When the February market correction ended, I had the lingering feeling that not enough damage had been done to investor complacency to provide for a sustained move higher. In spite of that, the major indexes continued to plow ahead. After Labor Day, the market was selling at fair value and investors were optimistic that nothing could go wrong in a strong United States economy with real growth in excess of 3% and unemployment at a 40-year low. A perfect set of sentiment conditions for a market decline was in place. I had been expecting a post-midterm election rally, but for that to happen the market needed to have a sell-off in order to make valuations more attractive and investors less complacent. The sharp recent rise in 10-year Treasury yields from 3.0% to 3.23% was the trigger, but there were other negatives in the market background that had an influence on the thinking of portfolio managers. With respect to these negatives, we will explore each one’s relative importance. Let me be clear, however. I do not believe we are beginning a bear market. We are in a correction in an ongoing bull market that probably has a year or more to run. Our strategy team does not expect to see the next recession until 2021 at the earliest. A more serious market downturn may occur sometime before then, but not now.
When the 10-year Treasury yield was below 3%, real yields were less than 1% and the market seemed comfortable with that. Now with real yields above 1% and the prospect of the Federal Reserve continuing to tighten further, investors have become increasingly concerned that higher rates will stifle economic growth. According to my dividend discount model, the market was fairly valued before the sell-off based on 2019 projected earnings and 10-year Treasury yields at 3%. Now the market is undervalued. My view is that inflation will increase somewhat, but remain generally subdued. I have a hard time seeing the core Consumer Price Index rising much above 2.5%. Average hourly earnings are rising at a 2.8% annual rate now. Perhaps yields will go to 3.5%, but that would still be below the 4% level that usually accompanies a slowdown in the economy. The current spread between the three-month Treasury bill and the 10-year note is a positive 86 basis points.
Wage costs continue to be the most important factor in the inflation outlook. Although the unemployment rate is at a record low and Blackstone’s private equity portfolio companies are complaining about the difficulty of hiring qualified workers, I nonetheless expect wage pressures to remain modest because of the reduced need for humans in the work force due to the greater use of technology and artificial intelligence.
The price of oil is also an important factor in the inflation outlook. It has moved from $60 a barrel (for West Texas Intermediate) to over $70 this year, and its rise from here may be gradual. As for other commodities, my view is that the slowdown taking place in both developed and emerging market economies will dampen prices for most industrial and agricultural products. I expect us to see somewhat higher inflation and interest rates but I do not expect a sharp increase in either over the next year.
A look at 15 indicators that have an influence on market valuations shows that they generally fall in the range of 1.0 to 1.2 times their 20-year average, not a sign of over-valuation. The current Standard & Poor’s 500 operating price earnings ratio is about 16.5x. The average since the 1950s has been 16x, but the 10-year Treasury yield since the 1950s has averaged 5.6% and it is 3.1% now. The dividend tax rate since the 1950s has been 53%, but under the new tax code it is now 24%. We are also growing nominally at a 7.6% rate compared with 6.5% since the 1950s. At 2700 the S&P is not overvalued.
Concern about a trade war with China is on every investor’s mind. We import over $500 billion in goods and services from China and sell only about $130 billion to them. Putting high tariffs on Chinese goods will surely increase costs for both American consumers and corporations, but our trade negotiators are right to be tough. China enjoys a current tariff schedule that was implemented when it was a developing economy, and it is the second largest economy in the world now. There is a broad political consensus that the Chinese have been using American technology without authorization, taking advantage of their partners in joint ventures and flouting World Trade Organization rules. I believe we will work out a trade agreement with China sometime next year. China is currently experiencing a greater-than-expected slowdown and is likely to be anxious to eliminate friction with its most important trading partner. One point the Chinese will never agree to, however, is slowing down their technology research effort, the “Made in China 2025” program. We should stop pushing for that.