The equities markets are hovering at all-time highs despite the uncertainty brought on by Brexit, and the 'interesting' U.S. election; the market seems to be in denial about the election, and has shrugged-off Brexit. In this piece, we try to answer the question "is there fundamental support holding-up the market?"
First, we are going to look under the hood of the economy to see if the rally in equities has a fundamental underpinning; starting with the velocity of money in the economy. According to the FED's definition:
"The velocity of money is the frequency at which one unit of currency is used to purchase domestically-produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy."
The narrowest definition of money supply is the M1, with the M2 and MZM consisting of increasingly broader definitions. The following charts show the velocity of the three money supply definitions.
Even to an untrained eye, it should be obvious from the above charts, that business transactions are at historically low levels. Low velocity in money supply is not supportive of equities.
Now let us look at capacity utilization.
Notice that capacity utilization tends to peak before recessions, and to bottom-out as the recession ends. The recent peak occurred at the start of 2015, and since recessions lag the utilization peak by one or two years on average, the probability is that we may see a recession of some sort sooner rather than later. No support to be found here.
Total industrial production is illustrated in the chart below.
Total Industrial Production
Notice the recent drop in industrial production and how the two previous recessions were preceded by similar drops in production. Again, no support here.
Next up is the labor market conditions indicator. We have been harping-on for some time now about the importance of the bottom of the economic pyramid (labor and wages) because without a healthy labor-force, there is no way to sustainably grow the economy.(read three of our relevant SA articles: 1, 2, 3)
Labor Market Conditions
The indicator has dropped below zero. Even though every negative reading in the labor market indicator does not historically lead to a recession, every recession is preceded by a negative reading. We do not see this as supportive for stocks.
Wages have increased 2.6% year-over-year, but only 40% of workers have received increases (see chart below). This implies an uneven-distribution of wage increases.
Percent Reporting Wage Increases
The chart below shows the increase in the percentage of college educated individuals working for minimum wage, or less. These individuals, one could argue, are representative of the "middle class", without whom there can be no sustained economic growth.
College Graduates Paid at or Below Minimum Wage
With 10.6% of this cohort working for minimum wage (or less), we can assume that they are not able to fully participate in the economy.
Does any of this justify the current valuation of equities? The charts below show the PE ratio and the price to sales ratio for equities.
At 26.5, the PE has only been higher in 1929, and during the tech rally.
Price to Sales Ratio
Investors are paying more for every dollar of sales than at any time in the past fifteen years.
We have to conclude that these valuations are not supported by the fundamentals. This means that the interest rate situation is completely (or nearly so) responsible for equities hovering near all-time highs. Monetary smoke-and-mirrors is not a solid foundation for the equities market.
The strong NFP (nonfarm payroll) number (287k) for June excited the market because it made-up for the downwardly revised (11k from 38K) May jobs report. The market rallied because, even though the NFP number demonstrates growth in the labor force, the market continues to price-in a zero chance of a rate hike at the end of the month, and only a 24% chance of a hike by the end of 2016.
We think this is a mispricing of the rate-hike probability. These relatively strong job numbers could cause the FED to telegraph their intentions of raising rates AT LEAST once before the end of the year. This could happen as early as this coming week, which would result in an immediate "risk-off" for the market. If low interest rates are what is elevating the market, then any hint (or threat) of a hike would transform the all-time highs that the market is currently flirting with, into a hangover-induced flashback.
Markets can be irrational for extended periods of time, but at this point we calculate the odds are against sustained new highs. Investors should stay alert and be prepared to deal with what gets revealed when the FED's smoke clears.
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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.