Investors shrugged off a few disappointing macroeconomic indicators this week as the market is currently hovering at an all-time high. Gross Domestic Product (GDP) fell at an annualized rate of 1% in the first quarter, a bigger decline than projected, after a previously reported 0.1% gain, the Commerce Department said.
Federal Reserve policy makers cited adverse weather as the catalyst for the slowdown in the first quarter said that the overall economy should strengthen through the second half of the year.
We are starting to see a pickup in receipts at retailers, stronger manufacturing and steady improvements in the labor market. These positive economic indicators should prove that the set-back in the first quarter was only temporary.
Consumers still appear to be somewhat cautious, but we are starting to see business sentiment improve as they are beginning to build inventory levels again and capital expenditures continue to rise. M&A activity has also been on the rise, which indicates businesses are more optimistic about the longevity of the current expansion.
Are Equities Still Cheap?
Although the S&P 500 has advanced over 180 percent from its bear-market low in March 2009, the gauge is currently trading at 16.3 times the projected earnings of its member firms. The current P/E ratio suggests that U.S. equities are no longer “cheap”, but they are also not particularly expensive from a historical valuation perspective.
During the last bull market peak in 2007, the S&P 500 traded at a P/E ratio of 18.4 times earnings and during the tech bubble the S&P traded at a P/E ratio of 32.5 times earnings.
For equities, valuation fundamentals do not tell the whole story. We also have to consider the current interest rate environment and the geopolitical and macroeconomic risks that exist.
Domestic tail risks related to political instability have faded and visible international problems seem less ominous given the improved financial stability in Europe and the promise of moderation in Ukraine. We understand that unforeseen tail risks could still emerge in Ukraine, Iran, China, etc… and trigger another market pullback. However, the memory of these “black swan” type of events of the past should continue to fade, nudging investors to direct excess liquidity towards the stock market, pushing valuations even higher.
Inflation and interest rates are poised to rise in the future, but should remain low enough over the next few years to foster stronger growth rather than undermine equity valuations. Low interest rates are a positive catalyst for stocks because they both increase the present value of future earnings and reduce the attractiveness of alternative assets such as cash and bonds. They also have the benefit of lowering interest expenses for the corporate sector.
We may start to see inflation increase as a falling unemployment rate could begin to increase wage inflation. Higher rental occupancy rates and tighter capacity utilization should begin to boost rents and wholesale prices, which will help push inflation slowly higher over the next few years.
Overall, the financial landscape suggests that low interest rates, moderate equity valuations and an improving economy should continue to bode well for U.S. equities going forward.
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