The market continues to grind higher since the election. From the day of the election through July 31, 2017, the S&P 500 Index is up more than 17%, the Dow Jones Industrial Average has advanced 21%, and the NASDAQ Composite is 23% higher. Optimism over the pro-business Trump agenda seems to be the catalyst for the initial boost in stock prices. But continued advances in the market after a very rocky start to the new administration’s efforts to implement its agenda seems to reflect a broader optimism beyond the challenged promises of health care reform, tax reform and infrastructure spending. A steady, synchronized global expansion, coupled with strong expectations for 2nd quarter U.S. corporate earnings (+9.1%, FactSet) have been enough to fuel stock prices higher without the certainty of these reforms being achieved.
While stock prices challenge new highs, unusually strong political discord and gridlock are keeping investors from becoming overly enthusiastic. Jamie Dimon, the chief executive of JP Morgan Chase & Company, voiced his impatience on Friday, July 14th with the media and politicians, complaining that bickering is standing in the way of solving real problems. We could not agree more. He went on to say, “If gridlock goes away we will grow faster. But if it continues we won’t grow slower.” In other words, favorable progress on reforms would aid growth and spur stocks higher.
In the meantime, a steady, resilient advance continues. Despite a lot of healthy skepticism, an increasing chorus of strategists are calling for a top in the stock market, pointing to valuations they say are too high in the context of an aging business cycle. They make their case by comparing gauges of value, such as price-to-earnings ratios, price-to-book ratios and other similar metrics over long periods of time. The Fed’s actions to begin to normalize interest rates over the last 1 ½ years and their recently announced plans to start to reduce the size of their balance sheet is further fanning concerns that a bear market and recession may not be far behind these moves.
The angst about valuations and the length of the current business cycle are all legitimate concerns, but we also realize the ease with which data may be misinterpreted. It is important to be sure any analysis we rely upon is not overly simplistic or fails to account for the uniqueness of the current market and economic conditions. We are just a few years removed from the worst financial crisis since the Great Depression. Like the Depression, the Financial Crisis of 2008-2009 caused most major equity indexes around the world to decline over 50% and left many investors afraid to invest again or too willing to flee the market at the least sign of market weakness. No one wants a repeat of an event like that. At the same time, no one wants to sideline themselves unnecessarily from the growth opportunities the markets provide, especially with interest rates so low and the markets performing so well currently. To the extent anyone decides to move to the sidelines, what will trigger them to get back into the market?
At a lecture in London on June 27, U.S. Federal Reserve Chair Janet Yellen said she does not believe there will be another financial crisis for at least as long as she lives (she is 70 years old), thanks largely to reforms of the banking system since the 2007-2009 crash. Will she be right? Maybe, maybe not. There will certainly be periodic corrections and bear markets, but crises of the magnitude of the Great Depression or the Great Recession of ’08 – ’09 will likely be few and far between. If we invest like every market downturn is the beginning of the next great recession or depression, there may be far more opportunities missed than losses dodged.
As a tactical manager, we begin with the premise that no one can be certain about the near-term path of the market; the horrific events of September 11, 2001 should make that abundantly clear to everyone. We believe our client portfolios must be diversified and structured in such a way that even the worst surprise does not leave us flat footed. We are committed to being on our toes, ready to act no matter what unfolds in the markets or the economy.
It is true the stock market is not cheap when compared to the valuations at the fear induced lows of the bear market in 2009. The greatest opportunities present themselves to investors at times such as these. As we moved past the fear and gloom and began to look optimistically about the future, a bull market ensued. Underlying this upward trend is a business cycle in the expansion phase. The cycle is mature now and is only 23 months and 9 months away, respectively, from becoming the longest or second longest expansion in the post-war era. The two longest expansions were from March 1991 to March 2001 and from February 1961 to December 1969.
Because the current recovery has lasted longer than average does not mean the end of the cycle is near. Like bull markets, business cycles are oblivious to the passage of time. Economic expansions and recessions occur at irregular intervals and last for varying lengths of time. They don’t have expiration dates, so time alone is insufficient information to forecast their demise. The default mode for the economy is expansion until something significant enough occurs to change its course. Excessive exuberance in the later stages of the business cycle can sometimes lead to a surge in asset prices or a bubble, which can contract suddenly leading to a recession. This was the case after the bursting of dot-com bubble in 2000 and the rapid declines in real estate prices leading up to the financial crisis in 2008-2009. This expansion has had quite a different tempo, expanding at a rate averaging less than 2 percent a year since its inception.
Absent outside influences, the growth in the economy could theoretically continue uninterrupted indefinitely. There is no reason why an economy in full employment must give way to an inflationary boom or fall into recession. The long-term trend of growth in the population and the natural increase in employment and output which result are the primary reasons for this. New productivity enhancing technologies discovered along the way also contribute to growth. Despite these facts, cycles do occur. This is because disruptions to the economy of one sort or another push the economy above or below full employment. Inflationary booms result sometimes from surges in private or public spending, from circumstances such as wars, extreme consumer or business optimism, or strong influences on the level of interest rates by the Federal Reserve’s monetary policy. Recessions can be caused by some of the same dynamics working in reverse. Monitoring these types of potential dislocations within the economy is the key to understanding the risks and opportunities that lie ahead.
Are there any signs of irrational exuberance? Look at the following table showing some valuation metrics for the S&P 500 Index. Included is data on the S&P Information Technology subset of the S&P 500 for comparison purposes:
Source: FactSet Earnings Insight and S&P Dow Jones Indices. Data is as of July 28, 2017, unless otherwise noted. Note: Over last 20 years, the average rate for the 10-Year Constant Maturity Treasury has been 3.8% versus 2.3% (source: Federal Reserve Bank of St. Louis, monthly data averaged over the period from June 1997 to June 2017). Past performance is no guarantee of future results.
As you would expect in a mature expansion and bull market, the data above reveals that trailing and 12-month forward price-to-earnings multiples for the S&P 500 are a bit higher than long-term averages. There are no signs in this data of excessive speculative buying taking place. There has been talk the technology sector may be overdone, but as you can see from the data, the S&P Information Technology sector’s 12-month forward price-to-earnings multiple is not meaningfully out of line with the broader S&P 500 Index. The ratio is also lower than its 20-year average.
An important point to note is the current yield on the 10-Year Treasury bond is 2.3%, almost 40% below its average rate of the last 20 years of 3.8%. More importantly, yields in March 2000 at the peak of the dot-com boom were 6.3% and 4.5% at the peak in 2007 (not to mention oil prices were over $100). These interest rates were more than double our current rates.
Why is the level of interest rates important? Because the value of a stock or an index of stocks is, in some measure, a function of its future earnings or shareholder dividends discounted back to the present (often referred to as the dividend discount model). The lower the current levels of interest rates (the discount factor used), the higher the price-to-earnings ratio for stocks is likely to be. This theory of valuing stocks supports the idea the market today should, ceteris paribus, be priced at a higher price-to-earnings multiple than other periods when interest rates were higher. A variant of the dividend discount model is the Fed model that theorizes that since stocks and bonds are competing, lower yields on bonds should allow for higher price-to-earnings multiples on stocks until an equilibrium level is reached. Historical data makes a compelling argument supporting the Fed model, showing a high correlation between interest rates and earnings multiples.
Based on our position in the business cycle and the current low level of interest rates, it is difficult to view current stock prices as very expensive, let alone excessive. Any valuation metric that fails to consider the level of interest rates is flawed, in our opinion. There is no clear sign speculative buying into stocks is sufficient enough to cause an economic d