Congress, The Fed, P/E Ratio

 

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Year to date the stock market continues to rise on the anticipation that the Trump administration will repeal and replace Obamacare with something better, that tax legislation will be passed that lowers the corporate and middle class taxes, that infrastructure legislation will be passed to create middle class jobs, and other legislation to give U.S. companies incentives to keep jobs in the U.S. If Congress does not do some or most of these things by the end of 2017 there could be a significant correction in the stock market.

In the first half of the year the S&P 500 was up 9.34%, the Dow up 9.35%, the Nasdaq up 14.71% lead by technology stocks and the MSCI ACWI Ex USA was up 14.10%. Growth stocks have outperformed value stocks by a large margin this year. Information technology stocks have lead the way (up 17.23%) followed by Healthcare (up 16.09%). Energy (down 12.61%) and Telecom Services (down 10.74%) have been the worst performing sectors. Interest rates on the 10-year Treasury bond have ranged between 2.20%-2.40%.

Hoisington Investment Management Company

The following commentary is from the Hoisington Investment Management Company “Quarterly Review and Outlook Second Quarter 2017”:

The Fed's Dual Mandate

“Dual mandate” is one of the most commonly used phrases in U.S. central banking. The current Chair of the Federal Reserve often mentions it in both speeches and testimony to Congress. Not surprisingly, this is an extremely hot topic in monetary economics, and execution of this mandate has profound significance.

The mandate originated in The Federal Reserve Reform Act of 1977. This legislation identified “the goals of maximum employment, stable prices and moderate long-term interest rates.” Ironically, these goals have come to be known as the Fed’s “dual mandate” even though there are actually three goals. The manner in which the Fed operates in following these goals has had and will have dramatic effects on economic activity.

From the Dual Mandate to the Phillips Curve

The Federal Reserve Reform Act of 1977 does not spell out the nature of the trade-off between the unemployment rate and the inflation rate, nor does it say how the Fed should act if the mandates are at odds in terms of the policy approach.

The potential problems that arise from this lack of clarity are clearly illustrated by the current situation. The Fed has extended the current tightening cycle twice this year, with the latest move on June 14. At the time of the latest decision, headline and core CPI had year-to-date price increases of 1% and 1.3%, respectively, substantially below their 2% target. Additionally, the latest twelve-month increases in both of these inflation gauges were below the 2% target. Only the unemployment rate warranted more restraint. This means that inflation and unemployment are at odds, thus the dual mandate is dead. It now boils down to the Fed’s interpretation of the Phillips Curve.

The Phillips Curve

The Phillips Curve represents the relationship between the rate of wage inflation and the unemployment rate. In a 1958 study, New Zealand economist A. W. H. (Bill) Phillips (1914-1975) found an inverse relationship between wage inflation and the unemployment rate in the United Kingdom from 1861 to 1957. A high unemployment rate correlated with slowly increasing wages, while a lower unemployment rate correlated with rapidly rising wages.

According to Phillips, the reasoning for this finding was that the lower the unemployment rate, the tighter the labor market, thus firms would raise wages to attract scarce workers. Conversely, at higher rates of unemployment the pressure on wages abated. Thus, this curve attempts to capture a cyclical process that can be used for evaluating the business cycle. This curve presumes the average relationship between wage demands and the unemployment rate is stable, thus there is a rate of wage inflation that results if a particular level of unemployment persists over time. As time has passed, Phillips Curve proponents have also asserted that a stable relationship exists between the unemployment rate and the overall rate of inflation, not just that for wages.

In a 1967 peer-reviewed paper, Edmund Phelps challenged the theoretical structure of the Philips Curve. Independently of Phelps, Milton Friedman (1912-2006) in his Presidential address to the American Economic Association in 1967 (published in 1968) came to similar conclusions. They reasoned that well-informed rational employers and workers would pay attention only to real wages (i.e. the inflation adjusted level of wages). In the view of Friedman and Phelps, real wages would adjust to make the supply of labor equal to the demand for labor, and the unemployment rate would then stand at a level uniquely associated with the real wage rate. In time this uniquely associated real wage rate has come to be called the “natural rate of unemployment.”

Friedman and Phelps argued that the government could not permanently trade higher inflation for lower unemployment. When the natural rate of unemployment prevails, the real wage is constant. Workers who expect a given rate of inflation insist that wages increase at the same rate to prevent the erosion of their purchasing power.

Phelps and Friedman also distinguish between these effects over the “short run" and the “long run”. Phillips Curves only prevail so long as the average rate of wage inflation remains fairly constant. Only in such a limited time frame will wage inflation and unemployment be significantly inversely related. Once the higher inflation is fully incorporated into expectations, unemployment returns to the natural rate, with the result that the natural rate of unemployment is compatible with any rate of inflation. These long and short run relationships can be combined in an “expectations augmented” Phillips Curve. The quicker workers adjust price expectations to changes in the actual rate of inflation, the quicker the unemployment rate will return to the natural rate and the less successful the government will be in reducing unemployment through monetary and fiscal policies. The expectations augmented Phillips Curve approach is used in and appears to play a major role in the Federal Reserve’s large-scale econometric model.

Empirical Evidence

The adherents to the Phillips Curve do not accept these various empirical criticisms. For many decades, they insist that the poor results are due to the fact that the basic relationship has not been properly quantified. They point to the problems capturing leads and lags between the unemployment rate and wage changes as well as difficulties that arise from measuring expectations and working with aggregate data. For followers of the Phillips Curve, it is just a matter of time before these issues of statistical quantification are resolved.

These arguments are not compelling, yet they have been used repeatedly for at least a half a century. As the years have passed, the constantly restated Phillips Curve formulations have regularly missed major business cycle developments, a pattern which has been evident in the Fed’s record. The Fed presided over the worst U.S. peacetime inflation from 1977 to 1981, and tightened before all of the recessions after 1977. The Fed did contain the Panic of 2008 with excellent lender of last resort tools, but a far better result might have been achieved if the Fed had learned the lesson of the 1920s and prevented the massive buildup of debt prior to 2008 that the regulatory powers of the Fed were designed to prevent.

For most of the past eight years, the frequently restated Phillips Curve models have pointed to a sustained acceleration in wage and price inflation that has failed to materialize. These failures not only impair monetary policy but also portfolio decisions based on the presumed efficacy of the Phillips Curve and the reliability of the dual mandate. Based on the slowdown in the monetary and credit aggregates, and the continuing fall in the velocity of money, the rate of inflation is more likely to moderate rather than accelerate, even as the unemployment rate in May 2017 stood at a sixteen year low. Thus, inflation, on average, moved lower during this current expansion, contradicting the forecasts for higher inflation based on the Phillips Curve concept.

Implications

For the Fed, the more advisable approach would be to pull the Phillips Curve relationships from their model and their policy decisions. Instead, they should rely on capturing the strategic role of the monetary transmission mechanism and its potentiality for moving through the reserve, monetary and credit aggregates in a highly leveraged economy. If the Phillips Curve proponents are right, and the quantification efforts are eventually proved to be valid, then at that point they can be inserted into the Fed’s model as well as into their subjective decision-making process.

This is relevant to investors as well. If adherence to the dual mandate induces financial insatiability, then investor performance, like overall economic activity, will be directly influenced. If the Fed’s mandate consistently leads them in the wrong direction, then long-term investors may often be forced to construct portfolios that are contradictory to the error-prone words, forecasts and policy actions of the FOMC. Moreover, investors should expect that the Fed’s actions will create substantially more volatility in the financial markets and particularly so over the short-term. Operating with strategic views and multi-year trends, rather than trying to focus on the Fed-generated noise in many monthly and quarterly indicators, may be a preferred method of generating investor returns.

Our economic view for 2017 is unchanged and continues to suggest that long-term Treasury bond yields will work irregularly lower. The latest trends in the reserve, monetary and credit aggregates along with the velocity of money point to 2% nominal GDP growth for the full year, down from 3% in 2016. This would be the third consecutive year of decelerating nominal GDP growth and the lowest since the Great Recession. This suggests that the secular low in bond yields remains well in the future.

Earnings By The Number (from the FACTSET "Earnings Insight July 21, 2017")

More Companies Beating EPS and Revenue Estimates than Average

Percentage of Companies Beating EPS Estimates (73%) is Above 5-Year Average

Overall, 19% of the companies in the S&P 500 have reported earnings to date for the second quarter. Of these companies, 73% have reported actual EPS above the mean EPS estimate, 11% have reported actual EPS equal to the mean EPS estimate, and 15% have reported actual EPS below the mean EPS estimate. The percentage of companies reporting EPS above the mean EPS estimate is above the 1-year (70%) average and above the 5-year (68%) average.

At the sector level, the Health Care (100%), Information Technology (85%), and Industrials (80%) sectors have the highest percentages of companies reporting earnings above estimates, while the Materials (25%) and Energy (50%) sectors have the lowest percentage of companies reporting earnings above estimates.

Earnings Surprise Percentage (+7.8%) is Above 5-Year Average

In aggregate, companies are reporting earnings that are 7.8% above expectations. This surprise percentage is above the 1-year (+4.7%) average and above the 5-year (+4.2%) average.

The Information Technology (+16.7%) sector is reporting the largest upside aggregate differences between actual earnings and estimated earnings. On the other hand, the Consumer Staples (+2.2%), Materials (+2.2%), and Health Care (+2.6%) sectors are reporting the smallest upside aggregate differences between actual earnings and estimated earnings.

Looking Ahead: Forward Estimates and Valuation

Earnings Guidance: Fewer Companies Issuing Negative EPS Guidance for Q3 than Average

The term “guidance” (or “preannouncement”) is defined as a projection or estimate for EPS provided by a company in advance of the company reporting actual results. Guidance is classified as negative if the estimate (or mid-point of a range estimates) provided by a company is lower than the mean EPS estimate the day before the guidance was issued. Guidance is classified as positive if the estimate (or mid-point of a range of estimates) provided by the company is higher than the mean EPS estimate the day before the guidance was issued.

At this point in time, 14 companies in the index have issued EPS guidance for Q3 2017. Of these 14 companies, 7 have issued negative EPS guidance and 7 have issued positive EPS guidance. The percentage of companies issuing negative EPS guidance is 50% (7 out of 14), which is below the 5-year average of 75%.

Growth Expected to Continue for Remainder of 2017

For the second quarter, companies are reporting earnings growth of 7.2% and revenue growth rate of 5.0%. Analysts currently expect earnings and revenue growth to continue in 2017.

For Q3 2017, analysts are projecting earnings growth of 6.4% and revenue growth of 5.0%.

For Q4 2017, analysts are projecting earnings growth of 11.7% and revenue growth of 5.0%.

For all of 2017, analysts are projecting earnings growth of 9.3% and revenue growth of 5.4%.

Valuation: Forward P/E Ratio is 17.8, above the 10-Year Average (14.0)

The forward 12-month P/E ratio is 17.8. This P/E ratio is above the 5-year average of 15.4, and above the 10-year average of 14.0. It is also above the forward 12-month P/E ratio of 17.5 recorded at the start of the third quarter (June 30). Since the start of the third quarter, the price of the index has increased by 2.1%, while the forward 12-month EPS estimate has increased by 0.1%.

At the sector level, the Energy (29.3) sector has the highest forward 12-month P/E ratio, while the Telecom Services (12.3) sector has the lowest forward 12-month P/E ratio. Nine sectors have forward 12-month P/E ratios that are above their 10-year averages, led by the Energy (29.3 vs. 18.5) sector. One sector (Telecom Services) has a forward 12-month P/E ratio that is below the 10-year average (12.3 vs. 14.2). Historical averages are not available for the Real Estate sector.

Targets & Ratings: Analysts Project 8% Increase in Price Over Next 12 Months

The bottom-up target price for the S&P 500 is 2663.48, which is 7.7% above the closing price of 2473.45. At the sector level, the Telecom Services (+13.4%) and Energy (+13.0%) sectors have the largest upside differences between the bottom-up target price and the closing price, while the Utilities (+2.0%) sector has the smallest upside difference between the bottom-up target price and the closing price.

Overall, there are 11,190 ratings on stocks in the S&P 500. Of these 11,190 ratings, 49.1% are Buy ratings, 45.3% are Hold ratings, and 5.6% are Sell ratings. At the sector level, the Information Technology sector has the highest percentage of Buy ratings at 57%, while the Utilities, Consumer Staples, and Energy sectors have the highest percentages of Sell ratings at 7%.

Summary

The Trump administration and Congress must do what they promised during the campaign or we may see a correction in the stock market. The Federal Reserve should stop relying on the Phillips Curve to make decisions about monetary policy because inflation is not increasing in spite of a sixteen-year low in the unemployment rate. Bond interest rates should continue to go lower. Corporate earnings growth is predicted to continue in 2017. If the projections are correct the forward P/E Ratio is 17.8x which justifies the price level of the S&P 500 index. At this time we see no systemic problems in the market.

 

Jamison Monroe
Chairman & CEO
Director of Consulting