David Rosenberg, chief economist at Gluskin Sheff + AssociatesThe Globe and Mail
Back in September, Donald Trump declared that "we are in a big, fat, ugly bubble." That was at the first presidential debate about his views on the equity market.
Goodness me, I wonder what he must be thinking now, especially since this is being dubbed the "Trump Rally."
If he hated the market then, he must despise it now. The S&P 500 has surged 5.7 per cent and the forward price-to-earnings multiple has expanded sharply to 19 from 17 1/2 times – this is the most expensive market in 15 years.
The Donald may well be right on this one.
Everyone talks about the need for interest rates to "normalize" and that is because the Treasury market is the arch enemy of the growth bulls.
But if the P/E ratio does its own version of mean-regression, then I can tell you the equity market is discounting 33-per-cent earnings growth in 2017.
That is a tall order – throw in everything including the kitchen sink from the Trump fiscal plan (of course, presidents typically only see 60 per cent of their promises come to fruition, though he did make 282 of them during the campaign), and you get to half that growth.
Look, if the market was even discounting 10 per cent to 15 per cent earnings-per-share growth, I would say fine – there is some moderate upside. But Mr. Market is priced for a one-in-20 event that only occurs at the early stages of the cycle, not heading into year No. 8.
On top of valuations, sentiment is wildly bullish.
The Market Vane consensus stock index, at 60-per-cent bulls and fewer than 20-per-cent bears, attests to the complacency. As if a VIX at a lowly 13 isn't saying the same thing.
I find the comparisons of Mr. Trump to Ronald Reagan fascinating. There actually are some striking similarities, in fact. Both enjoyed a huge honeymoon period following the election, but part of that was accentuated by a dearth of sellers because both promised lower marginal tax rates.
So remember that after an 8-per-cent run-up from Nov. 4 to Dec. 31 in 1980, the S&P 500 went on to correct 5 per cent in January, 1981.
Now Mr. Reagan cut top marginal rates from 70 per cent to 50 per cent starting in 1981. And guess what? We still had a recession that started in August of that year and didn't end until November, 1982.
Only after the recession ended, and that followed a 1,000-basis-point slice in the Fed funds rate and a depressed price-to-earnings multiple of eight, did the next secular bull market commence.
But what triggered that recession was the Fed doubling the Fed funds rate in short order after Mr. Reagan was elected. Not even a 20-per-cent slice in top marginal tax rates and all the pledges in the world to stimulate growth via massive military outlays could outweigh the effects that higher interest rates exerted on the economy.
The current Fed probably regrets not taking the opportunity to gather more conventional policy bullets in 2016, but will probably make up for lost time in the coming year.
The consensus at the Fed is for three hikes in 2017, but many see four moves – and remember, there was no fiscal stimulus in the forecast numbers released this week.
When the Fed has more details on what inevitably comes out of the House, all of its projections, including the Fed funds rate, are bound to move higher.
Recall that the Fed more than doubled the funds rate after Mr. Reagan was elected – getting the Fed funds rate to 2 per cent this time does the same trick.
My advice is to keep an eye on the two-year/five-year U.S. Treasury yield curve – because if the Fed gets to 2 per cent next year, the odds of this curve inverting will be high, and a recession in store for 2018.
Call it a premise, not necessarily a forecast.
But the business cycle is not dead, and this one is getting rather long in the tooth. And remember this – we have had 13 other Fed rate-rising cycles in the post-Second World War era, and 10 landed the economy in recession.
All fiscal policy could ever do, as it is never a match for monetary policy, was blunt the impact. The three soft landings, in the mid-1960s, the mid-1980s and the mid-1990s, all occurred in the third or fourth year of the cycle – not the eighth.
This is certainly not to say that there is nowhere to invest at all in the coming year.
We think there are opportunities in U.S. financials, which are inexpensive and now accelerating their dividend payouts, and will benefit from any watering-down of Dodd-Frank regulations.
Energy is an area of focus because if $50 (U.S.) a barrel WTI oil price holds (and we think it can), then it means tremendous profit-margin growth due to the substantial amount of costs that have been taken out in these recent turbulent years. This too will benefit the Canadian banks from the standpoint of loan-loss provisioning.
And with our global lens, we continue to see some value opportunities in the European financials, understanding the political risks, as well as in Japan which is benefiting from signs of a pulse finally emerging in domestic demand growth and, of course, the benefits of an ever-competitive currency.
All that said, 2017 will be about special situations beneath the veneer of the major averages and active finally surpassing passive investment management styles. But the major point is that the real money will be made based on classic value investing that focuses more on company fundamentals than on Trumponomics.
David Rosenberg is chief economist with Gluskin Sheff + Associates Inc. and author of the daily economic newsletter Breakfast with Dave