open Road. Second, growth of the Cloud continues apace. In 2017, the Cloud should account for 54% of all data center workloads, exceeding 50% for the first time. Growth is expected to continue with the combined public and private Cloud capturing over 90% of all workloads by 2021. For the IT Industry, it is Those Awesome Clouds. Third, new 10 kW fiber optic lasers are coming out in 2018 for cutting metal. These lasers are 5x as powerful and faster than the existing 6 kW CO2 lasers and more economic than stamping or water cutting. With the continued growth in robotics and automation, these new lasers will grow rapidly exhibiting their Cutting Edge nature. And Fourth, women continue to like their dress shoes. According to Shoe Carnival, despite 3 hurricanes in Texas and the closure of their Puerto Rico stores due to Hurricane Maria, Q3 comparable store sales rose 4.4% and the underlying cadence was ~7% adjusted for these natural disasters, with women’s dress shoes especially strong. This strength has continued into September and October. With women buying shoes again, we see Americans embracing, once more, that old 1980’s Shop Till You Drop attitude.

In Closing

Should you have any questions on how the above issues or the items discussed in our accompanying cover letter impact your family’s financial position or your business’s future as well as the potential actions you could take in response, please do not hesitate to contact us. We welcome the opportunity to discuss this with you.

Yours Truly,

Paul L. Sloate

Chief Executive Officer & Senior Advisor

 

Confidential – Do not copy or distribute. The information herein is being provided in confidence and may not be reproduced or further disseminated without Green Drake Advisors, LLC’s express written permission. This document is for informational purposes only and does not constitute an offer to sell or solicitation of an offer to buy securities or investment services. The information presented above is presented in summary form and is therefore subject to numerous qualifications and further explanation. More complete information regarding the investment products and services described herein may be found in the fund’s confidential private placement memorandum, the firm’s Form ADV, or by contacting Green Drake Advisors, LLC. The information contained in this document is the most recent available to Green Drake Advisory Services, LLC. However, all of the information herein is subject to change without notice. ©2017 by Green Drake Advisors, LLC. All Rights Reserved.