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Where Have All the Black Swans Gone?

Where Have All the Black Swans Gone?
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Wednesday, 25 October 2017 01:51 PM Current | Bio | Archive

Strategy I: White Swans. Pete Seeger’s song asks, “Where have all the flowers gone?” Today, the question is, “Where have all the black swans gone?” Is it really possible that we have nothing to fear but fear itself? It’s not that hard to come up with more substantial fears. For example, as I observed yesterday, many of our accounts are asking me, “Won’t the stock market take a dive if the Republicans fail to pass tax reform including tax cuts?” My answer, “What if they succeed in doing so?” That white swan seems to be driving stock prices to new record highs since the Trump administration presented its 9/27 Unified Framework for Fixing Our Broken Tax Code.

Another white swan for stock prices is earnings. Let’s review the latest data:

(1) Q3. The Q3 earnings season is showing that the blended estimated/actual earnings for S&P 500/400/600 are down sharply through the 10/19 week (Fig. 1). Some of the weakness reflects the hit from hurricanes Harvey and Irma. The traditional upside hook is showing up in the S&P 500’s Q3 earnings series. The stock market is obviously ignoring that y/y earnings growth rates are down for S&P 500 (from 10.0% during Q2 to 3.5% during Q1), S&P 400 (12.3% to 3.4%), and S&P 600 (6.1% to 0.9%) (Fig. 2).

(2) Q4. Analysts must believe that the Q3 weakness is temporary, because their earnings estimates for Q4 have been remarkably stable since the start of the year. They are expecting Q4 rebounds in earnings growth rates back into the double digits for the S&P 500 (12.0%), S&P 400 (13.0), and S&P 600 (18.1).

(3) 2018. Also holding up remarkably well are analysts’ consensus earnings expectations for the three market-cap categories in 2018 (Fig. 3). They are currently predicting solid growth rates for next year for the S&P 500 (11.6%), S&P 400 (15.2%), and S&P 600 (22.2%).

(4) 2019. Joe and I are now starting to track weekly consensus expectations for 2019 earnings. Analysts currently estimate that S&P 500 earnings will rise from $130.70 this year to $145.91 next year and $159.30 in 2019. The 2019 growth rates for the S&P 500/400/600 are 9.2%, 3.9%, and 5.7%.

(5) Forward earnings. Since they are time-weighted averages, forward earnings of the three S&P 500 stock market indexes are rapidly converging toward their 2018 consensus estimates. Next year, they will increasingly give more weight to their estimates for 2019 and less to those for 2018. In other words, company results being reported now for Q3 and to be reported in January for Q4 are mostly irrelevant to stock market investors at this point, except in cases suggesting significantly altered earnings outlooks for 2018 and 2019.

(6) Forward revenues. Driving earnings estimates higher are solid projected growth rates in revenues (Fig. 4). For 2018, they are estimating 5.1%, 5.0%, and 5.3% for the S&P 500/400/600. For 2019, their estimate revenues growth rates are 4.9%, 3.9%, and 4.3%. The march to record highs of the S&P 500 forward revenues since early this year has been particularly impressive.

Strategy II: Gray Swans. With so many white swans swimming in the stock market, it’s hard to see any black ones. Our worst-case scenarios currently are more like gray swans:

(1) 1987 all over again. The stock market melts up through early next year. Then something bad happens, which isn’t so bad but is bad enough to cause an ETF-led flash crash. Neither the bad event nor the crash are wicked enough to cause a recession. So it would be reminiscent of 1987, when the S&P 500 plunged 20.5% on Black Monday, October 19. The closing price of that day turned out to be a great buying opportunity. The S&P 500 retested this low on December 4 before starting a new bull market. The bad event in this scenario might be the failure of the Republicans to achieve their tax reform agenda.

(2) New Fed sheriffs. Another event that might trigger a meltdown, or cap a meltup, might be a more hawkish Fed. Under the leadership of newly appointed governors to replace Fed Chair Janet Yellen and Fed Vice Chair Stanley Fischer, the Fed might be more inclined to see a stock market meltup as a potentially worrisome bubble. If so, the FOMC might be more willing to employ either monetary policy and/or so-called macroprudential policies to take some air out of the bubble.

(3) QE termination. Another gray swan might be the termination of QE programs by the major central banks. The perma-bears (remember them?) growled that the current bull market was driven mostly by the Fed’s QE programs. They showed a chart with the S&P 500 compared to the balance-sheet assets of the Fed (Fig. 5). The two series were highly correlated until the Fed terminated QE at the end of October 2014. Since then, the Fed’s assets have been flat around $4.3 trillion, while the S&P 500 is up 27.1%!

This month, the Fed started to let its balance sheet shrink as its bonds mature. Yet there’s no fear showing in the stock market, or even the bond market for that matter. Perhaps the gray swan will make an appearance when the European Central Bank (ECB) and the Bank of Japan (BOJ) announce that they are terminating their QE programs. The S&P 500 may be hooked on the combined QE programs of the Fed, the ECB, and the BOJ (Fig. 6).

(4) Little Kim. Perhaps something bad will soon happen between the United States and North Korea. This past weekend, Japanese Prime Minister Shinzo Abe was re-elected with a decisive win. He is one of President Donald Trump’s strongest allies in Asia as both Washington and Tokyo grapple with how to handle Pyongyang. CNN reported: “Abe, a conservative hawk, has long been a supporter of Trump’s more aggressive North Korea policy, which has coincided with his attempts to rewrite Japan’s post-war pacifist constitution.

“Following Sunday’s vote, Japanese Defense Minister Itsunori Onodera warned the threat from North Korea—which has repeatedly fired missiles over Japan in recent months—had reached an ‘unprecedented, critical and imminent’ level.”

The question is, “Why don’t the Chinese remove Kim Jong Un, the belligerent nuke-obsessed leader of North Korea?” Thanks to him, Abe was basically given a mandate to upgrade Japan’s military capabilities, not a welcome development in Beijing. The Chinese know where all of North Korea’s nukes are located since they trained all of the country’s rocket scientists. They can always de-Kim and de-nuke North Korea. So what are they waiting for?

They may be hoping to use their obvious leverage to change North Korea’s regime to get recognition of their sovereignty over the South China Sea resulting from their man-made islands. It’s a dangerous game, but it isn’t likely to end with a military confrontation. That seems to be the widespread assumption among stock investors. I agree. However, that elusive black swan we’ve been looking out for just could be swimming in the South China Sea.

Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.

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Where Have All the Black Swans Gone?
black, swans, investors, trump
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2017-51-25
Wednesday, 25 October 2017 01:51 PM
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