Market Commentary
It’s Not a Bubble
With risk markets making new all-time highs, and credit spreads making secular lows not seen since 1997, the bubble question often comes up in market discourse. Rising treasury yields lead to conclusions about potential bubble popping, and elevated risks.
The S&P500 risk premium (foreword earnings minus the 10-year treasury yield) is now negative for the first time since 2002 (h/t @soberlook).
Given its effort to manage inflation down, the FED wants to engineer a stock market correction as portfolio management fees are now the dominant risk to the November and December inflation data sets to be released in December and January, respectively.
Kill the stock market => kill inflation => bring valuations back in line => lower rates => protect the labor market, init?
If only it were that simple.
Instead of the Buffet valuation indicator which looks at market cap as a percentage of GDP, Pinebrook prefers to look at U.S. corporate profits as a percentage of GDP. The reason is valuation is a function of sentiment, while profits as a percentage of GDP is an observable data point that informs us of actual economic activity today and in the past.
ZIRP policy was often blamed for valuations that were above anything seen in prior fifty years. Now, with ZIRP shot in the head by big fisc., corporate profits as a percentage of GDP are currently near all-time highs.
The tautological response is that public sector deficits are private sector surpluses, and current corporate profits reflect the massive WWII sized deficits of the post-pandemic era.
This argument is weakened if one considers that the S&P500 tech sector gets around two-thirds of its profits from outside of the United States, versus around 40% for non-tech of the index. Also, large cap tech has almost double the profit margins of non-tech, at 23% vs 12%, respectively.
The big ramp in corporate profits as a percentage of GDP came in the post dot-com era, as the internet and mobile computing spread throughout the world.
The market share dominance of U.S. big tech on the global stage, along with the scale and profitability of both the U.S. and non-U.S. markets which U.S. big tech serves, are more likely the reason for elevated profits as a percentage of GDP.
Current high valuations reflect investor sentiment of confidence in the sustainability of these chunky futurecash flows.
Recall that present day valuations are not a function of conditions today, but of expected conditions tomorrow. So, the question is if we are likely to see these expectations to remain elevated.
The waterfall in credit spreads that was referenced earlier reinforces this idea. Since the conclusion of the September FOMC on the 18th of that month, credit spreads have contracted across the credit spectrum in the following manner (11/14/24):