Frank Holmes A Comment -- General Comments From an Expert A Commentary N/A Nov 18, 2016

About 1/3 of S&P earnings are in the bank already. Couple of things to note. First is that companies that are beating are beating by a bit more than estimates, but fewer companies are beating. 

Also, when you take out big tech, and specifically anything that has some kind of link to AI capex, there's no real earnings growth. When you look at nominal growth, sales overall are up 3-3.5%, and that's roughly equivalent to inflation. So if a company is raising prices at about the rate of inflation, if it's growing it should be growing sales at a faster rate than that. It tells you the economy's slow on a broad basis beyond what's happening in AI.

He goes back and looks at the dot-com bubble. In December 1996, Greenspan was early with his comment about "irrational exuberance" and the market kept going for 3.5 years before it peaked out. Nobody can time this. 

What we do know is that we're early in AI adoption as the next phase of tech and productivity growth for the world. It's a very bullish theme. But what do you pay for that today, and what's the catalyst to upset that? A few months ago the catalyst was tariffs, but now the market's not so worried about them. The next catalyst might be higher for longer; if they're going to run the economy hotter, then rates might just stay up. The market multiple should not be expanding in that environment, but so far multiples have held up.

We just saw some new headlines of the new need to fund debt and deficits. The cost of that debt is big. Looks as though the estimate is a bit below consensus, so that's a slight positive. So they either expect more revenues from tariffs, or they expect less spending somehow. We'll find out Wednesday morning how they're going to fund that -- are they going to fund it with bills (as the president wants) or are they going to issue more coupon debt (which has a negative implication for risk premiums)?

We have the Fed on Wednesday. They're not going to move on rates, but do they signal in their dot plot that they'll begin to cut rates later this year? Two reasons to cut rates:  the economy is slowing and labour market is starting to weaken (some signs of that), or inflation is well contained (and we still don't know this piece yet). 

We get the PCE (Fed's favourite inflation gauge) this week. We have yet to see any real transmission of higher costs from tariffs. That's still coming because even though there's a deal with Europe, there's a tariff. The tariff rates are going to be mid-high teens from all the estimates he's read. A lot of revenue from tariffs, but how much is going to get into consumer prices at the end of the day? It'll take months and months to find out. 

Good case to be made that the Fed should be on hold until we see the labour market or the consumer really start to weaken. Typically, those start to line up together when people start losing their jobs.

It comes down to different styles. When BMO writes their options, they're writing a bit further out of the money so you get a bit more capital appreciation. The Hamilton style is writing more of the portfolio closer to the money, which increases your yield but limits your upside. 

If you're really bearish, the Hamilton ones are a little bit better because they'll generate more income. If you're bullish but you need the income, then the BMO ones will probably give you a better experience because you're giving up less of the upside.

If you can positively tell him what the market's going to do over the next year, he could tell you which one will outperform. In general over time, since markets go up more often than not, he'd expect the BMO ones to provide a bit better performance.

When you're investing in corporate bonds, you're investing in the spread of that bond over the government equivalent in terms of interest rate risk. Whether it's the 1-, 5-, or 10-year corporate, it's the additional yield (the credit spread).

Credit spreads have been very narrow. Here's the rule of thumb everyone should use:  when equity markets hit their peaks, credit spreads are at their narrowest. Not a good time for new investment in corporate bonds. Much better to put $$ into government bonds at that point. Because when equities correct, government bonds do better and credit spreads widen. So the corporate bond will underperform when equity markets are correcting. 

When equity markets have finished their correction (down 5-15% or whatever), that's a better time to own corporate bonds because the credit spread will narrow. And that's really what you're playing when you're investing in corporate bonds.

Bonds are less correlated with the ups and downs of the world. But when you're in an inflationary environment, bonds don't give you the same protection that they once did during the disinflationary environment we were in for decades. We're in an environment where inflation will be a bit more persistent than it's been for the last 40 years, so typically bonds will underperform equities. 

If we get stagflation (no growth, but inflation) that's bad for all assets.

The Coming Week

Lots going on, plus a lot of big tech earnings. This week has the potential of being an inflection week. We're heading into a negative seasonality period through September-October. Lots of risk to the market here. There's a rule of thumb when you're learning charts:  if the market can't go up on good news, it's probably a sell.

So the tariff trade was potentially settled with the EU on the weekend. China's deal is kicked out 3 months down the road, we think. The market started up today, but now it's soft. We'll see where we close. There's a lot of information this week, so if the market can't go up on good news then we should take notice. On earnings and what's expected, George Soros always said to look at what's priced in and bet on the scenario that's not priced in.

He's looking at a chart of the S&P 500 going back to 1990 with anticipated earnings for the next 3 years. Earnings growth expectations are huge for the next couple of years. Do we have the economic backdrop to drive that?

The Congressional Budget Office recently put out an update. They took the "one big, beautiful bill" and forecast it out. Notwithstanding everything else, they put out a chart of where debt to GDP is going to go. Then they put out another one that assumes that all this AI investment adds to productivity and improves growth in the US. In that second scenario, the debt:GDP outlook starts to look a lot better if the growth rate and the economy can boom. Basically, it's a huge tailwind. 

What's happening now in AI is huge. But so was the birth of the internet in the 1990s, and then the bubble broke and it collapsed for a couple of years. That's possibly coming.

Final chart shows the valuation of US long bonds against the S&P 500. When you take the PE ratio and invert it, you get the earnings yield of the S&P. We're now at the same level as we were at the dot-com peak. It's expensive. Bond yields today at the long end are ~5%. You're earning more in US treasuries than you are in the S&P 500. Historically, this isn't a buy/sell indicator but it tells you the market is very expensive at this point.

If we get a catalyst now, that catalyst is good news, and the market can't rally, then it's probably the end of this rally phase for the next 3-5 months.

Counter arguments to a rising stock market: U.S. fiscal imbalances and government debt

There has been worry about government debt for decades, but the recent budget bill in the U.S. has taken this worry to peak levels. The U.S. federal budget deficit is now projected at US$1.9 trillion in 2025 (about six per cent of GDP), far above historic norms. Excessive government spending, without clear plans for reduction, could force higher Treasury yields, increase the cost of borrowing for the government and corporations and threaten confidence in U.S. financial markets. Higher fixed-income rates could see money flow from the market to savings accounts and GICs. Higher rates could lower corporate earnings. Yes, government spending can also provide a stimulus, but at some point, the piper needs to be paid. Countries cannot simply borrow trillions for all eternity.
Unlock Premium - Try 5i Free   

AI should continue to dominate for the next few years. There is a need for a huge amount of power to run these big models. He is seeing efficiency across many different types of industries pick up with AI and this should continue to improve. While some industries have tariffs, inflation and interest rates take a bite out of earnings and profits, the AI economy is moving full force ahead and doing really well. Large companies have the resources to hire in-house developers but it will take a while for small and medium companies to build these tools into their business.

The question was on his favourites of the Magnificent 7. He likes Amazon, Microsoft, Meta and Alphabet. Amazon and Alphabet had recent strong reports. Amazon would be his top pick of all of them today. It has long tailwinds.

No, it's stock-specific. AZN reported a beat and raise today, for instance. So is Novartis. Gilead in the US is holding on well.