The chart below gives you an alternate way to look at the valuations in the stock market opposed to looking at the historical value of the Shiller PE. With the Shiller PE currently at 29.87, the market is in the 5th quintile meaning it’s in the category of market periods in the top 20% of valuation. At the bottom end of this range is markets which are 80% more expensive than historical markets and the top end is the most expensive market ever. Within this category, the average annualized 10-year returns are 0.2%. We’re in such a rarified period where there’s only a few examples to compare it to. Even going back to the 1890s, there’s not much precedence for a Shiller PE at 30. If the market experiences a final rally based on tax cuts, this will be the second most expensive market ever.
If you’re a trader, you can try to game the last few quarters of this rally and try to short the impending crash will inevitably come in the next few years. If you’re a long-term investor, it’s a tough situation to be in because if you have focused on valuations, you’ve probably missed the returns seen in the past two years which is an opportunity cost of 9.54% in 2016 and 8.91% year to date. The best way to hedge your opportunity cost is by having some money in stocks and an outsized cash position. I think a 30% cash position with the Shiller PE 2.5 points away from the 1929 peak is rational.
Another chart which looks at the same data I have discussed previously, but in a different light is shown below. It shows the amount of government bonds central banks own as a percentage of the total government bonds outstanding. Put another way, this chart shows the amount governments have monetized their debt. It’s scary how Japan has monetized 39% of its debt. Even if it stops the madness now, in the next recession it could conceivably run out of debt to buy and move to the U.S. The European countries aren’t high on the list even though the ECB has the largest balance sheet because Europe is the world’s largest economy. The Fed has never owned 20% of the debt besides this cycle, so there’s not much precedent for the Fed to lower that ownership considerably.
Doing back of the envelope math, if the Fed cuts its balance sheet to $2.5 trillion and the treasury issues new debt, it could lower its ownership to about 10%. The potential policy actions in the next recession are scary because the central banks will act in even more extreme ways. The Swiss Central Bank buying a few American stocks is nothing compared to what’s likely coming. There’s no telling what the ramifications of the central banks owning more of the economy than they do know would be, but there will likely be a lot of unintended consequences.
On a brighter note, both the St. Louis Fed and the NY Fed increased their estimates for Q2 GDP growth slightly. The St. Louis Fed increased their estimate from 2.32% to 2.37%. As you can see in the chart below, the NY Fed increased its estimate from 1.86% to 1.88% based on the new single-family houses sold data and some revisions. Next week’s important economic reports will be the durable goods orders on Monday and the final Q1 GDP revision on Thursday. This week was the calm before the storm as earnings reports for Q2 will begin come in next month.
While there weren’t many reports to affect the GDP forecasts, the most interesting economic report this week was the Markit Flash PMI. It was a bad report. It signals to me any expectations for above 3% GDP growth in Q2 should be dashed even though the Atlanta Fed is currently expecting 2.9% growth. Across the board the Markit report was weak. The June report is consistent with about 2% GDP growth. This is one of the few economic reports we have for June which is a bad sign for how the quarter ended. If June proves to be a bad month after the other reports are released, the NY Fed could be right about Q2 seeing sub-2% growth.
As you can see from the chart below, the Markit PMI U.S. composite index fell from 53.6 to 53.0 which is a 3-month low and the 2nd lowest since September 2016. Obviously, this stat isn’t a perfect reflection of how GDP will come in as it was very positive early in the year despite the 1.2% GDP growth Q1 saw. Breaking down the report, the Services Business Activity index also fell from 53.6 to 53.0 which was also a 3-month low. On the bright side of this report, new-orders increased at the fastest pace in 5 months. Prices charged by private sector firms increased at the fastest pace this year which is surprising given the disinflationary trend.
The worst part of this report was the manufacturing portion. As you can see from the chart below, the Manufacturing PMI Output index fell to 52.9 from 53.7 which was the lowest reading in 9 months. Also, the U.S. Manufacturing PMI fell from 52.7 to 52.1 which was also a 9-month low. The chart makes it look like we’re about to revisit the lows seen in the 2015-2016 manufacturing recession. Weakness in the auto sector might be to blame for this terrible number.
Conclusion
With the stock market being one of the most expensive on record, the pressure is on investors to figure out when the economy will turn. This turn will tell us when the stock market will correct. Even though the Markit report was weak, there’s little risk of a recession in Q2 or for the rest of the year. The two factors which are at play are monetary tightening and fiscal stimulus. They will determine whether this weak recovery lasts 2 more years or ends sooner.
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