A central quandary for equity investors is whether Emerging Markets (EM) represent an opportunity or a risk? Current relative valuations highlight the opportunity. The relative forward P/E multiple (versus the S&P 500) is as low today as it was at the start of this bull market in early 2009, and relative price-to-sales and price-to-book ratios have not been this attractive since the early 2000s!
Inflation has remained low throughout this recovery causing many investors to conclude it is not much of a problem even if it rises a bit further. However, inflation has been trending higher for much of the last four years and has already significantly impacted the stock market. Moreover, because both wage and price inflation recently reached new recovery highs, overheat pressure seems poised to become even more pronounced.
Despite a very strong economy, defensive stocks have been matching the performance of the overall stock market since early this year. Indeed, in the last three months, while the S&P 500 has returned to a new record high, the top four leading S&P 500 sectors have been those normally considered defensive (i.e., Health Care, Telecom, Utilities, and Consumer Staples), and the five sectors which have trailed the S&P 500 are much more cyclical (Consumer Discretionary, Technology, Financials, Materials, and Energy).
Everyone has a favorite stock market valuation tool. For some, it’s the celebrated Shiller CAPE P/E (price/earnings) ratio. Many prefer to value stocks based on expected future earnings or the forward P/E multiple. Others are more comforted by a “show-me-the-money” approach basing the P/E multiple on (actual) trailing earnings.
The potential for the stock market to rise depends on how much capacity there is for improvement. Can its valuation rise? Could investor confidence improve? Do corporate profits still have room to run? Will stocks become more competitive relative to alternative investments? How spent is the economic recovery?
The S&P 500 trailing Price-Earnings (P/E) multiple is currently higher than 84% of the time since 1950. Appropriately, high valuations have become a concern for many investors. Although the market’s high P/E profile has reduced future return potential, at least historically, it does not necessarily suggest significant downside risk.
As it often does, Friday’s jobs report will likely set the tone for the financial markets during the next few weeks. Since the January report, the employment numbers have been reassuring. A rise in the labor force has allowed solid job gains to coincide with a flattening in the unemployment rate near 4%, leaving an impression the labor market still has significant slack.
In the last few years, movements in the U.S. dollar have played a huge role in shaping the character of the recovery and the behavior of the financial markets. During the first half of this recovery, the trade-weighted U.S. dollar index (DXY) remained in a narrow range, but since 2014, its volatility has substantially increased.
We first published the accompanying chart in March of this year. The PP ratio had just spiked sharply upward in the previous three months, as it did near the end of the dot-com era in 2000. Since, as shown, the PP ratio has been largely marking time during the last four months even though technology certainly has not lost its popularity.
On a trailing earnings basis, the S&P 500 has been highly-priced above a 20x PE multiple (or below a 5% earnings yield) for most of the last two years. What does this suggest about future return potential, and perhaps more importantly, about the potential for negative returns? Although the absolute valuation of the stock market does impact future return potential, it has not been particularly useful in assessing the chance of losing money in the stock market.
Inflation/overheat worries have eased recently. The advance in the 10-year bond yield has stalled just below 3%, the upward trend in commodity prices paused once the U.S. dollar began rising in April, and wage inflation has failed to break above 3%. Indeed, the latest employment report left a goldilocks impression with a solid jobs gain, a rise in the labor force participation rate, and only a modest increase in wages.
The contemporary character of the Main Street economy has often been a harbinger of future investment returns. Specifically, the mindset of private economic players (i.e., are they confident enough to engage in aggressive behavior or are worries dominating economic decisions) and the degree of resource slack (the unemployment rate) have often provided a good indication of how the financial markets may perform during the next five years!
Perhaps the stock market is taking its cue from the NBA back-to-back champion, Golden State Warriors (and winners of three of the last four titles). They employ an aggressive and entertaining “Offense-First” style of play driven by multiple all-stars firing “threes” with rapid abandonment from distances normally reserved for long touchdown passes!
Haven’t we seen this movie before? Technology takes over the stock market late in a recovery cycle, seemingly making the bull ageless, pushing portfolios toward a more concentrated new-era exposure, stimulating investor greed bolstered daily by watching a chosen few (FANGs) rise to new heights, and convincing many that tech is really a defensive investment against late-cycle pressures which trouble other investments.
Fundamentally, the economic recovery has never been this good. U.S. real GDP growth is forecasted to rise by almost 4% in the current quarter, there is regular healthy job creation, the unemployment rate has fallen below 4%, household income gains are solid, profits are spectacular, confidence measures among both businesses and consumers are near historic highs, and for the first-time, economies about the globe are in a synchronized recovery!
Many investors are betting robust earnings this year will allow the stock market to regain its mojo. Earnings results should be spectacular, boosted by both a synchronized global recovery and by a sizable tax cut. However, the question for stocks is not whether companies will deliver, but rather, whether the stock market will respond?
Investors often face quandaries. Always present is whether the markets will rise or fall? Currently, a few perplexing issues are interesting and deserve some pondering. Is new leadership evolving in the stock market? Should you buy regulated or nonregulated FANGs? Why are energy stocks doing so well in Emerging Markets and so poorly in Developed Markets?
It’s not a question of IF, but rather WHEN. The U.S. output gap finally closed late last year, the unemployment rate is on the cusp of breaching 4%, and the pace of economic growth both here and abroad remains healthy. Wage inflation is going to rise above three percent soon! Maybe tomorrow, maybe later?
The biggest risk facing investors today is the start of the next recession. In a few months, this recovery will enter its 10th year and challenge the longest ever in U.S. history. Just prior to the next recession, the stock market will likely enter a bear market while credit quality deteriorates significantly. Although volatility and corrections are always present in the financial markets, recession is what is feared most.
Throughout most of this bull market, there has been too much panic. In the minds of investors, a return to the 2008 crisis or the second coming of the Great Depression was always just around the corner. In the last couple years, however, the U.S. economy has returned to full employment, the output gap has closed, real GDP growth has moved away from being stuck at slightly above 2% to perhaps trending closer to 3%, and the global economic recovery has synchronized in a positive way.
Bull markets do not age by the clock but rather by their character and often end with investor aggressiveness and the comfort of popularity. In the latter stages of a bull market, confident investors usually prefer hares (i.e., aggressive, fast moving, high beta investments that have been highly successful and are therefore wildly popular), while tortoises (i.e., conservative, high quality, defensive stocks that only widows, orphans, and worrywarts would own) become universally panned!