Newsflash: Nobody in the real world wants to pay higher prices for things. The economists tell us inflation is 2%. We all know that’s silly. It’s much higher. Most consumers are being squeezed. Everyone buying groceries, a house or a car and paying medical bills and tuition knows that. The new focus on inflation targeting is cover to allow the central banks to do whatever the heck they want without making people worry that the economy is soft. They just want control of the narrative.
Economic growth is the real problem and the Fed is unable to fix that. Add together workforce growth and productivity in the U.S. and it’s not hard to see why real GDP of 2% is tough to surpass, especially late in the cycle when the additional boost from bringing workers off the sidelines is diminishing. If the deciders want wage inflation, stop making capital so cheap. Why create asset bubbles that just make houses unaffordable and future returns on equity investments low?
Those buying stocks now because the “Fed has their backs” aren’t exactly making a contrarian call. They are expecting euphorically priced securities to become more euphorically priced even as earnings uncertainty rises. Profits are expected to be down about 4% for the first quarter and this quarter looks soft as well. Remember, some of the worst returns in the stock market occur when the Fed is easing, but investors become risk-averse as earnings deteriorate.
A recent article by Mark Hulbert re-visited an issue we have mentioned more than a few times. It discussed how misleading it is to say that the Russell 2000 trades at 17 times earnings as many pundits and participants do when it really trades at a P-E of 75. Yes, 75. The 17 figure is “derived” when the roughly one-third of companies that lose money are excluded from the calculation.
The S&P 500 has its own set of problems. Trailing twelve-month GAAP EPS is $132. The gap between GAAP earnings and Wall street’s contrived “operating earnings” number has now gapped to $20 from about $10 not that long ago. What happens when record profit margins that are already being squeezed fall from currently lofty levels? How much longer can wages be suppressed in favor of management and stockholders? Higher short rates should pressure interest expense figures and the strong dollar hurts as well. It’s not hard to get to a $100 EPS number and a market that would be trading near a 30 PE at current levels. A normal multiple of that $100 puts us at 1100-1500 not 2900.
It is the same every cycle. At market peaks, investors are routinely encouraged to use peak earnings and not worry about a negative inflection point. However, valuations should be based on more than just one year’s profit number. Also, if one wants to put a higher multiple on stocks because interest rates are lower than recent cycles, one must also reduce the earnings growth rate implied by those lower interest rates. The two basically offset each other. Remember, GDP used to run at 3-4% real rate, now we run at 1-2%. Interest rates are lower to reflect that fact.
From our vantage point, it comes down to whether equities return to anywhere near normalized valuations, let alone become cheap. Not only have indices become priced at 2-3 times normal, they have done so with value stocks being left behind as the most expensive growth stocks led the charge. The biggest reason they are ignored is not because sharp pencils were put to work regarding valuations. Blind buying of index funds has created its own momentum in the direction of growth stocks, creating a bear market in the value arena.
It’s likely that fading domestic factors including the passive investing mania, the tech narratives of this cycle, unsustainable profit margins, incredible corporate debt growth, and massive stock buybacks played more of a role in markets over the last ten years than many central bankers and investors would like to admit now that it looks like the Fed is becoming the only game in town. Regardless, U.S. equities are priced for perfection and the world is, if anything, less than perfect.
The views expressed on this blog are the opinions of the authors. This information is not intended as investment advice or to recommend the purchase or sale of securities. More information on Strategic Balance, LLC may be obtained by contacting investor relations.