J.P. Szafranski, BridgeTower Media Newswires
As equity markets in the United States continue trading near record-high levels, two fundamental factors will determine the forward trajectory of stock prices. First, future corporate profitability and second, the multiple on such earnings that investors are willing to pay for the privilege of being a shareholder.
While changes to both factors are notoriously difficult to predict, movements in the market multiple, driven by a cocktail of collective investor psychology and interest rate fluctuations, are nearly impossible to divine in advance. The more dovish tilt this year from Federal Reserve monetary policymakers has certainly helped on this front.
Let’s focus on the other factor, the path for future corporate earnings. While many unique elements combine to affect profits, driving disparate outcomes for individual stocks and even entire sectors, we can zoom out to the entire stock market and focus on macroeconomic data. Changes to economic growth are highly correlated to changes in corporate earnings.
We expect to see overall corporate revenue trends reasonably track changes to nominal gross domestic product, thus substantially impacting corporate profits. So how are things looking with the economy? Recent data such as October’s U.S. unemployment rate of 3.6% sure look impressive. Economic output keeps expanding, with real GDP up 2.1% year-over-year through the third quarter, albeit at a slower pace than the prior year’s rate of 3.1%. These markers tell us where we’ve been and where we currently are, but where might we be headed?
Two useful forward-looking indicators are the shape of the yield curve and the Conference Board’s Leading Economic Index. The “inverted yield curve” got a lot of press during the third quarter as the yield on the 10-year U.S. Treasury Note dropped below that of its shorter maturity counterpart, the 2-year Note. Such inversions have reliably predicted economic recessions in recent decades.
In our view, an inverted yield curve is a market signal that Federal Reserve monetary policy is too strict. Tight monetary policy absolutely acts as a brake on economic growth, risking a recession. In this case, the inversion was very brief, lasting less than a month. The Fed cut interest rates three times over three months. Did they act quickly enough to avert a recession?
We are either going to see a recession soon, or we will experience another near miss “growth scare” as in 2012 and 2016, ultimately avoiding recession with output re-accelerating soon. The Leading Economic Index is quite a reliable recession indicator when it dips into negative territory. It has decelerated to a measly 0.3% year-over-year increase in September and October. In 2016, we saw the index hit bottom at 0.3% in June before trending higher to close out the year.
While the services sector of the economy remains healthy, the manufacturing sector is actually currently experiencing a recession. The Institute for Supply Management Purchasing Managers’ Index has seen four straight months of contraction. We again saw a similar outcome in the early 2016 slowdown with five straight negative months. We averted recession then, but it’s no guarantee history will repeat this time. Perhaps now would be a good time to cut it out with all of the tariffs and finalize some trade agreements.
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J.P. Szafranski is CEO of Meliora Capital (www.melcapital.com).
