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Are equity prices too high?

It really must be confusing for the ordinary investor as the media continues to emphasize negative economic news. The current story line continues to be a sluggish economy, where GDP growth was 0.2 percent in the first quarter and likely to be revised to negative growth, while even Europe, long stuck with growth-killing socialism, grew at a 1.6 percent annual rate over the same time period. Are U.S. equity prices too high?

Despite media negativity, it appears that the probability of a significant and lasting dip in U.S. equity prices is highly unlikely without an unanticipated exogenous event because 1) no recession is in sight and 2) the Fed begins raising interest rates when the economy has exhibited permanent signs of strength, not weakness. According to economist David Rosenberg, the first rate hike occurs when the equity markets are only 35 percent of the way through their cycle and still some 18 percent away from their peak.

Indicators of the Health of the U.S. Economy Today

  • It looks like Q1 GDP will end up contracting slightly (preliminary data showed a 0.2 percent gain,) similar to 2014’s Q1. GDP was clearly impacted by an unprecedented rise in the value of the dollar, which caused a surge of imports and a fall in exports. This shaved 1.9 percentage points off of GDP’s growth rate. And the West Coast port strike; along with winter weather that, in some areas, was more than two standard deviations from normal; further impacted growth. With the recent retracement in the value of the dollar and the return toward normalcy of the West Coast ports, such a negative impact is not going to happen in Q2.
  • If we exclude the energy sector, the rest of America’s businesses are doing well. Through Thursday, May 7, 73 percent of reporting companies (ex-energy) beat their bottom line analyst consensus estimates (which is about normal) while 52 percent beat on the top line (also normal).
  • Institute for Supply Management Indexes (ISM): The Manufacturing Index stopped its five-month slide (from 57.9 last October to 51.5 in March), coming in unchanged at 51.5 despite a continued contraction in energy. The Non-Manufacturing Index, which has a weight of nine times that of the Manufacturing Index in service-oriented America, rose to 57.8 in April from 56.4 in March. The composite index of both Manufacturing and Non-Manufacturing rose to a five month high of 57.0 in April, a number which implies GDP growth in the 3-4 percent neighborhood.
  • The price of oil is rising (near $60/bbl) and for the first time in many months, oil storage in Cushing, OK fell. Saudi Arabia is boosting production. There is no doubt that demand, worldwide, is rising.
  • Housing looks like it is about to break out. Luxury home sales (homes priced at more than $1 million) rose 13 percent year over year in Q1. And, despite the backup in yields since mid-April causing some angst in the mortgage application market, purchase applications were up slightly in April’s final week.
  • Retail sales for April were a disappointment, but let’s not forget that this is only a measure of the consumption of physical goods, not services, and only represents about 30 percent of total consumption. The rise back to $3/gallon for gas may have kept consumers cautious.
  • Bond markets recognize the strength of the world’s economies, including that of the U.S.; the 10 year T-Note was 2.3 percent on Tuesday, May 12. This is significantly higher than its recent low on April 17 of 1.87 percent. The backup in yields appears to be a worldwide phenomenon (10-year German Bunds have backed up from .08 percent to .70 percent as of May 12.) Apparently the world has suddenly recognized that deflation isn’t the issue that everyone had feared.
  • Employment

-Payrolls staged a comeback in April (223,000.) This occurred despite the loss of 15,000 jobs in America’s energy sector, more than offset by a rise of 45,000 in the construction.

-The unemployment rate fell to 5.4 percent, a seven-year low.

-The four-week moving average of new claims for unemployment (279,500) is a 15-year low.

-While the consumer appears somewhat timid at this time, incomes are there to support future consumption.

  • Inflation

-The index of unit labor costs rose at an annual rate of 5.0 percent in Q1 vs. 4.2 percent in Q4.

-Real compensation was up an astounding 6.2 percent (annual rate) in Q1 vs. 2.8 percent in Q4.

On May 6, at an event sponsored by the IMF, Janet Yellen said: “I would highlight that equity market valuations at this point generally are quite high… There are potential dangers there…” We should interpret this not as a prediction that the equity markets will soon suffer a correction, but as a warning that the Fed intends to raise interest rates and that it won’t back off that position – so investors should prepare. Markets should have priced this in – whether they react to the event or not remains to be seen. But, as long as the economy continues to grow, even sluggishly, there is no reason for a permanent downdraft in equity prices. Today there is every indication that GDP will spurt higher in the coming quarters; that, except for energy, corporate profits and revenue growth are positive; and that there is no recession in sight. In addition, it is an historical fact that the first Fed rate hike occurs many months before the equity markets peak. Thus, without an exogenous event, any equity market correction would appear to be a buying opportunity.

  • Robert Barone (Ph.D., Economics, Georgetown University), an advisor representative of Concert Wealth Management, Inc., is a Principal of Universal Value Advisors (UVA), Reno, NV, a business entity. Advisory services are offered through Concert Wealth Management, Inc., a Registered Investment Advisor. Dr. Barone is available to discuss client investment needs. Call him at (775) 284-7778.


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