by Franklin J. Parker, CFA
The Fed decided to go big, cutting rates by half of a percentage point. Markets largely expected this move, yet it was the tightrope chair Powell walked in the press conference that was particularly impressive. In the past, large cuts like this one tend to indicate considerable weakness in the economy, and are usually done in response to an emergency — the COVID recession in 2020, for example. Powell managed to sell a “nothing is wrong and we want to keep it that way” narrative.
If the market rally is any indication, investors agreed with Powell’s “mission accomplished on inflation, let’s keep the good times rolling” message from last week. I, however, am much more cautious on the economy. The underlying data remains weak. A bigger issue for me, however, is valuations. For investors to simply break even at current stock valuations, earnings would have to grow about 23% per year for the next 10 years. Just for reference: the long-term average growth rate of earnings is closer to 8.5% per year.
Overall, I am very cautious. Underlying economic data is weak and valuations are stretched. While it is possible the Federal Reserve achieved an historic feat (no recession), I find it more likely that the economy follows a similar path to its history: a recession is not far behind rate cuts, and slowing economic data typically indicates a recession.
Chart of the Week
I admit to bringing you a wonky chart this week. We are looking at US Stock valuations relative to history. As we can see, the valuation of the S&P 500 is at the higher-end of the scale, but not as high as it has been during, say, the late 1990s. At current levels, valuations are higher than 80% of the time since 1985. The bottom chart shows 1-year earnings growth through time, and we can see that 8.5% is about average for this period, while 20% only happens in about 1 in every 3 years.
In short, expecting earnings growth of 23% for the next 10 years is excessive by any measure.
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