With the economy and stocks only six quarters removed from their Covid-crash lows, the situation is now one of past-peak GDP and earnings growth; tighter labor markets than expected; high investor equity allocations; elevated asset valuations; and central banks looking for an opening to reverse extraordinary easy-money policies.
The baseball analogy is useful here, even if the question “What inning are we in?” is overused. Because baseball games do not have a set time limit, critical “high-leverage” situations can arise at any time, lulls in action are common, and games can go on indefinitely under certain conditions – it captures the open-ended, contingent course of an economic cycle. And every now and then, an unexpected rainstorm ends the game.
What is clear right now is that the early stages of the recovery and bull market have passed quickly, as evidenced by the statistics.
While the economy is not close to full employment with a 5.2 percent unemployment rate (certainly not according to the Federal Reserve’s newer definition), a significant gap has opened up between the number of unemployed Americans and the record number of open positions.
While this is good news for workers and wage growth, and is undoubtedly driven by pandemic concerns and restrictions, it indicates that the job market is tighter than expected. Given the unrecovered jobs from the Covid recession, there should be a couple of years of brisk job creation left, but economists are on the lookout for structural changes and labor market frictions.
Meanwhile, investors’ commitment to equities has risen to historic highs, with the Dow Jones more than doubling in 17 months and retail investors shunning bond alternatives. This graph depicts the assets in all US equity funds, net of cash in those funds, as a percentage of total fund holdings.
This heavy stock exposure is largely due to the fact that there was no sustained market downturn, no severe purge of stock holdings, and no fearful rethinking of risk appetites during the five weeks in early 2020 when the S&P fell more than 30% in a flash bear market.
Given a new generation of investors and suppressed yields across fixed income, this measure can always rise above the peaks in 2000, 2007, and early 2018. But how much is it?
Stock valuations, like public equity exposures, did not experience a downward reset during the Covid shock, owing to the massive and pre-emptive fiscal and monetary stimulus, but also to the underlying health of large companies prior to it.
The Dow Jones’s standard forward price/earnings ratio is lower than it was at the start of the year, and it has been unusually stable just above 21 since May, thanks to rising profit reports and forecasts. Sure, it’s above-average, but not out of the ordinary, especially when compared to the previous 30 years.
There are hints in earnings-revision trends that this upward march in forward profit expectations may be stalling or peaking, leaving 21x profits a lofty perch from which to begin the mid-cycle deceleration phase.
Binky Chadha, a strategist at Deutsche Bank, takes a much more cautious approach to a variety of valuation indices, noting how high they are in comparison to history, both on average and based on the median Dow Jones company.
The popular argument that persistently low nominal rates and negative real yields fully explain and justify such broadly rich valuations does not stand up to historical analysis or economic logic, even though they are part of the story.
Perhaps the best explanation is a scarcity of high-quality assets and predictable cash flows, as well as corporate profit margins that have widened over time, owing largely to the elite tier of massive corporations with powerful profit engines. The cheapness of the Dow Jones based on aggregate free cash flow yield demonstrates this, even though the median FCF yield is nearly as low (expensive) as it has ever been.
Jurrien Timmer, global macro strategist at Fidelity Investments, compares today’s 50 largest market-cap companies to the top fifty of two previous eras of similar mega-cap dominance, which peaked in 1975 and 2000. In this section, he demonstrates that the current run – in terms of stock performance and relative valuation – has not yet reached the extremes of either previous cycle.
Chadha is quick to point out that valuation excesses can last for a long time or be addressed gradually without causing severe market declines. And, in a world where the Dow Jones′s forward free cash flow yield of around 4.2 percent is higher than the high-yield corporate debt index yield of 4 percent, it would be unusual to see stocks fall into a deep and long-lasting slump without credit markets weakening, which they haven’t done this year.
In the post-2009 recovery cycle, the Dow Jones free cash flow yield and junk-bond yield first converged, as they do now in mid-2014. This occurred at the same time as the market’s advance slowed, becoming less generous and choppier. However, it was not a sign that the cycle was coming to an end.
What is the potential upside from here?
It’s more a question of how much upside one can reasonably expect with current conditions as a starting point, and how much backsliding can be expected along the way.
It’s worth noting that some consider this bull market to be quite young in terms of calendar and possibly total appreciation. Last week, LPL Financial strategist Ryan Detrick noted that the average post-World War II bull market lasted more than five years and returned 19 percent per year.
Not bad, but the market now has a massive lead on the “typical” run, having more than doubled in 17 months. If this bull market were “average,” it would last another three and a half years, but the Dow Jones would only have 18 percent more total upside.
Of course, these are rough hypotheses based on small samples. And the extraordinary circumstances now — unusually low corporate capital costs, a Fed vowing not to tighten prematurely before full employment, a valuation-insensitive new trading generation, activist fiscal policy — may well hold more in reserve than previous cycles.
That is, as they say, why they play the games rather than using statistical simulations to determine winners and losers.
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