The Thing About Growth And The Recent Risk Rally

by: Danielle Park, CFA

The Atlanta Fed GDPNow model forecast for US real GDP growth (seasonally adjusted annual rate) in the first quarter of 2016 came in at 0.6% on March 28, down from 1.4% on March 24. The next update is due on April 1. Here is the chart which shows the trend in green since the end of January, along with the perennially optimistic range of consensus forecasters (in blue) still gunning for 2%+. They always do.

Bullish dreams aside though, the facts are that global data has weakened since February as risk markets have rallied. Spent of meaningful demand prods, this month the US Fed blinked on its promise of rate hikes and crude and stocks bounced on the dipping dollar. But this has only made downside risks larger.

The thing about growth, is that beyond short-term accounting gimmicks like 'ex-item' earnings and share buybacks, in aggregate corporate profits can't grow faster than GDP over a full business cycle and animal spirits can't expand price to earnings multiples beyond reason forever. Eventually things like wage and sales growth are needed to pay the bills. And with the S&P 500 trading at a breathtaking 23 x GAAP earnings today, tolerance for disappointment is about nil.

Crestmont Research sheds some useful perspective on present valuations in its report "Game Changer: market beware slower economic growth. When GDP is growing at 3% the historical price to earnings multiple has averaged 15.5 (so 32% below the current average). But when GDP is averaging 2%, the average historical PE has been 11.5 (50% below current levels).

As for GDP growth of less than 2%…well in that case the present over-valuation in stocks is nearly too obscene to comprehend.

Disclosure: No positions