The next recession, whenever it is, could face an unusual headwind. Normally, recessions are about liquidating fundamental excesses. Restoring health to balance sheets which were abused in the last expansion, purging bad business decisions, restoring liquidity, replenishing savings, and restarting the profit, job, and income creation cycles.
In 2018, the U.S. recovery was on a path toward recession. It couldn’t last much longer growing above 3% in real terms and 5.5% in nominal terms, with an unemployment rate below 4%. Wages, consumer, producer, and commodity prices were rising and the Federal Reserve (Fed) and bond vigilantes were tightening.
Amongst the carnage and ongoing financial market volatility are a few encouraging signs the stock market may eventually regain its footing. As the pictures below illustrate, a proprietary U.S. economic momentum indicator suggests that recession fears may lessen by the spring, valuations have now fallen well below levels justified by bond yields, investor mindsets are quickly shifting away from overheat fears, and the U.S. dollar may finally be breaking down.
Welcome to 2019! As we begin the New Year, volatility (the stock market’s VIX volatility index spiked above 30 last week) and uncertainty (Bear Market, Recession?) reign. Amongst all the chaos, and with much personal trepidation over what may actually happen this year, here are some observations and a few guesses for 2019.
Emerging Markets (EM) are not normally considered a safe place to hide during severe stock market corrections—but they have been in the latest equities swoon. As shown in Chart 1, while the S&P 500 composite stock price index has declined by more than 14% from its high on September 20th, the MSCI Emerging Market stock price index has only declined by about 7%.
Recently, when Federal Reserve Chairman Jerome Powell and President Donald Trump both blinked—one on rate hikes and the other on trade wars—the S&P 500 surged by more than 6% in about a week! Many sensed the primary challenges holding back stocks were finally resolving and sentiment quickly turned bullish as investors did not want to miss the Santa Rally!
The valuation of the stock market has been under steady pressure this year. The S&P 500 trailing price-earnings (P/E) multiple has declined by about 25% from a recovery peak of 23 in January to about 18. The hope for this bull market is that P/E contraction is almost over, allowing stock prices to again rise with earnings gains.
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 March, in a very similar fashion as shown, the PP Ratio has eerily traced the same path as during the dot-com era.
he velocity of the money supply measures the pace at which cash is spent in the economy, or the amount of total GDP activity created by each dollar of the money supply. Monetary velocity has long been a focal point for the Federal Reserve, economists, and investors because its growth often shapes the character of the recovery.
Solid economic growth and fabulous profit results have underpinned the stock market in the last couple years. Since the presidential election, the global economic recovery exhibited a rare synchronization for a time, and within the U.S., confidence measures rose from mediocre to near post-war highs...
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.