Macro-Economic Conditions Cannot Justify Stock Valuations

by: Power Hedge

Summary

Macro-economic conditions are currently near perfect with low inflation, low unemployment, low interest rates, and high corporate earnings growth.

History tells us that these conditions can never last long.

The economy appears to be at the peak of a business cycle and will likely begin to slow down in the near future, resulting in a market correction.

The only other time that we have seen an economy similar to today's is in the 1920s right before the Great Depression.

Investors should take precautions to avoid suffering significant losses when the market correction comes.

A few days ago, I published an article to this site entitled, "Long-Only Index Investors Should Be Very Worried About Market Valuations." In this article, I showed how American large-cap stocks are currently at their highest valuations in history and this situation is directly correlated with low returns going forward. This article proved to be somewhat controversial, as I expected. One of the most common arguments is that this time is different because of today's low interest rates, low unemployment, rapid levels of technological innovation, strong corporate earnings growth, and other factors. In truth however, this time is not likely to be different as will be shown in this article.

Low Interest Rates

One of the most commonly cited justifications for today's historically high market valuations is that interest rates are near historic lows. It is true that low interest rates are correlated with higher market valuations. However, there is a very high deviation associated with this correlation.

Source: Crescat Capital

As asset management firm Crescat Capital shows above, the current cyclically-adjusted price-to-earnings ratio is already at one of the highest levels ever for the current level of interest rates. In fact, in order to get back to the long-term average CAPE ratio for the 2% interest rate level, the S&P 500 Index would have to decline 50% from today's levels. Thus, low interest rates are no justification for today's market valuation.

Low Inflation Rates

Well, first of all, I believe that the official published rate of inflation is too low and does not accurately represent the rate of inflation seen by the average consumer. However, we will use the official rate as it is the one that most people are likely to agree on. As of right now, the official headline CPI inflation rate is 2%. This is at the low end of the Federal Reserve's target level.

Historically, stock valuations tend to be highest when the headline CPI inflation rate is in the very low but still positive range.

Source: Crescat Capital

As was the case with interest rates however, there is a very large deviation in the relationship between stock valuations and inflation rates. In order to get back to the long-term average valuation for the 2% inflation level, the S&P 500 Index would have to decline by approximately 50% from today's levels. Perhaps even more concerning however is that even a relatively small move in either direction could cause valuation multiples to shrink dramatically. Thus, even if we could justify today's valuation levels by the fact that inflation is low and manageable, the market today is still highly risky as valuations are still at very high levels relative to today's inflation rates and essentially require the Federal Reserve to somehow keep interest rates and inflation rates completely static. This seems highly unlikely to happen.

High Earnings Growth

Another justification that is given for today's high stock market valuations is that corporate earnings growth has increased to relatively high levels. On the surface, this justification makes sense because stocks of companies with high earnings growth almost always have higher valuations than companies that do not. However, in this case, high earnings growth does not justify the high valuations that the companies in the market have today.

This is because historically the only times that earnings growth picks up like it has recently is when the business cycle is at or near its peak. The business cycle is a common concept in economics that describes the periods of expansion and contraction in the economy. Investopedia has a more in-depth definition:

"The business cycle is the fluctuation in economic activity that an economy experiences over a period of time. A business cycle is basically defined in terms of periods of expansion or recession. During expansions, the economy is growing in real terms (i.e. excluding inflation), as evidenced by increases in indicators like employment, industrial production, sales and personal incomes. During recessions, the economy is contracting as measured by decreases in the above indicators. Expansion is measured from the trough (or bottom) of the previous business cycle to the peak of the current cycle, while recession is measured from the peak to the trough."

The United States economy is currently near the peak of the current business cycle. Admittedly, this is nearly impossible to determine prior to the onset of the next recession. However, we can make an assumption that this statement is true based on the aforementioned indicators. First of all, economists believe that the economy is currently at full employment. While I am not sure that this is true, it is an indicator used to officially measure the business cycle. Full employment is something that only occurs as we near the peak of a business cycle. Thus, this indicator appears to be pointing towards this conclusion. The Federal Reserve's recently initiated campaign to slow down the economy by raising interest rates also indicates that the economy may be nearing a peak. Finally, there is the correlation between today's earnings growth and historical precedent. This chart shows the year-over-year earnings growth in the current economic cycle and the one in the 1920s leading up to the Great Depression.

Source: Crescat Capital

As this chart shows, there are a lot of similarities between the current earnings cycle and the one that the economy went through in the 1920s. Thus, if history is any indication, the economy has currently reached its peak level of corporate earnings growth and is likely to see earnings growth begin to decline in the near future.

The Phillips Curve

Another important concept in economics is what is known as the Phillips Curve. The Phillips Curve is a theoretical concept that attempts to show how unemployment and inflation relate to one another. Investopedia defines it thusly,

"The Phillips curve is an economic concept developed by A.W. Phillips showing that inflation and unemployment have a stable and inverse relationship. The theory states that with economic growth comes inflation, which in turn should lead to more jobs and less unemployment. However, the original concept has been somewhat disproven empirically due to the occurrence of stagflation in the 1970s, when there were high levels of both inflation and unemployment."

The economy is currently on an ideal spot on the Phillips Curve in that it is experiencing low inflation and low unemployment. That is shown here:

Source: Crescat Capital

While the economy is in a perfect position now, history tells us that it does not stay in this range for long. This is due to the business cycle - both unemployment and inflation tend to vary over it and the curve tells us that one will have an impact on the other. High valuations cannot be justified by the fact that both are at an ideal level.

No Perfect Economy

By most measures, all official figures are those that would be seen at the peak of a business cycle and such situations are always followed by market crashes. Denver, CO-based asset management firm Crescat Capital explains this in its third quarter 2017 letter to its clients:

"Imagine the perfect economy: full employment, low interest rates, low inflation, strong corporate earnings growth. Perhaps that would be the market that could legitimately sustain a high valuation multiple. Irving Fisher, the most well-known economist of his time, thought so. He declared just nine days before the stock market crash of 1929 that prices had 'reached what looks like a permanently high plateau.'"

It was not to be the case, as any student of market history knows. There is a remarkable similarity between 1929, when Fisher made his statement, and today, as shown here:

Source: Crescat Capital

In short, the market today looks remarkably similar to the market in 1929 and history tells us that these markets never last and when they burst, investors get hurt.

Conclusion

In conclusion, based on history, the positive macro-economic conditions present today cannot justify today's market valuations. These same past events also point to a sharp and deep correction coming in the near future. Investors may want to take precautions.

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.

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