I watched as several self-styled pundits on the financial media were beside themselves trying to explain how stocks were actually gaining ground after split. Some give the example of exchanging five one-dollar bills for a five-dollar bill, asserting we haven’t really changed the value in any form. Others admit that while splits themselves have not increased the companies’ worth, as people buy, the capitalization goes up due to perceived value or simply speculation, particularly from retail (individual) investors, most of whom make investment decisions based on emotions.

 

Is Apple Stock Cheap or Expensive?

 

Apple shares presently trade for more than double their 10-year average price/cash flow ratio. Or, said differently, investors are paying more than twice as much for the same amount of cash flow. The same is true, more or less, for other metrics like price/earnings and price/sales. We highlight cash flow simply because it is less opaque. Earnings can be misleading or misunderstood but cash is either in the bank, or it is not. So, this doesn’t seem like an accounting artifact. It really reflects investor opinions about Apple’s current value.

 

 

Also, is there any logical reason for Apple to have triple the weight of Microsoft in the Dow Jones when its market is only 30% larger?

 

 

 

US Banks

 

In theory, banks are in the business of taking risk. They loan money to people who might not repay, and the interest income should suffice to cover those who don’t. But in practice, banks now prefer to avoid risk by loaning money to the government. They still have private loans, however, and those loans are getting riskier. Hence the spike on the right end of the chart below. One reason for this: Banks are flying blind. With so many workers furloughed but still nominally “employed” and receiving government benefits, bankers have only a rough idea of how much default risk they face. They fear, correctly, that borrowers could suddenly stop making payments and go bankrupt. Higher loss reserves are an attempt to protect the banks in that scenario. The problem is loan-loss reserves also have to be invested conservatively and thus earn little or nothing for the banks. This drags on profits and hurts the bottom line, even if no one defaults. And it seems likely to continue until the pandemic recedes.

 

 

US Restaurants

 

The restaurant industry, which has recovered somewhat, is nowhere near its pre-pandemic state. In the chart below, the red line is year-over-year percentage change in the number of “seated diners” at restaurants using the OpenTable reservation system—which is most US restaurants except fast food chains. Their survey data includes both customers who make reservations on the app and those who simply walk in. And despite almost four months of gains, traffic is still only half of its year-ago level.  Higher take-out sales may fill some of this gap, but many restaurant owners are still in serious pain. Very few businesses can lose half their customers and remain viable. Money spent in restaurants mostly stays in the US, unlike money spent on consumer goods that are imported from another country. So, stimulus money spent in restaurants does more for the economy, particularly the local economy, than stimulus money spent on imported gadgets.

 

 

US Economy

 

  • US personal incomes unexpectedly increased last month. Spending was also stronger than expected.
  • The overall US consumer spending is now back to early 2019 levels.
  • The US personal savings rate is still elevated.
  • Reduced interest burden (due to lower rates and delayed mortgage payments) has been supporting consumption.
  • Americans are moving into lower-density communities within their metro areas.
  • The move to lower-density areas and fear of public transportation have boosted demand for used vehicles.
  • The trade deficit in goods is approaching record levels again.
  • Longer-term inflation expectations continue to climb. The market is increasingly convinced that by letting the economy run hot (and not worrying too much about “full employment”), the Fed may reach its 2% goal.
  • The recent US dollar weakness will boost import prices.
  • The labor market continues to recover, with economists expecting the unemployment rate to dip below 10%.
  • US small businesses continue to struggle.
  • Higher home prices have offset rate-driven gains in US housing affordability.
  • The ISM manufacturing report surprised to the upside as the nation’s factory activity accelerated last month.
  • Manufacturing orders are growing at the fastest pace since 2004.
  • Manufacturers are reporting that their customers’ inventories are much too low.
  • Permanent layoffs have been relatively low.
  • The BLS measure of wage gains has been elevated because companies disproportionally shed low-wage jobs, boosting the average.
  • Small business employment is not recovering.
  • Despite a spike in housing demand, construction spending remains soft.
  • Spending on factory construction is down 10% from a year ago.
  • Office construction spending has declined by most since 2011.
  • Auto sales have rebounded sharply. However, auto sales to businesses are lagging.
  • US imports from China are picking up, boosting freight rates.
  • The ADP private payrolls report surprised to the downside. The number of jobs created in August was less than half of what economists were expecting.
  • Morgan Stanley expects the nonfarm payrolls report to show 1.5 million new jobs, with the unemployment rate dipping below 10%.
  • Consumer sentiment is improving.
  • Growth in factory orders was solid in July.
  • The Fed’s Beige Book report showed pandemic-driven economic uncertainty.
  • The Fed has been focused on employment and household spending instead of inflation.

 

Debt

 

When George W. Bush took office, the total national debt stood at a now-quaint $5.8 trillion. He (and the Republican Congress) doubled it. When Barack Obama took office, the debt was $11.6 trillion. He too nearly doubled it. When Donald Trump became president, the debt stood just shy of $20 trillion. Not yet to the end of his first term, we’re fast approaching $27 trillion.

Just read those numbers again.

And maybe sit down for these.

The Congressional Budget Office reported Wednesday that the annual deficit for fiscal year 2020 is $3.3 trillion, or 16% of total Gross Domestic Product. According to the CBO, publicly held federal debt will reach 98% of GDP this year and it will surpass 100% of GDP in 2021. For perspective, it was 35% of GDP in 2007. The double whammy? “CBO’s public debt estimates don’t include entitlements like Social Security and Medicare, which are political promises rather than binding contracts,” says the Wall Street Journal editorial board. “They also exclude the liabilities of Fannie Mae and Freddie Mac, the housing giants guaranteed by taxpayers.”

How are Capitol Hill’s two parties debating the debt crisis? They’re bickering over whether to spend another $3 trillion, as the House Democrats’ bill does, or rein that back in to “only” $1 trillion, as Senate Republicans and the White House counter.

The difference between 2010 and 2020 couldn’t be starker. When Democrats controlled both ends of Pennsylvania Avenue back then, many Americans suddenly cared so much about our spiraling debt that they marched — actually peacefully — in protest against such reckless spending. In fact, Republicans regained the House in 2010 by promising to put the brakes on the outrageous $1.4 trillion deficit.

 

Muni Bonds

 

Moody’s Investors Service has lowered its outlook to negative on all municipal bond sectors except for housing finance agencies and water, sewer and public power. Analysts predict downgrades.

Municipal bond defaults have reached their highest rate since 2011, the aftermath of the last recession, according to Municipal Market Analytics data. Average ten-year yields in munis are at 0.7%, the lowest since the 1950s.

The states who will see a 20%+ fall in revenue include: Idaho, Wyoming, North Dakota, Oklahoma, Missouri, New York, Alaska, Maine, West Virginia, Louisiana, and New Jersey. The top ten states for creditworthiness (meaning the most creditworthy) according to Eaton Vance are Idaho, Wyoming, South Dakota, Utah, Nebraska, North Dakota, Tennessee, Iowa, Virginia, and Minnesota.

 

The Fed

 

The Fed now says they will let inflation “run hot” for extended periods in order to achieve a 2% long-term average. I want to argue that the unintended consequences from recent Fed “policy” changes, not to mention those initiated in prior decades, have been at the very epicenter of some of the national problems we have.

Savor the irony of a central bank explicitly admitting it “seeks to achieve inflation” at all, never mind the level. Central banks once sought to stop inflation, not achieve it.

None of the inflation benchmarks truly capture the full inflation picture. Everyone experiences inflation differently based on their lifestyle and spending patterns. Yet the Fed indiscriminately forces the same strategy on everyone.

Core PCE [Personal Consumption Expenditures] understates to the greatest degree of any inflation metric the cost of healthcare and housing.

According to the Organization for Economic Cooperation and Development, in the United States, the average married worker with two children paid an 18.8% tax rate in 2019. In a January 2020 report, Harvard’s Joint Center for U.S. Housing reported that the median asking rent for an unfurnished unit completed between July 2018 and June 2019 was $1,620, 37% higher, in real terms, than the median for units completed in 2000. Median income in 2019 was $63,688.

On take home pay of $51,714 gets you to 37.6% that renters were spending out of their paychecks on rent last year. The PCE gives housing a 21.4% weight.

In other words, core PCE captures only 56% of the median family’s rent, but families don’t have a choice to pay only 56% of their rent. Healthcare costs are similarly undercounted because PCE imputes them from Medicare and Medicaid reimbursement rates that are far lower than those paid by most individuals and their private insurers. And that’s without even considering today’s higher premiums and deductibles.

And we have not mentioned University tuition.

Further, the Fed now owns about a third of all US securitized mortgages. One. Third. Great for homebuyers. Will they continue this policy? How long? Will the US securitized mortgage market become like the Japanese bond market? That is to say, controlled by the central bank?

The impact of present Fed policy on the stock market extends well past the zero-interest rate policy.

Inflation is already “running hot” for most Americans, but the Fed doesn’t see it. Core PCE serves the same function as those blinders you used to see on carriage horses. The difference is that horses don’t voluntarily blind themselves.

The Fed does.

The combined impact of all this means that the Federal Reserve is putting its thumb on the scale between Wall Street and Main Street, between the haves and have-nots, between the wealthy and the middle class, let alone the poor.

The economy should be viewed as having three parts. One is doing quite well; we could maybe even characterize it as in a boom. One is in a recession of indeterminate length but is managing. A smaller but significant chunk is clearly in a depression. And you wonder why emotions are running high?

 

 

The US Stock Market

 

This rally looks increasingly stretched.

The Nasdaq 100 deviation from its 200-day moving average:

 

 

Nasdaq gains with negative breadth:

 

 

Only 30% of S&P 500 stocks are above January/February highs.

 

 

The S&P 500 is testing resistance.

 

 

The following two indicators?

Market cap-to-GDP ratio (some of which is driven by increased foreign earnings):

 

 

Trailing P/E ratio:

 

 

Buffett Indicator – Market Cap-to-GDP

 

 

Price-to-Sales Ratio

 

 

Median Price-to-Earnings Ratio

 

 

Stock Market Capitalization-to-Gross Domestic Income Ratio

 

 

Debt

 

Global debt-to-GDP ratios are climbing.

 

 

Market Data

 

  • Shares sold short against NYSE securities fell to a 6-year low during mid-August. That’s more than 10% below the long-term trend in short interest.
  • Speculative activity in the options market has reached never-before-seen heightsand doesn’t show any sign of slowing. This is thanks in large part to stocks like Apple and Tesla. While traders are buying short-term calls to goose their accounts as much as possible, somebody has to manage risk on the other side. That’s a big reason why we’re seeing the Nasdaq 100 climb 1% nearly every day, but the VXN “fear gauge” is rising along with it. This is common in commodity markets like oil and gold – it’s nearly unheard of in equities. Since the inception of the VXN, it has hit a 30-day high as the Nasdaq 100 hit a multi-year high only twice before, on January 9, 2006, and October 30, 2007. Both led to pullbacks in the NDX over the next couple of months.
  • Speculative demand for call options (mostly deep out-of-the-money contracts) has been staggering (3 charts).

 

 

 

 

  • Short-term call options are notoriously difficult to hedge, and dealers who sold them rapidly become short the market as shares rise (and the probability that these options will get exercised increases). Dealers are forced to buy stocks to cover their exposure (delta-hedging), pushing the market higher. That, in turn, makes the dealers short again, creating a melt-up.
  • Looking at the 8 other times the Nasdaq Composite formed a major peak, there was not a lot of back-and-forth price action. The index tended to rally hard into the peak, then fall hard right after.
  • So far in 2020, the difference in year-to-date returns through August in technology stocks is more than 75% higher than for energy stocks. That’s the widest split since 1932. Only 1987 and 2000 saw a sector split nearing 50% through August of those years. Historically, the ratios between best and worst sectors tended to narrow after such wide differences in returns.
  • Apple lost $179.92 billion in market capitalization Thursday, the largest one-day loss for the company on record. The drop was larger than the market capitalizations of 470 of the 500 companies in the S&P 500.

 

 

 

All Content is the Opinion of Brian J. Decker