As financial media hits its audience with a constant one-two punch of theoretical recession indicators in the inverted yield curve and late cycle narratives, it becomes even more important to stay grounded in the tangible economic facts. This is not to say that a recession will never happen and that caution should be thrown to the wind, but that investors’ primary focus should be on the concrete data at hand. It becomes very easy to get wrapped up in financial media’s dooms-day scenarios instead of taking the time to analyze the data which is showing a strong probability of continued economic expansion.
Looking at the flattening yield curve and the prospects of the dreaded inverted yield curve as a recession indicator takes a belief in the ability of an asset class to be omniscient. Pundits will site numerous occasions when an inverted yield curve preceded a recession when it was really a coincident indicator, not a leading one. The fact is all asset classes take their cue from all available information and are managed by individuals seeking to maximize gains or minimize risks. That said, in the past it has been inflationary shocks, political upheaval and other macro-events that presupposed Fed actions. It was these actions combined with existing economic forces at work that may or may not have actually caused a recession.
As often is the case in economic analysis, the work becomes as much art as it is science. The science behind a flattening yield curve is current economic growth and inflation while the art is inflation expectations. Clearly, market participants are currently signaling subdued inflation and expectations. However, in the real world, inflation is alive and well in housing, healthcare, education and other costs, but when it comes to asset pricing, it’s dead. This “death” is most likely a function of various financial institutions’ demand for Treasuries and a structural price change across some goods and services. The Fed’s massive accumulation of treasuries through QE and the realized effect of lowering long-term rates has been compounded by demand for Treasuries from other institutions as well. Whether it’s regulatory-driven increased capital requirements or pensions and insurance companies just managing liabilities, the bid for Treasuries has been strong as evidenced in SIFMA data. So, while strong physical demand for Treasuries has helped keep rates down, there has also been a simultaneous suppression of inflation and its expectations through technological advances. Thanks to fracking (lower energy prices), hand-held computing, open source software and social media, there has been a suppression of prices across many goods and services. The fact that the world’s most powerful and easy to use programming language, Python, and its data analysis tools like pandas are free to use, shows that there is a highly pervasive price suppressing element making its way through the economy. In the past, broad price declines were often driven by reduced demand as opposed to the healthy reasons we have today. The point here is that the yield curve isn’t signaling anything other than the current situation, which is one that is beneficial to consumers, earnings and ultimately equities.
Then we have the late cycle narrative which has been pitched in financial media in earnest for the last three years. The late cycle narrative has its roots in historical NBER data which shows that recessions tend to occur about every six years. The problem here is that as the US economy has transitioned away from a manufacturing / export base to a services / consumption base, the cycle has extended since the economy has become more self-sustaining. If we regroup the existing NBER cycles for the change to a services economy, we can see the lengthening of cycles:
Since the preconceived notion of the six-year cycle is so embedded in investors’ thought processes, it has become a mental error or bias that causes people to stick with a concept even though new data has been presented which should cause a reassessment of the old concept. In behavioral finance, this is known as conservatism bias and can also cause investors to assign a higher probability to the unlikely event (recession) and a low probability to the likely event (continued expansion).
The best way to counter the imposition of inappropriate economic analysis is to look at the data and what it’s truly showing. Instead of worrying about the potential effects of theories, investors can focus on data like corporate earnings, business activity surveys and employment data which are all pointing towards a sustained expansion.
From what we have seen so far from some major names this earnings season is that business is strong, and the outlook is good. According to Factset, with 17% of the S&P 500 having reported, the blended revenue growth rate is the best since 2011 while earnings growth is the best since 2010. Given the trend of top and bottom line beats so far, the present blended rate should end up being below what is actually reported. A particular standout in earnings which ties in directly to the strength and sustainability of our services based economy is Cintas. Cintas supplies uniforms, cleaning services / supplies and safety products to industries such as hospitality, automotive, food services, healthcare and education. Cintas just reported a fantastic quarter last week which helped propel the stock to new all-time highs and is now up 30% YTD. The earnings out of Cintas are also a great company example of the strength of the services economy as represented in the ISM Non-manufacturing (services) index. The June reading for the composite index came in at a very healthy 59.1 with new orders at 63.2. An interesting fact about the new orders index, which doesn’t bode well for the late cycle theory, is that whenever the index touches 60, it takes an average of 34 months for the composite index to move into contraction (based on ISM data up till the financial crisis since the composite has been in expansion since 2009). Then we have employment data like weekly unemployment claims which have been the most consistent indicator of labor market strength throughout the expansion. Weekly claims have now drifted down to levels not seen since 1969, and they continue to grind lower. When we look at claims data in the context of job openings (JOLTS), we can see there is potential for them to move even lower.
So, with a solid understanding of how things stand and why the inverted yield curve and late cycle narratives are more noise than substance, we can look at where markets are headed. The S&P 500 is currently trading at 17.2x 2018 blended forward operating earnings and 21.1x TTM. We ended 2017 at 18.4x forward and 22.7x TTM so the market has gotten less expensive. Comparing today’s valuation to previous bull market expansions like what we had during 1997-2000 when realized multiples averaged 24.9x, we can see that there is justification for multiple expansion. However, it would be irresponsible to just assume that multiples must expand and that the compression we have seen so far this year isn’t going to continue. Given the pro-business policy stance of the Trump administration, a pragmatic Fed and assuming a benevolent outcome to trade issues, it seems more likely than not that multiples will experience some expansion. Even if multiples stay flat from here and using current earnings estimates, the S&P would trade up to 3,318 or a 24% gain on the year. That would certainly serve up some smiles for investors who stuck with the data and not the noise.
At the time of this posting, the author has the following positions: None
Marco Mazzoco is an associated member of T3 Trading Group, LLC (“T3TG”), a SEC registered Broker-Dealer & Member of the NASDAQ PHLX Stock Exchange. All trades made by Marco are placed through T3TG