With respect to the economic outlook, the markets have clearly been extrapolating a “goldilocks” scenario, and seem to be discounting the prospects of a stagflationary environment, which has been a more apt description of recent economic data.
One month of bad data certainly does not make a trend, but retail sales results badly disappointed in April. Moreover, the price charts of the stocks of the major retailers (e.g. Wal-Mart (NYSE:WMT), Target (NYSE:TGT), Best Buy (NYSE:BBY)) do not look healthy at all, especially in the context of a record-setting broader stock market. The typical historical pattern has been that when housing turns down, consumer spending follows with a several month lag; that sequence may be playing out now. Apart from a weak residential real estate market, which has dramatically curtailed cash-out refinancing activity, there are additional pressure points on discretionary consumer spending.
Gasoline prices are at their highest levels since last August, and food and medical prices grew at 7% and 9% annualized rates, respectively, in the first quarter. In addition, interest rate resets on adjustable-rate mortgages are inflicting pain on a growing number of borrowers. According to Equifax, mortgage delinquencies hit an all-time high of 2.87% in the first quarter, and delinquencies on home-equity lines of credit are two-thirds higher than a year ago.
Signs that the consumer is getting tired are preliminary, to be sure, but evidence of persistent weakness in consumer spending, which accounts for 71% of U.S. GDP, would certainly challenge the goldilocks premise now underlying the stock market. The leading economic index we track from the Economic Cycle Research Institute [ECRI] is providing reason for optimism that the current weakness we are seeing in the economic data may be short-lived. ECRI's leading index, which is designed to project economic conditions nine months into the future, has been strengthening in 2007 and its growth rate has just moved to a 3-year high. According to ECRI, the U.S. economic growth outlook is optimistic, which is certainly consistent with the message being sent by the buoyant stock market.
The recent rally in the stock market has made the stock market somewhat more overvalued. We take exception to the view, which is widely held, that "stocks are cheap" because they trade at price to current year (2007) earnings multiple of 16x. The inherent cyclicality of earnings makes it essential to normalize earnings and smooth out distortions caused by economic expansions and contractions.
One method used by the Leuthold Group that we believe is analytically sound takes a five year average of earnings using 18 quarters of historical results combined with two quarters of estimated results. On this basis, the S&P 500 is trading at a P/E multiple of 20.9x. Based on the past 50 years of data, this valuation multiple is in the 72nd percentile and is 8% higher than the median valuation over that period.
Smaller capitalization stocks are substantially more overvalued, falling in the 97th percentile using this methodology and requiring a 30% correction to get back to median valuations. Contrary to the overly simplistic static P/E analysis that is commonly used, stocks are certainly not cheap from a historical perspective.