From the January investment comments by Provident Investment
Is it anticipation of better economic growth that has investors in a buying mood, or is it fear of being left out of a powerful rally? Many investors are skeptical of the current stock market rally because stock valuations were already stretched at a time of slow economic growth. Recent earnings tell us where a company has been, but only offer a clue where they are headed next. Metrics such as price-earnings ratios often appear elevated at an economic inflection point, the point at which the growth trajectory bends upward.
Recent economic reports are similarly backward-looking, but also are our best indicators of where we might be headed. Third-quarter GDP grew at a 3.2% annualized rate. This is the fastest rate of growth in two years and compares to rates between 0.8% and 2.6% over the past eight quarters. GDP growth was heavily influenced by commercial construction activities after a long lull, and by exports that grew faster than imports. However, growth in consumer spending was within the range of recent years. Some measures of the factory sector hint that a rebound could be coming, although reports of recent activity suggest manufacturing continues to struggle.
Other indicators of consumer spending suggest that growth may be improving, although this could just represent a rebound from the moribund rates of three or four quarters ago. The personal consumption expenditures component of the monthly income report suggests an uptrend in spending. Enthusiasm must be tempered, however, by the observation that the rate of growth remains below 2% on an annualized basis. Personal income is within the recent range, and a healthy level of savings suggests consumers are generally living within their means. One early sign of an improving economic outlook would be for consumers to feel sufficiently confident about an impending improvement to dip into personal savings to fund additional consumption.
There has been considerable “noise” in the monthly employment figures. The unemployment rate fell to 4.6% in November, aided by a noticeable decline in the labor force even as population continues to rise. The number of new jobs rose 178,000. As has been the case with recent jobs reports, the number of new jobs increased the most in the services sector, which includes many lower-paying occupations.
Earlier in this piece, we described how economic statistics are backward-looking and that they may not be particularly meaningful if, and this is a big if, the economy is at an (upward) inflection point. We wonder about this inflection point because it is rare to see major markets in such agreement as they have been immediately following the election. Stocks have been on a tear, interest rates are rising, commodities have been generally improving, and the value of the dollar is up. All of these suggest that U.S. economic growth is expected to break out from recent trends.
The age-old question is, how much of the expected improvement is already reflected in stock prices? Investors using backward-looking measures of price-to-trailing-earnings may not be incorporating the expectation of improving growth. Since there has yet to be a report of economic or corporate activity including actual growth improvement, investors are betting on something that is more theoretical than actual. However, where there’s smoke, there’s usually fire. We would put our confidence in the collective wisdom of millions of investors over the opinion of economists.