You need to read this week's complimentary edition of Market Edges.

Dear Stock Market Bears, Valuation Is (Still) Not A Catalyst - crying bear

It's our contention that the U.S. economy is heating up and a lot of investors are missing out. Meanwhile, stock market bears point out that the U.S. stock market is expensive when looking at standard valuation measures like price-to-earnings. They ask: At 24 times trailing twelve month earnings, how on earth could an investor possibly buy the S&P 500?

The answer is simple. Valuation is not a catalyst.

Hedgeye Senior Macro analyst Darius Dale did a detailed analysis of a favorite bearish indicator - the cyclically-adjusted price-to-earnings ratio or CAPE - in a recent Early Look.

The CAPE ratio is a valuation measure defined as the current price divided by the past ten years of inflation-adjusted earnings. The ratio is designed to put into perspective current equity market prices versus market history.

Sure, stocks are expensive. The current CAPE ratio is 30.3; that's well into 90th percentile of all readings (i.e. more expensive than 90% of the data) going back to January 1881. That sure is expensive.

As Business Insider pointed out in December, "Stocks have only been this expensive during the crash of 1929, the tech bubble, and the financial crisis." But before you go out and sell your stocks, consider that since this Business Insider story ran the S&P 500 is up +10%. In other words, stock market valuations can get a lot more expensive, especially since U.S. economic growth is heading higher.

That's the point. As Dale wrote:

"The top 10 one-year-forward returns of CAPE Ratio readings between the ninth and tenth decile carry a whopping average of +34.8%! That figure drops to +30.2% for the top 20 and +21.3% for the top 50. Over the last 30 years, the average of the top 10 one-year-forward returns of CAPE Ratio readings between the eighth and ninth decile is +31.1%."

Dale asks a simple question: Can you afford to miss a +31% move to the upside in your benchmark?

Dear Stock Market Bears, Valuation Is (Still) Not A Catalyst - valuation catal

The U.S. Economy is Heating Up

Instead of anchoring on valuation, as the stock market heads higher, consider what's happening to economic growth. Specifically, we're watching economic growth, inflation and earnings. On that front, here's the score:

  • The U.S. economy has rallied to 2.1% year-over-year in the second quarter of 2017, from the low of 1.2% year-over-year hit in 2Q 2016. We think the economy continues to head higher from here.
  • Consumer Price Inflation: Year-over-year headline CPI decelerated for a 4th consecutive month to 1.6%. Core inflation decelerated for a 5th consecutive month. Inflation subtracts from U.S. GDP. To the extent inflation continues to fall that will be supportive of our U.S. #GrowthAccelerating call.
  • Meanwhile, 421 of 500 S&P 500 companies have reported aggregate year-over-year sales and earnings growth of +5.4% and 10.1% respectively.

Bottom Line

With U.S. economic data heating up and inflation falling, the burden of proof to the contrary is on the bears. We've been on the right side of this one for more than 9 months now. Watch Hedgeye CEO Keith McCullough explain why in the video below.