David Rosenberg is chief economist with Gluskin Sheff + Associates Inc. and author of the daily economic newsletter Breakfast with DavDeborah Bai
Janet Yellen delivered a truly seminal speech last week and the title was telling: "The Outlook, Uncertainty, and Monetary Policy." The Fed chief is more concerned about the downside risks to growth and inflation from the weakening pace overseas than before, that much is clear – and whenever a central banker is uncertain, rest assured that the only certainty is that he or she does nothing.
The trailing price-to-earnings multiple on reported (unscrubbed) earnings is 23.5, a high for the cycle. Up until the latest quarter, the range had been 13 (in the third quarter of 2011 when it was time to buy) and 21.7 in the second quarter of 2015 (when it was time to lighten up). An expansion in the P/E multiple of two points in barely over a month does not happen too often, but it did in this most recent rally from the mid-February lows. We have enjoyed a great run back up to the top of the range and at a time when the first-quarter earnings season is going to prove to be very challenging.
Ultimately, what we pay for as equity investors is for profits, and while the overall economy is not in recession, profits are, and the national accounts data from the Bureau of Economic Analysis last Friday showed pre-tax earnings dropping at a 7.8-per-cent annual rate in the fourth quarter, the biggest decline since the first quarter of 2011.
Not just that, but we are still very clearly in an earnings recession and the quality of earnings is deteriorating at the fastest pace since the Great Recession, seven years ago. The gap between reported and operating multiples has widened to 320 basis points from 190 basis points a year ago and the widest since the third quarter of 2009. So it isn't just a lack of quantity, but a lack of quality in terms of the profit picture.
Again, while it is true that the U.S. economy is not in recession, capital spending sure is, ditto for net exports, and so what is hanging the thread together is the consumer and housing and even here, we are seeing a loss of some momentum in recent months.
Ms. Yellen pushed against rate-hike expectations, which means a persistent search for yield by investors. She said "caution is especially warranted," which means she is downbeat on growth. In the immediate aftermath of her comments, the segments of the market with the highest yields and the lowest correlations with the economy advanced the most. But investors with three-to-five-year time horizons would be advised to heed the message that we have a Fed that is adopting a strategy that differs from the dual mandate of full employment (which we have) and price stability (which we also have).
Ms. Yellen will continue to hold policy rates negative in real terms as far as the eye can see, even with core U.S. CPI inflation at 2.3 per cent and rising (the Fed's preferred core PCE (personal consumption expenditures) inflation at 1.7 per cent and rising), and unemployment south of 5 per cent.
It is not evident to the naked eye just yet, but just as the Fed sowed the seeds in the second half of the 1960s for the unexpected "stagflationary" experience of the 1970s, something very similar is taking hold this time around.
In sum, this Fed rally has a short shelf life absent a re-acceleration in global growth in both the economy and earnings. So this will remain broadly what it has been – more of an idiosyncratic market of special situations and creative ideas than one of merely playing the major averages and hoping for the best, which worked so well from March, 2009, to May, 2015.
This is especially the case for "growth stocks," seeing as the Nasdaq 100 has fallen short of getting past resistance so far at its major trendlines.
Now, make no mistake – I am not saying we are in a bear market, but we don't seem to be in a bull market, either. We are in a stagnant or purgatory market where nimble security selection and sector rotation rules the roost. The S&P 500 peaked intraday on May 20, 2015, at 2,134 and bottomed on Feb. 11, 2016, at 1,810; the tighter band is 2,100 on the upside and 1,900 on the downside.
But as we saw in 2015, if you were in the "right" sectors (always so evident in hindsight) like health care, consumer staples/discretionary and tech, your total return was close to 7-per-cent-plus in what was basically a flat market.
This year – again a year that looks flat but has actually been a wild roller-coaster ride – being in the right sectors (bond proxies such as utilities and telecom, and weaker U.S. dollar proxies such as materials, industrials and consumer staples) and again, the returns again have been a touch better than 7 per cent thus far.
This is a market desperately searching for a theme – very much an idiosyncratic, stock-specific and special-situation-driven market, not to mention dominated more by the technicals than is typically the case.
But the next chapter in this post-recession cycle has likely gone from deflation to reflation to now, stagflation, or at least a mild case of it. This should be constructive for hard assets like basic materials and real estate – and one reason why I like the Canadian dollar because it is a currency play on a reflationary future.
David Rosenberg is chief economist with Gluskin Sheff + Associates Inc. and author of the daily economic newsletter Breakfast with Dave.