A lot of slack remains in the economy as evidenced by the GDP gap.
Employment indicators are still weak and labor still remains under-utilized.
Inflation and wage pressures are muted.
The overall market (SPY, DIA) is fairly valued, but has room to go up.
Let's reiterate the Federal Reserve's dual mandate of maximum employment and price stability. The Fed has historically abstained from popping the asset bubbles. The Fed doesn't use the stock market as a guide to set the monetary policy.
We've made enormous progress since the Fed started the QE and zero interest rate policy (ZIRP). Gains in payroll employment since the start of the year have averaged about 230,000 jobs per month, up a little from the average pace in 2013, and the unemployment rate declined to 6.1 percent in June, the lowest rate recorded in more than five years. There is still more work to be done.
1) The gap between potential and actual GDP is the largest for the last 80 years. The Fed keeps an accommodative stance until the gap is eliminated. Notice how the Fed changes from neutral stance to restrictive policy when GDP gap goes into negative. We're a long way from having a negative GDP gap.
The market continues to go higher as GDP gap becomes negative. Take a look at this graph below where Wilshire 5000 (a broader market index) continues to rally until monetary policy is really tight.
2) A considerable slack exists in the labor market. The unemployment rate only covers part of the story. The labor force participation rate is still historically low. As shown in the graph below, the actual employment rate is well above the long term natural rate of unemployment. The Fed funds rate is again superimposed to understand how Fed decides to keep an expansionary or contractionary monetary policy.
Another labor metric to watch for is the average mean duration of unemployment. This shows a pattern of bottoming out prior to the start of recession. The current level (~36 weeks) is nearly twice the levels of past peaks (~20 weeks).
3) Inflation remains very subdued and is well below the FOMC's long range target. Low inflation helps the Fed sustain the expansionary economic policy. As the US is experiencing a boom in energy, the Fed has more leeway in setting policy.
What is the Fed going to do?
In the latest monetary report, FOMC has provided its participants' assessments of appropriate monetary policy. The consensus is that the Fed funds rates will increase in 2015 to 1.5% and then to 3% in 2016.
Note that the rates in 2015 will still be considered as slightly accommodative and 2016 as neutral. In the past the market (SPY, DIA) has continued to rally into the neutral mode. Only in the late stages of tightening, the market corrects and recession ensues. One might expect the market to peak only during 2016. You might see mini-corrections along the way.
If one sells at the first signs of FOMC rising rates, a lot of gains are left on the table.
What about market valuations?
- Isn't the market already overvalued per the Shiller CAPE ratio?
Nothing could be farther from the truth. The Shiller CAPE is a poor barometer of market valuations. As expressed in this blog, it fails to consider the impact of accounting changes over the years, dividends, and others. At best, an adjusted CAPE ratio that uses pro-forma earnings shows that the market is fairly valued. As earnings improve the market would continue to go higher.
2. Isn't the market overvalued based on Warren Buffett's market cap to GDP ratio?
There are two issues to this ratio. First, GDP only measures the economic activity within the US.
A Wall Street Journal analysis of 60 big U.S. companies found that, together, they parked a total of $166 billion offshore last year. That shielded more than 40% of their annual profits from U.S. taxes, though it left the money off-limits for paying dividends, buying back shares or making investments in the U.S. The 60 companies were chosen for the analysis because each of them had held at least $5 billion offshore in 2011.
With rapid globalization, US companies increasingly report higher global sales. These sales would not show up under GDP.
Information technology continued to be the most successful sector in terms of foreign sales. In 2012, 58.3% of its declared sales were foreign. The sector represents 16.2% of all U.S. foreign sales.
The graph below shows that NIPA (national income and product account) comprises of more and more foreign profits. These are the profits earned from international revenues.
The second distortion to the market value/GDP ratio is the boom in profit margin. The profit margin is at a historically high level (no one knows if this ratio would remain at this level) due to several reasons. The chief among them are: Corporations have been adept in reducing the tax burden (companies like GE pay zero taxes), companies have been hiring less, giving out less pay hikes, using more automation, etc.
When profit margins are high, the firms become more valuable. This reflects in market capitalizations. The wide variation in profit margins over the last 70 years, coupled with increasing foreign sales, make market cap/GDP ratio irrelevant.
The market is nothing but a giant pricing mechanism. The future earnings of companies are discounted at a long-term rate. As long as the Fed funds rate hovers close to zero, the discount rates used by the market will remain lower than the historical average discount rate. The market is not going to be chained by archaic and irrelevant ratios. It would continue to zoom higher with higher valuations not withstanding until the Fed tightens.
1) BEA briefing: www.bea.gov/scb/pdf/2011/03%20march/0311
2) Federal reserve data: research.stlouisFed.org/fred2/
3) FOMC monetary report: www.Federalreserve.gov/monetarypolicy/