The Stock Market And The Economy: Out-Of-Sync? | Seeking Alpha

The Stock Market And The Economy: Out-Of-Sync? | Seeking Alpha

Summary

Most news on economic growth and productivity is that there is little seen on the upside; faster growth is just not there.
More and more people are finding information that indicates that the stock market may be overvalued.
What might break investors’ optimistic outlook? What “shock” might change the game? The devaluation of the Chinese renminbi? The continued decline in the commodity markets?

More and more, we are hearing investors and analysts express concern over the value of the stock market.

Right now, we read about credit traders sending a warning to investors. Not long ago, Jeremy Grantham expressed more gloomy thoughts on the world.

The question, therefore, becomes: Is the stock market ready for a fall? The S&P 500 is trading just under 2,090 these days, not far off its historic high of 2,135 achieved on May 19th of this year.

Certainly, one of the measures that I write about often, Robert Shiller’s Cyclically Adjusted Price Earnings ratio, or CAPE, has been indicating that the stock market is overvalued and has been for some time.

The thing one has to be careful about in discussing Shiller’s measure is that it says nothing about timing. The CAPE measure can indicate an overvalued stock market for some period of time, but the market may not adjust downwards for months afterward.

Right now, CAPE is showing for August a value of 26.45, down slightly from its near-term peak reached in February of this year.

The CAPE measure has not been this high since July 2007, when it reached 27.40. The peak in the S&P 500 came in October of that year, at a value of 1,540. The economy peaked in December 2007.

The Great Recession ended in June 2009, and the S&P 500 averaged a trough of just under 760 in March 2009. The CAPE measure was at 13.32 in March.

The usual pattern is that CAPE rises during the economic recovery as stock prices move up in anticipation of future increases in corporate earnings. As the economic recovery continues, earnings tend to accelerate and the rise in CAPE moderates, although still tending to rise faster than the increase in earnings.

The concern is that stock prices will not rise too rapidly ahead of earnings so that the CAPE measure will not rise too far above its historical mean.

Earnings generally have some relationship with the strength of the economy, and during the early years of a recovery, will keep CAPE at reasonable historical levels. In the later stages of the business cycle, earnings growth weakens and economic growth moderates, and the CAPE measure then tends to accelerate.

The CAPE measure has been accelerating quite rapidly over the past couple of years, as the quantitative easing on the part of the Federal Reserve System has exacerbated the climb. Over this time period, the “mantra” of investors was “don’t fight the Fed”.

That is, as long as the Federal Reserve System was pumping excessive amounts of reserves into the banking system, it was advisable for investors to keep putting money into the stock markets.

And stock prices continued to climb.

The Fed’s third round of quantitative easing ended last October, and much of this year, the debate has been about when the Federal Reserve was going to begin to increase short-term interest rates and start to bring the Fed’s balance sheet back into a more normal position.

Still, stock prices continued to rise. In October 2014, when quantitative easing ended, the S&P 500 averaged just under 1,940. And as mentioned, the market rose through May, when the new historical high was reached.

Although the market has backed off some since then, investors are still keeping prices within “striking range” of the recent highs.

The problem is that the economy continues to grow, but only modestly. In the second quarter of 2015, the year-over-year rate of growth of the economy was 2.3 percent. The compound annual rate of increase in the economy for the six years of the current recovery has only been 2.3 percent. This is the slowest recovery on record.

Furthermore, current economic data do not give much hope for any improvement in the rate of the expansion. The latest projections of the Federal Reserve’s staff do not see things getting better, projecting a rise in real GDP in 2015 of 1.8 percent to 2.0 percent; in 2016 of 2.4 percent to 2.7 percent; and in 2017 of 2.1 percent to 2.5 percent.

Furthermore, productivity growth, the driver of economic growth, has been downright tepid in recent years in the United States. This is not a good indication of a more robust economy.

There is little or no upside.

Yet, investors and analysts continue to look for “green shoots” in the economic data, hoping and longing for indications that things will get better.

Some relate this desire for good news to what is called the “Pollyanna principle,” the subconscious bias towards having a positive outlook on things.

But, how long will this last?

Given that the economy is now in its 74th month of its current recovery, the fourth longest since World War II, and is showing such minimal growth, there is concern that some kind of a shock will break the market optimism and result in a more-than-modest correction.

The stock market certainly appears to be overvalued, but what will the shock be that breaks current expectations?

Some people thought that the Chinese devaluation of the renminbi on Tuesday was the back-breaker, and the way the stock market reacted on Tuesday and early Wednesday, it certainly seemed as if that might do it.

Yet, the People’s Bank of China, the Chinese central bank, has been reassuring and has acted in a prudent, long-term way, and that has apparently calmed the market.

Commodity prices continue to fall with the price of oil reaching a new low. The impact of the China slowdown and other weak economies continues to haunt this market. This is not over.

However, the market seems susceptible to receiving such a shock. And that is why we are hearing more and more people talk about a correction. In my mind, the economics are there. The timing is still the question.

As mentioned above, stating that the stock market is overvalued, and even providing evidence that slow economic growth will constrain the increase in earnings, making the current price/earnings ratio too high, is not sufficient to cause stock prices to tumble. The underlying bias towards optimism continues to keep things where they are.

And this is where we are. All I can say is: stay loose, stay flexible, and stay aware. But I have said this before. Timing is everything.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…)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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The Stock Market And The Economy: Out-Of-Sync? | Seeking Alpha

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