Photo: David Williams for Barron’s
Forty years ago, a headhunter with a thick New York accent telephoned Ed Yardeni, a young New York Federal Reserve economist, and enticed him to join E.F. Hutton. Not long after, Yardeni’s former boss, Paul Volcker, became the Fed chief and kicked interest rates higher. As Volcker succeeded in crushing sky-high prices, his former employee became an early believer in falling inflation, and then, in 1982, in rising stock markets. Yardeni has rarely wavered through a sequence of jobs at Deutsche Bank, Prudential Equity Group, and now at his own firm, Yardeni Research. Stocks have been “a long good buy,” he says, and he’s right—when he started out on Wall Street, the Dow Jones Industrial Average was at 1000. Today, it’s about 24,800. And the Morning Briefing by his firm, published at the crack of dawn, is one of Wall Street’s most popular reads.
Yardeni invented the term “bond vigilantes” to describe investors who sell bonds to force the government to put its fiscal house in order. Recently, he introduced “Dow vigilantes” into the lexicon, as stocks sold off on concerns about President Donald Trump’s decision to impose tariffs on steel and aluminum, which triggered the resignation last week of Trump’s top economic advisor.
Yardeni recently finished his book, Predicting the Markets: A Professional Autobiography, an entertaining read that contains myriad lessons for investors. On the eve of its publication, Yardeni talked with Barron’s about insights from his long career, bitcoin (“central bankers won’t sit back and let cryptocurrencies reign supreme”), and why he’s still bullish. Click here for an exclusive book excerpt.
Barron’s: Are we heading for a trade war that will derail the markets?
Yardeni: The president is hard to predict, which makes the stock market’s reaction hard to predict. Back in the ’90s, the bond vigilantes disciplined Washington over inflation. Now we see the Dow vigilantes. The stock market is the one poll Trump follows. If it continues to decline, it will make him realize that [imposing tariffs] isn’t a good way to proceed.
Now it’s important to recall that Ronald Reagan also came in as a protectionist, and imposed 100% tariffs on Japanese semiconductors and twisted their arms with auto export restraints. It worked: It brought a lot of Japanese production here.
My sense is Trump is taking extreme stances, trying to convert multilateral trade deals into more easily adjustable bilateral trade agreements. He then compromises to get more or less what he wants. One theme in my book is that globalization has been a source of prosperity around the world and bullish for stocks. Assuming Trump succeeds in making trade fairer for Americans without crippling free trade overall, it would be positive for the U.S. and for stocks.
Still, it doesn’t seem like the market is out of the woods.
What could cause the stock market some real agita for the next few weeks is if he’s stepping on the accelerator and the brakes at the same time: on the accelerator with tax reform, on the brakes with protectionism. And then a few days after tax reform, Democrats and Republicans came up with an ingenious way to avoid closing the government down by agreeing to spend a lot more. On top of all that, the Fed is reducing its balance sheet. The bond market is calm because inflation remains remarkably subdued. The bottom line is, I don’t think this is the beginning of a bear market. We had an exchange-traded fund meltdown in early February triggered by wage-inflation concerns, and then another correction on this trade-war scare, which makes panic attack No. 61 since the beginning of the bull market in 2009. There have been only four corrections in this bull market, meaning declines of more than 10% and less than 20%. One of these days, one of these panic attacks will turn into a bear market. We know from history and common sense that trade wars are definitely not good for economic growth. So the president will get a lot of pushback; then the underlying power of earnings will carry the market higher.
You started your career when interest rates were on their way down from around 15% in the early ‘80s to what you dubbed “hat-sized yields.” Will we see those again?
Actually, it was Van Hoisington of Hoisington Investment Management who coined the term. I just popularized it. I’m inclined to think we’ll see the 10-year yield stabilize around 3%, 3.5%. I don’t think it will go above 4%. Bonds are in the process of normalizing. The bond-vigilante model compares the yield to nominal GDP growth, because they often tend to be in the same neighborhood. Right now, the nominal GDP rate is 4.4%. With true normalization, the yield would be over 4%. But I’m expecting that inflation will remain low because of the powerful forces of competition attributable to globalization, technological innovation, and aging demographics.
Credible people believe that after such a long bull market, we’re headed for a long period of low returns. Yet you remain bullish.
Look, history shows that if you buy stocks at high valuations, you often have below-average returns. Long-term returns are basically determined by the underlying growth of earnings, which has been around 7% since the data set started in 1935. Stocks aren’t cheap, and if you buy them here you have to have a pretty long time horizon, such as 10 years. The question really is whether there will be a recession over the next 10 years, because recessions are natural and are what cause bear markets and lower valuations.
That said, the earnings story is phenomenal. The tax cut has added seven percentage points to earnings growth this year. To quote a well-known president, that’s yuuge. The valuation story is getting clipped because of the Fed normalizing rates and bond yields moving somewhat higher. I estimate Standard & Poor’s 500 index earnings of $155 this year, up 16.8%, and $166 for 2019, up 7.1%. I have a 3100 target for the S&P 500, or 18.7 times 2019 earnings. I am sticking with it, though the trade fracas could push my target from the end of this year out to next year.
Your movie reviews are an entertaining part of your commentary. Which movie does this market bring to mind?
Get Out won the Academy Award for Best Original Screenplay. Investors have felt that way about the current bull market in stocks numerous times, only to jump back in. I’ll recommend getting out when I am convinced a recession is coming.
Where are the opportunities in the market?
There are some powerful secular trends. Globally, there’s an aging demographic. For relatively young demographics, you have to go to the emerging markets, where the middle classes are rising and spending more of their incomes on items rather than food and fuel. Even with the Fed tightening, these economies and markets have performed pretty well. In the past, the tightening would have been bad news. In the U.S., the demography is aging baby boomers and young millennials. The millennials are increasingly in their 30s. That should be very positive for housing. Home builders had a great 2017, and aren’t so great this year. On a secular basis, there’s a scarcity of new and existing homes.
Another is technological disruption. We have a high-tech revolution that started in the ’90s and is still going on. Now business models are changing radically, whether we’re talking about Amazon.com [AMZN], Uber, or Facebook [FB], which are reaching into other businesses. Everyone is being forced to use technology to increase productivity and remain competitive. The Internet of Things, the introduction of 5G wireless technology, and self-driving cars are creating a tremendous demand for semiconductors. Finance is also interesting. Bitcoin is getting all the buzz, but you’re seeing the big banks spending money on the blockchain, or the software behind it. I wouldn’t be surprised if major central banks latch on to cryptocurrencies, so we have bit euros, bit dollars, bit yen. The financial world is being turned upside down.
Speaking of currencies, what’s your view of the dollar?
There’s an inverse relationship between the dollar and the price of oil and other commodities. When oil goes up, oil exporters get a lot more dollars, and a lot of them don’t want all their assets in dollars because they aren’t our best friends. And so they like to diversify. A simple related thesis of mine is that the dollar does well when the rest of the global economy isn’t doing so well, and performs poorly when the rest of the world is firing on all cylinders.
We saw that simple model play out elegantly from the second half of 2014 through the beginning of 2017. In 2016, we started to see more evidence that Europe and emerging economies were doing better than expected and Japan was improving. It’s interesting that the dollar peaked even though the European Central Bank and the Bank of Japan were still maintaining ultraeasy monetary policies and the Fed had been normalizing since October 2014.
A lot of people were very bullish on the dollar early this year. I think it will go down another 5% to 10%.
Why did you write your book?
I had the 40-year itch. Also, I’m often asked by clients to recommend one book that their new analysts and portfolio managers could read as a comprehensive guide to understanding the economy and financial markets. I was stumped, so I wrote it. The professor in me wants to share what’s worked for me and what hasn’t.
What are the least useful theories?
Of all the kinds of macroeconomic phenomena, inflation is critically important to get right because it could have disastrous consequences for a portfolio. For example, if inflation makes a surprising comeback, bonds will get hurt badly, not just because inflation is going up, but also because the Fed will suddenly begin raising interest rates. If the Fed does too little, inflation can lead to recession, which creates real problems for stocks. Getting inflation right is extremely important.
We are getting another inflation test now. The Phillips Curve model has generally been misleading, and yet I can’t completely ignore it because the central bankers give it a lot of weight. I call myself a recovering macroeconomist. Like all macroeconomists, I have an urge to be a policy maker and criticize policy makers. One lesson I’ve learned over 40 years is that it’s not my job. My job is to understand what’s driving their thinking and policy-making and how that will impact the markets. Getting inflation right has been my most satisfying accomplishment, but in this business it’s never over until you’re six feet under. I’m sticking to my guns.
What is your favorite indicator?
The Commodities Research Bureau raw industrials spot price index is a quirky index with 13 commodities, some of which have been around for many years—tallow, rosin, and hides. It also has a lot of metals. It doesn’t include oil or lumber. At the end of the day, it’s very sensitive to global economic activity and has given me the heads up lots of times when we start to see changes. I have a funky homemade indicator in which I take the CRB raw industrials spot price index and divide it by initial unemployment claims. I call it the Boom-Bust Barometer. It has been awfully good at telling us where we are in the business cycle. Right now, we’re at a record high because initial claims are down and commodity prices remain on an upward course. And then, just to continue my home-brewed approach, I often take the Boom-Bust Barometer and average it with Bloomberg’s weekly consumer comfort index, and lo and behold, it has been a remarkably good coincident indicator of the stock market. I won’t claim it’s a leading indicator, but it helps me fathom whether underlying fundamentals are still bullish. These are the three ingredients I stir up in my wok that remain upbeat for stock-market fundamentals.