The misery index, which is calculated by adding the unemployment rate to the inflation rate, has never been this low but this is about to change. I believe 2020 is going to be the year where the market will return to misery as the unemployment rate will move back up and inflation will show its ugly head.
The stock market has been on a tear lately and we all know by now that central banks are the main reason why stocks are going up. Money gets printed by the central banks which pushes liquidity into the system. That liquidity must go somewhere and we’ve seen that money go into stock buybacks. However, earnings have not risen on the rise of the stock market. Only the valuation multiples (P/E ratios) have gone up.
Valuations have gone up instead on the back of a lower misery index, as shown on the following chart from Yardeni. Forward P/E ratios are now at 18, which shows that stocks are fairly overvalued. You could justify this high valuation due to a low misery index.
The Unemployment Rate
We have seen a significant decline in hirings versus separations… First, the hirings decline, then the non-farm payrolls will decline and finally, we will see a rise in the unemployment rate.
…[In addition,] delinquencies are a leading indicator for the unemployment rate and we are seeing a rise in delinquencies which started in 2018 . Therefore, I expect that the unemployment rate is likely to inch higher this year.
The Inflation Rate
My favourite indicator here is the productivity index (see chart below from FRED). Real output has been declining since the 1990s and when productivity slows down, inflation starts to appear. The trade war isn’t helping either.
Another obvious reason for more inflation ahead of us is the increase in money supply from the central banks of Japan, the U.S., and the Eurozone (see chart below from FRED). All three central banks are projected to send billions of dollars into the system this year.
The Taylor Rule Rate
…John Taylor, a Stanford University economist once considered to lead the Federal Reserve, developed a formula to calculate where the Fed funds rate should hypothetically be according to:
- inflation rates,
- strength of the labor market, and
- potential output of the economy.
Inflation became a problem during all times when the Taylor Rule Rate became higher than the Fed funds rate (see chart below from FRED). Today, the Taylor Rule Rate says that we should already be at 3% interest rates. Instead, the Fed funds rate is at 1.55% and chairman Powell has already said he won’t increase interest rates until he sees persistent inflation above the 2% level.
[The conclusion one can draw from the above analysis]… is that:
- both the unemployment rate and inflation rate will be moving higher and that will push up the misery index from these record lows.
- Once this happens, stock valuation multiples will crash down to reality along with stock prices.
Enjoy the ecstasy created by the central banks while you can because once their support ends, the party is over.