Strategy I: Diary of a Meltup. Now that the major US stock market indexes are back in record-high territory, I am starting to get more questions from our accounts along this line: “Is the meltup you’ve been expecting happening now?” The short answer is “Yes.”
The problem with the term “meltup” is that it suggests the runup in stock prices is speculative, thus raising the odds of a meltdown. However, it’s important to note that the meltup in stocks may be more sustainable because it is based on a meltup in earnings, as I discuss below.
I started writing about a potential meltup in the stock market in early 2013. I did so because the widely feared “fiscal cliff” at the end of 2012 was averted on New Year’s Day 2013. I concluded that there was “nothing to fear but nothing to fear.” The S&P 500 fell 7.7% in late 2012 on fiscal cliff fears, but still managed to gain 13.4% for the year (Fig. 1). It proceeded to gain 29.6% during 2013 on a big relief rally (Fig. 2).
An 11/9/13 Barron’s interview with me was titled “Lifting the Odds for a Market Melt-Up.” I said:
“I have met a lot of institutional investors I call ‘fully invested bears’ who all agree this is going to end badly. Now, they are a bit more relaxed, thinking it won’t end badly anytime soon. Investors have anxiety fatigue. I think it’s because we didn’t go over the fiscal cliff. … Investors have learned that any time you get a selloff, you want to be a buyer. The trick to this bull market has been to avoid getting thrown off.”
I also said: “Since the beginning of the year, I’ve been forecasting 60% probability of a rational exuberance scenario, 30% melt-up, and 10% meltdown. I’m still there, but I’m wavering and leaning toward the melt-up.”
The S&P 500 rose only 11.4% during 2014 and was relatively flat in 2015 as a result of a meltdown in commodity prices, particularly the price of a barrel of Brent crude oil, which plunged 76% from the summer of 2014 through the start of 2016. There was a 13.3% correction in the S&P 500 from November 3, 2015 through February 11, 2016.
It’s been mostly a meltup since that low in early 2016, with the S&P 500 up 58.6% through Friday’s close. The index is up 35.6% since Election Day, November 8, 2016.
The 12/9/17 Barron’s included an article titled “Outlook 2018: The Bull Market’s Next Act.” I was one of the 11 investment strategists surveyed by the author, Vito J. Racanelli. He wrote: “Edward Yardeni, President of Yardeni Research, is no stranger to Wall Street but a newcomer to our panel—and its most exuberant bull. He sees the S&P 500 ending next year at 3100, which would reflect a gain of about 17% from current levels.”
It sure seemed like a meltup was under way as the S&P 500 soared 9.3% from its low at the start of December 2017 through its new record high of 2872.87 on January 26. From that peak, the S&P 500 plunged 10.2% in 13 days through February 8. Since then, it is up 12.4% through Friday and only 6.8% from my year-end target of 3100. I suppose we have nothing to fear but a trade war and an emerging markets crisis. Strong earnings should continue to help us overcome those fears. The trade war will be resolved in a bullish fashion, in my opinion. Emerging market crises come and go.
Strategy II: Profits Meltup. The word “meltdown” originated with the invention of nuclear power reactors, referring to the accidental melting of the core of a reactor. The term has been widely used in the financial community to describe a precipitous and disastrous decline in an asset price. So it makes sense to describe a rapid increase in an asset’s price as a “meltup.” The implication, though, is that the price is rising faster than justified by the fundamentals, setting it up for a meltdown.
A price meltup that is justified by the fundamentals isn’t likely to be followed by a meltdown as long as the fundamentals hold their ground or get even stronger. This accurately describes the current situation in the stock market, in my opinion. Stocks are soaring because profits are doing the same. Consider the following:
(1) S&P 500 operating earnings in aggregate jumped 25.5% y/y during Q2-2018 to an all-time record high of $1.3 trillion (at an annual rate) (Fig. 3). The series was up 5.4% q/q, suggesting that the strong performance in after-tax profits isn’t attributable only to Trump’s cut in the corporate tax rate at the end of last year.
The Bureau of Economic Analysis (BEA) computes “book profits,” an after-tax series based on tax returns. It rose 6.7% y/y to a record $1.97 trillion (saar). Much more impressive is the 16.1% gain in after-tax profits from current production, which eliminates gains and losses attributable to inventory and depreciation accounting based on the Inventory Valuation Adjustment (IVA) and the Capital Consumption Adjustment (CCAdj).
(2) S&P 500 operating earnings per share (using Thomson Reuters data) jumped 25.9% y/y during Q2-2018, also to a record high of $41.03 (at a quarterly rate) (Fig. 4). S&P 500 revenues per share increased impressively over this same period by 10.4%. This implies that Trump’s tax cut might have added as much as 15 percentage points to earnings growth.
This effect can also be seen in the profit margin, which jumped from a record 10.9% during Q4-2017 (before Trump’s tax cut) to a new record high of 12.3% during Q2-2018 (Fig. 5).
(3) Cash flow received a big boost from Trump’s tax reforms, according to the BEA’s data. Corporate income taxes dropped from $351 billion during 2017 to $225 billion during H1-2018 (saar) (Fig. 6). Undistributed profits with IVA and CCAdj jumped from $533 billion during 2017 to $771 billion (saar) during H1-2018 (Fig. 7).
The bottom line is that cash flow increased significantly from $1,941 billion during 2017 to $2,531 billion during H1-2017 (Fig. 8).
Strategy III: Anatomy of a Meltup. Contributing to the bull run in the US since March 2009 have been occasional stampedes out of overseas stock markets as a result of European financial crises and troubles in various emerging market economies. That seems to be happening again this year. Consider the following:
(1) Here is the ytd performance derby of the major MSCI stock price indexes in local currencies: US (8.7%), All Country World (3.5), EMU (-1.8), Emerging Markets (-3.5), UK (-3.6), and Japan (-4.0) (Fig. 9).
(2) Here is the ytd performance derby of the major European MSCI stock price indexes in local currencies: Sweden (6.2), France (2.8), Switzerland (-3.2), UK (-3.6), Ireland (-4.0), Germany (-5.4), Spain (-7.0), Italy (-8.1), and Greece (-16.3) (Fig. 10 and Fig. 11).
(3) Here is the ytd performance derby of the major Asian Tigers and Emerging Markets MSCI stock price indexes in local currencies: Russia (9.9), India (9.2), Taiwan (5.2), Brazil (-0.6), Mexico (-1.4), Singapore (-6.1), South Korea (-6.4), Chile (-7.0), China (-9.0), and Argentina (-53.0) (Fig. 12, Fig. 13, and Fig. 14).
Strategy IV: Mr. Wonderful’s Meltup. On Friday, Kevin O’Leary (a.k.a. “Mr. Wonderful” and one of the sharks on Shark Tank) appeared on CNBC’s Halftime Report. He said that if Trump wins his trade war with China, the stock market could experience a meltup. I agree with that.
Joe and I have kept count of the number of panic attacks followed by relief rallies since the start of the bull market in early 2009. (See our S&P 500 Panic Attacks Since 2009.) Including the 13-day correction at the beginning of the year, we are up to 61. A resolution of Trump’s trade war resulting in fairer trade and less protectionism could trigger the “MAMU,” i.e., “the mother of all meltups.”
Last Thursday, the EU’s trade chief, Cecilia Malmström, said Brussels is willing to scrap tariffs on all industrial products, including cars, in its trade talks with the US! “We said that we are ready from the EU side to go to zero tariffs on all industrial goods, of course if the U.S. does the same, so it would be on a reciprocal basis,” Malmström told the European Parliament’s trade committee. “We are willing to bring down even our car tariffs down to zero … if the U.S. does the same,” she said, adding that “it would be good for us economically, and for them.”
Malmström’s comment goes beyond what was agreed to in July: The joint statement between European Commission President Jean-Claude Juncker and President Trump mentioned eliminating tariffs, non-tariff barriers, and subsidies only for “non-auto industrial goods.”
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.
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