Last week there was more bad news with retail sales (ex autos and gas stations) up just 0.2%, May NY manufacturing less than expected, U.S. Industrial production fell 0.3% month-over-month in April, University of Michigan Consumer confidence was down 7.3 points, and 30-year mortgage rates hopped to their highest level in nine weeks as interest rates continued the surge that began in mid-April. Despite this onslaught of negative news, the SPX notched new all-time highs. While the D-J Industrial Average (INDU/18272.56) has not done that, it is very close to its all-time high of 18288.63 (3/2/15). However, the D-J Transports (TRAN/8680.78) remain troublesome, having failed to confirm the Dow’s new all-time high since March. I have written about that upside non-confirmation ad nauseum, but would note the Trannies have also tried seven times to break below their support level, between 8520 and 8550, and as of yet have been unable to do so.
Meanwhile, my internal energy indicator has the highest charge of energy I have seen in years, and as repeatedly stated, “I think it is going to be released on the upside. If I am wrong, I will have to readjust.” “But Jeff,” one all in cash investor said to me in Philadelphia last week, “Stock valuations are extremely high, so how can the S&P vault above your ‘upside breakout’ level of 2100 – 2126 and push higher into your 2150, and maybe as high as 2250, zone?” My response was that while a few indicators are richly priced, most of the ones I use are not. I believe my thinking was best summed up by Clearbridge Advisor’s Paul Ehrlichman, who said, “The world is invested for ‘Stagflation,’ what if we get growth? The world is also invested for the ‘black swan,’ what if instead we get growth?” Obviously, he thinks we are going to get growth and I agree.
Speaking to valuations, the only valuation metrics I look at that suggest stocks are expensive are the Cyclically Adjusted Price Earnings (CAPE) and market capitalization to GDP. I rule out the CAPE for a number of reasons. I think changes in the accounting rules in the 1990s, which make companies take large write-offs when assets they hold go down in price, but do not allow them to boost earnings when the price of those same assets rise, is an issue since CAPE uses a backward looking analyses of earnings. The CAPE also requires a consistent measure of inflation, when in fact the government frequently makes changes to the index that measures inflation. Finally, the CAPE assumes a normal business cycle. In past missives I have argued that due to the severity of the 2007 – 2009 financial fiasco the mid-cycle recovery is going to be much longer than your father’s typical business cycle.
As for Warren Buffett’s favorite stock market valuation tool, the market capitalization to GDP ratio, hereto I think it is different this time. Coincidentally, my friend and terrific portfolio manager David Kotok (Cumberland Advisors) recently wrote:
The longer-term trend level of S&P 500 value to US GDP is about 95%. The current level of the S&P 500 is about 105% of GDP. So at first view it would appear that the US stock market is richly priced, but not by very much. But history suggests that analysis may not be really complete. The range of about 35 points from peak to trough in the ratio of stocks to GDP has held roughly constant for the last century. The 1929 high was an extreme overshoot. The World War II-era, 1942 low was an extreme undershoot; it occurred after Pearl Harbor and before the Doolittle bombing raid on Tokyo. So at today’s 105% we are not much above the range. But something else has happened since the 1982 low. The foreign-sourced profit share of American corporations has risen from 10% to 30%. Thus an additional 20% of profits now being earned by American corporations originates from their activity abroad. However, US GDP does not include the foreign GDP that is the source of that additional 20% profit share. In other words, our domestic GDP generates only 70% of profits; thus using GDP alone to value the stock market is ignoring the growing foreign GDP that has become very significant.
What can we infer? Maybe the current level of stock prices is forecasting that the profit share from foreign sources is going to decline abruptly, while the domestic share is not going to grow. That is possible, but we do not see any forces at work to make it happen. Maybe the taxation of American corporations is about to go up significantly so that after-tax profits will decline. That is possible, but we do not see it as likely. The other side of the argument is that the profit share from abroad will continue to grow, as it has for the last 30 years, and that US corporations will continue to gain global market share. Or, at least, we may infer that they will hold their own. They may gain by acquisitions, as we just saw with Monsanto. Or they may gain by market penetration, as we just saw with Apple in China. How they gain is not the important issue from the perspective of the stock/GDP ratio. As long as they gain, this measure of stock market value remains a critical macro indicator. If we are close to being right, the adjusted trend for the stock/GDP ratio would actually be below the current level rather than above it. Adjusted for the profit share change, the stock market is cheap, not richly priced. And if the foreign-sourced earnings trend continues upward, the S&P 500 Index could easily reach 3000 by the end of this decade, at a time when US GDP will be about $20 trillion.
What can we infer? Maybe the current level of stock prices is forecasting that the profit share from foreign sources is going to decline abruptly, while the domestic share is not going to grow. That is possible, but we do not see any forces at work to make it happen. Maybe the taxation of American corporations is about to go up significantly so that after-tax profits will decline. That is possible, but we do not see it as likely. The other side of the argument is that the profit share from abroad will continue to grow, as it has for the last 30 years, and that US corporations will continue to gain global market share. Or, at least, we may infer that they will hold their own. They may gain by acquisitions, as we just saw with Monsanto. Or they may gain by market penetration, as we just saw with Apple in China. How they gain is not the important issue from the perspective of the stock/GDP ratio. As long as they gain, this measure of stock market value remains a critical macro indicator. If we are close to being right, the adjusted trend for the stock/GDP ratio would actually be below the current level rather than above it. Adjusted for the profit share change, the stock market is cheap, not richly priced. And if the foreign-sourced earnings trend continues upward, the S&P 500 Index could easily reach 3000 by the end of this decade, at a time when US GDP will be about $20 trillion.
The call for this week: Monday is shaping up as a non-event with the trading action. Indeed, the preopening S&P futures are directionless. By mid-week, however, the stock market’s internal energy should be ready to be released on the upside; and that energy is as high as I have seen it in years. This suggests that the upside fireworks should begin in the Tuesday through Thursday timeframe with a very near-term price objective of 2145 – 2165. Of interest is the NASDAQ Financial Index has broken out to the upside. In my discussions last week with one savvy value-centric portfolio manager in Philadelphia, he said the Financials were likely the only value sector currently. For ideas in that space, please see our fundamental analysts’ recommendations.
Contributed by Raymond James
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