- The market selloff was prompted by noise rather than real data.
- On a YoY basis, the signals remain in range.
- There is no call for higher bond yields.
- Stocks remain cheap to bonds.
Once again, the bond market has demonstrated that it has a higher IQ than the stock market. Three numbers came out (second quarter growth, the July employment report, and the second quarter employment cost index) which spurred fears of higher inflation and interest rates, prompting a 500-point selloff in the DJIA. The bond market reacted much more calmly because bond investors study the data rather than reacting to a headline.
The data indicates that nothing has happened that would lead to higher interest rates. One can grow old quickly if he annualizes single data points. Annualized growth and employment data have a high noise to signal ratio when observed in isolation. I much to prefer to view the data on a year-on-year basis. This removes most of the noise and makes the trend visible and intelligible. On a YoY basis, there is no real news in the latest data.
Economic growth remains low, with NGDP growing at 4% and RGDP growing at 2.4%. Nominal growth at 4% is abysmal for an economy in recovery. In the post-inflation era (1983-2006), the economy often grew at 6-7%, which left plenty of room for 4% real growth. With 4% nominal growth, the post-Crash output gap will never close. We are in a new era of low money growth, steadily declining velocity, low inflation and low growth. This is not a promising environment for higher interest rates. Yes, the Fed is winding down QE. If that has any impact on money growth (doubtful), it will be negative, which means deflationary. So the end of QE is a reason to buy bonds, not to sell them.
Next, the employment data. Employment grew by 1.9% in July on a YoY basis, and by 1.8% on an annualized basis. This is within the range of employment growth since the recovery began. It is not a spike. There is no employment boom.
The employment cost index (all civilians) rose by 3% on an annualized basis, but by only 2.1% YoY. The 3% annualized rate is the highest since the Crash, but the 2.1% YoY rate is still within range. And price inflation? Core PCE inflation for June was 1.5%, which remains 25% below the Fed's target.
So, in sum, there is very little news when you extract the headline-grabbing noise in the most recent data. We are on a stable path of low growth and low interest rates.
Tomorrow, Professor Aswath Damodaran will publish his estimate of the equity premium for today at the closing bell. It should be quite a bit higher than it was on July 1st (5.45%), given the selloff. I expect it to approach 6%, which is historically high and means that we are being paid a lot of money to hold stocks versus bonds.
Investment Conclusion: Don't panic. Buy stocks.
Additional disclosure: I am long stocks and bonds.