We certainly live in interesting times. Outside of the main Trump / Brexit news three stories caught my our eye over recent weeks. All three are below the radar but may have a factor to play in determining market movements over coming months:
If Company ABC, as an example, were to remunerate staff in ABC shares to an equivalent value to their salary, instead of cash, and then not account for the issuing of these shares by being flexible with accounting practices their profitability would be significantly enhanced. Of course prudent accounting for share issuance would result in no change in profitability whether they paid staff in shares or cash. Alphabet (Google) trade on a P/E ratio of 27. Alter its treatment of stock-based compensation and its trailing P/E ratio would be 34 – much higher than its published figure. Alphabet mentioned in the recent earnings call that the next quarter’s earnings will no longer ignore stock costs (a bad habit prevalent within the tech sector). It will be interesting to see how these earnings are received. Furthermore if an increasing number of Companies move towards this more honest accounting approach the PE ratio of the market will look even more over-valued than it currently does. Something to watch.
The rise of index tracking funds has been relentless. Vanguard reached US$ 4 trillion in assets at the end of January and Blackrock topped US$ 5 trillion in assets late last year. These are such big figures that it’s difficult to get your head around them. When I started in the industry in 1978 Companies were largely valued on fundamentals and market-makers (jobbers) actually knew everything about the Company that they were making a price in and Company fundamentals were an important determinant in respect of the valuation of a share. This changed and today equities are largely priced on the dynamics of supply and demand. The rise of the index-trackers means that there is a steady flow of money into poorly managed large capitalisation stocks when index funds are going up. Well run, inexpensive Companies are sold just as indiscriminately when the index tracking investors withdraw funds. This may well explain why some large capitalisation stocks have valuations completely out of sync with their fundamental prospects. The question is whether you buy these stocks to keep up with an index, or buy when the fundamentals look right. If it is the former then logically you may as well join the herd and buy an index, hoping that the herd won’t jump off a cliff and take you with it. Patience often rewards the prudent.
The third story probably explains the mismatch between the desire of Donald Trump to reflate the US economy and the economists arguing that the marketplace is nearing full capacity. Each month the US produces six unemployment rates and it is the headline rate that is reported prominently in media coverage. At 4.9% it is below the magical 5% level that indicates that the economy is in rude health. This figure includes as unemployed only those individuals who are actively looking for work and fails to include discouraged workers or persons just marginally attached to the Labour force. These are perhaps the forgotten people that voted for Donald Trump, people that want a job but have given up looking. This rate stood at 5.8% in January and only slow improvement is expected over the next few years. The unemployment rate which also includes part-time workers looking for full time jobs stood at 9.4% at the end of January 2017 – this is a statistic that Janet Yellen watches carefully.
Put these observations together and you get to an investment scenario whereby interest rates in the US will probably remain lower for longer as there is still room for expansion within the economy without stoking the fires of inflation. It also shows than an expensive stock market may become more expensive before “rebalancing”. Market timing may be everything.