Stocks rose to new highs on Friday on the heels of a second consecutive robust employment report. In July, approximately 943,000 new jobs were created. In addition, previous monthly reports were revised upward. The unemployment rate fell to a post-pandemic low of 5.4%, approximately half of what it was before the pandemic began. However, the total number of Americans out of work still remains above pre-pandemic levels as does the unemployment rate.
This week we will see data on the number of job openings and consumer prices. Both are expected to rise, but at a more moderate pace than previously reported. The Delta variant of Covid-19 may impact the number of additional job openings although it shouldn’t impact the turnover rate. CPI moderation will be impacted by some slowing of commodity price increases. In fact, lumber is down over 50% from peak levels and oil is now down 10%. Gasoline prices should follow. Changes in energy costs are largely seasonal. Oil and gasoline prices tend to peak around Labor Day each year.
The unemployment report Friday offered a few more tidbits. The labor participation rate of 61.7% is still well below pre-pandemic levels. Several explanations are valid. The extended unemployment benefits continue until early September in many states. The incentive to return to work is impacted by the ability to sit on the couch or lie on the beach and collect $15 per hour. Covid-19 is another issue. Some are simply afraid to return to a work environment while the disease is still virulent. Finally, the pandemic accelerated retirements. Those who retired over the past 18 months are unlikely to reenter the work force without substantial incentive. What we don’t know is the mix of the three causes just noted.
Our suspicion is that at least half the decline in the labor force relates to retirement. Demographics plays an important role in almost everything economic. The growth in the number of Americans aged 60-75 is much larger than the growth rate of those ages 16-21. Many baby boomers delayed retirement for two reasons. First, they were healthier than past generations and preferred to stay actively employed beyond the normal retirement age of 65. Second, in a world of zero interest rates and after a decade of stagnant home prices, many felt their nest egg for retirement wasn’t large enough. The booming stock market and resurgence in home prices has now built those nest eggs to adequate levels.
As for the stock market, the initial reaction on Friday was the right one. Adding close to a million new jobs for two consecutive months is outstanding economic news. It will boost both GDP and corporate earnings.
Earnings are only half the equation of stock prices. P = E (earnings) x P/E (price earnings ratio). The E is closely correlated to GDP. The P/E is closely correlated to interest rates. The rate on 10-year Treasuries rose on Friday after the employment report and closed more than a dozen basis points above its Wednesday low.
The course of interest rates is related to central bank monetary policy. The Fed has already signaled that at some point in the not too distant future, it plans to slow its pace of bond purchases. Simply said, when the Fed buys bonds and increases the size of its balance sheet, it adds money to the economic system. What isn’t spent gets invested. More money seeking investment lifts asset prices, whether it be stocks, bonds, real estate or, yes, even cryptocurrency – all assets.
Obviously, as the Fed reduces its volume of purchases, the tailwind to asset prices will diminish. That doesn’t mean asset prices are destined to fall. First, reducing a tailwind isn’t the same as creating a headwind. That would only happen if the Fed decided to be a net seller of assets off its balance sheet or to increase the rate of interest it pays on federal funds. Any such move is probably at least 18 months away and it could be years before the first rate increase. Second, interest rates are only one component of asset prices. Earnings growth, consumer confidence, and the pace of inflation are other key factors.
As noted earlier, the creation of nearly a million new jobs per month is a powerful growth engine. The net result is that while the Fed may be withdrawing from providing a gale that helps to push asset prices higher, GDP growth is still expected for some time. Yes, it too is likely to slow. The net is that the tailwinds for both monetary policy and earnings growth will lessen over the next year.
The strong employment report could accelerate the Fed’s tapering timetable. While consensus forecasts had been for tapering to actually begin around year-end and take a year to complete, after Friday’s report, the consensus has been pulled closer. Now tapering is forecasted to begin between September and the end of November. The pace could be as short as 8 months depending on market reaction. While that would allow the first actual fed funds rate increase to happen in late 2022, such a prediction is putting the cart before the horse. The Fed was and is rate dependent. Any timetable laid out today is subject to change. In fact, with so many moving parts, and the poor predictive history of the Fed, the timetable is almost certain to change.
The only thing we can say post last week’s report is that tapering is likely to start sooner, assuming employment and inflation reports over the next six weeks don’t vary dramatically from what we see today. What we see today is minimal economic disruption from the Delta variant, and some moderation of commodity inflation offset by acceleration in wage growth and rent increases.
With all this said, let us assume that by 2023 we return to economic normality. That would imply growth of at least 2%, and inflation of at least 2%. Both could be somewhat higher but not dramatically so. Historically, stocks sold at 15-16x forward estimated earnings or 16-17x trailing results, but that is likely to change.
If I looked back a few decades, the largest companies in the world were oil companies and drug manufacturers along with a smattering of other corporate giants like AT&T#, Wal-Mart#, Philip Morris, General Motors, IBM# and a few banks. Beginning in the late 90s, a few tech names like Microsoft#, Cisco# and Intel got into that top echelon. For the most part, the big behemoths at the top were relatively slow growers, at least compared to the top of the S&P 500 today where Apple#, Microsoft, Amazon#, Alphabet#, and Facebook# are still at the top.
One argument global value investors give to justify an overweight to either Europe or Japan is the relative dispersion of P/E ratios. They are higher in the U.S., but they should be because the mix of businesses is different. Europe and Japan, economically, are dominated by a few banks, mature drug manufacturers and heavy industry. None are growth sectors. The five U.S. leaders mentioned above should grow 10-20% for a number of additional years. The law of large numbers will eventually catch up to them, but that will leave room for the next generation, like Nvidia#.
For these reasons, 15-16x forward earnings estimates may be valid for mature companies but not for larger growth names. With the mix heavily skewed toward tech, and likely to remain so, I think when economic normality returns, the S&P can sell for 17-18x forward earnings. Using $250 as a round number for 2023 S&P earnings, and18x as a P/E, yields a valuation of 4500.
That isn’t far from where we are today. The conclusions therefore are as follows:
1. The bulk of the appreciation associated with a post-pandemic surge in earnings and super low interest rates has already been achieved.
2. While the tail winds of aggressive monetary easing will fade, they aren’t likely to shift to a headwind any time soon.
3. Stock markets don’t move in a straight line, and investors have a tough time handling transition. Expect more volatility in the months and years ahead.
4. Once everything normalizes, growth in line with changes in earnings will resume.
The bottom line is obvious. For the past 30 months, stocks have risen at an annualized pace of 20%+. That isn’t sustainable, but there isn’t a recession in sight, a central bank headwind is more than a year away, and earnings growth continues. Stocks remain an outstanding long-term investment. Investors may traverse more potholes in the coming months, but these are not to be feared. Indeed, if they happen, they may present buying opportunities.
Today, Anna Kendrick is 35. Designer Michael Kors is 62. Character actor Sam Elliot is 77.
James M. Meyer, CFA 610-260-2220