Peddling fiction | Targeted Wealth Solutions

One of my first exposures to British comedy came courtesy of our local PBS station and reruns of Monty Python’s Flying Circus. I’ve found that Monty Python is pretty polarizing when it comes down to it: either folks appreciate the absolute madness of the group or loathe the over-the-top ridiculousness.

One of my favorite sketches is about a dead parrot. Despite the premise, it’s not macabre or cruel; instead, the plot focuses on a man attempting to return a dead bird to a pet store, much to the protest of the shopkeeper. As the bit runs on, the customer becomes more irate and the shopkeeper becomes more adamant in his position that the bird is sleeping and dreaming of fjords (the bird is a Blue Norwegian Parrot after all). The shopkeeper is completely delusional and the sketch continues to devolve into “silliness” until another Monty Python character steps into the sketch to stop it.

I was reminded of this episode after reading some of the respondent feedback that was buried in the Dallas Fed Manufacturing Survey on Monday. While the survey reported some stabilization in March, and manufacturing conditions finally crossed into positive territory at a reading of 3.3, the new orders index and growth rate of new orders remain in negative territory. Even though the survey only measures activity in Texas, it’s still an important piece of data given that the state ranks second behind California in factory production and first in the nation as an exporter of finished goods. The headline may have been that the survey came in at “less bad” than expected, but the devil’s always in the details — or in this case, the comments from the survey’s respondents, who are Texas executives in manufacturing companies.

Here are a few of the responses:

Bad: The instability of the domestic oil and gas exploration and production activity continues to wreak havoc on demand for our products. (Fabricated Metal Product Manufacturing)
Good: We manufacture accessories for the HVAC industry so it is very seasonal. We are ramping up for the season but have also been very busy all year. It’s hard to factor in the seasonality aspect when you’re getting slammed. I think revenues will be up 10 percent this year. (Fabricated Metal Product Manufacturing)
Bad: The positive March versus February comparison (as well as the six-months-ahead view) is due entirely to an extremely poor February. Volume remains well below monthly volume in the fourth quarter. Headcount was reduced in February, allowing remaining staff to return to a 40-hour workweek. (Fabricated Metal Product Manufacturing)
Good: Orders were stronger in March versus January and February. Customer expansion plans appear to be steady. (Machinery Manufacturing)
Bad: We are generally just bumping along in a weak macro environment. (Computer and Electronic Product Manufacturing)
Good-ish: We have picked up in March but only because February was so dismal. We were super slow with many 3.5 to four-day workweeks in the plant. Activity is trying to pick up, and it appears we will be busier in the coming months than we have been. (Printing and Related Support Activities)
Bad: We expect the weakening in the energy sector to ripple through to our primary end users in Texas. So far activity statewide has maintained some strength, but we are cautious that it will start to have a broader impact later in the year and into 2017. The degree to which the Texas economy holds up to the trouble in energy will be a testament to the alleged diversification in
the state. We are preparing for the worst and hoping for better. (Transportation Equipment Manufacturing)
Bad: As a long-lead-time capital equipment manufacturer, we are working off backlog. Anyone who says the economy is not in recession is peddling fiction. (Machinery Manufacturing)

The common threads are capital spending uncertainty, a strong dollar (hurting exports overseas), and second-order effects from the oil and gas industry. The comment by the long-lead-time capital equipment manufacturer stood out because it echoes a theme that we’ve mentioned before regarding U.S. corporate spending on capital investments on the premise of growth. Reuters ran an article in February about the spreading of anemic capital expenditure (CapEx) budgets from the Energy sector to other industries. However, as FactSet reported this month, CapEx — once you strip out Financials and Energy from the S&P 500 — continued its upward trend, although flatlining somewhat on the Trailing Twelve Month chart:

In contrast to the downbeat Texas report, the Philly and Richmond manufacturing surveys indicated a robust rebound from February lows. However, respondents in the Richmond survey indicated a declining outlook on CapEx spending in the next 6 months as compared to their February and January outlooks. Respondents in the Philly survey were split, with about half reporting that capital spending would decrease (31%) or stay the same (23%).

Federal Reserve Chairwoman Janet Yellen mentioned that economic conditions were “mixed” and “less favorable” than in December when the Fed raised rates, and subsequently took an another accommodative posture with respect to “proceeding cautiously” with future rate hikes. This sent risky assets soaring; however, safe haven assets like gold and Treasuries were also pushed higher as it appeared that investors just bought everything (aside from the U.S. dollar). The Fed’s dual mandate of unemployment in the sub-5% regime (maximum employment) and stable prices (inflation as measured by PCE at 2%) is on the verge of being met in its entirety: Unemployment came in at 4.9% for February and core PCE is ringing in at 1.68%:

(Source: Advisor Perspectives)

A few of the regional presidents (like Charles Evans of the Federal Reserve Bank of Chicago) have indicated that letting inflation run above the desired 2% is well within the realm of the possible for the Fed. Higher inflation seems to be the lesser of two evils based on the commentary (and policy actions) coming out the Federal Reserve lately. Indeed, the economic barometers — when taken in aggregate — have showed steady, if not remarkable, growth in the U.S. So the immediate risk seems to be external global shocks to the system, which is why the Fed is loathe to lean too far forward with their rate hike plan. Actions or words that hint at rising rates theoretically bring strength back to the dollar, which cuts into the already thin profits of U.S. companies doing business internationally.

One concern, however, is that market gains belie the low expected growth here in the U.S. Within a valuation context, we can look at the Cyclically Adjusted Price-to-Earnings ratio of the S&P 500 as proposed by Yale professor Robert Shiller. This measure uses the price of the index divided by a moving average of 10 years of earnings and then adjusts for inflation.

At its current (estimated) level of 26.10, the valuation measurement is almost as high as we saw last year prior to the crash in August. However, it’s not as high as the mid-late 90s or even prior to the 2008 financial crisis. So it’s important to not look at PE in a vacuum, but rather through the lens of a trend to help overcome our bias in assuming the economy hasn’t undergone any structural shift since the 90s or even the mid-2000s. We can use a mathematical technique called a Hodrick-Prescott Filter to smooth out our series of PE measurements and dampen some of the short-term fluctuations. With the filter in place, we can see if the PE is above its current trend — and analyze the deviations form the trend:

(Source: CAPE valuation from Multipl; data computed in R by author)

So while we can see we’re above the smoothed trend slightly, we can also see that there’s no time limit to how long that may be the case or how much further we can deviate to the upside. For those who believe that friends don’t let friends filter with the Hodrick-Prescott, here’s the same CAPE data with a smoothed Kalman filter applied:

So the Cyclically Adjusted Price-to-Earnings ratio is above the trend (slightly), and certainly high in an absolute sense given that the mean CAPE is around 16.7. But with soft economic data, elevated Price-to-Sales ratios, and a sputtering global economy, any crack in the expectations of corporate growth and earnings may result in a “overshoot” of the trend and a nasty pull-back of the markets. As earnings reports kick off in the next 2 weeks, it will be interesting to see if the market reacts to fundamentals or to an overly accommodative Federal Reserve.

Until then, however, we expect a continued peddling of fiction.

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