Wednesday, November 2, 2016

Blackstone's "Byron Wien’s Key Fears About the Stock Market"

From Barron's Wall Street's Best Minds column:

The veteran strategist discusses the looming negatives that could undermine his bullish case for stocks.
When the presidential election is over, investors can focus on what is going on in the world economy and what future investment opportunities are lurking out there. If Donald Trump were to win, the outlook would be very uncertain because of his maverick ideas on both domestic and foreign policy. Though Hillary Clinton’s victory is likely, we should not assume a seamless transition from the policies of the Obama administration. She will focus on infrastructure, improving the Affordable Care Act, job creation, revising the tax code and immigration. The question will be how much of her agenda will she be able to get passed by a Republican-held House of Representatives. 

Probably the most important lesson of the last six months is the importance of populism in the political process. A large segment of the population in the United States and Europe believes that their future economic opportunities are limited, and they want change from the path being followed by their governments. This discontent fueled the political success of Bernie Sanders and Donald Trump. Populism and immigration reform were the key factors abroad, influencing U.K. voters to leave the European Union. Most observers would agree we are in a period of secular economic stagnation, but the equity market in the United States is near an all-time high and initial unemployment claims are at a 43-year low. If Hillary Clinton wins the presidency, it may not be because a plurality of American voters embraced her policies, but because many were adverse to the prospect of a Donald Trump–led White House. A majority of voters actually distrust her, and she might have lost to John Kasich, Marco Rubio or even Jeb Bush had they been nominated.

While we all support the concept of improving infrastructure, the Obama administration actually got very little done, despite being committed from the beginning to “shovel ready” projects. To get infrastructure work implemented effectively and quickly is hard. Although Larry Summers believes infrastructure should account for 1% of GDP, we can’t count on fiscal spending to contribute in a major way to overall economic growth in the United States anytime soon, even if these programs get through Congress. There is also the question of how many new jobs would be created by increased government spending. Given the doubts that exist about the benefits of revising the tax code and modernizing immigration policy, these challenges reinforce the futility of looking to the new administration to get the economy on a much stronger growth path right away. 

We do know we are facing some headwinds. The Federal Reserve and other central banks are beginning to doubt the effectiveness of continued monetary expansion as a way to stimulate the economy, despite increased liquidity having been an important factor in driving the equity market higher since the end of the recession in 2009. We are also seeing the early signs of inflation. Both the Consumer Price Index and the Personal Consumption Expenditures indicators are still below 2%, but average hourly earnings are up 2.6%, the availability of skilled workers is getting tighter and inflation could become a negative factor some time during the next year. Rising rates and more inflation are likely to be interpreted negatively by equity investors.

The question puzzling investors is whether equities can continue to move higher when the economy is struggling. Real GNP has been growing at less than 2% and both short and long term interest rates are likely to rise, dampening price earnings ratios. The price of oil is moving higher, taking some money out of the pockets of consumers. Data on housing have generally been favorable to growth, but recent reports on starts were disappointing. The oil drilling rig count has increased (as the price of oil has come off its lows), and there is the prospect of improved capital spending from the energy sector, but it hasn’t appeared yet. 

Fracking has picked up but it is not as vigorous as it was when oil was above $70 a barrel. There are, however, countervailing winds. Commodity prices are rising, which should be good for emerging markets. The producer price index is rising in China, which usually coincides with improved growth there. No “hard landing” talk any more. Earnings for the Standard & Poor’s 500 have been essentially flat since 2014, but analysts believe they will be up sharply next year. That echoes their optimism in previous years.

While I believe we are in a period of secular stagnation where valuations are high and profits are likely to be disappointing, I do think there is a bull case out there: Hillary Clinton is elected president by a wide margin and at the top of her agenda is infrastructure spending. She persuades Paul Ryan to rally Republicans in Congress to pass an ambitious program to upgrade our roads, bridges, airports and tunnels. Her argument is that a bipartisan effort will benefit both political parties. Jobs are created as the projects get underway. 
Consumer spending improves because the infrastructure workers now have the resources to buy what they had postponed. The price of gasoline edges up and inflation moves above 2% but this gives companies some pricing power which had been lacking. The Federal Reserve begins to raise rates, putting more money in the hands of retirees. Energy companies are heartened by the improvement in the economy and the rise in oil prices and they begin to spend money on capital projects, creating more jobs. The minimum wage begins to rise across the country. With real growth above 2%, corporate profits begin to rise, justifying higher stock prices. Investors become enthusiastic about opportunities in equities. Entrepreneurship flourishes and the initial public offering market becomes strong again. 

You could also argue that historical multiples that indicate the market is expensive don’t apply because interest rates were much higher in earlier cycles. At these yields, equities should sell at somewhere between 25 and 30 times earnings. The public has been selling equity mutual funds and buying bond funds for several years. Hedge funds also have a low equity exposure compared to historical levels. Even long only investors are cautious. This kind of negative market mood generally creates opportunity. Another positive is the fact that no recession seems to be in sight even though the present expansion is 88 months old. Excesses like an inverted yield curve, investor euphoria, a hostile Federal Reserve and bloated inventories do not appear to be present. Even so, some prominent economists think there is a 70% chance of a recession in 2017. I would estimate the probability of the bull market continuing into 2017 at something like 35%.

My principal worry is earnings disappointment....MORE