My family and I spent last weekend in the Finger Lakes region of New York State. While enjoying our family gathering, I couldn’t help comparing summer in Upstate NY with my home in North Carolina. The crystal-clear water in Cayuga Lake was a cool and invigorating 66 degrees, while the gentle breeze blowing through the bedroom window provided a refreshing sleeping experience, especially when compared to the stifling humidity so common in the south. It’s really hard to beat the temperate summers in Upstate NY. Beyond that, I was able to enjoy an entire box of the most scrumptious chocolate halfmoon cookies on the planet made by Geddes Bakery of Syracuse. You haven’t lived until you’ve tasted one of those, trust me.
On the global scene, comparative advantage is a recurring topic of debate. This concept is always a critical component of our investment process. Our investment team is continually debating the competitive strengths and weaknesses of the major players across the various sectors and industries of the overall market. More recently, as global trade and immigration continue to dominate the headlines, comparative advantage has taken on a much broader scope. In terms of global trade, or more accurately, the potential for a global trade war, understanding the advantages the U.S. has over its trading partners is critical. Each country, and even each region of the globe, has certain advantages and disadvantages when it comes to world trade. For example, there are certainly stark differences when it comes to the two largest economies – the U.S. and China. Significant advantages of the U.S. include: tremendous economic diversity, huge sources of capital and innovation, well-established accounting standards, and abundant natural resources. Advantages of China include: a huge labor force, powerful production capabilities, and substantial foreign currency reserves under government control. On the other hand, disadvantages of the U.S. include: enormous federal debt, political polarization, and an ever-growing governmental bureaucracy. Meanwhile, China faces serious environmental degradation, along with a demographic challenge stemming from their “one-child policy” of the past.
Can our respective leaders establish a win-win economic partnership, or are we doomed to be enemies, first economically and ultimately, militarily? It would be an understatement to say that this is serious stuff with serious potential consequences. Without question, the future of the world economy will be driven by how well the U.S. and China work together economically and politically.
Related to these critical trade negotiations is another major comparison, which is the different style of our current president compared to previous administrations. Simply put, we just haven’t seen an approach anything like Trump’s bombastic style. Will it be effective is anybody’s guess. The fact that the stakes are very high doesn’t seem to bother him, but it sure makes a lot of people nervous. It’s also difficult to discern whether Trump listens to anyone in his inner circle.
Given these “knowable unknowables,” it is prudent for us to refocus on comparisons that we can analyze and quantify. In other words, even during uncertain times, historical valuation parameters can be useful in developing sound investment strategies. With that thought in mind, here are a few interesting comparisons…
The overall price to earnings ratio (PE) of the market based on 2018 earnings estimates is 16.7x. Compared to environments of low inflation and relatively low interest rates, this is a reasonable valuation level. However, if the Fed continues to raise interest rates, this will put pressure on the overall market PE. In short, PE levels and interest rates tend to be inversely correlated.
Taken to the next level of analysis, individual company PE ratios usually reflect relative earnings growth rates compared to primary competitors. Generally speaking, this relative valuation ranking holds true across different industries and sectors. Where there are anomalies to this rule investment opportunities sometimes exist. Not always, but sometimes.
One final interesting comparison involves the momentum in investor sentiment. The stock market is driven by emotion, especially in the short run. One critical question market forecasters routinely ask is this – Do you feel better about your current situation and future prospects? The stock market tends to do better when people are feeling better. That might sound simplistic, but it is too often disregarded. On this front, the news is overwhelmingly positive. Consumer confidence, small business optimism, even Trump’s approval ratings, have all improved over the past few months. In my view, most of this improvement is due to lower taxes and less government regulation. Despite President Trump’s abrasive personality, these two accomplishments are important, and they should continue to bolster the outlook for the economy and markets for the remainder of the year.
Michael Kayes, CFA