Our bullish note of May 28 explained why stocks would manage to scale a new “Wall of Worry.” Since then stocks have climbed 2.4%; I think they are headed higher still. “Central bankers gone wild” are pumping liquidity into the global economy as if we were still in a deflationary spiral. In reality the global economy is growing and U.S. profits are rising nicely. We are in the proverbial “sweet spot.” Enjoy it while it lasts; inflation lie ahead.
Let’s start with profits. First quarter S&P 500 pro forma EPS were $28.00, which would seem to imply $118 for the year, because Q1 on average accounts for 23.7% of annual earnings. But Q1 results were hurt by bad weather and weak Wall Street profits, and the economy is recovering from its January-March deep freeze. Recent profit reports have been pretty good; see Kroger, Jabil, FedEx, Adobe. And rising oil prices boost profits, unless they cause a recession. Net net, profits should be better than $118, maybe $120-$121. That’s above most forecasts, which are in the $116-118 range.
While profits are better than feared, central bank easing and low bond yields support high PE ratios. At the end of last year, after stocks spiked, the trailing S&P 500 PE was 17x. Using that multiple for the end of this year implies a target of a 2050, up 5% from here. But that may prove conservative if investors celebrate a big Republican win in November. Historically, stocks are strong in the final quarter of mid-term election years.
An Inflation Scare Will End this Rally, but It’s Hard to say When
Last December we explained why “Yellenomics May Blow an Asset Bubble.” The paradigm, which was discussed on Larry Kudlow’s radio show a few months later, is simple. Obama’s systematic macroeconomic malpractice—Obamacare, higher marginal tax rates, the War on Coal, no Keystone XL pipeline, corporate tax non-reform, immigration non-reform, fulminations about “millionaires and billionaires”—are hurting job creation. However, to fight high joblessness Yellen is pumping liquidity into the economy. Because she can do nothing to reduce structural barriers to employment, the result is anemic job growth but rising asset prices. (Which is increasing inequality, but that’s another story.)
I see no evidence that Chair Yellen has figured this out. Despite the fact that we are five years into an economic expansion, with continued moderate GDP growth and increasing evidence of inflationary pressure, we have a zero Fed funds rate appropriate to a financial emergency, and the Fed is still easing monetary policy. “Tapering” of QE bond buying simply means the Fed is not tightening but merely easing less aggressively than a few months ago. But it is still easing.
Inflation Risks: Don’t Forget the Supply Side
Focused as she is on unemployment rather than inflation, Yellen will pursue a too-loose monetary policy as inflation starts to accelerate. That’s fairly obvious at this juncture. But here’s a key point that Wall Street economists tend to miss. Obama’s aforementioned macro-economic malpractice has increased inflation risks by hurting the supply side of the economy. He has shifted supply curves to the left; for any given price offered, less is supplied than in the past. Let us count the ways:
- Higher minimum wages will constrain expansion of service industries and kill 500,000 entry-level jobs, according to the CBO.
- The war on coal will raise electricity costs (coal still provides 40% of electric power).
- Ozone regulation will raise the costs of manufactures, including gasoline costs.
- As the CBO has documented, Obamacare subsidies will keep 2 million people out of the labor force.
- Obamacare creates strong incentives for small businesses to stay small in order to keep “under the limit” of 50 workers.
- Well over $1.5 trillion in corporate cash is kept outside of the U.S., much of which would be invested in the U.S. if it had a rational tax regime. The U.S. loses tax revenue and jobs as major companies decamp for low-tax venues such as Ireland and Switzerland.
- Higher taxes on “millionaires and billionaires” discourage investment.
Excessively loose monetary policy and a sclerotic supply side will give us surprisingly high inflation, likely over 3%. Bond yields will climb, recession fears will rise, and PE ratios will fall. Historically, declining PE’s trump strong profits (see 1966, 1973, 1980, 1983-84, 1987, 1994). Stock prices may fall 10-20%, or perhaps just flatten out for a year or two while profits rise and PEs fall. In this environment “bond substitutes” such as tobacco, utility, and drug stocks will perform poorly, as will high-flying momentum stocks. “Inflation hedges” such as material, energy, gold, and mining equipment stocks should outperform. I would maintain a diversified portfolio and increase my cash position.
It will take a while for this inflationary scenario to develop, and it is hard to know when the inflection point will come. For now, equity investors will continue to enjoy the “sweet spot,” even if stocks become over-priced. Stocks usually trade above or below, not at, “fair value.” I’m glad I don’t have the job of calling the turn. To mangle an observation of Lord Keynes, “markets can stay irrational for longer than disciplined stock market strategists can stay employed.” In the late 1990s, many bearish—and ultimately correct–stock market strategists lost their jobs before stocks crashed. Cycles often last longer than you expect.
Copyright Thomas Doerflinger 2014. All Rights Reserved.
