The bearish theses I have had for the past few weeks have been coming to fruition in the past few days. The reward for being correct has thus far been less than a 2% correction in the S&P 500. The tilt is clearly positive. Being precisely correct on two negative catalysts still hasn’t brought a 5% correction which hasn’t happened in many months. The two negative catalysts are a crash in oil prices and a delay in the passing of the GOP’s pro-growth legislation. On Thursday, the price of WTI oil was down about 2% to $49.28 as it exits the range of the low $50s which it has been in all year. The GOP’s proposals aren’t going to be passed as quickly as previously expected. The market must’ve forgotten that politicians don’t get things done quickly. There are some quirky Congressional restrictions which are preventing quick passage, but the main reason the passing of healthcare reform won’t go quickly is because there is a big ideological difference between the moderates and the conservatives in the GOP.
Before I review the two latest bearish catalysts, let’s review how expensive stocks are. The chart below shows the S&P 500’s forward PE. It shows where the stock market would go if the forward PE fell to various levels. The 10-year average forward PE is 14.4. If it fell to that multiple, the S&P 500 would fall to about 1,900 which would be over a 400-point decline. Forward earnings estimates won’t have to fall as much as in 2008 to have a similar sized decline as the market was trading at about a 15 forward PE before the crash.
The second chart I have below uses the market cap of non-financial companies divided by the gross value added including foreign revenues to determine future 12-year annualized returns. Because the market is so expensive, the 12-year expected annualized return is slightly above 0%. As you can see, this future return estimate has been quite accurate in the past 50 years of data. This is a long-term forecast which allows investors to contextualize short-term movements in stock prices.
Oil has fallen below the $50 support level to the lowest price of 2017. The fall on Thursday was a continuation of the selloff Wednesday which was a full-on panic for certain short-term speculators. At this point, the latest report showing an increase in U.S. shale production and an increase in the inventory glut has been priced into the market. It doesn’t mean the selloff is over; this means more bearish data must come out to continue the move lower. The next date oil traders have circled on their calendars is March 26th. On March 26th OPEC and non-OPEC ministers will gather in Kuwait to discuss production cut compliance and potential future cuts or an extension to the current cuts. OPEC nations are trying to get non-OPEC countries to agree to more cuts. This is the cat and mouse game which is played. Every oil producing nation wants others to cut, but doesn’t want to cut its own production. U.S. oil producers have thrown a monkey wrench into an international group which already had a tenuous relationship.
The chart below shows the relationship between WTI oil and energy stocks. In the 2014 collapse, energy stocks led the decline in oil. You can either look at this chart and conclude that setup is happening again since oil stocks have fallen ahead of crude or you can conclude that even if oil falls, energy stocks won’t fall because they have priced in this move. My position has always been that oil prices falling will hurt S&P 500 earnings. I am ambivalent to whether energy stocks are overvalued or undervalued and sticking with focusing on formulating an outlook for the entire market. However, if demand for oil falls because the economy is weak, this will inevitably hurt energy stocks.
The market has had a dubious track record of reacting to political events in the past 6 months. First, it priced in a Hillary victory which was wrong. Then, it crashed the night Trump won even though he expressed a willingness to cut regulations and taxes. Now, it has gotten ahead of itself with the rally even though there are high hurdles to jump over to pass the GOP’s promised legislation. This is the same Congress who has had a tough time passing a budget. I don’t understand why the market has been expecting a pro-business agenda to be a slam dunk. There are many arcane rules Congress has and there are vast ideological differences within the GOP.
Speaker of the House of Representatives, Paul Ryan has explained the healthcare situation in the interviews he has done. He says the healthcare plan must be passed in 3 stages to be passed under what is called a continuing budget resolution. If the healthcare plan was passed all at once, it would be subject to being filibustered by the Democrats in the Senate. Ryan explained that the conservatives are unhappy with the process and not the policy of the plan. He said buying insurance without state lines, liability reform, and buying pools through joint associations would be approved in the next stages. If you agree with Ryan’s assessment that conservatives will vote in favor of this bill, then it makes sense to be bullish on stocks because everything is on track. If this gets passed quickly, an infrastructure plan and tax reform will come up for debate sooner.
I’m of the belief that Paul Ryan is biased. Every politician wants to play up the idea that their plan has a great chance of passing. They wouldn’t be able to explain why they support the plan if they didn’t think it would pass. Conservatives disagree with the refundable tax credits, which Ryan hasn’t directly addressed. Therefore, I think the fiscal stimulus plans will be delayed as this difference gets sorted out; the stock market will correct as a result.
As I said, arcane laws make the process of getting legislation passed tougher. The healthcare plan must be passed before tax reform is discussed. Senate Majority Leader, Mitch McConnell believes it will take until fiscal 2018 to get tax reform passed which is longer than what President Trump has said it will take. For those who are unaware, fiscal year 2018 starts on October 1st 2017. As you can see from the chart below, high tax bracket stocks have sold off relative to the S&P 500 because investors are now realizing that tax reform won’t get done soon. I think the overall market will follow the high tax stocks lower in the next few months.
Recent Comments