First Quarter 2017 Forecast and Opinion January 5, 2017

temp-post-image"L'Enigma", Gustave Doré, 1871. An embittered nation begs the Sphinx for answers.

The post-election Trump rally appears to be cooling, and as it does, realization that stocks are as expensive as they were in 1999 on a price-to EBITDA* basis is setting in. The following chart is not a price chart of the stock market but a “valuation” chart of the S&P 500. (*EBITDA is earnings before interest, taxes, depreciation, and amortization).


No one knows how the President elect’s policies will play out, but the stock market has rallied on hopes that he will provide huge fiscal stimulus on infrastructure projects, cut taxes, and decrease regulation.

The stock market has been pricing in nothing but good news, and there is little basis for it so far. It has risen not based on earnings, but expanding stock multiples based upon the assumption that “everyone is a winner under Trump”.
The bond market, on the other hand, has sold off severely since the election based on either fears of inflation or fears of remarks made by the President-elect concerning the full repayment of Treasury debt. This too is overdone because it assumes too much strength in the U.S. economy.
Meanwhile, the U.S. dollar has surged against other world currencies, which have negative consequences for U.S. exporters. A strong dollar hurts exports, because it makes American goods more expensive abroad, and because when the foreign profits are repatriated, we get less US dollars for those sales. The reason for the dollar surge is due to anticipation of higher rates in the U.S. which widely anticipate inflationary policies like tariffs by the President-Elect. Approximately 45% of the revenues of the S&P 500 come from exports.
Trump proposed during his campaign spending $1 trillion on infrastructure projects. Yet Republican lawmakers are looking for spending cuts. Trump wants to incent the private sector toward infrastructure spending with tax credits. Yet the only infrastructure projects which are profitable are new toll roads and new toll bridges. According to the American Society of Civil Engineers, $3.6 trillion of infrastructure spending is needed just to repair existing crumbling infrastructure. New toll roads and bridges are not needed, and the Republican Congress knows it. So Trump’s proposals for fiscal stimulus are at present very uncertain.

Trump would like to cut taxes as well. While campaigning he promised tax cuts “to the middle class, the forgotten people, the forgotten men and women of this country, who built our country." In reality, the top 1% of wealth in the U.S. will reap around 50% of the benefits of personal income tax cuts. The other half will, nonetheless be stimulative to the economy. Similarly, cutting corporate taxes from 35% to 15% would be stimulative, but in all these measures some $6.2 trillion of lost revenue would be lost over the next ten years, which will ultimately hurt the economy in the form of higher rates enforced by further bond market selling. Again, time will tell if a fiscally conservative Congress will allow this.

As for banking deregulation, Trump would like to eliminate the Dodd-Frank banking regulations put in place in 2010 to prevent future banking crises. Dodd-Frank has many critics, who feel that the law has hurt small banks and restricted access to credit. After running on an anti-Wall Street campaign, Trump has named three former Goldman Sachs executives to his cabinet. Since the election, Goldman Sachs share price has rallied by 52%, and that in turn is responsible for around 30% of the Dow’s rise since the election, since the Dow is a price weighted index. However, there are not enough votes in the Senate to overturn the Dodd-Frank Act, which is still widely supported by Democrats.

For wealthy investors, it is difficult to argue with a Trump Presidency, which clearly will favor the wealthy. The President-elect has chosen the wealthiest cabinet in modern history, consisting of three billionaires (Ross, DeVos, Mnuchin), and several others each worth dozens of millions (Tillerson, Chao, Price). The Trump administration will seek to cut taxes and completely eliminate Federal estate taxes. While it is noble for these wealthy cabinet members to offer service to their country, it should be noted that according to the tax code, they will all be able to divest themselves of all stocks and bonds with full deferral of any capital gains, if they invest in either treasuries or certain money market funds, until such time that these treasuries or money market funds are sold. If they never sell them, then they can defer paying any capital gains tax forever. It would be lucrative indeed for anyone with extreme wealth to serve as a U.S. cabinet member. It remains to be seen if they will all be approved by Congress.

The Federal Reserve lifted its benchmark federal-funds rate in December to a range between 0.50% and 0.75% and announced its intention to increase rates three more times in 2017. Two of the central-bank speakers have since suggested that more than three moves could be coming in 2017. The reason provided by the Fed is that the economy is improving, although if we consider that home ownership has hit a 51 year low, or the 2.3 million people who are “missing” from the unemployment statistics, or the fact that labor participation is near a 40 year low, it is with some skepticism that official GDP growth numbers should be taken at face value. The more likely reason why the Fed is suddenly afraid of the Trump administration’s inflationary policies.


Last week, the Chinese Central Bank increased the overnight rate of interest to 105%, in an effort to prop up its currency. This unprecedented and disruptive move was designed to squeeze out speculators who have shorted the Yuan. Yet it is not just speculators who want to sell the currency. The government only allows Chinese to convert $50,000 worth of Yuan per year, and now that we have entered 2017, it is trying to restore confidence as money heads to the exit door again. Chinese savers are rightly concerned about the falling foreign currency reserves, as are Chinese businesses. Capital is flowing out of China, whose fundamentals argue for a weaker yuan. The behavior of the PBOC does little to further China’s advocacy to make the Yuan a reserve currency, which is approaching all-time lows against the USD and nears the psychologically important level of 7:1. In fact, the move hints at desperation. Between June of 2015 and January 2016, a weak Chinese currency led to a hard selloff in the Chinese stock market of 45%, which softened stock markets globally. The Taiwanese President just concluded a visit to the U.S. this weekend, after a phone call with Mr. Trump a few weeks ago angered Chinese Communist officials who have promised to take revenge on a perceived threat to their “One China” policy. The Communist Party’s 19th National Congress takes place this autumn, and given rumored rivalries between President Xi and Premier Li, the former is likely to respond forcefully against Trump given his own personal political stakes.


The Trump transition team is considering between a 5-10% tariff on all imports, despite fierce opposition by Republican lawmakers and business leaders. Trump also has vowed to eliminate the NAFTA trade agreement with Canada and Mexico. He has also added two pro-tariff advisers to his economic policy team. If such actions lead to retaliation by America’s trade partners, which they surely will, this would lead to American job losses and result in a tax to consumers, both of which would harm the US economy. It may not be legal to impose such tariffs, because of existing trade treaties, particularly with the World Trade Organization. While many working class Americans think that this is a good thing for them (just as they did in 1931), it is actually a very bad idea because it will cause prices to increase, and potentially trigger a retaliatory trade war with former sovereign partners who themselves may block or tariff some of our major exports. Politicians opportunistically believe that it improves their status with working class voters to support tariffs, just as they did in 1931 when the Smoot-Hawley Tariff Act contributed to the Great Depression under the last businessman President Herbert Hoover.

Moving jobs from low wage countries back to the United States, a high wage country, provides American companies with incentives to automate production with robots, in turn could increase unemployment. In the case of the Indiana Carrier plant, that is exactly what CEO Greg Hayes of parent company General Dynamics has promised to do in the face of Trump pressure to keep the plant in Indiana instead of moving it to Mexico.


Trump Tweets have been causing huge market moves on individual stocks. Most recently Toyota, Lockheed Martin, General Electric, and Boeing have been impacted by the President-Elect’s 140 character messages. There now exists an iPhone app called “Trump Trigger” which alerts investors in real time when Mr. Trump mentions a publicly traded company on a Tweet. This amounts to an entirely new financial risk, heretofore unknown to investors.

At this time, nothing is obvious because markets are overvalued and Trump is a great unknown and undefinable. He is a disrupter, a provoker, a temperamental opportunist, sensitive and easily aroused, as volatile as his outbursts on Twitter. The direction of all markets since the election has been built on euphoria and a belief that one man can change the status quo in the face of his own party which dislikes him.

In a few weeks, earnings season begins for the fourth quarter, and those earnings are likely to be impacted by a U.S. dollar which now stands at 14 year highs vs other world currencies. If Trump declares a tax holiday on the $2.5 trillion of corporate foreign profits, the repatriation of this money will drive the dollar even higher, again a negative for exporters and likely to cause problems for many foreign countries which owe debt denominated in dollars. It is a mistake to believe that the repatriation of this capital will lead to new investment, which tends to be predicated mainly on opportunities for productivity/output gains from any such investments.

Fund flows tend to be a good short term contrary indicator, and November and December just saw a record amount of stock buying and bond selling in November and December, mostly by retail investors who tend to pile in at market tops.

There are a number indicators besides stock valuations which are flashing caution signals. The Bull/Bear ratio has become over-exuberant, and is indicating a pullback. While the “Economic Policy Uncertainty Index” is at an all-time high, the volatility, or fear index on U.S. stocks is near its all-time low. The same can be said for the corporate credit market, which paints a very rosy picture at a time when risks are unprecedented.


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