Encouraging signs

The news is certainly mixed these days. Britain's Brexit vote stirs fears of a global slowdown in trade, which would surely be bad for the economic outlook. But that's still something out on the horizon. In the meantime, more recent data point to a pickup in growth that began a month or so ago. 

The ISM manufacturing index was stronger than expected (53.2 vs. 51.3), and as the chart above shows, this suggests that second quarter GDP growth will be stronger than the tepid 1.1% registered in the first quarter. It wouldn't be surprising to see Q2 growth come in at 3%.

The export orders subindex continues to improve, which suggests that conditions overseas are improving.

Now that oil prices have been rising for over four months, it's not surprising to see a clear majority of firms reporting higher prices paid. Once more we say goodbye to concerns about deflation.

The employment subindex remains unimpressive, which suggests that firms are still cautious about the outlook. This recovery is still dominated by worries and risk aversion, but that's not necessarily bad. The time to worry is when everyone is optimistic.

Manufacturing activity has been improving for the past few months in both the U.S. and the Eurozone. This may be tempered in months to come by the Brexit vote, so it's too early to get excited about a coordinated rebound in activity. But in the meantime it's reassuring. 

10-yr Treasury yields are still amazingly low, closing today at 1.44%. 30-yr Treasury yields are also down to all-time lows, closing today at 2.23%. But the spread between the two, shown in the chart above, has been rising since last August. From a long-term historical perspective, the long end of the Treasury curve is plenty steep, and that suggests the market still expects the economy to improve over time. The time to worry is when the yield curve gets very flat or even negatively-sloped.

The PE ratio of the S&P 500 is about 15% above its long-term average, but this has to be viewed in the context of risk-free interest rates that are at their lowest level ever. Put another way, the PE ratio of 10-yr Treasuries today is about 80, whereas the PE ratio of equities is about 20 (i.e., an investment of $80 in 10-yr Treasuries will get you an annual return of $1, whereas an investment of only $20 in equities promises a return of $1). I'm thinking this is an unprecedented valuation gap in favor of equities.

As the chart above shows, the earnings yield (after-tax profits per share divided by share price) on equities is still well above average. Moreover, EPS appears to be stabilizing, having fallen only 2.7% over the past year—and quite likely to increase now that the problems in the oil patch are in the past. If profits merely hold at current levels, the expected return on equities will be significantly higher than the return on Treasuries.