An Antidote to the Talking Heads
Last year we forecast a rising equity market based on a growing economy with strong job growth, higher wages, and increasing capital investment – due primarily to the December 2017 tax reform act. All was performing to forecast until the evening of October 3rd when Federal Reserve Chairman Jerome Powell gave the worst interview in history for a Fed Chairman. His hint of monetary policy becoming “restrictive” seriously spooked investors. The result was a 4th quarter which ended the bull market, by most measures.
Fast forward: the Fed, fortunately, came to their senses and eased from their stance of aggressively raising interest rates. As a result, business investment resumed growing at our previously expected rate. Other economic measures have resumed growing as well, including the stock market which has made up most of its lost ground.
Surprising to us, many Wall Street analysts continue to forecast a recession. They believe that the 1st quarter of 2019 will produce negative earnings. They also cite 1) rising national & consumer debt, 2) a tight labor market producing rising payroll costs – thus hurting company profits, 3) an over-valued stock market, and more. It seems that whenever the stock market experiences a correction of a few percent, the talking heads feel a need to construct an explanation.
Bottom line: We believe many of these analysts are just plain wrong. Just released 1st quarter Gross Domestic Product was +3.2%. With almost 60% of the S&P 500 having already reported 1st quarter earnings, over 70% have beaten expectations, with the average beat at 7.5%. Our expectation: full year 2019 GDP will be close to +3%, with nominal GDP at +4.5% to +5.5%.
Is the Bull Market Old?
A Bull Market can run for years. This one is young – now about 2½ years old. You may hear many say it is 10 years old, because by their strict and arbitrary definition, it is. But this definition should be viewed as a guideline, not as a rule. In 2011, the market was down over 20% on October 4th (peak to intraday low) but closed that day at slightly less than -20%. (The rule calls for a close down 20% rather than just dropping to -20% intraday.) The next bull market started in the 1st quarter of 2012 and lasted until the Fall of 2014. Subsequently, the market was flat for the next two years. The current Bull Market began on November 9, 2016 – making it just 2 ½ years old, in our view.
Bull markets don’t die of old age. Bull markets usually die at the hands of the Federal Reserve raising interest rates. Now our Fed has come to their senses. Higher interest rates are no longer the threat to the market that they were in the 4th quarter of 2018. So this bull no longer faces higher rates and is not old.
Inverted Yield Curve
There has been much discussion about the yield curve inverting two weeks ago. Many say that recessions follow an inversion by approximately 18 months. First, anything credited for an event 18 months away must be considered, at most, a possible correlation, rather than a cause. There can be numerous other events which weigh much heavier on the economy over such an extended period of time.
Most inversions in the past have been caused by the Fed as they raise the Fed Funds rate, typically in response to high inflation. As they continue on that path, the short maturity bonds offer a higher yield than longer maturities. That condition is bad for both bonds and stocks. Banks don’t want to lend in that kind of environment and thus, the economy slows. However, that is not the case now. Fed Chairman Powell stated that they saw no reason to raise rates for the next two or maybe three years. In fact, we think the Fed may actually lower interest rates at least once this year to correct their mistake of hiking rates in December.
In our view, this short inversion was actually caused by bullish sentiment – not by investors being scared into Treasuries. When Chairman Powell said we should expect no additional rate hikes in the foreseeable future, it was a green light to foreigners to buy our debt. In Germany, the 10-year Bund pays a negative interest rate, so Europeans and Asians alike were happy to buy our Treasuries paying over 2.5%. They had only resisted buying for fear that the Fed would continue to raise rates, causing them losses on any debt they purchased. With that fear removed, foreigners bought with enthusiasm. We can see that was the case because the dollar strengthened during the same time. So we know it was not fear that motivated foreign demand – it was desire.
Is the Market Fully Valued?
If you have been watching CNBC lately you have probably seen Bob Pisani lamenting that “the stock market is overvalued”. He mistakenly talks about negative earnings growth and high P/Es (stock price divided by earnings per share). First, looking at data skewed by the Fed’s 4th quarter blunders is a poor starting point. Second, comparing today’s S&P 500 to that of 20 or 50 years ago is far too simplistic. 20 years ago, there were no smart phones and almost no one had an email account. There was no cloud computing and the S&P 500 was dominated by slow-growth financials and utilities. Today, the S&P 500 is heavily weighted to high-growth technology companies, and thus deserves a higher P/E in our view.
A savvy investor would not want to pay 15 times earnings for a company growing at 3% per year. That is a P/E/G ratio (price to earnings to growth) of 5, which is extremely high. But 16 or even 20 is a reasonable P/E for a company growing at 20%. A P/E/G of less than 1 is free growth; a P/E/G of 1.25 is cheap growth.
Looking at it practically, suppose you had your choice of buying either one of two convenience stores in different parts of town. One store is growing its earnings 3% per year. The other store is in a vibrant neighborhood and is growing its earnings 15% per year. They are both selling at a 15 P/E. One is selling at a P/E/G of 5, the other at a P/E/G of 1. The faster growing store with the lower P/E/G is the better buy.
Consequently, the next time you hear someone talking about P/E multiples as a measure of value, ask yourself: What is the growth rate? Knowing all three (growth rate, P/E and P/E/G) is key to understanding value. Knowing just the P/E is misleading.
We Believe More Gains Are Ahead
The 1st quarter of 2019 has been good, but there are many reasons we believe that the rest of the year will also produce gains. (Caveat: we reserve the right to change our view if the facts change.) Last year the stock market was strong until Chairman Powell’s atrocious interview on the evening of October 3rd when he alluded to raising interest rates until they became “restrictive” to the economy. His comments sent the market into a tailspin which continued until Christmas when Powell essentially admitted his mistake and changed course. The strength in the 1st quarter of 2019 has been a recovery of 4th quarter losses and a recognition that the U.S. economy continues to perform well.
Job and wage growth are strong, inflation is tame, and capital investment is rising. In the past, wage growth has been an early indicator of inflation and lower earnings, thus creating a weak environment for investment. Interestingly, today many companies are reporting that higher wages are actually helping their bottom line. For example, Darden Restaurants said that the higher wages are reducing employee turnover and increased productivity. Their employees are happier and the company spends more on training current employees. All of this produces a better customer experience and more tips for employees – a real “win-win”.
Higher wages and more jobs have a very positive overall economic effect. Underlying wage data show that lower-income Americans’ wage growth is rising faster than the overall average. This not only helps shrink the wage gap, but those dollars at the lower end of the scale move more rapidly and have a greater effect on the economy. More jobs and higher wages produce more commerce. According to Jamie Dimon, CEO of JP Morgan/Chase, consumers are now in the best financial shape they’ve been in during his entire career. FICO credit scores are at record highs, personal balance sheets are strong and debt service is a low percentage of income. This is great news for the economy. Since 70% of the United States GDP is consumer consumption, we can expect higher profits and an improving GDP.
As far as market valuation goes, if you look at discounted earnings, using the 10-year Treasury yield now 2.58% as your gauge, the S&P 500 is undervalued by our calculations. It would not be at fair value unless the 10-year Treasury went to 3.6%. With the 10-year Treasury yield at 3%, the S&P 500 would be fairly valued at 3500, 20% above today’s closing price. 3% or 3.6% is unlikely to occur while the German 10-year is at a negative 10 basis points (-0.1%) and the Swiss National Bank has rates at minus 75 basis points (-0.75%).
In addition to global bond rates near zero or below, our outlook of an undervalued market is compounded by many Street analysts lowering their earnings expectation dramatically in December. We have found that many of them are almost always “late to the party” – becoming too bearish during periods of market weakness.
With 1) interest rates low and likely to stay down, 2) GDP growth likely near 3% this year, and 3) earnings expectations likely too low, we believe there is more upside for the equity market. For now, we will stay with our January prediction of a year-end target of 3150 for the S&P 500. If we get an attractive trade deal signed with China, that level may be too low.
We hope you are enjoying the nice Spring weather,
The Beck Capital Management Team
April 24, 2019
Investment advisory services offered through Beck Capital Management LLC, a registered investment adviser. This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results. Nothing contained herein is to be considered a solicitation, research material, an investment recommendation or advice of any kind. The information contained herein may contain information that is subject to change without notice. Any investments or strategies referenced herein do not take into account the investment objectives, financial situation or particular needs of any specific person. Product suitability must be independently determined for each individual investor. Beck Capital Management explicitly disclaims any fiduciary responsibility or any responsibility for product suitability or suitability determinations related to individual investors, as may relate to the information contained herein. The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value weighted index with each stock’s weight in the index proportionate to its market value. There is no guarantee that companies that can issue dividends will declare, continue to pay, or increase dividends.