The market has become unhinged from reality in the past few years as investors have decided to ignore what companies are telling them and instead listen to what Fed officials are saying. If Fed officials say the labor market is strong and inflation is low, investors believe them. Maybe investors don’t believe them and are just making investment decisions based on their rhetoric, and know that reality is different from what they say. The Americans in Pennsylvania, Michigan, and Wisconsin voted on the economy. The stated, loud and clear, that the Obama economy hasn’t worked for them; they were willing to go with what they called an unqualified person to run the country and direct economic policy.
It’s nothing new that the market has believed what the Fed told it about growth. Investors can either do their own macroeconomic research and come to an objective opinion ignoring what they want to be true or they can listen to the Fed’s Beige book which usually says there is moderate growth. The Fed missed the last recession a few months after it started, so I think they have a poor track record. Investors appear to be dedicated to sticking their heads in the sand and ignoring this.
Ever since 2010, Obama has been obstructed by the Republicans as far as getting much of his desired economic plans passed. I’m not saying they would have worked, I’m merely saying Obama would have passed through more fiscal stimulus funded by deficits if the Democrats had a majority in both parts of Congress. The eternal short term thinking of policy makers and politicians knows no bounds. If you give a politician $10, he will spend the $10 and borrow against it as much as possible.
Investors now have added a new politician to believe while ignoring reality. The market decided Trump will be able to spend money on a new infrastructure stimulus plan while not cutting entitlements and cutting taxes. These are the same failed policies of past administrations. As long as economists continue to think deficits don’t matter, we will continue to see them tried. Along with decreasing tax rates, Trump will start off in trouble as tax revenues are peaking for the cycle. As you can see in the chart below, the past few quarters of government tax receipts have plateaued.
Corporations are the most levered they have ever been. With their margins peaking they will have to lay off workers which will decrease the amount of income taxes the government takes in. It looks like Trump’s deficit spending plan has increased inflation and thus interest rates. This means borrowing costs will increase. Firms will no longer have cheap money to fund stock buybacks. Buybacks help make earnings per share numbers look better than they are. When investors see the EPS numbers without the massive buybacks, the stocks will fall.
As I said interest rates are rising under the guise of President-elect Donald Trump. While the stock market has decided a President Trump would improve growth, the bond market is wondering how he will pay for these spending increases. The first 30 year auction under Trump priced at a high yield of 2.902%. This tailed the When Issued 2.889% by 1.3 basis points which indicates there was weak demand. As you can see below, the Bid to Cover ratio fell from 2.439 in October to 2.107. This indicates there was less demand for the bonds even though there were higher yields offered. In summary, the bond market is weary of Trump issuing this amount of debt. According to analysis, Trump could add $5.3 trillion to the debt over a 10 year period.
Today the TFAANG (Tesla, Facebook, Apple, Amazon, Netflix, Google) stocks are falling because interest rates rising is bad for these expensive stocks. These stocks should go down because they are at bubble valuations. However, while these stocks would normally the type of stocks which are expensive, the entire market is in a bubble. All stocks should be declining like theses technology stocks.
We have been hearing from bulls about how low rates mean stocks can have higher valuations. Now that rates are rising stock valuations need to decline. Caterpillar is one example of an expensive stock which should be hurt by rising rates, but is rallying. Not only is Caterpillar expensive, but it should be hurt by rising rates because it is a dividend stock. As rates rise, bonds will be more competitive with stocks with high yields, making dividend stocks less interesting to investors. In 2016 Caterpillar expects to earn $2.75 including restricting costs and $3.55 excluding them. This means Caterpillar trades at 34 and 26 times earnings respectively. The multiple will increase during trough periods, but the market is certainly projecting Trump’s new spending projects to help results. My question is whether this spending plan can happen when the deficit is $600 billion, tax receipts are declining, and the interest on the debt is increasing.
Conclusion
The market has decided to believe the Fed that the economy is strong. Now it has decided to suspend logic and math and believe Trump that he can spend money that the country doesn’t have on big infrastructure projects. Budget deficits and the total debt begin to matter when interest rates rise. All of the economists who have been saying that the debt doesn’t matter will be in for a rude awakening when the government has to spend an ever increasing amount of money on just servicing the debt. Eventually the country won’t be able to afford to service the debt if we continue on this path.