The Bull Case For Stocks Is Compelling
An economic slowdown might actually extend the life of the expansion and the bull market in equities.
The stock market is vulnerable to the manic behavior of investors who lurch between greed and fear. This happens so often that it is regarded as normal. The market is now priced for the fear of an imminent recession, which is unlikely. Barring some unexpected adverse shock, equities represent an exceptional buying opportunity.
Let’s start with market valuations. The S&P 500 Index is trading at about 15 times expected 2019 earnings of $178 per share below the average of about 16.2 times over the past 50 years. By itself, this is sufficient to suggest stocks are cheap, but that valuation is skewed by a few very large, rapidly growing firms that are valued at dramatic premiums to the average.
Excluding the “FANG” group of stocks (Facebook, Amazon.com, Netflix, and Google-parent Alphabet, plus throw in Microsoft for good measure), the remaining 495 stocks in the S&P 500 are priced at less than 13 times expected 2019 earnings. That’s not the only sign of cheapness. The appropriate price/earnings multiple for the stock market is inversely related to the level of interest rates, since valuations are discounted flows of future earnings. With rates still at historically low levels, stock multiples should be decidedly above historical averages. Historically, with inflation around 2 percent, the average price earnings multiple has been around 19 times earnings.
According to Value Line, more than 100 companies trade at forward price/earnings multiples below 8. There hasn’t been so many cheap since the peak of the credit crisis in late 2008, when forward earnings projections were probably not worth much anyway. The last time the market saw more stocks with single-digit price/earnings multiples was in 1984, after inflation was coming off its peak of 10 percent, 30-year Treasury bond yields were coming down from 15 percent, and Fed policy rates had decreased from above 20 percent.
And yet, the economy continues to grow at a solid pace. Some deceleration is evident, but that’s a desirable change. It is highly doubtful and a view of only a small minority that economic growth above 3 percent can be sustained for any significant period of time. Even the 2 percent growth rate experienced for much of the recovery from 2009 until 2018 was sufficient to drive unemployment down from 10 percent to 4 percent. The faster pace of growth in 2018 is rendering the labor market ever tighter, and the inability to find workers has become an impediment to growth, while putting upward pressure on labor costs and inflation. A slowdown might actually extend the life of the expansion.
The retreat in stock prices reflects a fear that the Fed might raise rates sufficiently to precipitate a recession, or that one may be underway already. This seems to be fear run amok. Some point to the slowdown in housing as signaling weakness, although there are multiple factors at work here. More expensive homes are under exceptional pricing pressure because of the loss of property tax deductions. In the Northeast, lower-priced homes continue to sell rapidly, mid-priced homes sell slowly, and expensive homes sell by appointment, if that frequently. In multiple communities, homes priced above $1.5 million to $2 million have two years’ supply on the market.
The nearly inverted yield curve is another factor used to project a recession. It is factually true that every recession in the post-World War II period has been preceded by an inverted yield curve. However, not every inverted yield curve is followed by a recession. Plus, the average period between inversion and recession is more than two years. Purveyors of the doom-is-nigh thesis are getting ahead of the data.
Nothing could be more attractive for corporate profits and stock prices than for the economy to continue expanding at a moderate 2 percent pace while rates remain low. The mere suggestion of some sort of detente between the U.S. and China on trade could trigger a massive rally and a new manic phase. And that would be entirely consistent with the market’s normally erratic behavior.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
To contact the editor responsible for this story:
Robert Burgess at [email protected]