Analysis: Q4-2017 Macro Update

Global economic expansion, falling unemployment levels, low interest rates, and low volatility have coalesced, creating a Goldilocks environment for asset valuations. This party continued throughout the fourth quarter and perhaps it will continue far into the future, as markets appear to be betting on; trees will grow to the sky, and everyone will get rich. But perhaps not.

As always, I have no idea what the near-term future will bring, which naturally leads me towards skepticism whenever expectations are at or near extremes (things are rarely as bad as they seem, and things are rarely as good as they seem). In the face of uncertainty, the best thing we can do is study up on economic history, trying to get a better sense of how today’s world fits in a larger picture. There isn’t much money to be made in trying to time the market, but there is plenty of money to be made in understanding the world a little better than the crowd.

Market snapshot

market snapshot q42017.png

Consider the following for 2017:

  • Indexes around the world traded near historical highs.
  • It was the 8th year of the bull market and the S&P still returned ~20%.
  • Stocks were up every single month in the year for the first time ever.
  • It marked the longest period in history without a -3% correction.
  • Volatility hit record lows.
  • The S&P’s relative strength index was at its highest level since 1929.
  • A Da Vinci painting sold for about half a billion dollars.
  • Bitcoin was a thing.

To say the markets were up would be an understatement.

In the U.S., the passage of corporate tax reform helped keep the party going. The long-term consequences of the reform are still up for debate, but in the short-term, companies with low overseas profits and low R&D expenses, who thus paid near 35% in corporate taxes under the old rules, should benefit. The possibility of a large infrastructure package becoming law and continued deregulation should also spark animal spirits.

The technology sector continued to claim a disproportionate share of the market’s rise. The “innovate business model” of attracting peoples attention and then selling that attention to advertisers, seems to demand a market premium well north of 10x sales. Elsewhere, the business model of borrowing money, burning it, and then borrowing more money was all the rage. Investors seem to be more worried about missing out on growth opportunities than they are about valuations. This risk seeking mindset rarely ends well.

The story was similar around the world. The 45 largest economies in the world were growing at the same time for the first time in over a decade. In Europe, economic growth continued to surprise on the upside, taking the Euro along with it. In Asia, China and Japan stepped up as drivers of global growth.

The question now becomes, when will central banks reign in the party? Historically, bull markets don’t end with a dramatic Lehman moment, but rather with a round of monetary tightening.

Market Valuation

To get a sense for the overall market valuation, we will be looking at the Case-Shiller PE10, the Market Capitalization to GDP ratio, Tobin’s Q, and the VIX.

Case-Shiller PE10 (CAPE):


The Case-Shiller Cyclically Adjusted P/E Ratio (CAPE) takes the real S&P 500 price index and divides it by the moving average of the preceding 10 years of real reported earnings. The idea is that by using a 10-year average we will be better able to capture the entire business cycle and not just the boom/bust periods. A problem with CAPE is that we aren’t always comparing apples to apples, as accounting standards can change.

The CAPE ratio rose in the fourth quarter to 33.6 and is now higher than every other period in history except for 1999. This would be less troubling if interest rates were still falling, but the Fed has signaled a desire to raise rates and the market appears to be complying. Though the CAPE has rarely proved useful in timing the market, it has proved useful in predicting future returns. Today, the CAPE is signaling a low single-digit return world.

Market Capitalization to GDP Ratio:


The Market Capitalization to GDP ratio takes the entire U.S. stock market capitalization and divides it by the U.S. GDP. Think of this as a kind of price-to-sales ratio for the entire market. The basic idea is that corporations shouldn’t be worth much more than the economy they operate in. This avoids the accounting issues of CAPE but has other issues in a globalized world. For example, if a U.S. based company is making a ton of money around the world, it doesn’t really make sense to compare it only to its local GDP.

The MC/GDP ratio rose in the fourth quarter to 1.80, matching its dotcom bubble peak. This suggests that equity valuations are disconnecting from the underlying economy. Take from that what you will.

Tobin’s Q:


Tobin’s Q works under the assumption that a firm’s market value should be close to the replacement cost of its assets. If those firms are really good at using their assets, then investors will be willing to pay more than replacement cost (Q > 1). It takes the market value of companies and divides them by their accounting net worth. Think of this as a kind of price-to-book ratio for the entire market.

The main issue here is that it’s extremely difficult to get an accurate measure of the replacement cost of a company. US GAAP accounting has this asymmetric nature to it where assets can be marked down but not marked up. This leaves companies holding decades-long real estate on their books at depressed levels and leaves intangible assets, like the network effects of Facebook, completely off book.

Tobin’s Q rose in the fourth quarter to 1.09 versus a historical average of 0.93 and high of 1.60. This suggests that market participants are optimistic that businesses will continue to use their asset bases to produce economic profits.

Volatility Index (VIX):


The CBOE Volatility Index is a measure of the market’s expectation of near-term volatility based on stock index option prices. Think of it as looking at how much people are willing to pay for index options, and then reverse engineering the implied volatility for that price.

The VIX fell in the fourth quarter to record lows, suggesting that investors don’t expect large moves in the market.

Market Valuation Summary:

Valuations are at record highs and investors are complacent. Now is the time for diligent risk management.


Inflation is the rate of increase in prices for goods and services in an economy. Back in the day, Keynes explained why a little inflation was necessary to avoid the paradox of thrift – a tendency of consumers to learn to hold off their purchases and wait for prices to fall. Tracking inflation is important because it gives us some insight into future interest rates. Over the long-term, 10-year Treasuries tend to return about 2% more than printed inflation and 30-year Treasuries about 3% more. We will be looking at inflation expectations, Core CPI, and the Taylor rule.

Inflation Expectations:


The 10-Year breakeven inflation rate is a measure of expected inflation derived from the price of inflation-indexed securities. Think of it as what inflation needs to be for investors to break even on inflation insurance.

Throughout the fourth quarter, inflation expectations were running below the FED’s target of 2%, but have since picked up in the new year. This suggests that investors are starting to gain confidence that the economy is picking up.

Core CPI:


Core CPI is the actual measured inflation in the economy, excluding food and energy which tend to be more volatile. Here we are looking at the percent change for the index over the last year.

Core CPI remained flat in the fourth quarter, hovering around 1.70%. Janet Yellen, in her one of her last speeches as FED Chair, explained with great humility the issues of trying to predict inflation going forward. She pointed towards the inherent imprecision in our estimates of labor tightness, inflation expectations, and other factors such as technology. With that humility in mind, it’s hard to say whether inflation will pick up and match expectations, or remain low for decades to come, as has been the case in Japan.

Taylor Rule:


The Taylor Rule is a guideline for how central banks should alter interest rates in response to economic conditions. It takes into account targeted inflation versus actual inflation and real output versus potential output. Think of it as a forecasting model to help us determine what the FED is likely to do with interest rates going forward. However, as with everything else, there are drawbacks. First, it is unable to account for real-time issues like a stock market or housing market crash. Second, it loses its relevance in a world where the FED funds rate is not the primary tool of monetary policy.

In the chart above, we can see the gap between what the Taylor Rule would predict for interest rates (Blue) and what the FED level is set at (Red). The Taylor Rule predicted a rate of 4.02% for the fourth quarter versus the effective federal funds rate of 1.15%. This suggests that there is plenty of room for interest rates to rise.

Inflation Summary:

Economic growth, rising energy prices, and a tight labor market should be leading to higher rates of inflation. This has yet to show up in the data and it is possible that a confounding variable, such as technology, is having an outsized effect on it. If inflation does pick up, and interest rates along with it, banks and insurance companies should benefit most.

Business Cycle

The whole point of macroeconomic forecasting is to figure out what is going on in the business cycle. As Howard Marks says, “There are two concepts we can hold to with confidence: Rule No. 1: Most things will prove to be cyclical. Rule No. 2: Some of the greatest opportunities for gain and loss come when other people forget Rule No. 1.” The business cycle can be thought of as the fluctuations in GDP relative to long-term trend growth. A normal cycle goes something like this: initial recovery, early upswing, late upswing, slow down, and recession. We will be looking at the output gap, yield curve, and the high-yield spread.

Output Gap:


The output gap is the difference between Real GDP and Potential Real GDP presented here as a percentage. The output gap is only as good as its estimate of Potential GDP, which is produced by the CBO’s estimate of what the economy would do with a high capital and labor use rate.

The Output Gap continued to rise in the fourth quarter, suggesting that little slack remains in the economy. This, more than anything else, suggests we are in store for rising inflation.

Yield Curve:


The yield curve gives us the relationship between bonds of differing time horizons. This is important because it reveals what investor’s expectations for the future are versus today. If investors believe the future holds economic growth and inflation they will sell long-term bonds, steepening the yield curve. If investors expect a recession, they will do the opposite, flattening the yield curve. Yield curves tend to invert (short-term rates higher than long-term) at the beginning of a recession.

The yield curve continued to flatten during the fourth quarter, but has since reversed and steepened in the new year. There’s not much to take away here, but if the yield curve continues to steepen, it would be a good sign.

High-Yield Spread:


The High-Yield spread measures the difference between what investors are charging for bonds below investment grade (rated BB or below) and the risk-free rate. When investors are optimistic, they tend to charge too little of a premium for risk and when they are pessimistic the opposite.

The spread continued to fall in the fourth quarter, suggesting that investors are getting complacent when assessing risk.

Business Cycle Summary:

The economy is running at full capacity and investors are throwing caution to the wind when assessing risk. We are closer to the end of the business cycle than the beginning.

Consumer Health

Consumer spending makes up about 70% of GDP and it’s worth checking in on how consumers are doing in the economy. We will be looking at retail sales, unemployment, saving rates, household debt, and consumer confidence.

Retail Sales (Ex Food):


Retail sales are what they sound like, the aggregated measure of sales of retail goods in a given month. Measuring this helps us gauge the direction the economy is headed. Here we can see the year over year percent change. Healthy retail sales tend to correlate with positive movements in the equity market.

Retail sales were up a healthy clip in the fourth quarter. Perhaps all those bitcoin millionaires went shopping.

Unemployment Rate:


The unemployment rate is the share of the labor force that wants a job but can’t find one. This measure usually lags the economy, reaching its peak at the end of a recession.

The unemployment rate fell from 4.4% to 4.1% in the fourth quarter. This suggests that there is little slack in the labor market and inflationary wage pressures may be on the horizon.

Savings Rate:


The savings rate is the amount of money that consumers as a whole deduct from their disposable income in order to accumulate a nest egg for the future and tends to be a double-edged sword. As far as the Keynesian multiplier is concerned, the lower the savings rate, the better, since every dollar spent gets magnified throughout the economy. As far as reality is concerned, a lower savings rate reduces the buffer that consumers have to deal with adverse shocks in the future, magnifying their effects.

The savings rate fell in the quarter to 2.4% which is the lowest level since 2005. This reinforces those rising retail sales numbers at the cost of future stability.

Household Debt:


Household debt is shown here as a percentage of GDP. High levels of debt can strain income (interest payments) and lead to bankruptcy.

The current ratio is 77% of GDP, down from the 2008 peak of 97%, but up from the pre-2000s average of 62%. It is clear that the consumer has gone through a long period of deleveraging since the financial crisis began and they may still be shell-shocked when it comes to borrowing. For now, borrowing from the future in the form of reduced savings is the consumers go to for purchases.

Consumer Confidence:


The University of Michigan releases a monthly survey of consumer confidence which is shown above. The idea is to get a measure of how optimistic or pessimistic consumers are about the economy in the near future. If they are optimistic, they might purchase more and spur the economy.

The index fell in the fourth quarter to 95.9 but is still near the highs for the past decade. This suggests that consumers are optimistic about the near-term future.

Consumer Health Summary:

Consumers are optimistic about the future and have increased their purchases at the cost of their savings. This should continue to work until it doesn’t.

Business Health

Consumer spending may make up 70% of GDP, but business investment is what moves the needle. Let’s see how businesses are doing in the current economy. We will be looking at profit margins, inventory ratios, corporate debt, and productivity.

Profit Margins:


The best way to see how business is doing is to look at how much profit they are making. Above we can see how profit margins have changed from the 1940s until today.

Profit margins were up slightly in the fourth quarter to 11.73% versus a historical average of 9.18%. Sales have rebounded from the great recession while input costs have remained low. In theory, rising wages and competition will force profits back down.

Inventory to Sales Ratio:


The inventory to sales ratio is a measure of how much inventory businesses are holding compared to their sales in a given year. If inventory buildup is greater than demand, GDP will rise but businesses will accumulate unsold products. This will force them to cut production, leading to lower GDP. However, this indicator becomes less reliable as an indicator when an economy is dominated by service firms that carry no inventory.

The ratio dropped in the fourth quarter to 1.33 versus the recent peak of 1.42 in 2016. This, along with the other data, suggests that sales are growing faster than inventories; adding further evidence that the economy is running near capacity.

Corporate Debt:


Non-financial corporate debt is shown here as a percentage of GDP. High levels of debt can magnify profitability but also leave a company vulnerable to adverse shocks.

Corporate debt rose in the fourth quarter to 45% of GDP which matches the previous highs made during the last two recessions. This suggests that corporations are reaching the limits of what leverage can add to earnings.



Productivity is the amount of output per labor hours worked in the economy and is the source of nearly all economic growth. The above chart shows the year-over-year percentage change in productivity.

Productivity rose at a slower rate in the fourth quarter, down to 1.06% from 1.40% in the prior quarter. Productivity gains during this cycle continue to be some of the lowest on record and partly explain the lack of wage growth in the economy.

Business Health Summary:

Margins are falling, sales are rising faster than inventories, leverage is near record highs, and productivity is stagnant. It appears businesses are starting to hit a wall. We’ll have to wait and see how much corporate tax reform counters this trend.


In summary:

  • Markets are at record high valuations.
  • Interest rates are starting to move up, steepening the yield curve.
  • Investors are complacent when it comes to volatility.
  • Investors are complacent when it comes to risk premiums.
  • Inflation is currently subdued but expectations are rising.
  • Monetary policy is tightening.
  • Consumers are optimistic.
  • Businesses are starting to hit a wall when it comes to margin expansion.

This all suggests that we are closer to the end of the cycle than the beginning. Trying to time the market is rarely profitable, and if I could find opportunities today, I would gladly be fully invested. However, we shouldn’t lower our standards just for the sake of putting money to work.


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