Market Update

Posted on April 27, 2018 by Gemmer Asset

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A lot of back and forth this week but stocks really didn’t go anywhere. The S&P 500 and EAFE were basically unchanged and small-cap U.S. stocks lagged modestly. Jitters about rising interest rates were largely offset by decent earnings reports (more below) and a lessening of tensions on the Korean Peninsula (who would have thought?).


10-year Treasury bond yields briefly surmounted the 3% threshold for the first time since 2014, as you can see below, before backing off. They closed the week at 2.96%, up just 0.01% for the five days. Government bonds were largely unchanged on the week. High-yield bonds lost -0.2%.




Economic Data of the Week – Housing & GDP


There were a couple interesting economic reports on housing this week as well as the first look at economic growth in the first quarter.


New & Existing Home Sales


New home sales grew at a seasonally adjusted rate of 694K in March (chart below), up +4% from February’s level and +8.8% from March of last year. However, existing home sales were up just +1.1% in March.


Why the discrepancy between new and existing home sales? Much of the reason is tied to inventory levels. There are plenty of new homes for sale nationwide – there is about 5 months’ worth of supply sitting on the market. This level is about average for the last 30 years. However, existing home inventories are tight. Existing homes inventory fell -7.2% year-over-year in March (blue line in the chart below) while there is only 3.6 months of supply (red line below), close to the lowest level since 2002.




This point will be important when we talk about the housing outlook shortly.


Home Prices


The other major housing report concerned prices. The Case-Shiller report for March showed that prices nationwide appreciated +6.3%. The top three markets were Seattle (+12.7%), Las Vegas (+11.6%), and San Francisco (+10.1%) – see chart below.




1st Quarter GDP


The other major report for the week was Friday’s GDP report. This showed that growth in the first quarter came in at +2.3%. While a slowdown from the +2.9% clocked in the 4th quarter, it was 0.3% better than expected.




The other key stat that came out Friday was the employment cost index. This showed labor compensation growing at an annual rate of +2.7%, modestly higher than expected and the best growth rate since 2009. This is consistent with the idea that the low unemployment rate is feeding through into accelerating wage growth.


A Closer Look at the Housing Market and Affordability


Back to interest rates and housing. One question economists and analysts are wrestling with is how much will higher rates slow the housing market?


Tot take a stab at answering this we first should look at mortgage rates in context. This week the news headlines talked about 30-year mortgage rates ‘soaring’ to over 4.7%. Granted, this is much higher than the roughly 3% rate not that long ago, but as you can see below, if you zoom out today’s rates aren’t particularly unusual. If anything, you might say they are at the low end of the range.




If you go back to the bubble years of the mid-2000s rates were bouncing between 6% and 7%. Even coming out of the financial crisis mortgage rates were about 5%, not too different from where we are now. There were a number of commentators back in 2008 and 2009 talking about mortgage rates being at generational lows.


In an and of themselves rates don’t have to be a problem. How about affordability? This takes into account mortgage rates as well as average home prices. The chart below shows the mortgage payment for the median priced home assuming a 20% down payment and a 30-year fixed mortgage. On this measure affordability has definitely deteriorated.




Back in 2011 the average home cost about $800/month and today it is closer to $1,400/month. This is obviously a big increase and is now above the bubble peak number of close to $1,300/month. But this doesn’t really tell us about affordability, only that payments have increased.


The missing factor is what has happened to incomes. Stansberry Research ran a model that incorporated incomes into the mix as well as interest rates and home prices. The chart looks like this.




So higher home prices and higher interest rates hurt affordability, but so far income growth nationwide has kept the average home pretty affordable. Of course, local markets differ (as we all know only too well living in the Bay Area), but if you are making the case for a nationwide housing bubble you might be waiting a while for it to burst.


What does it mean for housing prices going forward? Certainly, higher rates should slow the market in general and lead to an uptick in existing home inventory numbers. An increased overhang of unsold homes should slow price appreciation all things being equal. However, the nationwide housing market isn’t a bubble waiting to burst because income growth is accelerating and inventory levels are coming off a very low base. Higher mortgage rates are a headwind, not a death knell.


Earnings – Is This as Good as it Gets?


As you probably see from the headlines we are in the middle of first quarter earnings season. So far about a third of S&P 500 companies have reported, and roughly 80% are beating estimates (see below). This is the largest beat rate since 1999 and the recent tax law changes are almost certainly playing a part.




Earnings per share growth is coming in at +23% year-over-year, +6% better than expected.


Revenue growth is more muted, but still reasonably robust.  A little over 64% of companies have beat revenue estimates, which is nearly 16 percentage points below the EPS beat rate.  But this makes sense given the fact that tax changes are driving earnings growth, not revenue growth.




It is also notable that the number of companies guiding future earnings higher is running at a solid rate. So far close to 60% of firms have revised earnings guidance higher versus just 8% guiding lower, as you can see in the chart below.




This means the earnings outlook for the next few quarters is solid. Analysts think each quarter this year could see growth rates above +18%, something you generally see only coming out of a recession.




If there is a dark cloud behind all this, though, it is that longer-term expectations are getting frothy. The chart from BCA below shows earnings estimates for the next five years. It is now at the highest level since 1999. This seems a stretch and it is very tough to make a bet on this line continuing to go up.




And this is what the market is wrestling with. Short-term earnings are being goosed by the tax changes, but this trend is getting extrapolated out way too far.


And then there is the $64bn question of what happens with price/earnings multiples if rates continue to increase. The chart below shows that multiples have historically contracted during rate hike periods.






Investors are clearly being buffeted by opposing forces today. There is optimism about earnings but concerns about frothy expectations and the high likelihood that multiples will contract if the Fed keeps hiking rates. No wonder the market is bouncing all over the place and going nowhere fast.


Have a good weekend.


Charles Email Sig



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