Stocks again showed little change. Economic data was a bit negative. Producer Prices in October rose a bit faster than expected and jobless claims rose by an unexpected 15,000 over the prior week. One week doesn’t make a trend but this bears watching. Any significant rise in unemployment claims over a number of weeks is a true red flag.
Over the past several weeks, there have been early signs that the economic slowdown may have run its course. But over the past several days, there has been some conflicting data suggesting that slow growth is likely to be a prolonged event. The aforementioned rise in jobless claims bears watching. It comes after several monthly reports that show corporations are listing fewer and fewer job openings. Inflation is creeping up as well. The so-called TIPS spread, the spread between yields on normal 10-year Treasuries and those whose rates adjust for inflation, has widened by about 15 basis points. That doesn’t sound like a lot and it isn’t. But it is a movement in a direction opposite from what has been the norm for many years. It too bears watching. This morning we will get a report on October retail sales. They are expected to be good, in part reflecting the waning impact of Amazon’s Prime Day in July. The notion is that consumers spent big on the event, pulling forward sales from subsequent months. The trend may normalize with retail sales returning to healthy growth in October. Third quarter GDP growth appears anchored around 2%, certainly not the kind of growth expected when the Trump tax cuts were instituted. Capital spending remains moribund. Just this week, Cisco# reported OK results but lowered guidance for the next quarter, citing a slowdown in infrastructure spending. IT spending had been the one area of strength in a world of capital formation. But now, even IT spending is showing some cracks. Cisco is the world’s largest manufacturer of routers and switches, the plumbing of IT networks. When Cisco says businesses and governments worldwide are stretching out orders and buying less, that can only be taken negatively.
This all shows up in productivity. Investment is the lifeblood of productivity growth. You don’t get much increase in productivity by simply asking employees to work harder. You get it by using technology to make them work more efficiently. The slowdown in productivity growth (it actually was negative last quarter) can, for a short time, be offset by hiring more workers. But that reaches an endpoint when there aren’t enough productive workers to hire. A slowdown in capex also hurts industries tied to capital spending. Thus, manufacturing and oil drilling are in a funk right now.
A lot of this ties together with the overcapacity issues I mention all the time. The solution to overcapacity isn’t to build more capacity. Central banks, including the Federal Reserve, have been cutting rates doing what they can to prod more investment. But in an overbuilt world, what they do is stimulate bad investment. Look at the real estate market in New York City, for instance. Prices are falling, both for commercial and residential space, as new supply swamps any demand growth. Making construction loans extraordinarily cheap may stimulate some to jump in but that will be a big mistake if all it does is extend an oversupplied condition. Hudson Yards, the grand new West Side development is anchored by a Neiman Marcus store that is not exactly attracting huge crowds. Neiman Marcus is on life support as it is. Barney’s, the iconic retailer is closing its headquarter’s store just as Nordstrom is entering the market with a huge 57th Street store. New York’s remaining retail giants, Bloomingdales, Macys and Saks, are no longer growing. None of these moves are going to stimulate more shopping. They simply add space to a clogged market.
So why is the stock market setting record highs against this backdrop? While earnings remain flat, stocks continue to respond to low interest rates. But there may not be a lot of additional room to the downside. As noted, inflation is creeping up. And the Fed has signaled that, unless economic data deteriorates further and offers signs of recession, the Fed is likely to stop cutting rates for now. It has also hinted that it might let inflation get a bit hotter than expected before moving in to fight any rise in prices. All that suggests that the bond market may no longer be the best friend to equity investors.
Stocks have had a good run this year and are a bit extended right now. That isn’t to suggest that a big correction is right around the corner. A 2-4% correction might be in order, but there isn’t a reason to expect a 10%+ move right now. The White House this morning once again is signaling progress in trade talks with China. You better not take White House guidance to the bank, but clearly both the U.S. and China want to come to some agreement, however small. Because markets have been strong, investors have few losses to take and lots of gains they would like to defer to next year if possible. If you recall back to 2017, a good year for stocks, equities moved up steadily until the end of January 2018 when, suddenly, there was a 10% correction in just six trading days, including two days in one week when the Dow fell by more than 1000 points. History never repeats itself exactly. But we study history to learn its lessons. In early 2018, markets were a bit more overpriced than they are today. But the setup was similar. Economic optimism was improving. The Trump tax cuts were about to go into effect. Investors with large gains were hesitant to sell given no slowdown in the market’s advance. Only when the first cracks appeared late in January did they move to sell and then, suddenly, they all sold at once.
The good news is that valuation corrections don’t overwhelm markets very often. When they do, it is because overvaluation got extreme as in 1987 and 2000. But even then, markets tend to recover quickly. The February 2018 losses were fully recovered by April, for instance. In other words, valuation issues don’t normally wreck bull markets. That requires economic imbalances. About the only place I see recklessness within the economy today is in the auto sector where lending practices have gotten a bit risky for my tastes and default levels are rising. This won’t wreck the whole economy, but it will be a headwind for the auto sector.
Thus, despite a market at record highs, I think it is time for some caution. Valuations are full. Rising inflation expectations suggest little future help from lower rates. Earnings have been flat for several quarters. Tariff and election uncertainty are likely to continue to restrain capital spending and productivity growth. None of this spells recession, but it does suggest 20-25% gains in stock prices are not going to repeat themselves looking forward. For me, to buy a stock today, I have to be convinced that the company can grow at a solid pace within an economy growing no more than 4% in nominal terms. I want a solid supportable dividend that can grow in line with earnings. I want free cash flow to insulate the company from any economic weakness or tight financial conditions. And I want a fair price, low enough to give me some downside protection. That combination is hard to find at the moment.
Today, Ed Asner is 90.
James M. Meyer, CFA 610-260-2220