from Provident Investment Management’s November 2017 investment comments
Third-quarter “earnings season” is off to a strong start. According to FactSet, with 6 percent of the S&P 500 reporting as of Oct. 13, about 80 percent of companies have reported EPS and revenue results above consensus. Even with earnings and revenue growth, it is very hard for corporate fundamentals to keep pace with this long, relentless “melt-up” which has produced uncomfortably high valuations. According to multpl.com, the S&P’s estimated trailing P/E ratio is up to 25.6. Historically, the index P/E has only been higher during periods where earnings were artificially depressed, such as 2008, and during the two years leading up to the technology bubble which peaked in 2000.
We should note that continued low interest rates are consistent with high stock valuations. Interest rates have risen only slightly compared with their rock bottom lows from mid-2016. The 10-year Treasury currently yields 2.34 percent. This feels paltry compared to historical norms, but it is actually quite generous by global standards. German 10-year debt yields 0.34 percent. Japanese 10-year rates are only 0.06 percent. Swiss 10-year rates are slightly negative.
Those low global rates are acting as an anchor for U.S. rates. There are many reasons why we should expect U.S. interest rates to be moving higher. After four quarter-point increases, the Federal Funds Rate currently sits at 1.25 percent with more tightening to come. The Fed has started “tapering” its balance sheet — buying new bonds more slowly than old ones mature. This process has only barely begun. As reported by Bloomberg’s Christopher Maloney, the current pace of tapering is $4 billion per month, a drop in the ocean. By our math, it would take over 80 years for the Fed’s $4.5 trillion balance sheet to return to its precrisis norms. Tapering will have to accelerate. Maloney reports that by this time next year the Fed is expected to accelerate its pace of tapering to $20 billion per month.
Currency markets seem to think the Fed has it about right. Compared to a basket of foreign currencies, the U.S. dollar has declined steadily throughout most of 2017 but perked up starting in early September. The September inflation reading was only 0.1 percent, exempting food and energy. We can’t live without food or energy, but September was an especially good month to ignore them due to effects of hurricanes Harvey, Irma and Maria. Harvey was especially significant for energy markets because it directly hit Houston, a major energy-producing area. Gold has also been sluggish recently, further evidence that inflation remains tame.…
Stocks feel high, but valuations must be viewed in the context of continued low interest rates and the improving cadence of economic growth. There is also a possibility that meaningful corporate tax reform could produce a step-up in earnings, justifying current valuations. The question is whether investors can bank on any of these market- supportive forces going forward. “Cautious optimism” is a stock market cliché, but it is also typically the right perspective to bring to investing. We currently lean toward caution, but that is not a reason to be pessimistic. There are always opportunities out there. The trick is to find them.