Excerpt from fund manager John Hussman’s weekly essay on the US market:
...investors are moving along a “story line” that goes something like this: the Fed has gone through a long tightening cycle that is starting to have its effects. With its job now done, the Fed is likely to stop. From here, we'll probably see somewhat slower economic growth, but also slower inflation and maybe even lower interest rates. So the “end of the tightening cycle”, combined with sustainable but slower economic growth, slower inflation, and moderating interest rates should lead to an “expansion in P/E multiples” from their currently “attractive” level. End result: new life to the bull market.
Investors should be so lucky. Unfortunately, it's likely that every one of these assumptions will be violated.
On the subject of valuations, I've noted that the apparently benign valuations quoted by many analysts are based on forward operating earnings that contain a very strong assumption of continued high profit margins. Moreover, these forward operating P/Es are being compared either with values from the past decade alone, or with historical average P/Es based on trailing net earnings. Suffice it to repeat that when S&P 500 earnings have been close to their long-term 6% peak-to-peak growth trendline (as they are currently), the average price/peak earnings multiple has been about 9. The current price/peak earnings multiple is about double that. While this hardly implies that valuations must or will decline to their historical averages, it does imply that stocks continue to be priced to deliver unsatisfactory long-term returns.
On the economy, as I wrote in my May 15 market comment, “Stagflation is based on two factors. First, historically, and internationally, it's not the rate of money growth per se, but the growth of government spending as a share of GDP (particularly spending that doesn't add to the productive capacity of a nation), that drives inflation pressures. Second, the enormous current account deficit means, by definition, that a substantial portion of U.S. gross domestic investment is currently being financed by foreign capital inflows. There are only two ways out of this deficit – invest less domestically, or save more domestically. Given a profligate fiscal policy and a low propensity to save among U.S. households (saving more requires income growth to outpace consumption growth), “saving more” is probably not a likely source of adjustment. More likely, we'll adjust a good part of the current account deficit through weakness in U.S. gross domestic investment (mostly via a housing slowdown, in my estimation).”
“In any event, the U.S. has virtually zero likelihood of enjoying a sustained ‘investment boom' anytime soon – whatever growth we observe in capital spending is likely to come from a contraction in housing investment, leaving gross domestic investment relatively flat. So ‘stagflation' isn't an outside chance, but a reasonable likelihood here. My impression is that the Fed will have a fair amount of difficulty with this outcome, as central bankers have always had.”
Last week's GDP report was clearly consistent with stagflation pressures, with GDP growth coming below expectations and inflation figures coming in above expectations. In fact, that's been the general trend of the bulk of economic reports in recent months.
Investors are tenuously sticking to the first story line – moderating growth with no risk of recession, moderating inflation, beliefs that stocks are reasonably valued, and hopes for an end to the tightening cycle. Yet the data are actually consistent with a second story line – emerging (though not imminent) recession risks, persistent “structural” inflation, rich valuations, probable contraction of profit margins, and an incoherent Fed policy that is likely to become even more incoherent in attempting to battle weaker economic growth and persistent inflation simultaneously (not that I believe Fed actions will be effective in any event).
While it's reasonable to expect that the Fed will indeed pause at its next meeting, the more important issue is that investors are probably adopting the wrong story line here.
If and when they shift to the second story line, it probably won't be funny.