With Slow Economic Growth, Are Current Stock Prices Justified?

NEW YORK (TheStreet) -- Are current stock prices justified?

Given the expectations for economic growth, somewhere in the 2.25% to 2.75% range for the next year or two, is it reasonable to believe in stock prices that are hanging around all-time highs?

Looking at current valuations, price-to-earnings ratios seem to be stretched. Price-to-earnings ratios based on forward earnings seem to be stretched. Bob Shiller's measure, the cyclically adjusted price-to-earnings ratio (CAPE) has reached a level in excess of 27.0, which is substantially above the long-term average, around 15.0 and is getting close to being at its third highest level, exceeded only by the levels reached in 1929 and 2000.

Analysts are trying to determine what might drive further increases in stock prices and the answer keeps coming back to rising earnings. Somehow, some way, earnings are going to have to rise, but with projections for economic growth being so modest, where are those increases going to come from?

Furthermore, the argument is that a large portion of the earnings achieved in the current expansion has been due to cost-cutting and not to revenue growth because of demand factors. On top of this, corporate use of accumulated cash balances to buy back stock and to raise dividends has propelled higher stock prices. These efforts are running out of steam and will not contribute as much to higher stock prices in the future as they have contributed in the past.

This analysis, however, just looks at the aggregate numbers. A lot seems to be going on below the surface and this is important for us to understand. One of the major reasons why this economic recovery has been as modest as it has been is that the United States economy (and the world's) is going through a major transition period. Some industry groups are becoming more prominent, while others are falling behind. One result of this transition is that, on average, the aggregate numbers will turn out to be mediocre by historical standards.

Looking a little more closely at what is going on in various sectors, we can perhaps learn a little more about what is growing and what is slowing down. Here we can see how the mix of the economy is changing.

Given this argument, look at the data provided by Nicole Bullock this week in the Financial Times. The article shows the year-to-date change in different sectors of the S&P 500 stock index.

The top five sector performers are health care (up 9.2%), consumer discretionary (up 5.5%), info technology (up 4.5%), materials (up 3.7%), and telecom services (up 3%). All these sectors are being driven by the changes that are taking place in American industry.

The sectors suffering the most: Financials (down 0.8%), Industrials (down 1.4%), energy (down 2.6%), and Utilities (down 6.4%). All sectors that will not be as strong in the new economic era as they have been in the old order of things.

The financial industry is changing as information technology fully infiltrates the sector and the shadow banking space becomes more and more the future of banking.

The industrial sector is suffering as new technologies take over and labor arrangements change. Furthermore, this sector is being hit by the presence of a strong dollar and how it affects exports and will be impacted even further in the future if federal government policy gets serious about maintaining a strong dollar.

Energy companies have been struck by the huge decline in the price of oil over the past year, but this seems to be only a part of the shift in world energy sources taking place globally. With the spread of fracking practices taking place worldwide and the political shifts that are accompanying this move, these changes are not going to be short lived.

The utility sector is also changing, with major technological movements expected along with substantial structural changes taking place.

The bottom line is that a lot has been going on in the economy during this economic recovery and the expectations are for further major adjustments to take place. We are not going to be able to discern these changes if we only look at aggregate data. Current stock prices are only justified if the relative sectors of the economy are correctly priced.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.

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