The Days Ahead: Big data day on Tuesday for U.S. and Japan
Slower holiday week. The Fed minutes reported that PCE increases are just round the corner at the same time as saying that there was very little loan demand and that inflation would stay less than 2% (I know they contradict themselves but contain multitudes). They’ll go for a rate increase in December but bond yields barely moved at the long end. It wasn't news. Stocks hit an all-time high but it’s not all clear sailing. The newly split Hewlett Packard businesses (HPE and HPQ) reported disappointing results. Stall on the tax front. We reminded ourselves that the Reagan tax overhaul took from December 1985 to October 1986 to pass and that was revenue neutral. The House and Senate sit for only 12 more days in 2017.
1. Is the market overvalued?
There’s no one metric that gives an answer. One can use P/Es, a time tested measure, that tells one we’re in the top end of the range. Or we can use an earnings yield, the reciprocal of the P/E, and compare that to earnings and the 10-Year Treasury. That puts us at 5.6% for the earnings yield, at 3.5% for a real earnings yield and 3.2% for the earnings yield less the 10-Year Treasury. By those measures, we’re at the expensive end of the long-term average but still way cheaper than in 1999. Other measures like ROE (at the high end), net margins (strong), P/Es (slightly expensive), yield (cheap), dividend growth (strong) and earnings growth (solid), tell the same story. Somewhat expensive but not disconcerting.
There are a couple of other ways to look at it too. Here’s one:
It shows hours worked to buy the S&P 500. Right now, it’s around 132 hours with a ten year moving average of 88. This may say the market is expensive. Or it may say that average hourly earnings have failed to keep up with the quoted part of the economy. We'd lean to the latter.
Or we can look at this:
This is the S&P 500 market cap at around $24 trillion compared to the U.S. economy at $19.5 trillion. This one comes out regularly but our reaction has always been “eh?”. GDP is total U.S. production but the S&P 500 is only 500 companies (and not the 500 largest at that) and includes 30% of sales outside the U.S. These (mostly) won't get picked up by the Export/Import line of national accounting. It’s also comparing an asset value to an income value.
Anyway, the ratio is at a cyclical but not record high.
And that’s pretty much where we end up. U.S. stocks have done well. They're supported by valuations but overseas markets look cheaper and with more upside opportunity in the next 12 months.
2. Hedonic Adjustments.
We show this chart monthly because core CPI is critical for the economy, Fed policy and investment strategy. All investments should preserve purchasing power, otherwise just keep it in the bank. That's why deflation is so pernicious to an economy. No investment makes sense. If prices fall, cash, or negative yielding bonds, are a rational investment as they buy more tomorrow than today. There are other horrendous issues with deflation (banks stop lending, mortgages become unmanageable, economic activity seizes) that scares us silly when it happens (luckily not that often).
So, look at the bottom of the chart:
The price of wireless services and TVs has plummeted for years but here's the thing: I’ll bet your Verizon bill is as big as it ever was. You just have a better plan.
This is when hedonic adjustments come into play. It’s the BLS adjusting the price of a service for its changing quality. So if the price of a computer was $1,000 10 years ago and is $1,000 today, you're clearly buying a better product but for the same dollar amount. Instead of showing 0% inflation, the BLS will try to adjust for that clearer screen, faster CPU and that Lightening, Thunderbolt thingy that made your USB obsolete. Here are some other examples:
- Your rent is $2,000 a month. The landlord refurbishes it. Your rent is $2,050 a month
- Your health care is $500 a month. The deductibles are increased. Your healthcare is still $500 a month
- You pay $200 for cable. Comcast improves the download speed. Your cable bill goes up $20.
- The cheap cell phone you bought 10 years ago cost $200. It died. The cheapest one today is $300 although it’s loaded with features.
In every case, the BLS says prices have fallen. But the effect on your wallet is very far from zero. Now there’s no big conspiracy here… although the government saves or pays $8bn more in indexed Social Security payments for every 1% move in the CPI.
So what? For investors we need to a) stay well ahead of inflation and b) understand what our clients’ inflation basket looks like. Because while the headline number is benign, individual experience may be very different.
We posted a note that got some attention. It showed that shareholders in Altria made considerably more money than Apple shareholders since the day Apple went public in December 1980. Yes, Apple was dead money for 15 years when Steve was away. But our point is that steady earnings, dividend yields and predictability can be very good investments. Here’s a similar chart showing the world’s four big tobacco stocks against the S&P 500. It’s a startling outperformance.
Now, we’re no fans of the product and cannot defend the harm cigarettes do. But as investments, we can't ignore them.
Bottom Line: Europe should come back after the German coalition issues.
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Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice. We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security. The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended. Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data. Past performance is no indication of future results.
All charts from Factset unless otherwise noted.