US economy added 255,000 jobs in July, above the consensus 180,000. This positive surprise arrived after a healthy 292,000 in June and a very poor 24,000 in May. The equity market reacted positively. S&P 500 advanced 0.86%; Dow Jones and Nasdaq, about 1%. The yield on the 10-year Treasury rate was also up modestly to 1.59%. So where does the market go from here? Will this positive news carry the market up next week? How will Fed react?
According to a recent research published by Goldman Sachs, the rally on Friday on the positive job stats may be an exception. The research firm finds that the Treasury market no longer reacts to economic data. Goldman Sach's Elad Pashtan wrote that "the sensitivity of US Treasury yields to economic data surprises has declined to near record lows over the last two years. […] For breakeven inflation reactions to growth data are not discernible from zero." From finance and/or economic classes, one knows that different economic data (e.g. job stats, inflation) would impact the trading behavior in the market. When the economic growth is healthy and/or when the Fed is tightening the monetary policy, treasury yields should increase and vice versa. The observation made by Goldman is perplexing since the Fed is actively considering increasing rates and economic data serve the basis for their action (or inaction). These days we see evidence of investors reacting more to Fed's communications and deciphering every one of Yellen's words, rather than economic data releases. One explanation of this phenomenon relates to the divergent global monetary policies and this may be causing Fed to lose its credibility. In other words, because of weaknesses in other parts of the world, Fed is delaying rate hike in preserving US's relative competitiveness to other countries. This new paradigm makes investors' decision making much more difficult. It may even constrain growth in the long term as most investors are treading carefully.
In a July "US Weekly Kickstart" from the Goldman Sach's Portfolio Strategy Research desk, it made some interesting observations.
- Since September 2011, S&P 500 forward P/E has grown by 75% (from 10x to 18x). This expansion has only been surpassed twice since 1976, when the multiple rose by 111% from 1984-1987 (ending with the 22% Black Monday collapse) and by 115% from 1994-1999 (ending with the Tech Bubble pop).
All-time high should not be a sell signal. Per Bloomberg data, the return since each year's high water mark is 47.4% (March 28, 2013), 23.2% (December 31, 2013), 6.8% (December 29, 2014) and 3.9% (May 21, 2015). However, the high multiples investors assign to the market should not be overlooked.
- The Fed model compares the gap between the earnings yield of equities (5.7%) and the 10-year US Treasury yield (1.6%). The current yield gap equals 415 bp, slightly below its 10-year average (440 bp), but well above its 40-year average (250 bp). Yield gap may narrow from either direction (rising bond yield or falling earnings yield which means higher P/E multiple). A rise in the P/E multiple > 20x is unlikely. During the last 40 years, the only instance in which S&P 500 forward P/E exceeded 20x was the Tech Bubble (peak of 24x in December 1999).
- A weighted average of consensus price targets for all S&P 500 constituents implies an index level of 2330 in 12 months (+9.8% return with dividends).
For the months ahead, I believe that the gap between earnings yield of equity and treasury yields should narrow from both the equity and treasury sides. While I do think equity will continue to climb a bit, there is limited room that equity multiple can keep expanding without better support of earnings growth. The last time that P/E multiple exceeded 20x, the market reacted poorly. Earnings growth will be challenging despite a relatively healthy market environment in the US. We see pressures with wage growth. Both US presidential candidates support more fiscal spending. It is likely that they will raise corporate tax rates to fund some of his/her plans. Treasury yield is likely going to climb with the rate hike. I think one hike post the general election in December is likely. These days Fed seems to be looking for confirmation of stability and certainty before taking an action.
I believe that the direction we are heading toward is fairly clear. Fed will raise rates. Treasury yields should increase modestly. Equity market will cool down or slow its climb. It is a question of when. The challenge is that Fed seems to be losing credibility and investors may not respond rationally. Therefore, my suggestion is to be cautious with one's investments and do not go full risk-on.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.