Crazy Stock Valuations – Maybe Not

Stocks have been in rally mode with the prospects of fiscal policy aimed at generating stronger and more consistent U.S. economic growth, especially corporate tax cuts.  This rally comes as corporate earnings are trying to recover from a contraction phases started over two years ago.  Earnings have improved in Q4 but there’s worry stocks are overvalued.  A better understanding of what is driving current valuations may reduce anxiety for those investors looking to put new money to work.

Before we dig into current factors driving stock market valuations it is important to recognize the S&P 500 P/E ratio has spent consecutive years at levels considerably higher than they are today, as illustrated in the graph below.  Stocks have only just become slightly more expensive than their 20-year average.  The influence during the late 90’s is significant but it is reasonable to believe this is the current value range for the U.S stock market and we could test much higher levels before a decline.

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The current P/E for the S&P 500 is 17.6 based on estimated operating earnings.  This is the highest the ratio has been since 2004 as reported by the Wall Street Journal.  For a better understanding of the current environment we need to look at what’s driving today’s valuation.  Let’s begin with the price of oil and its impact on earnings from the energy sector.

Economist have been plagued by wild swings in the price oil price over the last couple of years.  Companies in the energy sector have been hit particularly hard, driving down their earnings.  This has pushed the energy sector P/E ratio up to around 30.  If you exclude the energy sector from S&P 500 earnings it falls to a more palatable 16.6.  Indeed, an earnings recovery from energy companies should help bring the S&P 500 P/E ratio down.

Interest rates are another important factor in the current environment driving valuations for the stock market.  Low rates tend to drive valuations higher because future earnings are worth more when discounted back into today’s dollars.  Said another way, the present value of future earnings are higher when interest rates are low.  Cheap debt has also boosted profit margins and there is reason to believe this will continue.  The Fed may have started the process of raising rates but they still trail the rate of inflation.  There is likely a cap on how high rates will go because of the costs imposed on the federal budget to refinanced and service new debt.

Low interest rates have pushed every sector of the S&P 500 to elevated levels but nothing extraordinary. As the chart above illustrates, it may be premature to act as though this market is too expensive for stocks to continue to advance.  The most expensive sector after energy is Consumer Staples, hardly what you would expect from an overheating market.

Right now investors expect oil prices to stabilize leading to improved energy sector profits.  In terms of interest rates, inflation is expected to remain subdued providing cover for slow rate hikes by the Fed.  Investors shouldn’t be surprised if this market continues to advance for a considerable period if those factors follow their expected paths while the Trump administration works on implementing their fiscal stimulus plans.

Is The Stock Market Rising Because Of Trump?

There’s a lot of talk in the financial media about the stock market being overvalued and at risk of a correction.  It is not all Trump talk driving markets higher, an improved earnings environment has also contributed.  Approximately 71% of S&P 500 earnings have reported Q4 2016 earnings and they are on track to deliver two consecutive quarters of growth for the first time since Q4 2014 and Q1 2015.  52% of reporting companies for Q4 have beat their mean revenue estimate for the period. (Factset Research)

An analysis of corporate earnings calls suggests many executives are evaluating the potential impact of President Trump’s policy agenda on their businesses.  The biggest cited policy topics were tax related followed by regulation and trade.  Investors have been bullish on Trumps pro-growth policies since the election and corporate boardrooms are now actively factoring them into their planning.

We are also at a unique point in history where innovation is accelerating and entrepreneurs are hungry to commercialize new ideas.  For this reason investors should be prepared for an even stronger rally if conditions in Washington D.C. improve.

You would have thought the stock market rally had come to an end with all the negative reporting on the new President.  The novice immigration executive order along with different groups unhappy with the new President is a less than ideal way to get started.  Fortunately for investors the market has looked the other way and once again moved to new high ground just last week.  The most recent consolidation is much shorter than the 6+ week period back in December-January.

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Market behavior is the driving factor in what investors are currently experiencing.  This behavior, should it continue, has brought to mind the “irrational exuberance” phrase coined by Alan Greenspan in the late 1990’s, a period where the Nasdaq P/E ratio reached a high in the low 40’s.  The current twelve-month trailing (TMT) P/E ratio estimate for the S&P 500 is 23.6 based on GAAP earnings and 20.2 based on operating earnings (Stockcharts.com/Decision Point). Indeed, stock prices are elevated based on historical averages but earnings growth for 2017 should help stocks continue to rally if those earnings are ultimately realized.

Recent economic data has once again suggested we could be on the verge of a recession, a characteristic that has been with us for much of the Great Recession recovery.  It appears the window may be narrow for President Trump to shift the U.S. economy into a higher gear.  Employment, while improved, is well below potential when you take into consideration workers that left the workforce.  Under employment is also a problem.  Here too we have the potential for improvement to increase economic activity as consumers feel better about their futures and become willing to spend more.

Let not forget about the loose money monetary policy of the last 8 years.  There is a lot of money in the world today and it is looking for a return.  It is a feedback loop which often defies logic and reason for a time.  Continued earnings improvement and actual passage and implementation of some pro-growth economic policies should provide a runway well into Trump’s first term.

There is also legitimate concern at the potentially negative effects of some of President Trumps economic policies, for example a protectionist policy relating to trade.  There is also the potential an unwelcome level of inflation will materialize from stimulus efforts.  It may also turn out he is not able to get much accomplished.

There are other risks too.  President Trumps political inexperience has already dealt him an embarrassing set-back and his outsider position has placed him at odds with both political parties and the media.  Combined with his abrasive personality and lack of self-control this entire environment could change quickly.

We have started to see the President relax his stance on some initiatives which is a good sign even if it may disappoint some supporters.  In the end compromise is what is needed to forge policy in our government.  The President will need to maneuver skillfully if he is going to be able to push through his economic agenda.