Thursday, 10 January 2013

US ECONOMY (January 10th 2013): Are US Stocks Beyond Fair Value? Are Business Conditions Improving? What Next for the Rally?

The first week of 2013 saw the biggest percentage gain in the S&P and Dow Jones average since November 2011. Is this optimism built on a solid foundation of improving business conditions in the US? Are US stocks, on average, worth purchasing for investment at current valuations? And for traders, is it too late to take advantage of the momentum presented by the rally, or are there still opportunities to profit?

We'll take a look at the latest ISM Manufacturing PMI survey, as well as the December Non-Farm Payroll report, to assess the trends in US business conditions. We'll look at the "central value" for the S&P 500 relative to prevailing business conditions, and consider what the market breadth indicators are telling traders about the momentum behind the rally.


At the start of December, we noted in our review of global manufacturing indicators, that the US economy continued to "slip and stumble along" into the end of the year, without any reasonable improvement or deterioration in business conditions. Uncertainty over the election and fiscal cliff issues, the unfortunate timing of Hurricane Sandy, generally depressed conditions in Europe and China, and a lack of any meaningful effect in conditions from QE3, all combined to make for a damp six months.

The conditions in the non-manufacturing sector did pick up more noticeably, although historically this sector can be less insightful in perceiving future conditions than the manufacturing survey. The two are shown below.

Obviously analysing trends in both Manufacturing and Non-Manufacturing sectors are crucial to understanding the overall state of business conditions in the United States. However, the most "economically sensitive" arena tends to be the highly cyclical Manufacturing indicator - which accurately reflected the serious concern the market had for economic growth in 2011. This same concern was given scant attention in 2012 by comparison, despite US earnings considerably slowing (even falling), a symptom that an analyst could glean from the Manufacturing indicator and not the Non-Manufacturing version in 2012.

So understandably, we're concerned about the rate at which corporate earnings and GDP will grow in 2013 while the US manufacturing sector remains in a slump. This is less down to the economics of the sector itself, but the leading "bellwether" qualities of the manufacturing indicators. The rate at which the US economy increases the number of non-farm jobs may be tempered by this also.

However, one important component in the Non-Manufacturing report is Construction, cited as one of the biggest drivers of the indicator's recent performance, an industry which was depressed until 2012. We posted on this subject in September here. These broad trends have continued into 2013, and despite the "trade" being overheated as stated in the post, a further 12.1% growth has been observed in the XHB Homebuilders Index.

We expect that if this trend continues throughout 2013, the effects are likely to filter through into the wider US economy, in terms of job creation, consumer spending and financing activity (creating opportunities within the mortgage sector in 2013, something that Jamie Dimon noted as improving in JP Morgan's latest results). Earnings growth could easily come at a rapid pace in sectors with cyclical exposure to the housing industry because they come from a depressed base - but this does rely on continued improvement in the construction sector.

In summary of US business conditions, and the outlook for earnings and economic growth, we really need to see improvements on 2012 in the following forms: less uncertainty over US politics and aspects of the tax code; a continued improvement in the US construction sector; a return to normal activity for the Manufacturing sector; continued improvement in the number of jobs added to the private sector; continuation of subdued cost-pressure on US businesses; positive effects of monetary policy filtering into business activity; and any signs of pent-up activity after the uncertainty in late 2012 translating into higher 2013 growth.

Bullishness on US business conditions, and thus corporate earnings for 2013 will hinge on the above factors producing a net improvement on 2012.

It is worth noting that while the average ISM Manufacturing PMI has stagnated above and below the 50 level in recent months, S&P earnings have made very little improvement on mid-2011 levels.

Below we'll show Non-Farm Payrolls and US Capacity Utilization Rate:


We can see that more and more jobs have been added in the private sector (since the job losses of the "Great Recession") each year, with around 900k added in 2010, 1.4m in 2011 and 1.7m in 2012. However, there has been a worrying lack of progress since early 2012, something we hope will be corrected as soon as possible Meanwhile the US Capacity Utilization Rate shows a lack of progress in 2012, starting at 78.1% and ending the year at 78.4%. You can read more about our use of the above indicators in their dedicated articles elsewhere on the site - but naturally, we'll want to see both indicators rising to new bull-market highs in 2013.

At the very least, we'll want to see capacity utilization stabilise around the level of its 2012 79.2% peak, without substantially falling back to 2011 levels. Similarly, to sustain current favourable market conditions, the US Non-Farm Payrolls need to at least maintain this current rate of growth.


This is a fairly abstract concept - but an important one when evaluating the long term state of the market. In the short and medium term, we spend a lot of time discussing the trend in business conditions. For trading and other forms of speculation, we can glean important insight into global markets and economies in a variety of methods outlined on the website.

In the long run however, it is important these these conditions are discussed... relative to price. At the very least, the aim is to discuss the context behind which these conditions are prevalent, so that we might understand what growth rates our current valuations might support. In the overall market for US stocks, the S&P will suffice, including historical earnings, dividends and previous valuations (going back to 1871 courtesy of the excellent data provided by Prof. Robert Shiller on his website).

What do we need to consider in placing a range of "fair value" on the S&P, so that we might discuss whether US stocks on a whole are cheap or expensive?

  • Long Run Interest Rates serve as a discount rate in evaluating the intrinsic value of any financial asset. They act as a form of "gravity" for long-run valuation - something which hasn't escaped the attention of the Federal Reserve, who you will have noticed are trying to reflate asset values. In the same way that a higher rate of inflation will eat away at your expected long run returns, a lower "risk free" rate of interest (or "equivalent risk" from say high-grade corporate bonds), will increase the attractiveness of owning alternatives. Therefore, with long run interest rates expected to remain low for the time being, our investment decisions today must rationally reflect this. Stocks earning 7% (earnings yield) will look far more attractive if 3% interest rates prevail rather than 5% etc. With interest rates at historic lows, equity investors must be expected to attribute slightly higher P/E multiples to their stocks, to reflect the unattractive rates in the bond market.

    So this particular factor leans towards a moderately more lenient valuation of stocks.

  • Moody's 20 Year Maturity AAA Bond Yields courtesy of St. Louis Fed

  • Earnings Relative to Market Level of the S&P will give us a broad understanding of what growth rate the market is currently factoring into stock prices. While this really deserves an article of its own, we'll try and keep things brief by using the Ben Graham/Robert Shiller method of comparing ten-year average earnings to the market price (thus eliminating any business cycle effect). We can then compare this valuation to other points in history to gain insight on whether the market is historically undervalued or overvalued. The Shiller Cyclically Adjusted P/E (CAPE), which is also adjusted for inflation, is currently sat at around 21.8.
Table Courtesy of the Excellent Dr Cliff Asness (AQR)

As shown in the table provided in a recent report by Dr Cliff Assness (co-founder of AQR Capital Management), the current Shiller P/E of 21.8 falls into the upper 20% of historic variations. On average, the S&P has returned only 0.9% in 10 year average returns (excluding dividends) when reaching valuations of this level. It corresponds to clearly "above average" expected growth in the earnings level over the next several years. This measure gives inflated readings when there is a high tendency towards earnings growth in a 10 year period (implying that 2003 earnings are too distant to still matter in a growth environment, while real ten-year earnings in the 1935-48 were flat and thus comparable). Nevertheless, we need to understand that a rate of earnings growth is being assumed as standard at a Shiller P/E of 21.8. Similar conditions existed in the early 1900s (ended in a crash), the 1920s (ended in a crash), the 1960s (ended in a protracted bear market), the 1990s (ended in a crash), and the 2000s (ended in a crash). In each instance high levels of growth were factored in (more extreme than today's valuations) and each time they were justified - up to a certain point. After that point, growth in stock prices far exceeded rational expectations for growth, and investors were at the very least left disappointed.The purpose is not to discourage attributing above-average levels of growth into stock prices - simply be aware that those growth rates cannot be extrapolated to infinity, and that stock valuations must live up to their expectations. To buy the S&P at current valuations is to state that current ten-year average earnings are some way below what we might expect over the next ten years.

  • Total After-Tax Shareholder Profits vs US GDP is an indicator that might disagree that current corporate earnings are understated. This is an indicator used by Warren Buffett in his rare commentaries on the overall market valuation. US GDP (or GNP) can be used as an approximation for "Revenue" of the US economy. Total After-Tax Profits can be considered the "Profit", as if we were looking at the sum of the US economy as a single entity to value. The percentage of profit to revenue is the operating margin.
    If we expect earnings and GDP to grow in line with one another, this rate would be constant. Usually, Total After-Tax Profits are around 4-7% of total GDP, in data going back to the 1900s.

    Check this out at the excellent

    However, that figure now stands at over 11%. This trend cannot continue sustainably (profits cannot be greater than GDP/GNP), and history would suggest that we'll see a reversion to mean. Either GDP must grow in greater proportion to present corporate earnings, or alternatively corporate earnings could fall relative to current standards of GDP. Another component of this equation, the rate at which shareholder owners are taxed on their earnings, could also affect this statistic in a negative way for investors. This measure supports the idea that corporate earnings are possibly in the upper-end of their expected range, rather than being depressed.
  • GDP Growth and Corporate Profits, as a further point to the above, must rise regardless of the relationship between the two. A rich valuation of US stocks does not necessarily imply expensiveness, if the market is correctly anticipating a above-average economic growth over the next 7-10 years. Valuations were supported in the 1920s, 1960s and 1990s (before getting out of hand), for several years by rapid expansion in earnings and economic activity. The market appreciated considerably as a result. The problem comes when a certain attributed level of growth fails to be realised. Suspecting that earnings may need to grow at a slower pace than GDP for the above chart to be sustainable, we know that GDP must advance to justify paying current S&P prices for long-term investment. Here is another Warren Buffett measure for comparing overall market valuation - the ratio of Wilshere US Total Market Cap vs Gross Domestic Product, courtesy of GuruFocus.

    As we can see from the interactive chart above, this measure is already modestly overpriced compared to history. GuruFocus also provide a table to show the historical tier of valuation by this metric:
chart and table can be seen here on Guru Focus

In summary of these factors, relatively expensive valuations are currently being placed on US stocks compared to historical standards, although valuations are far from extraordinary. This does not imply stock prices are too high - so long as they are justified by realistic expectations of corporate earnings and GDP growth. We must also consider that interest rates are very low - and can be expected to remain so for at least a few more years, making stocks "worth" the higher prices in the near-term.

With that in mind, we have relatively little interest in adding long term investments in average US stocks that reflect this valuation. Stocks on a whole are at least in the range of fair value, so any investment must be on the basis that earnings and GDP growth will be considerably better than expected over the next several years. The basis by which we can realistically expect this in the short term, is presented above in our analysis of ongoing trends in business conditions. 

The room for capital growth in the average US stock meanwhile, must otherwise rely on stock prices outstripping the rate of increase in underlying earnings - something we fail to see as an attractive option. We'll meanwhile be cautiously limiting ourselves to conservatively priced opportunities with any new funds, knowing the risk priced into the current market level.


The above valuation concerns should be of more interest to the investor, rather than the trader (or speculator) in capital markets.

For the many who are not planning permanent investments, trends in medium term business conditions (above) are important - not just conditions in the US, but in Europe, China and Japan too. The former two have continued their positive trends of improvement on a whole this month, while Japan has continued its deterioration.

However, are conditions "fertile" for adding long momentum trades in common stocks? In my experience, the market breadth indicators are often useful in judging the market's "mood", and the likely momentum the overall market will enjoy over a period of weeks and months.

The above BPNYA indicator from is perhaps our favourite market breadth indicator, measuring the % of NYSE stocks that are showing a bullish P&F pattern. Protracted periods above the 70% level tend to be associated with new bull market highs, and a general "overdone" momentum in stocks. At this stage of such a rally, in BPNYA terms we recognise that the market is in a particularly "bullish mood", and that stocks on average are likely to overextend themselves with momentum.

These conditions are normally good for "letting trades run", maybe with a trailing stop order, in recognition that the trend could abruptly end at any time. Using BPNYA, instead of second-guessing the Dow's movement to determine that trend, will likely provide less volatile (and less stressful) returns. Until the BPNYA indicators comes crashing down (you usually then get a chance to sell near the top), we can be relatively comfortable in letting momentum trades run.

The NYSE High-Low index and Summation Oscillator above both show market breadth reaching levels of optimism, with positive correlation to "favourable market conditions", most suited to letting momentum trades run. We've written more about using these types of indicators to determine market conditions here.

Note that the trough, seen in November on oversold conditions, was technically the "right time" to add new positions, although the trough was far from certain at the time. At this time, adding new trades of this nature contains more inherent risk that you're adding trades once a bullish period has already begun, which can only pay off if we really do see a protracted period of market optimism.

Most importantly - avoid getting carried away with current S&P price levels. As per the analysis above, business conditions and corporate earnings will need to improve substantially to support current S&P estimates. The current S&P and Dow levels are bound to be overblown with the BPNYA indicator in such a bullish mood - don't be surprised if we see the S&P back to 2012 levels in later months.

At Big Macro Picture, we're less than entirely convinced that these bullish conditions are here to stay for the whole of 2013 - so our recommendation is to enjoy it while it lasts and to be careful in your decision-making.

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