The news and the economic fundamentals haven't changed much in recent months, but on the margin there has been some modest improvement. The following charts highlight some of the more interesting developments that bear watching.
Rising profits have been the source of most of the gains in equity prices in recent years. Since the post-recession low in PE ratios (13.9 in August 2010), ratios have increased by 35% to almost 19 today. Over the same period, earnings have increased almost 50%. However, profits growth has declined in the past year, with S&P 500 trailing earnings up only 4.4% in the past 12 months, thanks in part to falling oil prices. Fortunately, that's not exactly a bad thing for everyone. PE ratios are above average, but not by a significant amount.
I remain fascinated by the chart above, which I've been following for the past few years. It shows a decent correlation between the earnings yield on equities and the price of 5-yr TIPS (using the inverse of their real yield as a proxy for their price). When earnings yields are high and real yields are very low, that is a sign of a market that is very risk-averse: investors don't trust earnings, and are willing to pay very high prices for the safety of TIPS. Risk aversion has been declining for the past few years, however, as confidence slowly improves. This is a significant trend that is likely to continue. Expect higher PEs and higher real yields over time.
Equity risk premiums (defined here as the difference between the earnings yield on stocks and the yield on 10-yr Treasuries) have come down sharply from their October 2009 highs, but remain relatively high by historical standards. The earnings yield on stocks today is still substantially higher than the yield on safe Treasuries. That's another sign of risk aversion: in a strong, growing economy like we had in the 1980s, investors are typically willing to give up yield (i.e., accept a lower earnings yield on risky stocks than the yield on safe Treasuries) in order to benefit from a rising equity market. Today, investors still demand a higher yield on risky equities because they are still somewhat risk averse. Today's relatively high equity risk premium is reminiscent of the high equity risk premiums that prevailed in the late 1970s, when investors were reeling from the shock of double-digit inflation, a weak dollar, and soaring Treasury yields. Today's investors are still reeling from the shock of the Great Recession.
Earnings yields on stocks are still higher than the yield on BAA corporate bonds. This is relatively rare, since corporate bonds are higher in the capital structure. In a "normal" world, equities should have lower yields than corporate bonds, since equity investors are willing to give up yield in order to benefit from the expected growth of earnings. Bond investors, on the other hand, are willing to give up price appreciation in exchange for a higher and safer yield. Today, however, investors are unwilling to pay up for equities, in a sign that risk aversion that still prevails. I wouldn't be surprised to see equity yields continue to decline (i.e., rising PE ratios) even as bond yields flatten or begin to rise.
Equity prices continue their slow upward march, climbing a major wall of worry that is fading away (e.g., Greek defaults, collapsing oil prices, Ukraine tensions, Fed tightening).
The February ISM manufacturing index was about as expected. Although it's off quite a bit from its recent highs, it is still consistent with overall economic growth of 2-3%. The economy has been doing a bit better over the past year, but it's nothing to get excited about. The outlook for growth remains moderate; not great, but not bad either, with some modest improvement on the margin. Significant improvement will come when and if fiscal policy becomes more growth-friendly (e.g., lower and flatter tax rates, especially for corporations, and reduced regulatory burdens).
One of the more encouraging developments in the past year is the pickup in C&I Loans. This reflects increased confidence on the part of banks and businesses—banks are more willing to lend, and businesses are more willing to borrow. Bank lending to small and medium-sized businesses is growing at a solid 12% annual rate these days. The increased confidence this reflects lends solid support to a forecast of continued economic growth.
Money supply growth has averaged just over 6% per year for the past 20 years. No sign here of the Fed "printing money" in any unusual way. However, nominal GDP growth has averaged 4.4% over this same period. When money growth exceeds nominal GDP growth, we can infer that the world's demand for "money" has increased; people want to increase their money balances relative to their incomes, usually out of a desire to reduce risk.
Demand for money (i.e., the ratio of M2 to nominal GDP) has risen strongly over the past 20 or so years, especially since the Great Recession. But the rate of increase in money demand is slowing, as risk aversion declines. Rising money demand was the major impetus for the Fed's Quantitative Easing, whose major purpose was to "transmogrify" notes and bonds into T-bill equivalents (bank reserves). The world wanted a lot more safe assets, and QE generated over $3 trillion of safe assets to meet that demand. As risk aversion declines, QE is no longer necessary.
The important thing to watch for is a decline in money demand. It's been a long time coming, but sooner or later we are likely to see nominal GDP growth exceed M2 growth. That time will most likely coincide with rising confidence, a stronger economy, and a tendency for rising inflation. This will test the Fed's ability to keep the supply and demand for money in balance by increasing short-term interest rates.
The main source of M2 growth since the Great Recession has been bank savings deposits. Note the slowing in the growth rate of savings deposits that began about two years ago. Savings deposits were growing about 12% per year, but have only grown at about 6% over the past year. This growth slowdown is likely to continue, as households become less interested in accumulating savings deposits that pay almost nothing in a world in world in which stocks rise 1% a month, earnings remain at record levels, and inflation is at least 1-1.5% a year and rising.