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The Economy and Stocks Start to Diverge

Published on: Oct 21 2021

The tight relationship between the economy and markets might be ending. For some time, economic growth has been accompanied by higher stock prices, and stock indexes faltered when growth slowed or declined. Going forward, it is likely economic growth will continue while the stock indexes remain in a trading range or decline.

Growth should continue even as the Federal Reserve slowly reduces its monetary stimulus and the fiscal stimulus fades. But stock prices were supported by the stimulus, especially from the Fed, and won’t do as well without it. Household incomes will continue to rise because of wage increases, excess savings during the recession and stronger balance sheets.

The combination will support household spending. The Federal Reserve recently reported that household net worth reached a new high in the second quarter of 2021. Also, debt service levels for households are at or near historic lows, thanks to low interest rates. These factors now are self-reinforcing and don’t depend on additional stimulus. Businesses are experiencing demand that exceeds their current capacities, so they are increasing capital spending, hiring and wages.

These moves also support continued economic growth. At the same time, trends that caused U.S. stock indexes to outperform the rest of the world are fading, and stock valuations are stretched. Profit margins in the United States expanded over the last few decades to historic levels. Growth in profit margins is unlikely to continue, and there’s a good probability margins will begin to decline. Pro-business policies are being curbed around the globe.

Businesses, especially the dominant technology firms, are facing higher taxes, increased antitrust enforcement and more regulations. Labor costs are increasing. Commodity prices are higher and appear to be in a multi- year rally. Businesses also face higher energy costs due to an abrupt shift in climate policies by governments worldwide. Governments are prohibiting or penalizing the use of fossil fuels.

The most extreme case is China’s recent decision to close many facilities that generate electricity using coal. These sudden policy changes are increasing demand for other energy sources and pushing prices substantially higher. Slower growth in China and supply shortages are the main risks to global growth. I’m monitoring them carefully. History shows us the stocks that have done best over the previous 10 years usually don’t repeat that performance in the next 10 years.

U.S. stocks, especially technology stocks, have dominated global returns. Technology now is a larger percentage of the S&P 500 than any sector ever has been. A turnaround is Higher inflation also will be with us for a while, despite the Fed’s assurances that it is transitory.

Demand outstrips supply in almost every sector of the economy. In most sectors, these are multi-year imbalances. Businesses also face higher costs associated with climate change policies, as well as cybersecurity. There are aging work forces in most developed nations, and an older work force usually leads to higher inflation because of lower productivity. Interest rates are more likely to rise than to fall.

Declining interest rates were a major factor pushing stock valuations higher because investors determine today’s stock prices by using interest rates to discount future profits and cash flows. Investors have been discounting extremely high earnings growth and low interest rates. If interest rates rise, investors will give stocks lower valuations. Also, if the growth rates of profit margins and cash flow decline, investors will give stocks lower valuations.

The Fed has provided a lot of support for growth stocks since 2009. It is ready to reduce that support. Even if it doesn’t, recent indications are that monetary stimulus has pushed growth stock prices about as high as it can. Investors are shifting away from the last decade’s big winners to investments with bigger margins of safety. probable.

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