The resiliency of the economic expansion continued throughout the third quarter. GDP growth remained steady, unemployment remained low, the US dollar weakened, and the Fed remained on track for its second interest rate hike of the year. On the other hand, geopolitical concerns increased, the chance of tax reform decreased, and market valuations rose to a level that leaves little room for error.
As always, I have no idea what the near-term future will bring. This post is merely an attempt to see if we are closer to the top or the bottom of the economic cycle.
The S&P 500 continued its nine-year-long bull run, in large part due to the rapid rise of the technology sector. The index’s 37% technology weighting exceeds even the former DotCom bubble peak. At this rate, we’ll eventually have to ask if the technology sector really represents 50% of the U.S. market or if something has gotten out of whack. Despite what recent experience suggests (the last notable double-digit correction was six years ago), markets do eventually decline.
The Yield-Curve continued to flatten during the third quarter. Short-term rates increased from a low of 1.27% to a high of 1.63% while long-term rates held constant. The looming Fed rate hike could explain away the move in short-term rates, but the lack of a move in long-term rates could signal increased skepticism about the macroeconomic future.
Elsewhere in the world, the Japanese NIKKEI 225 index reached a two-decade high. A recent election ensured political stability, a continued focus on aggressive monetary easing, fiscal stimulus, and structural reforms. At the same time, GDP growth came in at the fastest pace in more than 2 years, the Yen continued to depreciate, and equity valuations remained modest relative to the United States. However, Japan has one of the lowest birth rates in the world, the highest life expectancy, and a poor history of corporate capital allocation. Market reforms can help with the later, but the demographic headwind remains a real concern.
Market Valuation Watch
To get a sense of how the market is being valued we will be looking at the Case-Shiller PE10, Market Capitalization to GDP ratio, Tobin’s Q, and the VIX.
Case-Shiller PE10 (CAPE):
A popular market valuation metric is the Case-Shiller Cyclically Adjusted P/E Ratio (CAPE). The numerator is the real S&P 500 price index and the denominator is the moving average of the preceding 10 years of real reported earnings. The idea is that using the 10-year average will control for business cycle effects. A problem with using CAPE is that accounting standards can change over time and we aren’t always comparing apples to apples.
The current CAPE is 31.21 versus a historical median of 16.16 and average of 16.80. The reading has only been higher during two other periods in history: 1929 when it hit 32.56 and 1999 when it hit 44.2. Note, however, that interest rates are nearly three times lower today than they were in 1999. Interest rates act as a kind of gravity on valuations – the lower they are, the higher valuations can rise. The important question is where interest rates are going. If we believe they will rise significantly from here, the market is clearly overvalued.
Market Capitalization to GDP Ratio:
Market Cap to GDP is a valuation metric popularised by Warren Buffett. It takes the entire U.S. stock market capitalization and divides it by the U.S. GDP. Think of this as a kind of price to sales ratio of the whole market. The idea is that the two should match up since corporations shouldn’t be worth much more than the economy they operate in. This avoids the accounting issues of CAPE but has other issues in a globalized world. For example, if a U.S. based company is making money around the world, it doesn’t make sense to compare it only to its local GDP.
The current ratio is 1.78 versus a historical median of 1.24 and average of 1.19. The only higher reading was during the Dotcom bubble when the ratio hit 1.80.
Tobin’s Q was developed by James Tobin and works under the assumption that a firm’s market value should be close to the replacement cost of its assets. If those firms are really good at using their assets, then investors will be willing to pay more than replacement cost (Q > 1). Think of this as a kind of price to book ratio of the market, where the numerator is the value investors are willing to pay for companies and the denominator is the accounting net worth of those companies.
The main issue here is that it is extremely difficult to get an accurate measure of the replacement cost of a company. US GAAP accounting has this asymmetric nature to it where assets can be marked down but not marked up. This leaves companies holding decades-long real estate on their books at depressed levels and leaves intangible assets, like the network effects of Facebook, completely off book.
The current Q is 1.08 versus a historical median of 0.90 and average of 0.93. During the Dotcom bubble, Tobin’s Q reached 1.60.
Volatility Index (VIX):
The CBOE Volatility Index is a measure of the market’s expectation of near-term volatility based on stock index option prices. Think of this as looking at how much people are willing to pay for index options, then reverse engineering the implied volatility from that price.
The current VIX is at 10.2 versus a historical median of 17.55 and average of 19.42. From 1990 to the start of this year, the VIX has only closed under 10 nine times. So far this year, the VIX has already closed under 10 twenty-seven times. This tells me investors are getting complacent. As Minsky noted – stability leads to instability; the longer things are stable, the more unstable they will become.
Market Valuation Summary:
Markets are priced for perfection and volatility is non-existent. Low-interest rates and a hope for pro-business tax reform could explain some of the exuberance, but it is clear we are closer to the top of the valuation cycle than to the bottom.
We spoke about the importance of interest rates for valuation so it makes sense to look at inflation, which is the key driver of interest rates. Inflation is the rate of increase in prices for goods and services in an economy. Back in the day, Keynes explained why a little inflation is necessary to avoid the paradox of thrift – a tendency of consumers to learn to hold off their purchases and wait for prices to fall. That’s not to say runaway inflation is a good thing, look at the 1970s, but today, undershooting inflation is a bigger risk than overshooting. We will be looking at inflation expectations, Core CPI, and the Taylor rule.
The 10-Year breakeven inflation rate is a measure of expected inflation derived from the price of inflation-indexed securities. It’s basically what inflation would need to be for inflation-protected securities to be worth their cost. It’s useful because it gives a glimpse into what investor’s expectations for future inflation are.
The current expectations are for inflation of 1.88%, down from 2.08% near the beginning of the year and 2.59% in 2013. This suggests investors aren’t that optimistic about the macroeconomic future. However, a key here is that expectations remain stable, which they are. It is when expectations break to the upside or downside that markets get screwy.
Core CPI is the actual measured inflation in the economy, excluding food and energy which tend to be more volatile. Here we are looking at the percent change in the index over the last year.
The current Core CPI reading suggests an inflation rate of 1.69%, down from 2.27% near the beginning of the year and 2.31% in 2012. This matches expectations.
The Taylor Rule is a guideline for how central banks should alter interest rates in response to economic conditions. It takes into account targeted inflation versus actual inflation and real output versus potential output. Think of it as a forecasting model to help us determine what the FED will do with interest rates going forward. However, like with everything else, there are drawbacks to the Taylor Rule. Firstly, it is unable to account for real-time issues like a stock or housing market crash. Secondly, it loses its relevance in a world where the FED funds rate is not the primary tool of monetary policy. In the chart above, we can see the gap between what the Taylor Rule would predict for interest rates (Blue) and what the FED level is set at (Red).
The current rate that the Taylor Rule would predict is 3.78% versus the current Fed funds rate of 1.15%. This suggests that there is plenty of room for interest rates to rise given the current economic environment.
The market is telling us that inflation is weakening but the underlying economy is telling us that interest rates have room to rise.
Business Cycle Watch
The whole point of macroeconomic forecasting is to figure out what is going on with the business cycle. As Howard Marks said, “There are two concepts we can hold to with confidence: Rule No. 1: Most things will prove to be cyclical. Rule No. 2: Some of the greatest opportunities for gain and loss come when other people forget Rule No. 1.” The business cycle can be thought of as the fluctuations in GDP relative to long-term trend growth. A normal cycle goes something like this: initial recovery, early upswing, late upswing, slow down, and recession. We will be looking at the output gap, yield curve, and high-yield spreads.
The output gap is simply the difference between Real GDP and Potential GDP presented here as a percentage. Of course, the output gap is only as good as the estimate for Real Potential GDP, which is produced by the CBO’s estimate of what the economy would do with a high rate of use of its capital and labor.
The current output gap was positive for the first time since 2007. Historically, the output gap has run positive before all 10 recessions since 1950 except 1981.
The yield curve gives us the relationship between bonds of differing time horizons. This is important because it reveals what investor’s expectations for the future are versus today. If investors believe the future holds economic growth and inflation they will sell long-term bonds, steepening the yield curve. If investors expect a recession, they will do the opposite, flattening the yield curve. Yield curves tend to invert (short-term rates higher than long-term) at the beginning of a recession.
The current spread between short and long-term bonds is 0.78, down from 1.26 during the beginning of the year and 2.66 in 2013. This flattening suggests investors expect long-term macroeconomic conditions to deteriorate relative to the short-term.
The High-Yield spread measures the difference between what investors are charging for bonds below investment grade (rated BB or below) and the risk-free rate. When investors are optimistic, they tend to charge too little of a premium for risk and when they are pessimistic the opposite.
The current spread is 3.48 versus a historical median of 5.10 and average of 5.72. This suggests, as did the VIX, that investors are currently complacent when it comes to discounting risks in the market.
Business Cycle Summary:
Both the output gap and yield curve suggest that we are towards the end of the business cycle. Investors, on the other hand, are showing no interest in believing the end is anywhere in sight.
Consumer spending is the most important factor affecting GDP (about 70%) but also the most stable when compared to investment and government spending. For this reason, it is worth seeing how consumers are doing in the economy. We will be looking at retail sales, unemployment, saving rates, household debt, and consumer confidence.
Retail Sales (Ex Food):
Retail sales are what they sound like, the aggregated measure of sales of retail goods in a given month. Measuring this helps us gauge the direction the economy is headed. Healthy retail sales tend to correlate with positive movements in the equity market.
In the current month, retail sales were up 4.68% from the prior year versus a historical median of 4.7% and average of 4.3%.
The unemployment rate is the share of the labor force that wants a job but can’t find one. This measure usually lags the economy, reaching its peak at the end of a recession.
In September, the unemployment rate decreased to 4.2% from 4.4% in the month prior. Employment in food services dropped the most while employment in health care gained the most. Average hourly earnings for all employees rose by 12 cents to 26.55 and is up 74 cents over the past 12 months. All in all, the employment situation looks healthy.
The savings rate is the amount of money that consumers as a whole deduct from their disposable income in order to accumulate a nest egg for the future. The savings rate is a double-edged sword. As far as the Keynesian multiplier is concerned, the lower the savings rate, the better since every dollar spent gets magnified throughout the economy. As far as reality is concerned, a lower savings rate reduces the buffer that consumers have to deal with adverse shocks in the future, magnifying their effects.
The current savings rate is 3.1%, down from a post-recession high of 11%, but up from the pre-recession low of 1.9%.
Household debt is shown here as a percentage of GDP. High levels of debt can strain income (interest payments) and lead to bankruptcy.
The current ratio is 77% of GDP, down from the 2008 peak of 97%, but up from the pre-2000s average of 62%. It is clear that the consumer has gone through a long period of deleveraging since the financial crisis.
The University of Michigan releases a monthly survey of consumer confidence which is shown above. The idea is to get a measure of how optimistic or pessimistic consumers are about the economy in the near future. If they are optimistic, they might purchase more and spur the economy.
The current confidence reading is 95.1 versus a historic median of 88.9 and average of 86.8. For comparison, the reading was at 112 during the DotCom bubble and 96.9 in early 2007. Consumers are clearly optimistic.
Consumer Health Summary:
Consumers are optimistic about the future and as such have increased spending, lowered savings, and maintained their debt load.
Consumer spending may make up 70% of GDP, but business investment is what moves it. As such, it is important to see how businesses are doing in the current environment. We will be looking at profit margins, inventory ratio, corporate debt, productivity, and the PMI survey.
The best way to see how business is doing is to look at how much profit they are making. Above we can see how profit margins have changed from the 1940s until today.
Currently, profit margins are 11.27% versus a historical median of 9.15% and average of 9.18%. Though down from the 2014 highs, this is still up dramatically from the 2008 low of 5.63%. This makes sense since sales have rebounded strongly from the great recession, while wage costs have remained low. The mean-reverting nature of profit margins would suggest that the future doesn’t look as bright as the present. In theory, rising wages and competition will force profits back down. However, increased monopoly power in the economy could delay that balancing act.
Inventory to Sales Ratio:
The inventory to sales ratio is a measure of how much inventory businesses are holding compared to their sales in a given year. If inventory buildup is greater than demand, GDP will rise but businesses will accumulate unsold products. This will force them to cut production, leading to lower GDP. However, this becomes less reliable as an indicator when an economy is dominated by tech firms who carry no inventory.
The current ratio is 1.38 versus a historic median and average of 1.37. This is down from the recent peak of 1.42 in 2016, but up from the post-recession low of 1.24. This all suggests that businesses are building up their inventories in the face of steady demand. If that demand falters, they may be in trouble.
Non-financial corporate debt is shown here as a percentage of GDP. High levels of debt can magnify profitability (a lot is used for stock buybacks) but can also lead to bankruptcy.
The current ratio is 45.28% which is near the highs of 2001 and 2009, both of which occurred during a recession. It would appear that after a prolonged deleveraging cycle, businesses have used the calm markets to leverage up their balance sheets.
Productivity is the amount of output per labor hours worked in the economy and is the source of nearly all economic growth. The above chart shows the year-over-year percentage change in productivity.
The current productivity level rose 1.46% from the previous year versus a historic median and average of 2.1%. Productivity gains during this cycle have been some of the lowest on record. Some of this can be explained by the rise of the technology sector where productivity is high but prices are low or even free, meaning they have a smaller weight in GDP.
Lastly, let’s look at the Purchasing Managers Index (PMI). PMI is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment. This information is gathered by monthly surveys sent to executives at about 300 companies. Note that above 50 indicates expansion and below 50 contraction.
In October, the manufacturing index declined by 2.1% to 58.7 but is up 5.2% from 53.5 this time last year. Of the major categories, inventories contracted the most and new orders gained the most.
In October, the non-manufacturing index gained 4.5% to 60.1 and is up 5.2% from 56.2 this time last year. Of the major categories, new orders and production gained the most.
This suggests that manufacturing business expanding at a slower pace while non-manufacturing business is expanding at an accelerating pace.
Business Health Summary:
Profits are at record highs, inventories are piling up, businesses are leveraging up, and productivity is modestly rising. All in all, businesses appear to be healthy and optimistic about the future.
- Markets are at historically high valuations.
- With that caveat that interest rates are low.
- Technology and Financial companies are leading the rally.
- Investors are complacent when it comes to volatility.
- Investors are complacent when it comes risk premiums.
- Inflation is subdued.
- The yield curve is flattening.
- Monetary policy is tightening.
- Consumers are healthy and optimistic.
- Businesses are increasing production and leverage.
All of this suggests that we are closer to the end of the cycle than we are to the beginning. However, we could have said almost the same thing one, two, or even five years ago.