Fed officials have more or less been declaring “mission accomplished” since early March.
They mostly are convinced that they have achieved their dual congressional mandate of full employment with low and stable inflation.
The unemployment rate has been below 5.0% for the past 10 months through February (Fig. 1).
The “jobs-hard-to-get” series compiled by the Conference Board (with data collected from a monthly survey of consumer confidence) fell in March to 19.5%, the lowest reading since July 2007. It is highly correlated with the jobless rate and suggests this rate might be heading closer to 4.0%. So does the initial unemployment claims series, which is hovering around its lowest since 1973 (Fig. 2).
The headline and core PCED inflation rates, on a y/y basis, were 2.1% and 1.8% during February, close enough to the Fed’s 2.0% target for the Fed’s preferred measure of core consumer price inflation (Fig. 3). The headline and core CPI inflation rates were 2.8% and 2.2% in February (Fig. 4).
Now, Fed officials seem to be moving surprisingly quickly toward their third, though unofficial, mandate—i.e., financial stability. This is a subject many of them have discussed from time to time since the Great Recession, but it has always taken a back seat to the official dual mandate.
Until recently, Fed officials had been stressing that monetary policy was “data-dependent.” In other words, it would remain very accommodative, even ultra-easy, until the economic data confirmed that the labor market was at full employment with inflation rising closer to the 2.0% target. Believing that they were nearing the Promised Land, the members of the FOMC voted to raise the federal funds rate by 25bps at the end of 2015, 2016, and again this year on March 15. They also signaled that they would stick with a gradual normalization of monetary policy with two more rate hikes this year and three next year. But some of the natives are getting restless, recently saying that a faster pace of normalization might be appropriate.
What has changed? The “hard data” still look relatively soft. The Atlanta Fed’s GDPNow is tracking a growth rate of only 0.9% currently. On the other hand, as we’ve been monitoring in our new Animal Spirits publication, the “soft data” have been remarkably strong. Leading the way has been investor confidence, as evidenced by the surge in stock prices since Election Day. In our opinion, Fed officials may be starting to turn from being data-dependent (focusing on the economy) to being valuation-dependent (focusing on the stock market). A few already may be worrying about a melt-up scenario in the stock market.
On March 7, Joe and I lowered our subjective probability of a Nirvana scenario for the stock market from 60% to 40%. At the same time, we raised the odds of a melt-up scenario from 30% to 40%. Consequently, we raised the odds of the meltdown scenario from 10% to 20%. We figured that if the odds of a melt-up have increased, so have the odds of a subsequent meltdown.
Valuation measures are elevated across the board, for sure. The forward P/E of the S&P 500 is currently 17.7 (Fig. 5). It is highly correlated with the forward price-to-sales ratio (P/S) of the same stock market index. This valuation metric closely tracks the Buffett Ratio, which is equal to the market capitalization of the entire US equity market (excluding foreign issues) divided by nominal GNP (Fig. 6). During Q4-2016, the Buffett Ratio was 1.67, not far below the record high of 1.80 during Q3-2000. The forward P/S rose from 1.58 in early 2016 to a record high of 1.93 in March.
These all are nose-bleed levels. However, they may be justified if Trump proceeds with deregulation and succeeds in implementing tax cuts. His policies may or may not do much to boost GDP growth and S&P 500 sales (a.k.a. revenues). Nevertheless, they could certainly boost earnings.
The risk is that Trump’s victory activated a melt-up mechanism that has nothing to do with sensible assessments of the fundamentals or valuation. Instead, structural market flows may be driving the market’s animal spirits.
Consider the following:
(1) Lots of corporate cash is still buying equites. At the end of last week, Joe updated our chart publications with Q4-2016 data for S&P 500 buybacks. They remained very high at a $541 billion annualized rate (Fig. 7). For all of last year, buybacks totaled $536 billion, a slight decline from the previous year’s cyclical high of $572 billion. S&P 500 dividends rose to a record high of $396 billion last year. Since the start of the bull market during Q1-2009 through the end of last year, buybacks totaled $3.4 trillion, while dividends added up to $2.4 trillion. Combined, they pumped $5.7 trillion into the bull market, driving stock prices higher without much, if any, help from households, mutual funds, institutional investors, or foreign investors (Fig. 8).
(2) Passive is the new active. On the other hand, equity ETFs have been increasingly consistent net buyers of equities during the current bull market (Fig. 9). Their net inflows totaled a record $281 billion over the past 12 months through February. Since the start of the bull market during March 2009, their cumulative net inflows equaled $1,167 billion, well exceeding the $179 billion trickle into equity mutual funds (Fig. 10).
So there you have it: The bull may be chasing its own tail. We know that image doesn’t quite jibe with the bull charging ahead, but work with us here. The bull has been on steroids from share buybacks by corporate managers, who have been motivated by somewhat different and more bullish valuation parameters than those that motivate institutional investors, as we have discussed many times before. Most individual investors seemingly swore that they would never return to the stock market after it crashed in 2008 and early 2009. But time heals all wounds, and suddenly some of them may have turned belatedly bullish on stocks after Election Day. Add a buying panic of equity ETFs by individual investors to corporations’ consistent buying of their own shares, and the result may very well be a melt-up.
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.
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