The strong U.S. economy supports the bull market in stocks


After a big rally in 2017, some investors and traders think that the U.S. stock market is too overvalued and that a significant correction will ensue. Here is the popular valuation indicator Tobin’s Q.

Here’s my problem with investing based on valuation:

  1. The U.S. stock market was overvalued by 1995, 5 years before the bull market ended in 2000.
  2. Q ratio growth can slow down if the U.S. stock market goes up slowly next year. If U.S. earnings continue to grow in 2018 at a similar pace to 2017 (which it is expected to), and if the U.S. stock market experiences a choppy year in 2018 (which I expect it to), then the Q ratio will not rise by much.
  3. How do you define valuation that’s “too high”? You can’t. In an era when there’s too much capital in the world (i.e. today), people are willing to pay higher multiples than before for the same asset. Hence, it’s only logical for valuation’s upper range to increase.
  4. Most importantly, history proves that valuation does not end bull markets. The fundamentals (i.e. the U.S. economy) lead the stock market. The economy will deteriorate before the stock market tops.

There is no sign of economic deterioration in the U.S. today.

U.S. economic indicators today

Unemployment rate
The U.S. unemployment rate continues to make new lows in this economic expansion.  It fell to 4.1% for October 2017. The unemployment rate typically picks up before the bull market in equities ends.

Initial jobless claims
Likewise, initial jobless claims continue to fall. Initial claims typically rise before a bear market or recession begins.

ISM’s manufacturing PMI

The manufacturing PMI is more sensitive to medium term changes in the U.S. economy than indicators related to the labor market. The manufacturing PMI continues to trend higher.

Industrial Production
Like the manufacturing PMI, Industrial Production continues to trend higher. This is a positive sign because Industrial Production is an important coincident indicator for the U.S. economy (neither leading nor lagging).

U.S. consumer sentiment
The University of Michigan’s Consumer Sentiment continues to make new highs in this economic expansion. This indicator is important because the U.S. is a consumer-based economy.

Retail Sales
The one not-so-hot point in the U.S. economy is Retail Sales.

As you can see in the above chart, Retail Sales yoy isn’t a good indicator. YoY Retail Sales growth was falling in 2012 and 2013, even though the U.S. economy really started to recover from the GFC during those 2 years.
New Home Sales
New Home Sales is important because the housing market leads the economy. New Home Sales is making new highs, which means that the U.S. economy is solid.

Housing Starts
Housing Starts is important as well. Although it is not as strong as New Home Sales, Housing Starts continues to trend higher.

The Republican tax cut will impact the housing market in an adverse way (mortgage deductions). I don’t think it’ll reverse the upwards trend in housing – I think it will merely slow down the growth.

Bottomline

U.S. economic growth is solid. This is partially why my Medium-Long Term model states that there is no significant correction or bear market on the horizon for U.S. stocks.
Sure, you can argue that the U.S. economy is too good. This can be seen via Citigroup’s Economic Surprise Index, which is close to hitting a plateau.

There are a few problems with this bearish argument:

  1. It’s clear that the Economic Surprise Index can go higher.
  2. The Index can plateau for a few months before rolling over.
  3. The Surprise Index is too sensitive to small fluctuations in the data. Focus on the economic data’s overall trend, not the month-to-month fluctuations (which the Economic Surprise Index captures).

4 comments add yours

  1. I’ve been slowly shifting some of my investments in late 2017 as I rebalance my portfolio into some sectors that have underperformed in 2017. I have also started putting trailing stops of 20% on my new investments.
    Thanks for the insight. It makes judging the pulse of the market a lot easier!

    • A lot of investors/traders are rotating from tech (which outperformed) to small cap (which underperformed). The tax cut will benefit small cap the most

  2. Troy thanks for all you do helping make the small timers at home like myself understand how all this works! By far the best go-to blog on the internet!

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