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By HaleStewart February 26, 2017 7:34 am
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US Equity and Economic Review: The Fundamentals Support Current Market Valuations

     There are numerous factors that support the stock market: psychology, the overall size of the population, the national and international political environment and domestic policy, just to name a few.  But perhaps the economic fundamentals are the most important.  With the market making a series of new highs, it seems an appropriate time to look at the long-leading, leading and coincident indicators to see if they confirm the recent market trend.

The Long Leading Indicators

     There are 4 long-leading indicators; corporate profits, M2 money growth, building permits and BBB corporate bond yields.

The left chart shows corporate profits, which have risen in 2 of the last three quarters.  More broadly, this indicator has trended sideways for the last 5 years as the result of several factors: a strong dollar that lowered overseas profit growth and the oil price drop that hurt the energy sector.  But the latest earnings season has been very positive (see below).  The right chart shows M2’s Y/Y growth; it is currently in very solid shape as well.

Building permits (left chart) have risen for most of 2016.  The broader trend shows they’ve moved sideways for the last two years.  BBB yields (right chart) are once again trading at low levels, which points to continued expansion.

Conclusion: the long leading indicators are pointing to continued modest expansion.

Leading Indicators

     The leading indicators have recently increased in strength.  After growing .2% in September through November, they rose .5% in December and .6% in January.  This led to an increased growth rate in the rolling six-month rate of change, which rose to 1.5% in December and 1.6% in January.  The big reason for the change is a sharp increase in the ISM new orders index, which contributed .10 to the last two leading index readings.  Should this overall increased rate of change in the leading indicators continue, it should lead to faster growth.

Conclusion: the leading indicators continue to point to continued expansion.

Coincident Indicators

     The chart below adjusts 4 of the primary coincident indicators to a base 100, with 100 being the end of the last recession:

Three of the indicators (real retail sales, payrolls and real manufacturing sales) are all rising.  Industrial production is moving sideways.  The decline in oil output was the primary reason for the industrial production decline in 2015.  Since then, mining has held its own while utility output has fluctuated. 

Conclusion: there is insufficient weakness in the coincident numbers to indicate a coming slowdown.     

Market Overview

     The current rally started after the election, as investors placed bullish bets on the combination of massive infrastructure spending, tax cuts and regulatory reform.  The combination of these three items should lead to increases in corporate profits.  But Confgess has not implemented any of these policies – they remain promises which have a positive impact on market psychology but not market numbers. 

     However, 4Q16 revenue and earnings numbers have been positive.  The following two charts are from Factset.com

Both S&P revenue and earnings increased 5%, which is the best growth rate the market has seen in several quarters.  That leads to a discussion about valuation, which is fairly rich (from the WSJ):

The current PE for the major averages are all over 20; the forward PEs are fairly expensive, but could increase a bit given current sentiment. 

     Overall, the current macroeconomic environment supports the current market.  All three sets of indicators -- the long-leading, leading and coincident -- all point to increased growth.  Corporate earnings are once again growing.  And while market valuations are high, there is room for growth based on the forward PE numbers.

Hale Stewart is a tax attorney and financial adviser based in Houston, Texas.  He specializes in captive insurance, international taxation and complex tax planning.  He also sponsors free CPE programs for CFPs and CPAs every month. 

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