Relevant and even prescient commentary on news, politics and the economy.

S&P 500 P/E

Friday evening the S&P 500 closed at 3013.77, up 20.2 % year to date. But much of that gain is just recovering from the drop in late 2019, as  it is only up some 3.4% from September, 2019.

This is the first time the S&P closed above 3000 and people are wondering if the market is overvalued. The S&P 500 PE is now at 19.6, almost exactly where my model implies it should be.  As the chart shows it is right in the middle of my estimated fair value band just as it was when Trump was elected.  But the PE was 21.3 in November, 2017 as compared to 19.6 now. Both the actual PE and the fair value band declined through 2017  and 2018 and the fair value band has stabilized so far this year.  Interestingly, this means that S&P EPS has been rising faster than the market since Trump was elected. So, aside from the tax cut, investors are not projecting that his economic policies will generate stronger earnings growth.

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But my model PE is strictly a function of interest rates.  It is an expression of what is the present value of a perpetual stream of earnings growth. You can see how the model said the market was very expensive in the 1990s when investors came to believe that we were in a new era of stronger growth  with out a significant  risk of recession. The early 2000s were just the opposite, when investors feared we were in a new era of permanent stagnation and very weak earnings growth. So the PE was very far below its fair value.

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LONG BOND YIELDS

Everybody and their brother has an opinion about the direction of long bond yields so  it should be OK for me to stick my two cents worth in.

This chart of the composite of all long bond yields versus the long wave is one I published every month on the back cover of my monthly publication for over 20 years before I retired a couple of years ago.  Basically, I thought of it as a good way  to show that I was a long term bull on interest rates in a way that money managers would remember. But it did get their attention. The basic message was that on the up-sweep of the long wave, bear market were long and deep while on the down-sweep, bear markets were short and shallow while  bull markets were long and deep.

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Of course it is always nice to have some basic data to support such a chart and the economic data that seemed to have the best fit over the long run was MZM ( zero maturity money) velocity —

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Real Per Capita Income by State ( 2012 $ ) Updated

You can not use inflation data like the CPI to compare living cost is one location to another.  So the BEA has constructed a database  of Regional Price Parities  ( RPP) that allow you do do that for all states and the some 383 Standard Metropolitan Areas in the USA. I was preparing to show them when BEA published the 2018 data.  But that data will not be released until next year so I’m going ahead and showing the 2008 to 2017 data. Note, that in the tables for real per capita personal income by state for 2012 and 2017,  I have converted the data in 2012 $ to an index of personal income as a percent of the national average to facilitate comparisons.

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The first thing I noticed in the data is Connecticut and Massachusetts  at the top of the tables with per capita real incomes of 129.6% and 121.6% of the national average, respectively.

Even adjusted for the high cost of living they still have the highest real per capita income in the US.  I’ve long  thought of these two states as prime examples of the post-industrial economy.They were the first industrial states and  went through major problems when the textile and shoe industries departed for cheap labor in the south — something quite like the rust-belt states are now experiencing. But that was decades ago and they have now developed economies based on education, finance, high technology and medical care.  The basis for each was  the state investing strongly in education throughout the decline of the old industries so that they had the trained labor force to take advantage of new opportunities.

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Trump and the market

When the market is up,  Trump likes to credit it to his economic policies and when the market is down he likes to find someone else to blame, like the Fed.

After being in office for some two years it is time enough to either give him credit or grief and to compare him to other recent presidents.  Compared to the last half dozen presidents it looks like he is in the middle of the pack,with not really much to brag or much to complain about.

It is interesting to note that at this point in the Presidential cycle Obama has the best record on any recent President.   Under Obama the market was up some 55% from his inauguration versus only some 25% for Trump.

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REAL TRADE BALANCE

The real trade deficit ( million 2012 $) increased from $81,558 in February to $ 82,054 in March.  The March observation was between the January and February data points so it was not large enough to generate a significant change in imports  0.58 percentage point contribution to first quarter real GDP growth.   In the first quarter real GDP report the significant contribution of foreign trade to real GDP growth has been interpreted by the administration as a sign of success with its trade policies.  But the underlying real import and export data suggest that it is premature to call  it a trend change.

Figure 1

In evaluating the trade balance it is important to remember that it is the difference between two very large numbers so that a small change in either imports or exports can generate a large change in the balance.  Recently  real imports have been some 150% of real exports. This implies that even if imports and exports have the same growth rate the trade deficit would still widen.  For the trade deficit to improve, exports need to growth much faster than imports.

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S&P 500 PE

Based on the 5 May 2019 close the S&P 500 PE on trailing operating earnings is 18.25.  That places it at the bottom of my fair value band that is based largely on  long term treasury bond yields.  We can each have out own theories, but it appears to be that the market is correcting on fears of what Trump’s trade war will have on earnings growth.

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Expect a core CPI of 2% this year.

My discovery that half the annual increase in the not seasonally adjusted core CPI occcurs in the first quarter and that simply doubling the first quarter increase gives you an amazingly accurate estimate of the December to December reading work again in 2018.

In 2019 it is saying the annual increase in the core CPI will be about 2% — the same as the widely accepted consensus.

Figure 1

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2019 Core CPI

In a low inflation world firms tend to raise prices once a year, typically in the first quarter of the calendar year or their fiscal year.   Because of this very strong seasonal pattern, on a not seasonally adjusted  around 50% of the annual increase in the core CPI —  excluding food and energy — occurs in the first quarter

This very strong pattern gives great insight in to the annual inflation rate. One, is if this year’s first quarter is greater than or less that the prior year’s first quarter, this year’s annual increase will be greater of less than the prior year’s annual increase. This has worked every since year since 1990. Second, just doubling the NSA first quarter rate gives you an amazingly accurate estimate of the annual increase in  the core CPI for that year. In 2018 the first quarter rose 1.20% and the annual increase was 2.16%.  This year the first quarter rose 1.06%.  This implies that the rise in the core CPI should be slightly less in  2019 than  it as in 2018.

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