Pairing Price with Fundamentals


If markets stumble as 2017 progresses, it is unlikely to be because of some unexpected political event, but rather because of a reversal in the coordinated upturn in world trade we’ve seen over the past three quarters. The stock market is reacting more to a synchronized global growth wave than to policy changes in Washington or elections in Europe. Japan, China, the eurozone and the US have gotten upside economic surprises in recent months and the market has reacted accordingly.

But now there are signs that this growth upswing — like three prior waves within this eight-year-old cycle— could falter. Here are the reasons another slowdown may lie ahead:

  1. China — the main driver of the synchronized improvement in the global economy beginning in mid-2016 — is beginning to show signs of strain. Year-over-year growth in both credit and money supply is slowing from the pace we saw in 2016. Furthermore, Chinese authorities have recently tightened credit for car and home purchases. In the past, credit has been both an economic accelerant and a braking mechanism within China, especially for commodity prices. Now we may be entering the braking phase.
  2. The star of world growth surprises in 2017, the eurozone, is also flashing warning signals. Like in China, credit growth is slowing. Additionally, inflation has lost its upward momentum. Further, European exporters are heavily exposed to a slowing China.
  3. Despite solid labor markets and upbeat sentiment indicators, trouble lurks in the United States, too. While wages have been rising modestly of late, inflation has been rising faster, squeezing real incomes. Moreover, surging health care outlays and high housing costs are combining to restrain consumer spending.
  4. Like consumers, US companies are faced with rising costs, which are squeezing once-lofty profit margins. Rising margins have been perhaps the most important underpinning of the eight-year bull market. But, the present margin squeeze, combined with unimpressive pricing power, are elements which threaten the positive free cash flow story that has propelled this economic cycle. In order for profits to grow in the later phases of a cycle, margins need to expand on the back of cost cutting, or on the wings of rising inflation. That way, pricing power can carry the day, driving year-over-year profit growth. Right now, we see no convincing evidence of either more cost cutting or better revenue growth.

Despite these headwinds, though, we don’t appear to be at risk of tumbling into recession.

Does Washington have our back?

So, with a recession unlikely, and the markets expecting a cocktail of tax cuts and regulatory rollbacks from Washington, shouldn’t investors hold an overweight in US equities? The answer is no. Against a fundamental backdrop of downward profit and revenue pressures, we must consider market pricing. While equities were relatively cheap for much of this market cycle, that’s no longer the case.

Here are some measures I use to gauge relative valuations. First, I examine the free cash flow yield of the S&P 500 Index. It has slowed to a pedestrian 2.6% today versus cash flow yields of 5% and 6% earlier in the cycle. This tells me that the market is no longer cheap compared to other cycles and that pricing dynamics have discounted lots of good news ahead.

Another measure I use to gauge valuations, the cyclically adjusted price-to-earnings ratio, is flashing warning signs. It has moved close to 30x, a very high reading, exceeded only twice in the gauge’s more than 100-year history. The price-to-sales ratio of the market is also high, while small companies have reached some of the highest price-to-forward-earnings ratios ever seen.

Not a lot of cushion

Even with these warning signs, the market continues to discount a very benign fundamental and macro backdrop. It discounts that firms will be able to raise prices faster than costs, boosting profit margins back to robust levels seen earlier in the cycle. It also discounts relatively stable interest rates, falling tax rates and that trade barriers will not rise. Add to this the implicit notion that the duration of this business cycle will be extended, perhaps for years.

When stocks have relatively low P/E ratios and low priceto- sales ratios, investors can absorb some disappointments, especially early in the cycle, as these setbacks tend to be overcome quickly. But eight years into a cycle, the days of cheap valuations are long since passed. The current high price of financial assets suggests that each step upward leads owners to a more precarious perch. To paraphrase Chris Bonington, famed Mt. Everest climber, each step towards the summit entails more and more risk. We can’t see the summit from here, but right now, it seems to be shrouded in clouds.

James T. Swanson, CFA is the chief investment strategist of MFS Investment Management.


Past performance is no guarantee of future results.

The views expressed are those of James Swanson and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.

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