Even as economic confidence is improving, investors are worried about the rapid rise of the stock market. In fact, the question I am still most often asked is whether this market has gone too far too fast, and whether we have seen its peak.
Let’s look at some of the facts. First of all, as of June 19, the S&P 500 is up 14.2% year-to-date and 20% higher than a year ago. The Russell Value Index is up 24.9% over the last 12 months. However, I believe that fundamentals still support this market. Investors are searching for yield and thus willing to take on more risk. While this more aggressive stance could cause US stocks to become overbought, this does not yet appear to be the case. Right now, fundamentals are pretty solid, particularly in the United States, and are slightly improving overseas.
US business cycle support
There is no doubt that US stocks have come under some pressure. The US economy has entered another slow patch, which is not an uncommon occurrence during an expansion. Even so, I believe that the US business cycle is still in good shape, driven by pent-up demand, affordability and a pickup in the housing sector, which will become much stronger in the second half of the year. Houses are being built, and the housing sector is a labor-intensive part of the economy. In the last recession, most of the private sector job losses came from this sector, which is starting to recover from depressed levels.
Private sector support
Additionally, stocks are supported by growth in the private sector. While the US economy as a whole is growing at about 2% on a quarterly basis, real private sector growth has been running closer to 3.3%. The recent rise in the US stock market reflects that growth. Stocks have decoupled from the government-reported GDP accounts. They are much more reactive to what is happening in the international economy, global manufacturing and technology.
Corporations are also healthy. They have cash on balance sheets, profits as a share of GDP are near record highs, debt levels are relatively low and leverage is under control. Stock valuations are neither high nor low. Forward PEs on the S&P are about 15x, and PEs for the tech sector are about 14x.
The current stock cycle is being underwritten by the Fed. The Fed is not driving the stock market, but the market knows the Fed is backstopping the economy. As a result, the stock market is not selling off as drastically in response to bad economic news as it once did. Bernanke’s tenure is up in February, and whether he will stay on in his post remains a question. He has a liberal view toward money printing, and his likely successor, Janet Yellen, seems to share his view.
And if rates rise?
Stocks and interest rates do have a direct relationship. Interest rates tend to be driven by a combination of growth and inflation, and we are having moderate growth and very moderate inflation in the United States. A reacceleration of inflation is not necessarily bad for stocks. Historically, stocks have re-rated, meaning their multiple has gone up, when inflation rises from 2% to 3%; 3% to 4%; and from 4% to 4.5% in terms of the annual Consumer Price Index. Above 4.5% stocks will de-rate. Ultimately stocks will de-rate while multiples fall as investors anticipate that companies will not be able to raise prices fast enough to cover the rise in inflation. We’re not there yet, but there is a sweet spot to anticipate yet with stocks, if we go through a growth-driven
inflation period ahead.
All in all, what we are seeing in the US economy is a self-reinforcing phenomenon, or a virtuous circle. US assets offer a higher return on equity; that has historically been the case against Japan, but it is also now true against the major European indices. This higher return, combined with lower US energy prices, is attracting capital to the United States. The capital flow to the United States is driving the US dollar higher. And then there is the inverse relationship between the dollar and commodities. In other words, as the dollar rises, commodity prices tend to fall. In the US economy, which is consumer-driven, lower commodity prices give the US consumer, who has been somewhat constrained by moderate wage increases, more buying power. And that is the virtuous circle that is keeping the US consumer and the US stock market alive.
No forecasts can be guaranteed.
The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation or solicitation or as investment advice from the Advisor.