Financial Insights

A New Market High Amidst Continued Low Inflation

Last week saw the S&P 500 cross the 2,500 mark and markets tend to focus on such round number crossings as if they bear special significance.  They don’t. But they do serve as a reminder for investors to check to see if valuations have reached dangerous levels. In the background, economic data continues to reassure. Jobs abound, unemployment remains low, and GDP plods ever higher. And, confounding Fed projections, the inflation rate remains stubbornly low. Earnings growth remains robust and next month’s third quarter reports should reinforce recent trends and point to further growth through 2018. But with the S&P 500 trading at 17.7 times expected future earnings, for how much longer can we expect this upward trend to continue? A bit of comfort may be found in those low inflation numbers.

A recent Brookings Institute report* revealed that years of low inflation have allowed real wages (dollar wages adjusted for inflation) to rise faster in the last decade than they did in the prior three. Labor appears to be increasingly in short supply as evidenced by the growing numbers of “help wanted” signs appearing in storefronts and by weakness in housing starts as construction labor dries up. As labor markets continue to tighten, we can expect real wages to rise further, either through a faster pace of growth in the dollar wage, or through a continuation in the slow pace of increases in the general price level. Workers are gaining buying power, as a result, which combined with rising stock and home valuations, is translating into higher household net worth and rising consumer spending. And that rise in consumer spending helps reinforce the earnings growth which ultimately lies behind the rise in the S&P.

Low inflation also helps to explain the above-average multiple at which the S&P is trading.  Over the last 40 years, the average forward price-to-earnings ratio of the S&P 500 is 17.0, so today we sit slightly above that long-term average. When we look at that history and compare the P/E to inflation over those 40 years, we see that when inflation was between 1.0% and 2.5%, the market traded at 19.5 times earnings. With the latest report of core PCE inflation at just 1.4%, we are well within that range. The link between inflation and stock market valuations comes back to future earnings expectations – with low inflation comes low nominal interest rates, and that means that those future earnings are being less heavily discounted and so companies are worth more.

Current earnings outlooks, economic data, and low inflation all point to the market sitting at a discount to the last 40 years of history, but this does not mean investors should be complacent. Tighter labor markets will almost surely lead to both higher dollar wages and higher inflation. Moreover, last week the Federal Reserve announced that it would begin to reduce its balance sheet. Reductions in the Fed’s holdings of long-term assets, such as mortgage-backed securities, should help drive long term interest rates higher, as my colleague, Steve Zurilla, explained in a recent commentary. Valuations of today are not alarming, but history tells us that as inflation rates rise beyond 3.5% the S&P 500 has traded closer to a multiple of 15 times. We see that as a distant concern since that target looks well into the future and since continued earnings growth may very well bring the market multiple lower even as valuations continue to rise.

 

* http://www.hamiltonproject.org/papers/thirteen_facts_about_wage_growth

The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.

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