Contributed by: Matthew E. Chope, CFP®
I’ve said before that I believe market corrections are as natural as the day is long. That’s why, in my last blog, I shared 3 steps to prepare for market volatility. But how do you know if the winds of market change are about to blow? These are some indicators I like to watch.
The Bigger Picture: The Fed & Price Ratios
Beyond the US equity markets, there is more going on behind the scenes that can come into play. In my opinion the Federal Reserve has been keeping money extremely cheap for an extended period of time. The Fed wants to stimulate the economy and encourage job growth. Recently low inflation has allowed the Fed to stay on this path. This works very well for the US treasury also since low interest rates keep the US Government balance sheet solvent and interest expenses manageable. It has also allowed banks the time needed to replenish balance sheets and squeeze out the bad debt on their books.
Earnings are usually necessary to allow equities to sustain long-term values. Generally, the price of a security today is the sum of all future discounted cash flows into perpetuity. When earnings are stable and getting better and money is cheap this allows for higher price multiples like we are seeing today. We are at or near the highest price ratios ever witnessed in the US equity markets. The following chart is measuring the price to many other gauges of earnings cash flow and book value over the last 65 years. It’s not much different if you view it over the last 200 years.
Ratios of various equity valuations
We are at this point in history because of cheap money, cheap labor and now even cheap energy (which is more of a positive shock). Money, Labor and energy are the 3 main expenses that go into every income statement of most companies in the country. The next two charts give a valuation of corporate equities values to nominal GDP (price of publicly traded companies/gross domestic product) the important thing to see here is that the chart is indicating very high prices compared to output from a historical standpoint.
The next chart below is very similar depiction of valuation. Each point on the chart is the price of S&P 500 stocks at that point in time divided by the previous 10 years of earnings for the S&P 500.
Shiller P/E for the S&P 500 Chart
More Indicators to Watch
From a historical standpoint, these 3 expenses for companies are close to, if not at, the lowest they have been for a generation or two. It’s hard to see how it can get much better. On top of that, we have moderate energy prices again. That indicates that earnings should be fantastic (and they are), but what's next? When the cost of money increases and labor costs rise again (as projected for later this year or early 2016 in the chart below) we could see the earnings improvements slow and possibly fall. And what if there is any type of energy shock the other way (and there always is eventually)?
The following chart from GMO provides some understanding of the last 50 years of initial unemployment claims. When initial claims are high, we are usually deep into a recession. When they are rising, we are usually entering a recession. And when they are near the level we see today, the labor force is beginning to tighten, which typically leads to wage inflation and motivates the fed to increase interest rates and slow the economy down from overheating.
This chart is initial claims for unemployment 1965 to present.
Winds of Change?
The wind, which has been blowing behind us for so long, has allowed us to feel confident, but it’s beginning to slow considerably from some of the indicators I watch. Over the next year we could see the economic winds actually begin to blow at us. On top of that some don’t see a lot of room for upside in US equities over the next 7 years as shown in the chart below. Those at GMO have forecast for US equities to have negative returns after counting for inflation. So, if you haven’t recently, now may be the time to review your portfolio allocation, time frame and risk tolerance with your advisor.
Matthew E. Chope, CFP ® is a Partner and Financial Planner at Center for Financial Planning, Inc. Matt has been quoted in various investment professional newspapers and magazines. He is active in the community and his profession and helps local corporations and nonprofits in the areas of strategic planning and money and business management decisions. In 2012 and 2013, Matt was named to the Five Star Wealth Managers list in Detroit Hour magazine.
Five Star Award is based on advisor being credentialed as an investment advisory representative (IAR), a FINRA registered representative, a CPA or a licensed attorney, including education and professional designations, actively employed in the industry for five years, favorable regulatory and complaint history review, fulfillment of firm review based on internal firm standards, accepting new clients, one- and five-year client retention rates, non-institutional discretionary and/or non-discretionary client assets administered, number of client households served.
This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Any opinions are those of Matthew Chope, CFP® and not necessarily those of Raymond James. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor's results will vary. Past performance does not guarantee future results. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. The Dow Jones Industrial Average (DJIA), commonly known as “The Dow” is an index representing 30 stock of companies maintained and reviewed by the editors of the Wall Street Journal. Investing involves risk and you may incur a profit or loss regardless of strategy selected.