Clear as Mud

Published On: October 8, 2019

Written by: Ben Atwater and Matt Malick

The track record of strategists, economists and every other variety of pundit in predicting financial markets and the economy is poor at best. 

That said, it seems that markets and the economy have come to a juncture.  The economy seems to be slowing, while stocks have stalled following a robust year-to-date rally. 

Investors have been balancing the somber signals of an inverted yield curve (long-term rates are lower than short-term rates which suggests markets expect a recession) against a consensus view that the U.S. Federal Reserve will act aggressively to fend off recession. 

For now, almost every Wall Street observer sees “no sign of recession on the horizon.”  Rather, many suggest we put aside the inverted yield curve warning sign in favor of a “strong” U.S. consumer and, therefore, a “strong” U.S. economy.

Last week, however, we received a splash of economic cold water with Tuesday’s release of the Institute for Supply Chain Management’s (ISM) Manufacturing Report, which showed significant weakness in U.S. manufacturing, registering the worst reading in ten years.  The ISM followed the manufacturing report later in the week with a report on the service sector, which registered a three-year low. 

Historically, these ISM numbers have been one of the more accurate economic indicators.  The survey combines current conditions with expectations for future conditions.  As such, the ISM readings are somewhat forward-looking, whereas most other data are backward-looking (especially employment data). 

Although manufacturing is a relatively small part of the U.S. economy, it’s sensitive to economic changes and it picks up on trends ahead of services data.  Although both the ISM manufacturing and services numbers came in light, the services survey still indicated growth, while the manufacturing survey showed outright contraction. 

Where does a slowing economy leave equity markets?  Clearly, the answer is probably lower, but how much lower?  This is where things get clear as mud. 

Stocks trade at elevated valuations, with Bloomberg reporting that the Nasdaq 100 fetches 24.4 times earnings while the S&P 500 trades for about 19.4 times earnings.  Yet with the economy growing modestly and interest rates low, these valuations are arguably quite reasonable.  (Keep in mind the long-term average price-to-earnings ratio is about 16 times earnings.) 

Bloomberg also reports that analysts predict S&P 500 companies will grow profits next year by 10%, which would leave the S&P 500 at 16.5 times next year’s expected earnings.  Again, a reasonable valuation if earnings growth continues.  However, it’s hard to imagine that an economy growing at 2% can continually sustain double digit S&P 500 earnings growth. 

Not only do we not know where the economy is necessarily headed, but we have no clue where equity market valuations are headed. 

The $64,000 question might be, what should stock markets trade for in a world of low or no growth with interest rates heading to 0% and the Fed actively engaged in quantitative easing?  The answer to that question might be what determines the direction of equity markets over the next couple of years. 

Regardless, given the current backdrop, it’s hard to imagine that it will be smooth sailing.  We must mentally prepare for the likelihood that equities won’t climb consistently higher as they did for much of the last decade.