Paulsen's Perspective

Technology stocks have outpaced the overall market during the last five years, and by an accelerating margin since the end of 2016. Naturally, they have become market darlings, replete with stories about remarkably innovative products with phenomenal growth potential.

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The S&P 500 trailing Price-Earnings (P/E) multiple is currently higher than 84% of the time since 1950. Appropriately, high valuations have become a concern for many investors. Although the market’s high P/E profile has reduced future return potential, at least historically, it does not necessarily suggest significant downside risk.

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As it often does, Friday’s jobs report will likely set the tone for the financial markets during the next few weeks. Since the January report, the employment numbers have been reassuring. A rise in the labor force has allowed solid job gains to coincide with a flattening in the unemployment rate near 4%, leaving an impression the labor market still has significant slack. 

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In the last few years, movements in the U.S. dollar have played a huge role in shaping the character of the recovery and the behavior of the financial markets. During the first half of this recovery, the trade-weighted U.S. dollar index (DXY) remained in a narrow range, but since 2014, its volatility has substantially increased.

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We first published the accompanying chart in March of this year. The PP ratio had just spiked sharply upward in the previous three months, as it did near the end of the dot-com era in 2000. Since, as shown, the PP ratio has been largely marking time during the last four months even though technology certainly has not lost its popularity.
 

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On a trailing earnings basis, the S&P 500 has been highly-priced above a 20x PE multiple (or below a 5% earnings yield) for most of the last two years. What does this suggest about future return potential, and perhaps more importantly, about the potential for negative returns? Although the absolute valuation of the stock market does impact future return potential, it has not been particularly useful in assessing the chance of losing money in the stock market. 

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Inflation/overheat worries have eased recently. The advance in the 10-year bond yield has stalled just below 3%, the upward trend in commodity prices paused once the U.S. dollar began rising in April, and wage inflation has failed to break above 3%. Indeed, the latest employment report left a goldilocks impression with a solid jobs gain, a rise in the labor force participation rate, and only a modest increase in wages. 

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Most traditional recession indicators remain uneventful. The recovery is old by calendar standards, the unemployment rate is low, and the Federal Reserve has begun to tighten monetary policy. 

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The contemporary character of the Main Street economy has often been a harbinger of future investment returns. Specifically, the mindset of private economic players (i.e., are they confident enough to engage in aggressive behavior or are worries dominating economic decisions) and the degree of resource slack (the unemployment rate) have often provided a good indication of how the financial markets may perform during the next five years! 
 

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Considering how this bull market began, while it may not be widely recognized, it has simply been too quiet now for too long. The accompanying chart illustrates that the last eight years have been among the four calmest and quietest of all stock markets during the post-war era!

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Another interesting echo, today, of the 1990s’ dot-com era, is how much the S&P 500 Technology sector has come to dominate price momentum (MOM) within the stock market. Like the late 1990s, stock market winners have become synonymous with technology. 
 

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Perhaps the stock market is taking its cue from the NBA back-to-back champion, Golden State Warriors (and winners of three of the last four titles). They employ an aggressive and entertaining “Offense-First” style of play driven by multiple all-stars firing “threes” with rapid abandonment from distances normally reserved for long touchdown passes!

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Haven’t we seen this movie before? Technology takes over the stock market late in a recovery cycle, seemingly making the bull ageless, pushing portfolios toward a more concentrated new-era exposure, stimulating investor greed bolstered daily by watching a chosen few (FANGs) rise to new heights, and convincing many that tech is really a defensive investment against late-cycle pressures which trouble other investments. 

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This year started with strong expectations for economic growth. A substantial tax cut and evidence the global recovery had finally synchronized significantly raised expectations for both the pace of economic growth and corporate earnings results.. 

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Since its early-2011 peak, gold has been a disappointing investment. Despite significant bouts of international turmoil and periodic renewed-crisis fears, the salve often provided by the shiny metal has eluded investors.

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The jobs report this morning was spectacular! A 223K gain in payroll employment, a 15K upward revision to past months’ numbers, a drop in the underemployment rate to 7.6%, a decline in the unemployment rate to 3.8%, and a respectable monthly rise in wages of 0.3%! 

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Equity investors face a dilemma. Since the economy and profitability are doing well, should cyclical stocks be emphasized, or with the recovery getting old and because valuations are high, should defensive stocks be favored?..

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Here are a few unrelated concepts to chew on this week. No major overriding theme. Just a bunch of interesting “one-offs!”

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Fundamentally, the economic recovery has never been this good. U.S. real GDP growth is forecasted to rise by almost 4% in the current quarter, there is regular healthy job creation, the unemployment rate has fallen below 4%, household income gains are solid, profits are spectacular, confidence measures among both businesses and consumers are near historic highs, and for the first-time, economies about the globe are in a synchronized recovery!

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As the Federal Reserve keeps raising interest rates and the 10-year U.S. Treasury yield nears a seven-year high, investors wonder what yield level will bite the stock market? This may be the wrong question...

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