But we have seen sharp one-day rallies within significant market corrections. When selling pressure evaporated midday yesterday, buyers stepped in. Today, we will see if that rally is enduring.
I would be foolish to say in a declarative way that the market has found the bottom or what level will constitute bottom. But I think I have a sense for what fair value might be. The current estimate for S&P 500 earnings for 2019 is close to $170 but I think that is probably a bit high. The recent dollar strength is going to be a headwind to earnings at least through mid-2019 assuming it doesn’t escalate further from here. Thus, I am going to use $165 as an estimate for valuation purposes. If I assume the Fed will normalize rates in 2019, then using a normal P/E, based on over 75 years of history, of forward earnings estimates of 15 shouldn’t lead me to far astray in an attempt to calculate fair value. 15 times $165 is 2475 or about 7% below current levels.
But there are reasons to believe that calculation may be a bit too severe. According to data we used from S&P Capital IQ, stocks currently sell at 18.6x estimate earnings as determined a mean but only 15.4 using a median. What causes the difference? There are 48 stocks in the average that now sell at 30x or more times 2019 estimated earnings. You know some of them including Amazon and Netflix. But you would probably be surprised to learn that 23 or the 48 stocks are REITs. REITs are valued based, not on earnings, but on funds from operations (FFO). By law they must distribute 90% of their income to protect their tax-free status. Most pay out a high percentage of FFO. Simply said, earnings per share are a meaningless valuation tool when it comes to REITs due to the impact of very high non-cash expenses (e.g. depreciation). If I use historic data to come up with an average multiple of 15, I need to adjust for the fact that there are now 32 REITs in the S&P 500 versus none in 2000. Thus, the average today is somewhat inflated. By our calculation, the inclusion of REITs in the calculation could provide a distortion of close to a P/E point. Using 16, only slightly above the historic median, times $165 yields a value of 1640. That is virtually where the S&P is today.
Another valuation measure I use is to take the yield on high-grade junk bonds, add one percentage point to account for the added risk of owning stock, and use the inverse to calculate a P/E that is equivalent to where high grade junk yields are today. That number calculates to the same P/E of 16.
Thus, trying to be perfectly rational, which is difficult in a market that is very emotional at the moment, I come to the conclusion that stocks at this moment are fairly valued. Said another way, the 10% correction was natural and rational. The catalyst no doubt was Fed Chairman Jerome Powell’s strong assertion at the September meeting that he wants to see Fed Funds rates return to neutral. Or, said in a different way, he believes the economy today is strong enough to withstand the central bank’s effort to stop propping up asset prices in order to stabilize the economy or allow it to grow at acceptable rates.
There are many who blame the Fed for the correction itself. While I explained that taking away the cookie jar or excess and free money was a catalyst for the correction, that was an inevitable step that was going to happen sooner or later. If a brief 10% correction is all investors are going to have to suffer in return for steps taken to save the economy, cure the financial crisis, and restore growth to something above 2% without excessive inflation, I would call it a fair trade. As for the talk that rates might have to go to 3% or higher, I would suggest don’t listen to conjectural game plans 12-18 months out. The Fed has and always will respond to data at the moment of each rate decision. If inflation, which is currently below 2% without any signs of moving higher, stays subdued and economic growth starts to slide from the 3-4% rates currently, it would seem obvious, that the Fed will achieve its goal of balance will before reaching 3.0-3.5%. I think we will see a rate increase again in December. As for the next possible increase, probably in March, whether that happens or not depends of data between now and then. While everyone, including members of the FOMC, have their thoughts about whether there will be a rate increase in March or not, nothing is written in ink nor will it be until the March meeting itself.
Another consideration in trying to just fair value for this market is the value of the dollar relative to other currencies around the world. The currency market serves as a stabilizer. It balances economic values worldwide. When the dollar is strong, as it is now, it means the U.S. is the best or one of the best games in town. Not only are we growing faster than virtually all other developed nations but anyone investing in the U.S. will get a higher return, expressed in dollar terms since our interest rates are higher. Because of the cost to hedge back into local currencies, not every international investor can take advantage of that. A strong dollar attracts capital. Why wouldn’t anyone want to invest in a nation with faster growth opportunities? But it also has negative implications. Foreign earnings get translated back into fewer dollars. It also weakens commodity prices. Oil, all other factors being equal, will fall in price as the dollar rises. The same will be true for metals and other commodities. Thus, a strong dollar holds back the rate of inflation, good news as far as the Fed is concerned. On the other hand, many emerging nations that need to fund debt in dollar terms are hit with added expenses. We have seen serial problems in places like Turkey, Argentina, and lately even Mexico. Sudden change is never a positive in financial markets.
Pulling this all together, stocks as a whole, after the correction, now seem close to fair value. Growth from here will be tied to future changes in interest rates and earnings growth. There is no current message from the market that suggests an imminent recession or even one out on the horizon. The long term sustainable growth rate of our economy is a product of population growth (currently about 0.7%) times gains in productivity. Productivity growth has been rather anemic for the past decade although there have been some signs of improvement in recent quarters. With that said, the growth in investment spending of less than 1% in the third quarter is mildly disturbing. Based on data we see, it would seem sustainable growth is somewhere between 2% and 3%, a bit higher than in the Obama years but not anywhere near the 4%+ President Trump likes to talk about or the 3% built into budget estimates. One corollary to a modestly slower rate of growth is the expansion of Federal debt requirements since tax revenues are less buoyant than expected. The Treasury now plans to issue over $1 trillion in net new debt next year and probably the year after. If anything, that will put upward pressure on rates and downward pressure on stock prices.
There is nothing wrong with 2-3% growth and 2% inflation. We lived with that through most of the recovery years since the Great Recession and equity investors did just fine. Sharp market moves as we have experienced in October get prognosticators all worked up and emotional but, if shares today are roughly fairly valued, then markets should begin to calm down shortly, perhaps after the mid-term elections. Economically, I am not sure whether the mid-terms mean a whole lot. Mr. Trump wants to cut taxes further but, until there is a plan to do that without expanding the deficit, there won’t be serious consideration. Democrats in the House, should they win a majority, might press forward with an infrastructure bill but here again it won’t go anywhere if the costs aren’t paid for in some manner. Any ideas of raising taxes to fund infrastructure will die a quick death in the Senate, almost sure to remain in Republican hands. And even if the Senate also flips, such a measure would be vetoed.
In my mind, the biggest near term economic risk is a further and rapid increase in the value of the dollar. I have no reason to expect that to happen other than a body in motion tends to stay in motion. In 2014 and early into 2015, the trade-weighted dollar index rose by about 25% as Europe entered a recession caused, in part, by the rising costs of imports. The recent move in the dollar has only been 10% although it is quite a bit higher against certain emerging market currencies. In 2015, the U.S. experienced a decline in corporate profits caused mostly by the reduced translation of foreign earnings. At this juncture, the weak dollar might limit grow for the next two quarters but it shouldn’t stop it entirely unless the dollar moves significantly higher.
In summary, stocks today are reasonably valued. A violent correction has created some individual bargains while other stocks remain overvalued. 85 stocks within the S&P 500 now trade at less than 10x estimated 2019 earnings. I have no idea when the FANG correction might end but I can make a case that some of the more egregiously valued names are still overvalued.
If I abide by my two-day rule, today’s action will tell us a lot. Futures point to a higher open, a natural response to yesterday’s rally. The key will be whether the market can withstand the inevitable midday attempts to sell into that strength. Even if we get a recovery rally over the next few days or weeks, some retest of this week’s lows is a reasonable expectation. If you accept my premise that stocks today are fairly valued, one shouldn’t expect a quick recovery to recent highs.
Today, Michael Collins, the pilot of the mission that first landed on the moon, turns 88.
James M. Meyer, CFA 610-260-2220
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