Well, I have to admit that I'm starting to think that maybe Jeremy Grantham was on to something with his melt-up comments, made at the turn of the year, upon entering this last chapter of the bull market.
It is a curious comment from a legendary value investor, but worth paying heed to nonetheless.
I'm not sure where he gets the notion that there is another 60-per-cent upside to the S&P 500, though if the pace so far this year is maintained, we'll be there before we finish the year. But when push comes to shove, he was really only describing human behaviour, and that we now are moving into that classic final euphoric phase that typically ends in greed. In fact, the CNN fear-greed index, sitting at 80 per centm already has entered extreme terrain as a case in point (the mirror image of being at 20 per cent back in March 2009). And so, while I am sympathetic to Jeremy Grantham's melt-up view, I find myself aligned to Sam Zell, who said back on Jan. 16 that "the current situation seems like irrational exuberance," and this from someone who nailed the last cycle when he unloaded his apartment portfolio in February 2007.
The question I think that has to be answered first is whether or not this is a fiscal policy-led melt-up we are seeing in the equity market, or is it a Fed melt-up?
Everyone seems convinced this last vigorous leg up in the equity market is all about the tax relief plan. No doubt there is an earnings boost for 2018, but as has been the case for so much of the cycle, the market is being fuelled much more by multiple expansion. Liquidity is the operative word.
If I think to one event in the past month that stands out as reinforcing the bullish market view, it was the last FOMC meeting on December 13th. The Fed raised its GDP growth forecast by 40 basis points to 2.5 per cent, ostensibly in a tip of the hat to the tax package, but did not change its inflation view or its dotplots on interest rates. That seems to have investors of the view that the Fed is set to accommodate the tax plan, and must see it in a Larry Kudlow lens as being 'supply-side' since this boost to growth apparently does little to drain much more capacity out of the economy.
Janet Yellen actually had the temerity at the last FOMC meeting to say, this back on December 13th, in her parting words at the post-meeting press scrum: "I think when we look at other indicators of financial stability risks, there is nothing flashing red or possibly even orange." Not even orange. And yet, when you go back to the archives, back on July 15th, 2014, she went on the record to say "valuation metrics in some sectors do appear substantially stretched." Interestingly, when she was worried back in July over valuations, we had the trailing price-to-earnings at 17.8 times, today it is 23 times; we had the forward multiple at 15.5 times, today it is 18 times, and we had high yield credit spreads at 372 basis points, today we are at 338 basis points. The change of view from what seemed to be an amber light three and half years ago to basically green today is in my view more important for the markets than even the tax package.
The Fed owns this bull market and it owns the bubble that is forming, just as it owned the late 1990s tech bubble and the mid-2000s housing bubble. Since that severe correction of 1987 when I first started in this business, the Fed has been run by serial bubble blowers and this has been as true in this cycle as it was in the past. The U.S. economy increasingly depends on record amounts of debt and on asset inflation for its success. Education and productive investing have taken a back seat to a debt-financed bull market in stocks and other financial assets. We have seen this movie before – these sorts of cycles are fun on the upswing but always end badly, and it is senseless to try and time when the peak comes in. But my biggest fear is the acronym I hear the most right now which is FOMO or the Fear of Missing Out, which is the poorest reason to be investing in risk assets. We are starting to see accelerating inflows into ETFs and mutual funds in the past month as this FOMO psychology take hold, and it takes me back to Bob Farrell's Rule #5 which is that "the public buys the most at the top and the least at the bottom".
What is interesting is that the tax cut gets all the press and the credit behind this last leg to the rally, but Janet Yellen's proverbial 'green light' comment occurred at almost the same time and receives scant attention. I would say her comments are very much behind this rally which has far surpassed the increase we have seen in analyst EPS estimates due to the tax cuts. I think I had mentioned that the P/E multiple is now over 18x on a forward basis even with the tax cuts embedded in the earnings estimates, taking out the 2007 bubble peak in valuations, and more than a full point higher than it was a year ago. On this basis the stock market has only been richer in the past less than 10 per cent of the time. In fact, the median stock has only been this richly valued 1 per cent of the time in the past. The S&P 500 trades at 2.1 times on sales, just below the dotcom peak in 2000; the market on this basis has only been this expensive 4 per cent of the time in the past. Finally, the price-to-book ratio on the S&P 500 is 3.4 times and has been this high or higher just 7 per cent of the time historically.
This is a familiar pattern. The Fed has been committed to boosting the stock market in all sorts of ways for many years. When the Fed embarked on QE2, if you recall, the very next morning Ben Bernanke had ensured that his op-ed piece made its way to the Washington Post to make it very clear that he wanted this next round of asset purchases to boost stock prices in order to generate a wealth effect on spending. And remember, more QE rounds were to follow even as the recession was increasingly in the rear view mirror.
Now some will say that the Fed stopped QE three years ago and begun to nudge rates up in December 2015 and that it is tightening monetary policy. But this obscures the point that Fed policy has never before been this stimulative for this stage of the business and market cycle and the central bank has found some very innovative ways to convince market participants to load up on equities. Let's examine them.
Let's take a look at the mandate. Full employment and price stability. Well, according to the Fed, NAIRU (the estimated unemployment rate that is consistent with the economy running flat out at its potential) is now 4.6 per cent. This estimate has gone from 5.0 per cent in June 2015 to 4.9 per cent in September 2015 to 4.8 per cent in March 2016 to 4.7 per cent in March 2017 to 4.6 per cent in June 2017.
So two things here to note.
First, the economy has officially been performing below NAIRU now for ten months in a row. One would think the Fed would be stepping up its rate hikes and balance sheet unwind.
Second, it is clear that the Fed recognizes the fundamental changes in the economy that have allowed the jobless rate, consistent with a fully employed economy, to have declined over time. The Fed deserves credit for understanding these secular shifts.
But it cuts both ways. In July 1996, Ms. Yellen asked then Chairman Greenspan what his definition of price stability is, and he correctly said 0 per cent. It was decided at that meeting, and promulgated by Ms. Yellen, that the inflation objective should really be 2 per cent given the imperfections in the data, not to mention a number that gives the Fed a ton of flexibility. But does it make sense, more than twenty years later, with improvements in the data (post Boskin Commission) and the fundamental disinflationary forces at play (demographics, debt, technology, global competition, consumer inflation expectations, labour power) to still believe that a 2-per-cent core inflation objective is appropriate? It may have been appropriate in 1996 but not today. The question is how the Fed can recognize structural shifts in NAIRU but not in what constitutes price stability in today's high-tech economy.
So think about it. We have had the economy operating through full employment for ten months, and the Fed is moving more glacially now than it did in that 2004-06 cycle, when the jobless rate never even got as low as it is today.
The reason? Well, you hear it all the time – the core inflation rate is 1.5 per cent.
How can the Fed possibly raise rates that much with core inflation 50 basis points below its target? But that's the problem – the target shouldn't be 2 per cent. That 2 per cent has always been arbitrary but more than that, today it is irrelevant. The Fed has not hit its 2 per cent target since April 2012 and in fact, has missed it 90 per cent of the time over the past decade.
So the Fed is pursuing a consumer inflation target that is completely elusive, and in so doing, is creating massive inflation in financial assets. As if we haven't seen this movie before. If you did this statistical exercise and inputted the various stock market pricing from the consumer segments of the broad S&P 1500 index and weighted it to the consumer price index, instead of the prices of the items these companies charge to their customers, the inflation rate would be 35 per cent!
So Mr. Grantham could well be onto something in his blow off thesis. But he also is intimating that we are heading into the final bubble phase and these don't end well. We do, after all, have a new and inexperienced Fed on our hands, and if there is a risk, it is that it steps up the pace of tightening.
After all, the one thing we know about Jay Powell is that he is not a traditional macro economist. In the past he has expressed concern about excesses in financial markets, which have only become more excessive in recent months. This is the critical issue for 2018 as far as I'm concerned. Will a Powell-led FRB do things differently?
The consensus and complacent view is that Mr. Powell is another Ms. Yellen. But I'm not too sure about that. He actually reminds me more of Jeremy Stein, who did understand how central banks can fuel asset bubbles and expressed concerns for several years over the Fed's role in distorting the pricing in financial markets. Let's see if Jay Powell will be one who actually does take excessive inflation in real and financial asset markets into account. In October 2012, he said "I think we are actually at a point of encouraging risk-taking, and that should give us some pause."
In October 2012, the S&P 500 was 1,412, the trailing P/E multiple was 14.5 times, the forward multiple was 12.7 times, high yield spreads were 554 basis points, and the VIX was sitting at 18.6 times.
Then in April, 2015, he said "for now, I would be more concerned with a second risk, which is that more-accommodative policy could lead to frothy financial conditions and eventually undermine financial stability."
In April 2015, the S&P 500 was 2,085, the trailing P/E multiple was 18.8 times, the forward multiple was 16.9x, high yield spreads were 459 basis points, and the VIX was sitting at 14.6 times.
Compare and contrast to today – the S&P 500 is 2,800, the trailing P/E multiple is 23.4x, the forward multiple is 18.4x, high yield spreads are 337 basis points, and the VIX currently sits at 10.2 times.
Now as I said, Mr. Powell hasn't really said much recently about his own current views, not even at his confirmation hearing in front of the Senate. But he is not an academic. He is not an economist. He hasn't spent his life at the Fed. And he is not a left-leaning Keynesian. So those who think he will be a Yellen clone may be clueless. Plus this promises to be a much more hawkish FOMC voter rotation this year. And I will just go back to the last time Mr. Powell did address this topic of market excess in a speech he gave to the American Finance Association in Chicago, exactly a year ago:
"It is not the Fed's job to stop people from losing (or making) money." Now this indeed is a break with the past three decades when Mr. Greenspan, Mr. Bernanke and Ms. Yellen overtly pursued policies to boost equity wealth and to be there to hold investors' hands any time the going got tough. I just find it more than a subtle shift that the new leadership at the Fed doesn't feel his job is to "stop" people from incurring losses on their portfolio.
No more needs to be said except if you haven't begun the process of booking profits, trimming risk and rebalancing the portfolio, there is no better time to start that process than today; that is what I would do in the face of the Jeremy Grantham meltup; I'd use it as an opportunity to sell into, not buy into. As the legendary multi-billionaire Baron Nathan Rothschild famously said a century and a half ago, "I got wealthy by never waiting for the peak."
David Rosenberg is chief economist with Gluskin Sheff + Associates Inc. and author of the daily economic newsletter Breakfast with Dave.
David Rosenberg