This economy is too hot! This economy is too cold! Where is the economy that is just right?
Written by: Benjamin Bimson CIMA® / BCJ Financial Group
Goldilocks paid a visit last week in the form of a best-case jobs report on Friday.
The jobs report from the US Bureau of Labor Statistics showed that 287k jobs were added in non-farm jobs, far above estimates by economists. In fact, Friday’s jobs were the single largest economic report that the market was waiting for this past week and sent the rally further into the green for equities.
The Fed movements, and really all central bank movements, are the dominating effect that the market is looking at in the consideration of what to do next. Now that the uncertainty of Brexit is over, the next great anticipation is that more of that addictive drug, aka market stimulus, will pour into the markets, remaining at the forefront of the collective market mind.
There are a number of pharmaceuticals that are potentially habit forming and central bank stimulus has become the economic equivalent. The reason the jobs report was so smashingly successful is that it was perfectly positioned to indicate that the economy is not yet ready to dive into recession, but also not so strong as to push the Fed into another interest rate hike. This is why I consider it last weeks’ Goldilocks scenario.
The following shows how the monthly data dramatically improved since last month’s unexpected drop-off. The chart shows the past 10 years of jobs numbers (monthly data). We are holding fairly steady, which is a positive economic indicator and one that the Fed has specifically mentioned they will continue to watch in order to determine the next Fed move.
What about reality? What about PE ratios and how high they are? What about corporate profits? Don’t worry, those will get some attention pretty soon as the third quarter earnings season kicks off. There is no doubt that the forward PE ratios are fairly high as the next chart illustrates. However, when we look at the relative dividends of the underlying S&P 500 stocks, relative to the current treasury yields, it might justify the relatively overvalued nature of the current PE ratios we are illustrating below.
Let jump straight into the next chart. As you can see, the current dividend of the S&P 500 per share is plotted with the 10-year treasury. Notice that the spread between the bond and dividend has been growing the entire market expansion.
We find the treasury has a more attractive yield relative to the S&P 500 dividend per share when recessionary forces are at work. That is something we are not seeing currently, despite being late in the business cycle. Things can change direction quickly, but until we see rates start to climb, there is incentive for investors to hold stocks relative to treasuries historically until such a point that earnings growth becomes negative and markets seek equilibrium by going through a significant equity market correction or recession.
It is theoretically possible that this time is different though. It seems like that gets brought up a lot when economists cannot explain exactly what is going on. Perhaps, due to the tremendous stimulation that the central bankers around the world have used over the past 8 years, the treasury rates are being held artificially low and will be forced to unwind in a messy fashion.
The situation we find ourselves in is unprecedented for certain. There is really no way to know how this will unfold in the future. So far, central banker activism (sometimes no more than anticipated potential-action) has caused financial markets to expand. How long that can and will continue, nobody knows. It has also been a losing proposition to try and fight the Fed or any central bank. This is why it is such a dominant feature in investment decision making today.
The jobs report was important to the Fed, therefore important to the market. Inflation and global growth are also concerns of the Fed. These will likewise continue to get quite a bit of market attention as long as they remain dominant in Fed-speak (what we lovingly call everything any member of the Federal Reserve says in print or verbally, publicly or privately).
As a result, we remain cautiously optimistic that this economic cycle has a bit longer to run. Leading indicators place it solidly in growth phase but far from robust. Volatility is the byproduct and it likely will continue to be hyper-reactive in the markets on a day to day basis so we are remaining vigilant but trying to avoid being emotional, which is very hard to do some days.
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