As it has for quite some time now, the stock market continues to defy the poor fundamentals in the underlying economy. This weakness was one of the reasons that Donald Trump defeated Hillary Clinton in the recent presidential election as the Republican candidate made this weakness a focal point of his campaign. However, as I have noted numerous times in past articles, this is most certainly not the narrative that has been presented by most mainstream media sources, which cite things such as the decline in the unemployment rate to its current low level as evidence that the economy is quite strong. As will be shown in this article however, this is most certainly not the case and investors should take this fact into consideration when evaluating their portfolios.
The most commonly used metric to measure the strength of the jobs market is the unemployment rate. As of October 2016, the time of writing, the unemployment rate stood at 4.9%, a level that is very close to what is considered "full employment." Investopedia defines full employment thusly,
"Full employment is an economic situation in which all available labor resources are being used in the most efficient way possible. Full employment embodies the highest amount of skilled and unskilled labor that can be employed within an economy at any given time. Any remaining unemployment is considered to be frictional, structural or voluntary."
According to the unemployment rate then, everybody in this country, or nearly everybody, who is willing to work has a job. This is a significant improvement from the level that prevailed in 2009 when the country was going through its last recession.
Source: Bureau of Labor Statistics
Unfortunately, the unemployment rate is a flawed measure for several reasons. The first reason is that it excludes discouraged workers. A discouraged worker is defined as,
"A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment in the last four weeks. Discouraged workers have usually given up on searching for a job because they found no suitable employment options and/or were met with lack of success when applying."
Discouraged workers are not considered to be part of the labor force when calculating the unemployment rate. Therefore, it is not only entirely possible but also quite probably that more than 4.9% of the labor force is without a job. This is, in fact, the case. This can be seen by looking at a much more accurate metric known as the labor force participation rate. The labor force participation rate is defined thusly by Investopedia,
"The participation rate is a measure of the active portion of an economy's labor force. It refers to the number of people that are either employed or are actively looking for work. During an economic recession, many workers often get discouraged and stop looking for employment, resulting in a decrease in the participation rate."
Unlike the unemployment rate, the labor force participation rate does take into account discouraged workers. It therefore provides a much better overview of the employment situation in a nation. Here is how the labor force participation rate has varied over the past 10 years:
Source: Federal Reserve Bank of St. Louis
As this chart shows, the labor force participation rate declined sharply following the end of the Great Recession and has continued to decline ever since, falling from approximately 66% at the beginning of the recession to just under 63% today. This most certainly does not agree with the narrative that the jobs situation in the United States has been improving. However, this is due in part to structural changes that have taken place in the United States economy over the past 10 years. One of the most significant of these is the mass retirement of the baby boomers made possible by the rising stock market over the past several years. This has caused the retirement savings of these individuals to surge in value, thus giving them confidence in their ability to retire on their assets. As these retirees are largely uninterested in working, they should be excluded from the figures when we attempt to find the true jobs situation.
There also exists a sizable portion of the Millennial generation, and some older members of Generation Z who likewise have no interest in holding down a job at present because they are still attending school. Therefore, we should also exclude these individuals in order to get a true picture of the jobs situation in the United States. The best way to do this is to only look at the labor force participation rate among those individuals aged 25-54 as this will exclude most retired individuals as well as traditionally-aged college students. Here is the labor force participation rate trends chart for these individuals:
Source: Federal Reserve Bank of St. Louis
As this chart shows, the labor force participation rate among those aged 25-54 also has broadly declined over the past 10 years and remains considerably lower than it did during the most recent recession. This also indicates that there has been, by and large, no recovery in the jobs market. While, as shown above, we have begun to see an improvement here over the past year, the economy clearly has a long way to go in putting Americans back to work.
Unfortunately, even the labor force participation rate does not tell the whole story. This is because it does not discriminate between the quality of jobs. For example, it considers a minimum wage or part-time job to be equivalent to a full-time executive position but the two are obviously not the same. Therefore, we must also look at the quality of jobs in the United States in order to truly evaluate economic performance.
As readers of some of my past articles may note, I have continually stated that the new jobs that have been created since the end of the Great Recession have been lower quality than the ones that have been lost. That continues to be true today. For example, the October 2016 jobs report from the Bureau of Labor Statistics states that the number of people employed by "food services and drinking places" increased by 10,000 during the month while the number of people employed in manufacturing decreased by 9,000. This is the continuation of a multi-year trend. As Zero Hedge recently pointed out, since 2014, the US economy has added 547,000 jobs as waiters or bartenders and lost 36,000 manufacturing jobs.
Source: Zero Hedge
Historically, manufacturing has been one of the few sectors in which an unskilled worker (defined as a worker without a college education) could earn a wage high enough to support a middle class family. In fact, manufacturing jobs are historically the highest-paying jobs in any sector, excluding some highly specialized positions. Therefore, the conversion of these jobs into lower-paying ones is most certainly not a positive for the economy.
At this point, some may argue that a higher percentage of people have college degrees now than in the past. While that is true, and the percentage of the population with degrees has been growing over the past decade that has thus far not translated into employment. We can see that by looking at the employment-to-population ratio. According to the Organization for Economic Cooperation and Development, the employment-to-population ratio is defined as,
"The employment-to-population ratio is defined as the proportion of an economy's working age population that is employed."
This chart shows the employment-to-population ratio in the United States over the past 10 years, broken down by educational level achieved:
Source: Zero Hedge
As this chart shows, the percentage of the population with either high school or college educations that have jobs has fallen precipitously since the last recession and has remained relatively flat since 2010. Meanwhile, the percentage of employed people without a high school education has recovered to the levels that it held prior to the recession. This serves as evidence that the majority of jobs created since the end of the recession have been low skilled and low paying jobs. Unfortunately, since approximately 70% of the United States economy is dependent on consumer spending, this is a worrying trend for the economy as a whole.
The stock market fails to reflect this reality in the jobs market, however. In fact, on November 14, 2016, the Dow Jones Industrial Average reached an all-time record high, following a short-lived slump after the election. This is at least partly due to both uncertainty and exuberance following the election, although US stocks are alone in this as all other asset classes have declined in value. Regardless of your views about whether a Trump presidency will be positive or negative though, stocks are clearly overvalued by any measure. One metric that can help us see this is the cyclically adjusted price-to-earnings ratio, also commonly referred to as the P/E 10 ratio. Investopedia defines this ratio thusly,
"The P/E 10 ratio is a valuation measure, generally applied to broad equity indices, that uses real per-share earnings over a 10-year period. The P/E 10 ratio uses smoothed real earnings to eliminate the fluctuations in net income caused by variations in profit margins over a typical business cycle. The ratio was popularized by Yale University professor Robert Shiller, who won the Nobel Prize in economic sciences in 2013. It attracted a great deal of attention after Shiller warned that the frenetic U.S. stock market rally of the late-1990s would turn out to be a bubble. The P/E 10 ratio is also known as the 'cyclically adjusted PE (CAPE) ratio' or 'Shiller PE ratio.'"
In short, the cyclically adjusted PE ratio allows an investor to evaluate the valuation of the market in comparison to its historical levels while being able to ignore or at least compensate for the fact that real net income is likely to be lower during a recession than during periods of normalcy or economic booms. Here is how this ratio has varied since the early 1880s:
As this chart shows, the cyclically adjusted PE ratio is currently at 26.88. This is higher than at any time in history except during the tech and housing bubbles and the lead up to the infamous Black Tuesday crash. During each of those times, the overall employment environment was much better than it is today. Moreover, this ratio adjusts for economic strength or weakness. Therefore, even if one disagrees with my conviction that the economy is weak, the stock market still appears overvalued.
There is further evidence that the U.S. stock market is overvalued at today's levels. One of value investing legend Warren Buffett's preferred methods to use to value a stock market is known as the total market cap to GDP ratio. In short, a nation's stock market is considered to be fairly valued if the combined market cap of all publicly traded equities is between 75% and 90% of that nation's GDP. If the ratio is below that, then the stock market is considered undervalued and vice versa.
|Ratio = Total Market Cap / GDP||Valuation|
|Ratio < 50%||Significantly Undervalued|
|50% < Ratio < 75%||Modestly Undervalued|
|75% < Ratio < 90%||Fairly Valued|
|90% < Ratio < 115%||Modestly Overvalued|
|Ratio > 115%||Significantly Overvalued|
As of the time of writing, the total market cap of all the equities in the Wilshire Total Market Index, which purports to include all publicly traded U.S. stocks, is approximately $22.6 trillion. Meanwhile, the last reported U.S. GDP was $18.7 trillion. This gives us a total market cap to GDP ratio of 121.2%, which clearly falls into the significantly overvalued category. Here is how this ratio has varied historically:
As this chart shows, the total market cap to GDP ratio is significantly above its historical average and is, in fact, higher than at any point since 1970 except for during the tech boom. Thus, by using the metric that Warren Buffett once called the "single best measure of where valuations stand at any given moment," the stock market appears significantly overvalued. Therefore, unless an investor expects forward growth to be significantly above its historical average, which is unlikely, it would be wise to be cautious.
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.