What I Care About This Week | 2021 May 17

Photo by Michael Goyberg on Pexels.com

by Franklin J. Parker

The Summary

  • 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.

S&P 500 CAPE Ratio

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.

Relationship between earnings growth and valuation.
note: the actual number representing “valuation” is not important, it is the change in these figures with which we are concerned

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.

Relationship between stock valuations, earnings growth, and discount rates.

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.

Relationship between money supply and market pricing.

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.

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