by Franklin J. Parker
- This week is a pretty light on data—earnings are mostly done, and there isn’t much fundamental economic data posting. Of course, initial unemployment claims will be important, and the Federal Open Market Committee (FOMC) minutes post on Wednesday. Investors will parse those minutes for clues as to how members see the economy and policy evolving over the coming year.
- Last week was a big week for data. Namely, markets got figures for April’s job creation and inflation. Inflation was a surprise, with many pockets of goods and services beginning to see considerable upward price pressure. Prices for used cars and trucks, for example, jumped 10% over last month! The Fed has repeatedly stated that they fully expect short-term inflation pressure, but that they expect it to be transient. In that context, the recent inflation report is not of particular concern, however, investors must decide if they believe what the Fed has said, or if they think the Fed’s hand will be forced sooner than they have planned.
- Looking ahead, there is a bit of a respite from market-moving data. However, we are coming into late May and there is an old saying: “sell in May and go away.” Should investors heed that advice? I’m inclined to say “no.” My general thesis is that so long as the Fed is printing money, the bias in market prices is up, and the Fed is still printing money. While the summer is typically more volatile than the rest of the year, it can also deliver significant gains. If you had sold last year around this time, you would have missed out on 23% gains in the S&P 500 (and bought just in time for markets to go down 10%).
The Details & Chart of the Week
Let’s talk about stock valuations.
Obviously, stock valuations are extremely high. In fact, by one popular measure, stocks are more expensive than 95% of their history. Historically, stocks tend to deliver subpar longer-term performance when valuations are this stretched. Of course, valuations can remain stretched for quite some time (as they were in the late 1990s), so we can’t use valuations as a short-term timing mechanism.
But this does bring up the question of valuations—specifically what might cause them to shift back to normal. In a normal environment, investors would shift their valuation of stocks in direct proportion to their view of earnings growth. As you can see from the chart below, earnings growth affects the multiple investors are willing to pay for cashflows. For example, as growth expectations shift from 10% to 7.5%, investors would decrease their current valuation of stocks by 23%, all else being equal.
Of course, not everything is equal—especially in our current environment! In our current environment, I see at least three factors heavily influencing stock valuations. First, earnings growth is, of course, an important component. Second, low interest rates have served to pushed valuations higher. Third, the Fed’s increase in money supply has further served to stretch valuations. Let’s look at each component in turn (we’ve already considered the first), and then we may have at least some sense of how each component might influence market valuations.
Adding the influence of interest rates adds some complexity to our simplistic model of valuation above. Shifting both earnings growth and interest rates creates some interesting and nonlinear dynamics, as the chart below shows us. It also shows us an important point: valuations may stay high even if interest rates rise. It is not a foregone conclusion that valuations shrink when rates rise, as earnings growth can more than make up the change.
Finally, there is the influence of printing money. This is a considerably more difficult factor to pin down. I do have a framework for thinking about it, though I will be the first to admit it is still experimental, and there are lots of assumptions that must be made. Even so, let’s throw caution to the wind and charge ahead anyway.
Currently, the Federal Reserve is expanding the money supply by about 7.5% per year. Based on our back-of-the-envelope analysis, this yields an increase in market prices of about 3.5%, all else being equal. In other words, we can attribute about 3.5 percentage points of the coming year’s market growth to the Fed printing money at its current pace.
By developing a reasonable forecast for each of these components, we might have a better sense of how the Fed’s actions might affect markets in the coming years.
Based on this rough model, here are the consequences of various actions:
- For every 1 percentage point upward change in long-term earnings growth expectations, we should expect an 8% upward change in prices.
- For every 0.5 percentage point move upward in the 10-Year US Treasury yield, we should expect a 5% downward drag on prices.
- When the Fed stops printing money, we should expect a 4.5% drag on prices.
- A contraction of 2.5%in the money supply yields a 1.6% drag on prices.
As you can see, the strongest effect on market prices is still earnings growth expectations. However, that single effect can easily be overwhelmed by higher interest rates and an end to current Federal Reserve policy. Of course, as I mentioned, this is a very rough analysis.
The point is, higher interest rates coupled with an end to existing Federal Reserve policy creates a significant headwind for market prices. As I have long said, investors may do well to monitor these data points very closely, and adjust their portfolios accordingly.
As always, I would be delighted to open that conversation with you.
This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.