Monthly Economic Update August 2018
Welcome to the Monthly Economic Update, as of writing this it is August 28, 2018 so the data we will be covering will be through August 27, 2018. We’ll go over what’s gone on in the last four or five weeks and what we anticipate is coming for the balance of the year.
I want to start with interest rates, and I’m going to tie interest rates and the market very closely. The reason I want to do that is due to a lot of people asking, “What in the world is driving the stock market?”
“What in the world is driving the Stock Market?”
Just about any way that you look at it, the stock market is priced very high. Relative to historical trends, it’s maybe the 2nd highest all-time highest, depending on how you want to measure, as far as the valuation of stocks not where the stock market is currently. Of course, we know that the major indices are hitting records, especially the S&P 500 and the NASDAQ. That’s just a number. That’s a number of where the markets are today relative to where they have been in history. What we want to look at is the real price of stocks. What does the price of the overall market look like?
What we see today is that from a price to earnings ratio, a price to books ratio, the Tobin Q ratio, even the smooth longer-term cyclically adjusted price to earnings ratios – all of these valuation metrics put the stock market at valuation levels that haven’t been seen since before the Dot Com Bubble. However, the valuations are not to the high level we saw before the Dot Com Bubble. However, they are substantially higher, from a valuation stand point, than where they were just before the Great Recession.
There were a lot of other dynamics with real estate and bad mortgages that were going on back in 2007 and 2008 that are not present today, but the current valuations are not normal. They are at the very high-end of historical averages. That doesn’t mean they come crashing down tomorrow, next week, or even next month, but at some point in time, those valuations have to come back down to a normal level.
So, what is it that’s causing those stock prices to soar up into the stratosphere? Corporate earnings are very solid, unemployment is very low even as measured by the U6 numbers, and corporate America is still buying back their own stocks at a rapid pace. When you combine the aforementioned points with the ultra-low interest rate environment we have today you see the rising stock prices and you have to ask yourself, “Where do you go to make money?” You definitely know it’s not in the banks, CDs aren’t paying much.
With that, what I want to look at is where interest rates are today compared to where they were just a few months ago. If you pay any attention to financial news you know the Fed is talking about raising rates, they’re likely to raise rates again in September. What does that really mean? The Fed has raised rates a couple of times already this year, and the fluctuations in the market, which you will see if you go back and look at each time we have had a major event in the market, has all surrounded the fear of rising interest rates. The markets know that they are expensive, and they know that if you had an opportunity to go out and buy a 5%, 6%, or 7% CD you wouldn’t even think twice about doing that and pulling your money out of the stock market. Fact is, you just can’t do that today. So, what do you do? You keep putting money into the market. Couple that with the billions of dollars put into the market through 401(k) plans and automatic purchases and it supports these stock prices where they are today.
Those supports are temporary, and as we see rates continue to rise into the future those supports are going to be harder and harder to maintain.
Figure 1 – U.S. Treasury – https://www.treasury.gov/
Looking at Figure 1, the blue line reflects where treasury yields were on March 1, 2018 and the green line is where they are as of August 27, 2018. Starting with the 10 Year Treasury as of March 1, 2018 was 2.81%, and as of August 27, 2018 we were at 2.85%. Almost no change on the 10 Year Treasury during that time.
If we look at the 20 Year Treasury, it has actually gone from 2.97% in March to 2.92% as of August 27th. This is supposed to be a rising interest rate environment, right? The 30 Year Treasury was 3.09% in March and is down to 3.00%. Essentially what we’re seeing is a flattening of the yield curve. If you look from the 2 Year Treasury up to the 30 Year you can see the green line for our current rates flattening. This is what people have been talking about, a flattening of the yield curve or an inverted yield curve.
You can talk about trade and corporate profits, which do play into it, but the reason why the markets have maintained their bull run is because we haven’t seen these longer-term interest rates rise – which has helped to fuel the market.
Figure 2 – Chaikin Analytics – https://www.chaikinanalytics.com/
Figure 2 is a year-to-date chart of some of the major indices. If we look at March specifically, we were in negative territory with the S&P 500, Dow Jones Industrial Average, and the S&P 100. The only two that were in positive territory, then even just slightly, were the SmallCap and the NASDAQ. Because we haven’t seen much of an increase, and in some cases like the 20 and 30 Year Treasury a decrease, in those interest rates, that’s allowed the markets to really take off.
The Fed is going to meet again in September and is likely to raise rates based on their previous conversations. We are keeping a very close eye on what’s happening with interest rates because we believe that as good as the economy is, as good as the markets are, there is going to be a breaking point. Something is going to happen that will turn things around. It could be that it doesn’t happen for another 18 months or even two years.
I said all the way back in January of 2015 that I felt we would finish this decade with interest rates on the 10 Year Treasury somewhere between 2.5% and 3%. I still think I’ll be pretty darn close on that, and if that’s the case this market still has some room to run because that means we’re not going to see that much of an increase on the 10 Year Treasury. Now, I don’t have a crystal ball and don’t pretend to be able to forecast everything accurately, but the reason there hasn’t been a rise is because we still don’t have money velocity which is another whole discussion.
I went into a lot of the things talked about today in much greater detail in our Half Time Report which you can find on our Education Center. This video will give you a lot of the background data about what I covered today.
To conclude, I will just say this – I think the Fed will raise rates in September and I think it will have almost no impact on the 10, 20, and 30 Year Treasuries. I think corporate profits stay in line, in fact, I think they will continue to grow at least through the first quarter of next year. I don’t expect a smooth ride in the markets between now and the end of the year. However, in my opinion, there isn’t a lot of risk in a substantial downturn in the short-term.
As always, we’re risk managers trying to make sure we don’t take on undue risk. If we see things we think warrant getting more conservative that’s exactly what we’re going to do. We encourage you to stay in constant contact with your advisor on any questions, concerns, or whatever it is that’s going on with your financial plan.
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Thanks for being with me today.
Founder & CEO
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