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Early Warnings?
Toronto: July 28, 2014
By John Stephenson

In the latest pessimistic salvo to be leveled at investors Goldman Sachs issued a report this past Friday suggesting a rising rate environment could lead to tough times in the bond and stock markets.  While the firm is bullish on stocks in the longer term they believe that “a sell-off in bonds could lead to a temporary sell-off in equities.”  This warning follows the July 15th warning by the U.S. Fed, which said, “valuation metrics in some sectors do appear substantially stretched – particularly those for smaller firms in the social media and biotechnology industries.”  To many, these and other comments are reminiscent of former Fed chairman Alan Greenspan’s comments in 1996 about irrational exuberance in markets.

With a steady drumbeat of negative pronouncements many investors are grasping at straws for the trigger that will send markets scurrying downward.  In the U.S. and U.K. financial press there have been more mentions of market bubbles in the past 18 months than any time previously. 

Yet, despite the growing storm cloud of negativity, there remains precious little evidence that a market meltdown may be in the offing any time soon.  Economic data, particularly a recent uptick in U.S. ISM manufacturing data suggest that the American economy is humming along just fine.  And given that most bull markets end with recessions and there has never been a U.S. recession without the yield curve first inverting, a recession seems unlikely. 

The market’s multiple gets a lot of attention by skeptics these days, and while the forward multiple is slightly ahead of its long-term average, forward price/earnings ratios have ranged from 6x to 24x over the past 40 years, suggesting that the market is pretty reasonably valued. 

While the Fed’s warnings over the valuation of the Biotech and Internet sectors caught investors off guard a few weeks ago, these industries appear attractive for a variety of reasons.  They are fast growing industries in a low GDP environment and investors typically pay a premium for growth.  Valuations for these two sectors is quite attractive when growth is factored in, such as in a PEG (price/earnings to growth) analysis and the gap between the most and least expensive stocks in these two sectors is currently below average.

The growth rate year-over-year for the Internet software companies such as Netflix and Priceline has revenue increasing at 16.4% while earnings are up more than 31.8% over the prior year.  In Biotech the year-over-year growth rates are even more compelling with revenues soaring 42.7% and earnings up a staggering 100.9%. 

Still, for many in the correction crowd the concern centers on the timing of Fed rate hikes and the potential for a market meltdown once the Fed begins to move.  But inflation is unlikely to be an issue for the U.S. economy for at least a few more years.  The main determinant of inflation is labor costs, which explains more than 80 percent of U.S. inflation since 1950.  With plenty of slack in the labor market and older workers crowding out younger ones, it looks like inflation will likely remain on the sidelines for a while.  Breakeven inflation rates on Treasury Inflation Protected Securities (TIPs) are clocking in around 2.2%, a very reasonable level, suggesting that the market isn’t expecting much in the way of inflationary pressures. 

But despite the worries over inflation and the prospect that higher rates could soon follow, a rise in interest rates is probably a good thing, since it signals an improving economy.  In fact, many sectors do quite well in a modestly rising interest rate environment.  In such an environment, the performance of the tech sector is pretty stable, while financials show the strongest incremental improvement when rates are rising.   Cyclicals typically outperform in the early months following a rate hike while defensive sectors struggle. 

While I don’t expect a rate hike anytime soon, I am continuing to focus my portfolios around the financials and I’m avoiding the over-valued telecommunications and utility names.

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