Wage rates spook the Dow

The Dow Jones Industrial Average fell 666 points on Friday as the market was spooked by an upsurge in wage rates.

Dow Jones Industrial Average

From the Wall St Journal:

Concerns about rising interest rates pounded financial markets Friday as investors started to take the threat of inflation more seriously, a sharp shift from the sentiment that has characterized most of the stock market’s nearly nine-year bull-market run.

Annual growth in average hourly earnings for the private sector jumped to 2.88%, close to the 3.0% expected to trigger a more hawkish stance from the Fed.

Hourly Wage Rates

The market is skittish about higher interest rates, with the VIX jumping to the highest level since November last year.

CBOE Volatility Index (VIX)

GDP slow growth as stocks power on

GDP growth for the third quarter is out and I can see little to indicate that growth is improving despite tweets to the contrary from the White House.

Nominal GDP is growing at just over 4 percent per year, continuing the narrow band established since late 2010. Growth closely follows our monthly estimate: total weekly hours worked multiplied by the average wage rate.

Nominal GDP

Real GDP, beset by problems in accurately measuring inflation, grew by 2.3 percent over the last 4 quarters. But growth remains relatively soft and our latest monthly estimate (growth in total weekly hours worked) slowed to 1.2 percent in September.

Real GDP

The S&P 500 powers on, climbing to a new high of 2581, while rising Twiggs Money Flow signals buying pressure.

S&P 500

Retracement of the Nasdaq 100 successfully tested its new support level at 6000, confirming a fresh advance.

Nasdaq 100

Bellwether transport stock Fedex is advancing strongly while a Twiggs Money Flow trough above zero suggests strong buying pressure. A bullish sign for broad economic activity.

Fedex

Stage 3 of the bull market continues.

It was never my thinking that made big money for me. It was my sitting…Men who can both be right and sit tight are uncommon. I found it one of the hardest things to learn.

~ Jesse Livermore

Are US stocks really over-valued?

Let us start with Warren Buffet’s favorite market valuation ratio: stock market capitalization to GDP. I have modified this slightly, replacing GDP with GNP, because the former excludes offshore earnings — a significant factor for multinationals.

US stock market capitalization to GNP

The ratio of stock market capitalization to GNP now exceeds the highs of 2005/2006, suggesting that stocks are over-valued — approaching the heady days of the Dotcom era.

Corporate Profits

If we dig a bit deeper, however, while the ratio of market cap to sales is also high, market cap to corporate profits remains low.

US stock market capitalization to Business Sales and Corporate Profits

Clearly profit margins have widened, with corporate profits increasing at a faster rate than sales. The critical question: is this sustainable?

Sustainability of Profits

At some point profit margins must narrow in response to rising costs. Increases in aggregate demand may lift employment and sales, but also drive up labor costs.

Profits and Labor Costs as a percentage of Net Value Added

The brown line above depicts labor costs as a percentage of net value added, compared to corporate profits (blue) as a percentage of net value added. There is a clear inverse relationship: when labor costs rise, profit margins fall (and vice versa). At first the effect of narrower margins is masked by rising sales, but eventually aggregate profits contract when sales growth slows (gray stripes indicate past recessions).

Interest Rates and Taxes

Other contributing factors to high corporate profits are interest rates and taxes. Corporate profits (% of GNP) have soared over the last 30 years as bond yields have fallen. The benefit is two-fold, with lower interest rates reducing the cost of corporate debt and lower finance costs boosting sales of consumer durables.

Corporate Profits as % of GNP and AAA Bond Yields

Lower effective corporate tax rates (gray) have also contributed to the surge in profits as a percentage of GNP.

US stock market capitalization to GNP

The most enduring of these three factors (labor costs, interest rates, and tax rates) is likely to be taxes. Corporate tax rates have fallen in most jurisdictions and US rates are high by comparison. Even if a long-overdue overhaul of corporate taxation is achieved in the next decade (don’t hold your breath), the overall tax rate is likely to remain low.

If Not Now, When?

The other two factors (labor costs and interest rates) may not be sustainable in the long-term but it will take time for them to normalize.

Treasury yields are rising, with the 10-year at 2.37 percent. Breakout above 3.0 percent still appears some way off, but would confirm the end of the 35-year secular down-trend.

10-Year Treasury Yields Secular Trend

Interest rates are likely to remain low until rising labor costs force the Fed to adopt a restrictive stance.

Labor Costs as a percentage of Net Value Added

Labor markets have tightened to some extent, as indicated by the higher trough on the right of the above graph. But this is likely to be slowed by the low participation rate, with potential employees returning to the workforce, and a strong dollar enhancing the attraction of cheap labor in emerging markets.

Hourly earnings growth in the manufacturing sector remains comfortably below the Fed’s 2.0 percent inflation target. Any breakout above this level, however, would be cause for concern. Not only would the Fed be likely to raise interest rates, but profit margins are likely to shrink.

Manufacturing: Hourly Earnings Growth

For the present

None of the macroeconomic and volatility filters that we monitor indicate elevated market risk. I expect them to rise over the next two to three years as the labor market tightens and interest rates increase, but for the present we maintain full exposure to equities.

Are US stocks really over-valued?

Stock Market Capitalization

Let us start with Warren Buffet’s favorite market valuation ratio: stock market capitalization to GDP. I have modified this slightly, replacing GDP with GNP, because the former excludes offshore earnings — a significant factor for multinationals.

US stock market capitalization to GNP

The ratio of stock market capitalization to GNP now exceeds the highs of 2005/2006, suggesting that stocks are over-valued — approaching the heady days of the Dotcom era.

Corporate Profits

If we dig a bit deeper, however, while the ratio of market cap to sales is also high, market cap to corporate profits remains low.

US stock market capitalization to Business Sales and Corporate Profits

Clearly profit margins have widened, with corporate profits increasing at a faster rate than sales. The critical question: is this sustainable?

Sustainability of Profits

At some point profit margins must narrow in response to rising costs. Increases in aggregate demand may lift employment and sales, but also drive up labor costs.

Profits and Labor Costs as a percentage of Net Value Added

The brown line above depicts labor costs as a percentage of net value added, compared to corporate profits (blue) as a percentage of net value added. There is a clear inverse relationship: when labor costs rise, profit margins fall (and vice versa). At first the effect of narrower margins is masked by rising sales, but eventually aggregate profits contract when sales growth slows (gray stripes indicate past recessions).

Interest Rates and Taxes

Other contributing factors to high corporate profits are interest rates and taxes. Corporate profits (% of GNP) have soared over the last 30 years as bond yields have fallen. The benefit is two-fold, with lower interest rates reducing the cost of corporate debt and lower finance costs boosting sales of consumer durables.

Corporate Profits as % of GNP and AAA Bond Yields

Lower effective corporate tax rates (gray) have also contributed to the surge in profits as a percentage of GNP.

US stock market capitalization to GNP

The most enduring of these three factors (labor costs, interest rates, and tax rates) is likely to be taxes. Corporate tax rates have fallen in most jurisdictions and US rates are high by comparison. Even if a long-overdue overhaul of corporate taxation is achieved in the next decade (don’t hold your breath), the overall tax rate is likely to remain low.

If Not Now, When?

The other two factors (labor costs and interest rates) may not be sustainable in the long-term but it will take time for them to normalize.

Treasury yields are rising, with the 10-year at 2.37 percent. Breakout above 3.0 percent still appears some way off, but would confirm the end of the 35-year secular down-trend.

10-Year Treasury Yields Secular Trend

Interest rates are likely to remain low until rising labor costs force the Fed to adopt a restrictive stance.

Labor Costs as a percentage of Net Value Added

Labor markets have tightened to some extent, as indicated by the higher trough on the right of the above graph. But this is likely to be slowed by the low participation rate, with potential employees returning to the workforce, and a strong dollar enhancing the attraction of cheap labor in emerging markets.

Hourly earnings growth in the manufacturing sector remains comfortably below the Fed’s 2.0 percent inflation target. Any breakout above this level, however, would be cause for concern. Not only would the Fed be likely to raise interest rates, but profit margins are likely to shrink.

Manufacturing: Hourly Earnings Growth

For the present

None of the macroeconomic and volatility filters that we monitor indicate elevated market risk. I expect them to rise over the next two to three years as the labor market tightens and interest rates increase, but for the present we maintain full exposure to equities.

US GDP: Where is it headed?

I originally got this from Matt Busigin (I think). Average Hourly Earnings multiplied by Average Weekly Hours (Total Private: Nonfarm) gives a pretty good indication of where GDP is headed, well ahead of the BEA accounts.

Nominal GDP compared to Average Hourly Earnings of All Employees (Total Private) multiplied by Average Weekly Hours (Total Private Nonfarm)

Remember this is nominal GDP, so the latest (April 2015) figure of 4.38% would need to be adjusted for inflation. Inflation is somewhere between 0.5% and 1.75% depending on how you measure it. The GDP deflator looks like it will come in below 1.0% which would leave us with real GDP of at least 3.38% p.a.

GDP Price Deflator compared to Core CPI

Gold, inflation and the Dollar

The (5-year) inflation breakeven (Treasury yield – TIPS) recovered from the oil price fall to post 1.66% on May 8.

5-Year Inflation Breakeven

Growth in average hourly earnings (manufacturing – production and non-supervisory employees) also recovered to 1.49% at the end of April.

Average Hourly Earnings

The stronger inflation outlook lifted the yield on 10-year Treasury notes above resistance at 2.25%. Recovery of 13-week Twiggs Momentum above zero also signals an up-trend. Target for the breakout is 2.65%*. This is a bearish sign for bonds, but only breakout above long-term resistance at 3.00% would signal that the secular bull market is over.

10-Year Treasury Yields

* Target calculation: 2.25 + ( 2.25 – 1.85 ) = 2.65

The Dollar Index found support at 94 in response to rising yields. 13-Week Twiggs Momentum is declining, but recovery above 96 would suggest that the correction is over and another test of 100 likely. Otherwise, expect strong support at the primary trendline around 92.

Dollar Index

Gold

Gold is testing medium-term support at $1180/ounce. Breach would test the primary level at $1140. 13-Week Twiggs Momentum holding below zero suggests continuation of the primary down-trend. Failure of $1140 would test the long-term target of $1000*.

Spot Gold

* Target calculation: 1200 – ( 1400 – 1200 ) = 1000