Stocks Lose Steam In The Afternoon
On Monday, the stock market had a strong morning, but then gave up most of its gains in the afternoon. The Dow was up 440 points in the afternoon, but only closed up 46 points or 0.19%. The S&P 500 was up 0.33% and the Nasdaq was up 0.51% as the tech sector was up 0.78%. This was another day with big swings. So far this year there have been 27 days with a 1% move which is more than triple the 8 days in 2017. The average since the 1960s is 53. Clearly, the market is on pace to shatter that average.
We can never know for sure why stocks move especially with the headlines roaring. For example, a prevalent headline on Monday was the FBI raiding Trump’s lawyer’s home. That sounds daunting, but ultimately, it’s dubious how that affects corporate earnings.
CBO Provides 10 Year Estimates On GDP Growth & Budget
The other negative headline on Monday was more substantive as the CBO came out with its projections. On the positive side, the projection for GDP growth in 2018 went from 2% to 3.3%. I think that’s too optimistic. It’s higher than the Fed’s forecast for 2.7% growth. The CBO also increased its estimate for 10 year growth from 1.8% to 2%. The chart below shows the affect the tax plan is expected to have on growth in the next 10 years. As you can see, the estimates are more optimistic than what many private firms have projected. The tax plan is also expected to add 1.1 million jobs over the next 10 years. The spending plan is expected to help GDP by 0.3% and 0.6% in 2018 and 2019 respectively.
The reason stocks sold off on the CBO announcement is because the tax law is expected to add $1.9 trillion in deficits over the next 10 years. As you can see from the chart below, the CBO expects the debt will be 96% of GDP by 2028. Weirdly, the CBO expects the Fed funds rate to be at 4% in 2021 which is higher than the FOMC’s estimate. It’s an unlikely prediction which relies on the assumption that the tax cuts will accelerate GDP growth, inflation increases because of this growth, and the economy avoids a recession in the next 3 years. The scary part is the debt projections might be too optimistic because there will be a recession or two in the next 10 years. The negative part of the projection about higher interest rates is that the U.S. is expected to pay more on interest payments that it does on the military starting in 2023. Furthermore, interest payments will be higher than all non-defense discretionary spending by 2025.
The Market’s Reaction To The CBO Estimates
The interesting part of this situation is that it appears the market thinks the CBO has more credibility when it comes to deficit projections than it does on growth projections. The economic outlook on the next 10 years improved, but Wall Street would rather trust its own estimates. Personally, I agree with the market’s assessment because it seems very likely that the debt to GDP will increase. The other estimates can easily be wrong. It’s very difficult to predict growth in the next year let alone the next 10 years. If Wall Street thinks the CBO is too optimistic on growth, this leaves open the possibility that the debt to GDP will get even worse than estimated.
There are two ways to look at the daunting debt. On the one hand, this is barely news since everyone knows the debt is going to be an issue in the next 10 years. Forecast models change depending on the inputs. No one can create a perfect model. Even the more optimistic CBO estimates on growth make the deficit look like a problem. Because everyone knows about this issue, you wouldn’t expect the market to react.
On the other hand, it’s laughable to see the stock market only fall about 1.5% from the high on the day with the projection that the U.S. government could be in dire straits if the spending binge continues. It’s almost impossible for a politician to win on the platform of cutting spending and raising taxes. It’s more likely that the GDP growth is higher than the CBO’s projections than it is that the government suddenly shows fiscal restraint. Tangible impacts of the debt, might spur reform. The low interest rates might be a negative in the long term because they have masked the government’s spending problem.
Investors Are Bearish
It’s amazing to see articles purporting that being long volatility is now the safe trade, but it’s the truth if you’re backwards looking. As you can see from the chart below, the net non-commercial positions in the VIX have recently reached a record high. The trading hits records often because the trading has increased overtime, but it’s still remarkable to see the sharp reversal from late 2017 where there was a record short position in the VIX.
The chart below is another way of expressing that the market has shifted from euphoria, like never before seen, to pessimism. It shows the TD Ameritrade Investor Movement Index which measures sentiment. Even with a relatively normal correction, the sentiment is almost as negative as it was at the trough in 2016. The optimism built up since the election is almost completely gone which is a bullish sign for near term stock performance. If you are a bull, it’s much easier to deal with a volatile range bound market than a large decline which wipes out the euphoria. It feels terrible especially for retail investors, but the S&P 500 is only down 2.26% year to date. The bears state this isn’t close to ‘blood on the street’ or capitulation which is correct. However, there’s no reason for such a scenario to occur since earnings growth is in the teens and there’s no recession. We’re in a range bound market which I expect to continue for the next few weeks.
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