The surprisingly strong U.S. employment report was a notable curve ball in understanding the U.S. economy. It was only weeks ago that we saw an employment revision that wiped out 818,000 jobs. So, what gives? The bottom line is that the U.S. Federal Open Market Committee’s (FOMC) reaction function is based on the data we see that, while subject to revision, is the data on the ground.
There is no shortage of market participants (including this one) that has an opinion on the growth and inflation outlook. I believe that the labour market, and thus consumer spending, will be stronger than expected this cycle given the increased reliance on the domestic economy versus the global economy.
But the part that is hard to reconcile is that the manufacturing economy has been in recession for close to two years, but other sectors (the consumer, read jobs) have more than made up for it.
Following the strong labour report for September, the market is ratcheting back rate cut expectations and increasing forward based earnings estimates. David Kostin, Chief U.S. Strategist at Goldman Sachs, is increasing the earnings outlook for 2025 while Goldman’s Chief Economist, Jan Hatzius, is lowering the odds of a U.S. recession to 15 per cent over the next year.
Kostin somehow thinks that 22X EPS is fair value, where we are in the 18X range (long-term is 16.5X). The Sahm rule seemingly has failed for the first time to identify a recession. Or is this all just bad data subject to massive revisions?
Geopolitics is raising global growth risks to be sure, and rising oil prices for a longer-term period could ignite the more persistent inflation concerns that seemingly disappeared with the FOMC’s 50 bps rate cut just a few weeks ago.
As we start another U.S. earnings season this week, from a risk/return point of view, the market is a little on the expensive side relative to the past decade. The market is a better buy when cheap relative to 12-month forward earnings expectations and a better sell (or more cautionary) when it is closer to fully priced.
This chart shows analyst bottom up forward 12-month consensus (blue line) EPS consensus versus the S&P 500 (red line) and measures the deviation with a 10-year Z-Score (lower chart). Generally, when the market is 1-2+ standard deviations cheap to forward based price targets we want to be a better buyer, and when 1-2 standard deviations expensive a better seller.
Currently, with price targets likely to rise in the coming weeks given the recent data, the market is closer to neutral, and could rise still.
When we factor in what a fair multiple is on EPS using a discount factor based on longer-term yields, we see where the risks lie. It’s not on the earnings side, it’s likely on what we should pay for them.
Goldman Sachs says the current multiple is fair value. While we do not agree, we do believe that as long as we remain at full employment, stocks can hold the multiple. But if bond yields continue to rise, that fair value multiple is much closer to 19X than the 22.5 forward multiple we are at today.
It’s about a 15 per cent valuation gap when the labour market breaks, but that may not be anytime soon. The earnings yield (earnings/price) of the market is the inverse of the P/E.
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