The Market Never Falls Anymore

Even though the Dow was overbought heading into the week, the biggest determining factor for how it would go was earnings. This shows how technical analysis has its limits when news is released. The Dow rallied 0.73% because Caterpillar and 3M reported great results. These reports are evidence of the strong global economic recovery. Before we look at their results, let’s look at the latest streaks the S&P 500 has gone through without corrections of various sizes. As you can see from the chart below, the streak without a 5% correction is 331 days; we’re closing in on the longest streak in that category. It has been 425 days without a 10% correction which isn’t a long streak. It has been 2,170 days without a 20% correction which the second longest streak ever. It shows that the fact that we are in the longest streak without a 3% correction isn’t a completely random event. Volatility has been suppressed and corrections don’t happen as much.

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Caterpillar - CAT And 3M Had Great Earnings

As I mentioned, Caterpillar - CAT had a great quarter. It shows that buying cyclical stocks when they are doing poorly and selling them when they do well makes sense. If you bought the stock in 2016 when the results were poor, but there was a glimmer of hope, you would have made a lot of money. I’m not saying now is the time to sell because the recovery has only just gotten started. However, most of the gains for this cycle have likely been made. CAT’s earnings for Q3 were $1.95 which beat estimates for $1.22. Revenues were $11.4 billion which beat estimates for $10.73 billion. Full year revenue guidance was $44 billion which was above estimates for $43.13 billion. Full-year earnings are now expected to be $4.60 which is an increase from the previous estimate of $3.50.

During the downturn in the 3 segments CAT operates in, the company focused on cutting costs which gave it operating leverage for when the recovery came. In the construction segment, CAT used to have margins in the low teens; now margins have been 18% for 2 straight quarters. The chart below breaks down the dealer sales growth by region. As you can see, all the segments are growing again, with Asia Pacific being the strongest. The Chinese soft landing is finally here as its economy has stopped the free fall.

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3M also had a great quarter. Sales were up 6.6% on a local currency basis in Q3. GAAP earnings per share were up 8.4%. The full year outlook was increased from $8.80-$9.05 to $9.00-$9.10. 3M saw the same strength in the Asia Pacific region as sales were up 10.8% making it the region with the fastest sales growth. Obviously, there are some company-specific metrics which helped 3M succeed, but the momentum is coming from the same place as Caterpillar. The global economic recovery has been spurred by improvements in emerging markets.

Fed Chair Changes

Just as it seemed like Powell would be picked as Fed chair, the odds changed once again. Today Powell’s odds fell by 2% to 56% and John Taylor’s odds increased by 14% to 28%. The shift occurred because President Trump asked the Republican Senate leadership for a show of hands who he should pick as Fed chair. Senator Tim Scott said he thinks Taylor won the informal vote. It’s not a surprise to me that Taylor won. What is surprising is that President Trump asked the Senate who they’d pick in an informal way which got reported by the press. I said that it’s not surprising Taylor was picked because Taylor and Speaker of the House, Paul Ryan, wrote a joint article about monetary and fiscal policy a few years ago. If the President listens to the Senate leadership, he might change his decision. To me, this means the decision between Powell and Taylor is close, so the President is looking for a tie breaker.

It’s tough to understand what this means because it’s an unprecedented act. I would still lean towards Powell being picked because he’s a dove. It’s not as if the Senate wouldn’t accept Powell’s nomination. It has been always known that if President Trump went with his party, he would select a hawk-like Warsh or Taylor. However, he isn’t with his party on this issue because he believes a dove will support the stock market. He’s in a lucky situation because the global economy appears to be accelerating to the point where the stock market would go up no matter who is picked.

New Valuation Model?

We all know that the stock market is expensive according to most metrics. We also know that the low inflation and strong economic growth imply that the market deserves to trade at a premium multiple. The million dollar question is what that multiple is. The chart below helps us understand the answer to that question. As you can see, when inflation is below 3%, the Shiller PE is 22.32 on average since 1950. Currently, the Shiller PE is 31.35, so the market is above the low inflation average, but not by as much as the overall average. The trailing 12 month PE multiple since 1950 with inflation below 3% is 21.08. The current trailing 12 month PE multiple is 22.3. That is, once again, slightly above the low inflation average. The current S&P 500 earnings yield is 4.29%. That shows the same relationship as the other valuation metrics.

Finally, the current difference between the S&P 500 earnings yield and the 10 year bond yield is 1.87%. That’s a better difference than the average with inflation below 3%. That makes sense because the 10 year bond yield of 2.42% is much lower than the average yield when inflation is below 3%. Interestingly, the difference between the S&P 500 earnings yield and the 10 year bond yield grows when inflation falls which means low interest rates don’t increase stock multiples on a 1:1 relationship. Investors know that inflation will eventually rise again, so they don’t go all in on stocks. We’re seeing that same relationship play out now as the difference between the earnings yield and 10 year bond yield is higher than average.