Monday, September 18, 2017

Big Picture charts

The global economy and global financial markets are huge, but just how huge? Answer: a lot bigger than most people realize. Here are some charts which help put things in perspective. They also show that what's going on today is not unprecedented nor extraordinary. As always, all the charts contain the most recent data available at the time of this post.

Global GDP is roughly $80 trillion, about four times the size of the US economy. As the chart above shows, the global economy supports actively traded bonds and stocks worth $132 trillion, of which about 40% are US-based. There's nothing unusual about any of this, considering that a typical US household has a net worth (stocks, bonds, savings accounts and real estate) equal to about three times its annual income. 

As the charts above show, the market cap of Non-US equities has grown at a much faster rate than US equities since 2004 (US equities have grown at a 5.4% annualized rate, non-US equities at a 8.9% annualized rate). US equities are now worth about 50% of the value of non-US equities, down from more than 80%. Non-US equities have suffered somewhat, however, due to the dollar's 5% rise (on a trade-weighted basis) over the period of these charts, but that's relatively insignificant in the great scheme of things.

The defining characteristic of the current US economic expansion is its meager 2.1% annualized rate of growth, which stands in sharp contrast, as the chart above shows, to its 3.1% annualized rate of growth trend from 1965 through 2007. If this shortfall in growth is due, as I've argued over the years, to misguided fiscal and monetary policies, then the US economy has significant untapped growth potential and could possibly be $3 trillion larger today if policies were to become more growth-friendly.

As the chart above shows, the value of US equities relative to GDP tends to fluctuate inversely to the level of interest rates. This is not surprising, since the market cap of a stock is theoretically equal to the discounted present value of its future earnings. Thus, higher interest rates should normally result in a reduced market cap relative to GDP, and vice versa. Since 10-yr Treasury yields—a widely respected benchmark for discounting future earnings streams—are currently at near-record lows, it is not surprising that stocks are near record highs relative to GDP. If the economy were $3 trillion larger, however, stocks at today's prices would be in the same range, relative to GDP, as they were in the late 50s and 60s. Valuations are relatively high, to be sure, but not off the charts nor wildly unrealistic.

As the chart above suggest, over long periods the value of US stocks tends to rise by about 6.5% per year (the long-term total return on stocks is a bit more due to annual dividends of 1-2%). The chart also suggests that the current level of stock prices is generally in line with historical trends. 

Adjusting for inflation, we see that stock prices tend to rise about 3% a year, and the current level is not unreasonably high, as it was in the late 1990s.

US equities have significantly outpaced Eurozone equities over the past nine years. That has a lot to do with the fact that the US economy has grown faster as well.

US households (i.e., the private sector) have a net worth that is approaching $100 trillion. That figure has been growing at about a 3.5% annualized rate for a very long time. The current level of wealth is very much in line with historical experience.

Adjusting for inflation and population growth, the average person in the US is worth almost $300,000. That is, there are assets in the US economy which support our jobs and living standards (e.g., real estate, equipment, savings accounts, equities, bonds) worth about $300,000 per person. We are richer than ever before, but the gains are very much in line with historical experience. (Note: the last two charts are based on Q1/17 data from the Federal Reserve. Data for Q2/17 will be released Sept. 21st, at which time I will be able to update these charts.)

Wednesday, September 6, 2017

A better PE ratio

This post is an update to a 4-yr old post titled "Equity valuation exercises." Back then I observed that stocks were fairly valued according to a standard measure of PE ratios (prices divided by 12-mo trailing earnings per share from continuing operations). But they looked to be quite undervalued if measured against the most recent quarterly annualized measure of after-tax, adjusted corporate profits that is produced in the National Income and Product Accounts (NIPA).

Art Laffer long ago taught me the value of using NIPA profits. This measure of profits is based on information supplied to the IRS, and it is then adjusted for capital consumption allowances and inventory valuation. It's been calculated the same way since 1947, and we can be reasonably sure it doesn't artificially inflate profits (who would overstate their profits to the IRS?); Laffer calls it simply "true economic profits." Using this measure, which is calculated quarterly, also gives us a more timely measure of profits, compared to using a 12-mo average of profits.

Here is a chart of PE ratios for the S&P 500 using trailing earnings per share, which suggests that stocks today are moderately overvalued:

And here is a chart of PE ratios for the S&P 500 using NIPA profits (I've normalized the result so that the long-term average is the same as the average for the standard measure of PE ratios), which suggests stocks are only modestly overvalued:

Both methods produce similar results, but the NIPA method suggests that PE ratios are only about 13% above average, whereas the standard method suggests PE ratios are about 28% above average.

For the curious, here is a chart that compares NIPA profits to 12-mo trailing earnings per share (the latest NIPA profits, released last week, are as of Q2/17, while EPS are as of August 2017):

In my 4-yr old post linked above, I discuss some of the reasons for the divergence in these two measures of profits that began around 1990 (e.g., changing accounting standards and changing taxation regimes). Those problems don't affect the NIPA measure of profits, which is why I tend to prefer them.

The two charts above compare NIPA profits to nominal GDP. Note how strong profits have been since the recession of 2001. Since the end of 2001, NIPA profits have almost doubled (+185%), while nominal GDP has increased by only 80%.

Over the years I've argued that this is at least in part due to globalization. Large and successful US corporations have been able to generate a much higher level of profits by selling into the rapidly expanding global market. Global GDP has increased 125% since 2001.

All things here considered, it's not surprising that stocks have done so well of late, and that PE ratios are moderately above their long-term average.

Tuesday, September 5, 2017

12 charts to watch

North Korea remains the biggest threat to world peace, but markets remain nonplussed. Gold prices have inched higher, but are nowhere near levels that would suggest panic buying. The dollar has declined about 10% so far this year, but it is still trading above its long-term, inflation-adjusted average value relative to other currencies. Stocks show no sign of any significant correction despite trading near record highs. Sovereign yields are uniformly low, but still comfortably above their all-time lows of mid-2016.

Is the market overly complacent? Overly optimistic? Absurdly cheap or expensive? A great buy on dips? "No" is the best answer to all these questions, in my view. Nothing obvious is staring us in the face. I'm with Howard Marks in thinking that now is not a time to take on oversized risks, but neither is it a time to cash in all your chips.

I've been fascinated by the above chart for years. Why is it that the prices of two unique assets—gold and 5-yr TIPS—have been tracking each other for the past decade? The best answer I've come up with is that both are havens of a sort—safe ports in a storm. TIPS protect you against inflation and default, gold protects you from systemic collapse. At current levels they tell us that although conditions today are somewhat better than they were 5 years ago, investors are nevertheless still paying a premium for safety. The long-term average, inflation-adjusted price of golds is somewhere in the range of $500-600/oz., by my calculations; and in normal times the real yield on TIPS would be expected to trade around 1% to maybe 2%. Both are priced to a premium these days, which suggests risk-aversion is still alive and well in today's market.

The chart above shows that the real yield on TIPS tends to track the trend growth rate of the economy. With a real rate today of zero, the TIPS market seems to be expecting real growth of the US economy to continue to average about 2% per year, which is what we've seen for the past 8 years.

The value of the dollar vis a vis other currencies rose following the November elections, but it has fallen by about 10% so far this year. As the chart above shows, the dollar is still above its long-term, inflation-adjusted average against two baskets of currencies. No big message here, but it seems to rule out excessive optimism and excessive pessimism.

The chart above shows how the market has reacted to major events in recent years. The recent reaction to the heating up of North Korean risk is rather tepid, and significantly less than other episodes of panic attacks.

Last week's release of the ISM manufacturing indices for August was very encouraging. The chart above suggests that the new-found strength of the manufacturing sector points to overall economic growth of at least 3-4% in the current quarter. The Atlanta Fed's GDP Now forecast for this quarter currently stands at 3.2%, a bit better than the second quarter's 3.0%.

The manufacturing employment index was very strong, suggesting that manufacturers see improving conditions and thus plan to ramp up their hiring plans.

The upturn in US manufacturing mirrors a similar improvement in the Eurozone. Synchronized recoveries are always welcome!

Based on past correlations, the strength of the ISM manufacturing index says that revenues per share of major US corporations are likely to remain strong for the foreseeable future. Coupled with near-record profits, this provides a reasonable basis for a continuing rally in equity prices.

Not all industries are looking up, however. The August report on car sales was decidedly weak, as the chart above shows. Construction activity has softened in recent months, and bank loans to small & medium-sized businesses have been flat for over six months. Their are pockets of strength and weakness, and that probably means no boom and no bust, as I noted last month.

The US may be stuck in slow-growth mode, but emerging markets are on fire. Measured in dollars, the Brazilian stock market has climbed 150% in the past 20 months. It's still far below its previous highs, however. Brazil is hardly booming, though, but the outlook has changed from dire to somewhat promising. This is one of those cases where the market was expecting a disaster which has failed to materialize. Regardless, emerging markets are riding the crest of two powerful waves: a weaker dollar and rising commodity prices. There is reason to be optimistic about the outlook down south, mainly due to ongoing improvement in the outlook for fiscal policies and politics in general.

Industrial metals prices are up 66% in the past 18 months. This strongly suggests that global economic activity is picking up.

The fact that the dollar is now weakening as commodity prices rise (which is their natural tendency) suggests that the rise in commodity prices may reflect a weakening in the demand for dollars at a time when their supply is abundant, and that is a classic recipe for rising inflation. It's premature to make a big rising inflation call, however, since the bond market continues to expect inflation to be relatively low, in the range of 1.5-2.0% for the foreseeable future. As I mentioned last week, this is something to worry about, not a reason to panic.