Wednesday, February 7, 2018

What is a Common Sense Stock Market?

Financial FAQs

Pundits and stock traders seem to believe Friday and Monday’s stock “massacre” was caused by too-quick trigger fingers—in computers controlled by algorithms, not people.

Whereas, investors and traders using their common sense would have seen the ‘yuge’ drop in valuations made no sense for many of the S&P 500 stocks of the largest US corporations that were making record profits.  Then they might not have oversold their holdings, as happened to those with the trigger-finger algorithms.

For instance, Boeing’s common stock price dropped $20 in a day when news came out that its profits are increasing and there are predictions of large future cash flows from its booming airline and defense businesses. And corporations such as Boeing will be saving $billions in future taxes due to the lower corporate tax rate.

What about the rest of the economy? Stocks have historically been a prediction of future economic activity, since they are priced at a discount to future earnings. So the total annual return of capital gains plus dividends can be a prediction of a company’s financial health.

Nobel laureate economist Robert Shiller in his best-selling Irrational Exuberance, a historical analysis of stock and bond yields, says stocks have earned $7 per year on average in capital gains plus dividends, bonds 4 percent per year for the past 100 years

And Dr. Shiller said Price-to-earnings ratios, another measure of stock values, averaged 15 to 1 historically. Today, the S&P P/E ratio is 17, meaning 17 times earnings, which is high, but not that high. In fact, the stock P/E’s reached 26 times earnings just before the Great Depression, and an oxygen-deprived 44 times earnings in 2000 on the eve of the dot-com crash.

That was why Dr.Shiller and Fed Chairman Alan Greenspan sounded the alarm over the  irrational exuberance that was “infecting” investors at the time. Dr. Greenspan’s famous warning was given in 1996, four years before the 2000 crash, when he said: “But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”

Japan has finally worked their way out of two decades of virtual deflation at a tremendous cost to growth, because of their spate of irrational exuberance. They now rank behind China and the European Union in the size of their economy.

Our stock market is in a similar circumstance today when too much money is chasing 50 percent fewer publicly listed stocks than in 1996, as I said in yesterday’s column. And there are already indications that corporations will be doing more of the same with the new tax savings.

But there is good news for employees. Friday’s unemployment report unveiled the largest pay increase in years. Average hourly earnings jumped to a year-on-year expansion best of 2.9 percent.  This is while the Fed’s core PCE inflation index is just 1.5 percent, way below its 2 percent stated target.

Graph: Econoday

Wages and salaries, the actual hourly incomes of normal working stiffs that excludes interest-bearing bank accounts, rental income, retirement benefits, stock dividends or annuities, actually rose year-on-year to 4.9 percent for its 5th straight climb and is now at its highest rate since November 2015.

And the just released JOLTS report of job hires and openings showed more workers quitting jobs voluntarily, which means they were finding better paying jobs. Job openings have slowed a bit, down 2.8 percent in December to 5.811 million, whereas Hires are steady, down fractionally in the month to 5.488 million. But that is keeping the spread between openings and hires also steady, at 323,000—which means 323,000 net job openings that haven’t been filled.

This might be why wages and salaries are finally increasing faster than the inflation rate, but it can also be that minimum wages in coastal states in particular are creeping toward $15 per hour by 2022, since 80 percent of the workforce depends on wages and salaries.

What should we make of the possibility of more irrational exuberance pushing stock valuations too high? Corporate profits will increase with the tax cuts, wages and salaries are soaring, and inflation is far away from the 2 percent target.

I believe investors should focus on price-to-earnings ratios, which also tell us whether stock prices have strayed too far from actual earnings.  Dr. Shiller warns irrational exuberance could infect investors again, if the S&P P/E ratio strays once more into the mid-twenties.

Harlan Green © 2018

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