Anecdotal evidence that the market is in bubble has hit me. I’m sure most people involved in finance have heard questions about the stock market from those not in the industry. It has become an exciting time to invest, so the number of questions I’ve received has increased recently. The reality is the stock market shouldn’t be exciting for most people; it’s not a form of entertainment. Personally, I like reading 10-K reports and the Fed Minutes, but most people normally aren’t interested in the details. Some investors use newspaper headlines as a form of anecdotal evidence that a bubble is present.
The fact that I explained how the pre-market futures work to an electrician at a Super Bowl party is enough anecdotal information for me to notice we must be near a peak. I’ve also had a manufacturing worker ask me how he can get more money to invest because he’s doing so well. Obviously, valuation metrics and economic reports are the principle focus when making investment decisions. The reason why anecdotal information is valuable is because human psychology is what drives markets in the short term. Investors are either willing to take risk or they aren’t. The reason why markets often over-correct is because they fall from being overvalued to undervalued instead of simply returning to the mean.
Putting this anecdotal evidence into quantitative data, the change in the market multiple expresses the change in sentiment. As you can see in the chart below, multiple expansion has been responsible for much of the gains in this bull cycle. Forward multiples have increased 75% in this bull market. It only increased more in the 1987 and 2000 expansions. Stocks started at a more expensive level in this bull market than those bull markets which is why this rally has reached historical valuation levels quicker than in 2000. The reason bulls are optimistic about the market in the next few years is because they think earnings will start to drive the market higher. Even they recognize multiples can’t go much higher. This is why I have been focusing on earnings so much in my articles even though it hasn’t been the driver of the market.
The chart below is an interesting way of depicting how valuations impact future equity returns. When you buy stocks at expensive levels, you are agreeing to have subpar returns over the next few years. While predicting when crashes will happen is impossible, what’s more certain is returns decrease when you pay more for an asset. Sometimes individual stocks can be a Giffen good which is a product that’s consumed more when prices increase. Stocks can move higher because they have a good track record of performance, but that’s not a good long term strategy to follow. As you can see, when stocks are as expensive as they are now, there never has been great performance over the next four years. Because stocks are so expensive, there isn’t much data to compare the current market with. If you told someone over the next four years, at best, they will make a 10% return and, at worst, they will lose 40%, I doubt their excitement level would be as high as it is now. When investors lose their appetite for risk, they require more returns and the market unravels.
One of the more contentious indicators in the economy appears to be the labor market. This is because the establishment reports appear to be more bullish than other indicators. I thought after the cycle peaked, it would immediately lead to a downdraft. I was expecting the labor market to weaken in the middle of last year. However, it has remained at this plateau for a few quarters. Having year over year non-farm payrolls growth peak, but not start falling on an absolute basis, has extended this discussion. Many times, the BLS number has lagged the economy as many firms don’t start firing people until after the recession starts. However, because 2/3rds of GDP is driven by consumption spending, it is still a critical measure to observe.
The chart below breaks down the recent data we have received. The most disconcerting stat shown below is the decline in total quits. Workers are less likely to quit their job when they think the chance of them finding a new job is low. This may be part of the reason why the jobless claims are so low. The employee turnover is historically low. In an individual firm, you want low turnover to develop a healthy culture. However, when looking at the economy at large, the ability of employers to fire people and workers to quit is a sign of a healthy market.
All the statistics in the chart below are decelerating which gives credence to the bears’ claim that the labor market is signaling a recession is likely in the next 12 months. Total hires are also declining which goes back to the point about the labor market being less fluid. The key will be if this lack of fluidity causes the total job openings to start declining. That will be the moment when I can safely say the labor market is signaling an impending recession.
The theory behind why a person not wanting to quit their job may signal the labor market is about to get weak is that a person may know that sales have dried up at their company, so they assume it is happening elsewhere in their industry and they stay put. This assumption may be wrong in specific circumstances, but it is only showing up in the overall market because this feeling is common. If you feel your company is the only one struggling, you’d be more likely to jump ship to avoid the stress. Stagnant wages/salaries are another reason for a lack of quitting. Unless your firm is in the unique position of paying you the most for your job, the grass will always be greener at other firms. If this isn’t the case because of low wage hikes, you may be more likely to stay at your job. Normally, at the maturation stage of the cycle, hourly earnings increase because the supply of labor is tight However, I think this status will be skipped entirely in this cycle because of the high slack in the labor market which is driven by the high level of underemployed workers.
Conclusion
When stocks are overvalued, they have a very low likelihood of achieving above average returns. The turn in the labor market may be a key indicator which will tell us when the penchant for taking risk will end. When the total job openings start declining, I think this will happen. The question is when total job openings will start to slow. This may not happen in the next few months if business optimism remains strong.
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