"Kee" Points with Jim Kee, Ph.D.

  • US Update
  • Fed Fallacies
  • Corporate Cash
  • Current Bull Market

US Update

The Federal Reserve indicated last week that it intends to stay on track with one more rate hike this year, and in October it also intends to begin a very gradual process of allowing assets that it owns to mature without being replaced. GDP growth is expected to be around 2.4% for all of 2017. Both the Atlanta Fed and the San Francisco Fed are expecting third quarter GDP growth to drop from 3% in the second quarter to a little over 2% in the third. The San Francisco Fed argued that the drop in the third quarter would be primarily due to the impacts of hurricanes Harvey and Irma, but that a fourth quarter rebound would reflect post-hurricane rebuilding efforts. Those are the offsetting impacts I outlined in Kee Points following hurricane Harvey, which is why the long-term effects on the economy are expected to be negligible. Other big issues in the US are continued efforts at health care and tax reform. What I have heard of most importance in these very fluid discussions is a corporate tax rate target of 20% rather than the current 35%, and a 25% tax rate on “pass through businesses,” which currently pay the (generally) higher individual business owner’s tax rate. There is no real clarity yet on tax-deduction reforms or whether tax cuts would be permanent or temporary.

Discussions over the Fed’s balance sheet have uncovered a logical fallacy of sorts. The Federal Reserve creates money by buying securities from the banking system and crediting the accounts of those banks (that are held at the Fed) with cash. That is how most money is created by the Fed with the stroke of a pen, or a keystroke these days; it is not by printing currency with a printing press. Most of this created money is held in the form of “excess reserves” by the banking system (reserves in excess of required holdings). Historically, these reserves earned no interest, which is why banks typically didn’t like to hold a lot of excess reserves but instead preferred to loan them out. But post-financial crisis (and thanks to Congress) the Fed can pay the banks interest on their reserves held at the Fed, which reduces this “reserve tax” (income lost by not loaning out reserves). Now, on to the fallacy: Many believe that the act of the Fed reducing its balance sheet will hurt markets, on the assumption that it was the Fed printing money that goosed markets in the first place. But if that were true, if all of that Fed money was out bidding up the prices of securities, then that money wouldn’t be sitting on the Fed’s balance sheet in the first place, and the Fed wouldn’t have a large balance sheet to contract. What the Fed’s actions have done is eliminate the fear of a credit freeze/collapse and a collapse of the global financial system, and that has made global investors more comfortable holding risky assets like stocks.

Corporate Cash

One of the more interesting items in the news that I have seen has been a discussion (several pieces in the Financial Times) about cash-rich US corporations. About 30 US companies hold cash or short-term securities worth more than $1.2 trillion, which, “dwarfs the holdings of some of the country’s largest asset managers” and makes companies like Apple money managers in their own right (Financial Times). For investors in those companies there is a big question mark as to how this cash will impact company performance (e.g., will it lead to poorly-fitting or excessively priced acquisitions? Will it attract lawsuits? etc.) Of course, having a lot of cash is good problem to have, but managerial attention is scarce, and many scholars feel that managerial attention is THE scarce resource that has to be rationed in any big company - and a key constraint on just how large a company can profitably be. Managing $150 billion, as is the case with Apple’s corporate debt holdings, takes non-trivial amounts of managerial resources away from the business of coming up with high tech products. Other interesting factoids: Tech giants like Microsoft and Intel also own a tremendous amount of US Treasuries - Microsoft alone owns more US treasuries than all but 12 foreign countries. And if the total cash held by US corporations was its own country, it would rank in the top 10 countries of the world by GDP (Financial Times).

Elsewhere in the world, German chancellor Angela Merkel won a fairly decisive election on Sunday, as expected (her fourth term). Merkel did admit, however, that her controversial open stance towards refugees has polarized her country. In Japan, Prime Minister Abe has called a snap-election in order to, in his words, “break through our national crisis.” That crisis, according to Abe, is mainly an aging population and a declining birth rate, along with tension in North Korea (in my opinion its corporate governance). Abe wants to raise the consumption tax in Japan from 8% to 10% (which is already scheduled for 2019) but use much of the proceeds to provide free childcare for three-to-five-year olds. Opposing Abe is Tokyo governor Yuriko Koike, who would delay tax increases until the economy is on more solid footing. Japan has had 6 quarters of positive GDP growth in a row, but all below .6%.

Finally, on stocks I think Barry Ritholtz had a great piece recently on BloombergView. Ritholtz pointed out that the idea that a 20% decline or gain in stocks indicates a bear or bull market is based upon convention, not science. He points out that the S&P 500 declined 21.6% from May to October 2011, a “bear market” based upon intraday moves, but only a 19.4% decline based upon daily closing prices. Using that -19.4% number (as the media does) makes this “the second longest bull market on record,” while using the former -21.6% number does not. Also, small-caps as measured by the Russell 2000 Index fell 30.7% during the same period. In one of our previous STMM webcasts, Jeanie Wyatt and Christian Ledoux talked about a “stealth” bear market that we had already experienced back in 2015-16. Ritholtz argues the same, and provides the following peak-to-trough numbers for the mid-2015 to early 2016 period:

  • Median S&P 500 stock down 25 percent (index itself fell 15 Percent)
  • Russell 2000 down 27 percent
  • Japan stocks down 29 percent
  • Dow Jones Transportation Average down 32 percent
  • Emerging-market stocks down 40 percent
  • Small-cap biotech stocks down 51 percent

Current Bull Market

Ritholtz makes the case that if you insist on arguing that the current bull market began in March of 2009 (the bottom), then you have to acknowledge that the prior bull market actually began in 1974 (the bottom for the 1974-2007 period). His point is that you don’t measure the start of a bull market from its bear market lows, because a lot of the first few years are just a rebound from a prior collapse. This means that the current bull market is, in Ritholtz’s view, only about 4 and ½ years old (I don’t really have a problem with this reasoning). Looking to valuation, I look at market valuation levels (variously measured) and other data points like an engineer looks at a statistical process control chart. You see normal variation around some average measure, with “breakouts” here and there signaling some important development (like good or bad policies, inflation/interest rate regimes, technological breakthroughs, etc.). Right now I don’t see valuation levels in breakout territory, but I do see them at the higher end of the normal range.