The '90s Valuations Were Right, Just Early, Says JPM Strategist

J.P. Morgan senior economist James E. Glassman says the stock market remains cheap, and thinks that the macroeconomic picture remains bullish for stocks while the micro outlook involves some cautiousness.

“The macroeconomic backdrop indicates that the wind remains at the back of the stock market,” Glassman writes in recent market commentary. “Cyclical recoveries and the above-trend growth that comes with that as the economy returns to full employment are spreading. Economic opportunities abroad are expanding. Monetary policies everywhere are highly accommodative and will stay that way until the global recovery is secure. … Even after the stock market’s recovery, traditional valuation benchmarks indicate that the stock market remains ‘cheap'”.

Glassman says that while some big parts of the economic recovery — the unemployment decline and the rebound of the construction industry — have really just started, corporate earnings growth is slowing, which is a headwind. But he offers an interesting take on valuations and profit margins. Glassman says that the rise in stock prices in the 1990s was based on the expectation that the Internet, globalization, and other factors would increase efficiency and lead to higher corporate profits. And the expectation was right, he says — but it took some time for the process to play out.

“The elevated valuations reflected optimism about the earnings of the business sector that eventually was validated by a near-tripling of after-tax business profits,” Glassman writes. “Nonetheless, because equity investors drove share prices up in the 1990s in anticipation of improved business performance, the 2000s represented a catch-up decade. … Because investors were willing to front-run the promise of new technological innovations in the 1990s — and their optimism proved in large measure to be justified — most retail investors who first entered the stock market after the late 1990s came in when share prices were relatively expensive in relation to earnings.”

Glassman says it seems “plausible that earnings are being powered by secular forces, because margins have been expanding since the mid-1980s, not long after China began to open up, followed by India’s rapid development. That was followed by the economic liberation of many others as the rigid, planned Soviet Economy collapsed and many began to liberalize their economies, shifting to market-based systems.” The secular profit shift “seems the more dominant and durable development of recent decades”, and is part of the reason that stocks are trading at their cheapest valuations since the end of the Nixon administration. As investors warm to the idea of this new profit paradigm, he says valuations should rise and the stock market should benefit.