After an extraordinary 2017, for stocks anyway, it’s only natural to wonder if valuations have moved too high. Every day, we see and hear analysts call for a market top and a new bear market. It is important to realize that the popular media that interviews and broadcasts these opinions, CNBC in particular, tends to express market data and index data in nominal terms. For example, “the Dow Jones just crossed 26,000 for the first time in history.” However, it is important to remember that relative valuations/prices are what really matters.
In that context, that is Relative Valuation, we believe three components in particular are still bullish suggesting US equities could continue to work their way higher still in 2018 now that the US economy seems go be finally gathering momentum.
1) Forward Price/Earnings multiples. Culver Investment Company LLC maintains a “universe” of companies that are always under consideration for investment. That universe currently consists of 689 primarily US-based companies of varying capitalization (small-cap, mid-cap, and large-cap). The average Forward Price/Earnings multiple (based on estimated 2018 earnings) for that universe is currently 19.66. By comparison, the long-term (60-Year) average Forward Price/Earnings multiple for that universe is 18.02. Typically, we wouldn’t get too concerned about excessive valuations until that measure moved above 1 standard deviation from the average. In this case, that would mean 20.78 times Forward Price/Earnings. So, even based on the current 2018 earnings estimates, the broad market seems reasonably valued. However, one big consideration that we do not believe is yet fully factored into 2018 earnings estimates is the cut to the corporate tax rate recently implemented by Congress and the Trump administration. We recently prepared an admittedly rough estimate of the impact to 2018 earnings of that tax cut and we believe the net effect will be to cut the Forward Price/Earnings multiple from the above stated 19.66 to a very modest 16.00 without any adjustment (up or down) for the improving economic background. It is our belief that these adjustments to 2018 earnings will be forthcoming over the next month or so as companies report their Q4-2017 earnings and issue their forward guidance for 2018, which should include their best estimates for the new tax rates on their respective operations.
2) Interest Rates. Although interest rates, particularly on the short end and up to 5-year US Treasury maturities have moved higher recently, they are still at remarkably low levels given the strong economic activity in the US today. Not only does a low interest rate environment provide cheap financing for companies to access capital for investment and stock buy-backs, but they also make stable dividends and appreciating stock prices even more attractive. To this point, the yield on the 5-year US Treasury recently broke above a long term downward trend that extends back to 2012. Our sense is that this move indicates a flow of funds, or rotation, from bonds into stocks which we really have not seen to any meaningful degree for years. That said, we do need to guard against becoming overly optimistic on the interest rate matter as the longer-term maturities, specifically the 30-year US Treasury have yet to participate in this rotation. We would feel a lot more comfortable calling an end to the 30-year bull market in bonds once that very important measure comes along as well.
3) Low Inflation/Low Wage Pressures. Headline Inflation, primarily as measured by the CPI and the GDP’s PE Inflation gauge both remain remarkably low given the headline Unemployment reading we are experiencing, which has remained in the 4.1% - 4.3% range for months. Ordinarily, we would expect inflation readings to be picking up in this type of labor market as we would expect wages to be accelerating. The only explanation that makes any sense is that a lot of labor is still being withheld, which is a thesis supported by a still weak labor force utilization rate less than 63%. Our thesis is that any uptick in wages is drawing labor at the margin back into the job force and stabilizing wages almost immediately (and therefore wages/demand-type inflation). If this assessment is true, we could conceivably see wages and wage-related inflation remain stagnant for quite a long time. Given that a Labor Force Utilization Rate of 65% is much more in line with the long-term norm for the US, that 2.0% difference represents approximately 4 million people withholding their labor for higher wages. Considering that even in the best of times, the US economy will add around 175,000 jobs/month, it could take several years yet to absorb that withheld labor.
That said in defense of low inflation, we are seeing evidence that investors are expecting inflation to start creeping back into the picture fairly soon with both energy prices (WTI Crude) and gold prices moving higher while the US Dollar has weakened moderately in recent months. These moves might suggest more inflation ahead more from the supply side of the equation, as opposed to the demand side from higher wages. We tend to agree with this assessment as a strengthening US economy, and indeed a strengthening global economy, should reduce the supply of goods and commodities as those economies consume those items. Consequently, we have recently taken meaningful positions in your account with us in the manufacturers and miners of these commodities, specifically oil and gas, gold, copper, and steel production.
We are continuing to maintain a fully invested profile in all stock allocations with our cash targets generally at or below our typical minimums. As the US economy and the business cycle continues to improve and move forward, we are more positioning and reallocating to some of those sectors and companies that have a tendency to perform better as interest rates, commodity prices, and costs in general, begin to move off the cycle lows.
As always, please feel free to contact us if you have any questions or if you need to schedule an appointment to discuss your account or financial plan with us. This is particularly important if you have experienced a big change in your life recently (got married, retired, changed employment, bought/sold a business, etc.).
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