Trumpian Exuberance

Look at these charts.

 

What do they tell you?

Current Shiller PE Ratio: 33.27 +0.22 (0.67%)

Mean:  16.81

Median:           16.15

Min:     4.78     (Dec 1920)

Max:    44.19   (Dec 1999)

Shiller PE ratio for the S&P 500.

Price earnings ratio is based on average inflation-adjusted earnings from the previous 10 years, known as the Cyclically Adjusted PE Ratio (CAPE Ratio), Shiller PE Ratio, or PE 10.

 

Current S&P 500 Price to Sales Ratio: 2.31 +0.01 

(0.49%)

Mean:  1.47

 

Median:           1.44

Min:     0.80     (Mar 2009)

Max:    2.31     (Jan 2018)

S&P 500 Price to Sales Ratio (P/S or Price to Revenue).

Current price to sales ratio is estimated based on current market price and 12-month sales ending June 2017 — the latest reported by S&P.

 

Current Price: 2,736.39 +12.51 (0.46%)

Mean:  254.17

Median:           16.19

Min:     2.73     (Jun 1877)

Max:    2,736.39          (Jan 2018)

S&P 500 historical prices. Prices are not inflation-adjusted. For inflation-adjusted comparison, see Inflation Adjusted S&P 500.

 

Well I will tell you what they tell me?

First of the basics. The S & P is NOT the GDP. But … Equity price performance depends – at least in part – on real earnings growth, and earnings should be reflected in GDP somehow. Ignoring lead/lag effects and timing issues, the chart shows U.S. real GDP vs. the S&P 500 (both year-over-year percentage changes).

Using quarterly data frequency, the correlation of the two series since 1958 is 0.45; the correlation since 2009 is more than 0.8. The median real GDP growth is 3.2% while the median Year on Year price change for the S&P 500 is 9.3%. Since January 2009, the median real GDP growth is 1.9%, and the median Year on Year price change for the S&P 500 is 12%.

In fact, since 1950, the S&P 500 median return is 13% (average is 12%) when real gross domestic product (GDP) grows less than 3%, with the S&P generating a positive return 68% of the time. However, a good portion of those returns come during recessions — historically, the best time to buy stocks is at recession troughs. But even if we take those periods in and around recessions out of the equation and look at annual returns when GDP growth is between 1–3%, the median (and average) S&P 500 return is a respectable 7–8%. Stocks tend to like average (or slightly below average) GDP growth, (which is not strong enough to generate worrisome inflation).

Bottom line, real GDP growth has been below its long-term median while median price changes for the S&P are well above the long-term median of 9%, i.e., the economy is growing slower than normal, while equity prices are increasing faster than normal. While this dichotomy may continue for a while, it is indicative of asset price inflation.

Now back to the question of what has driven this stock market to far outperform economic growth. Some might say quantitative easing (QE), which ended at the end of October 2014 in the United States (the Bank of Japan expanded its QE program last week on Halloween). While QE has benefited U.S. stocks (how much is up for debate) by helping keep interest rates low and encouraging investors to buy riskier assets the bull market has been driven by much more than that. Increasing confidence in the economic recovery especially after Trump took office, and recent tax law changes have also been factors. But, the best answer is that over the past four decades, earnings have provided solid support for equity market gains see the figure below.

By highlighting the differences between the S&P 500 and GDP, i.e., the U.S. economy, to shed some light on how corporate profits can grow so much faster than the economy, and bring stock prices right along with them.

The backdrop of solid business spending within a trajectory of overall GDP growth can be a favorable one for the stock market. The economic data, while good recently, do not accurately reflect the earning power of corporate America. Stocks are fundamentally driven by earnings, which have supported the gains during the current bull market.

But, (big but), my first chart of this blog show (the Shiller P/E graph) is the clue to what is about to happen.

Price to Earnings ratios are now near a historical high – at around 33. The average and median ratios are between 16 and 17. And the highest ever ratio was 44 (right before a crash).

There is clearly much exuberance in the market! Trumpian exuberance, I call it. People should NOT forget that Trump filed for bankruptcy 4 times. He was ‘exuberant’ himself.

But the fundamental prognosis is that this bubble, will last least another 6 to 9 months right up to mid-term elections (Trump and his party will pull every trick in the book to keep it rolling so they don’t get hammered politically in November). This means the S&P index will rise another 50% and the ratio will rise to maybe the 40’s!! They call this a melt up.

But then, there is a very high probability – almost definitely – that there will be a massive melt-down. i.e. the Index will fall 50% or more. This is very serious.

And then the market will slowly work its way back to the its historic levels for the subsequent 2 years.

But, another big but, can the federal government control all this? Is it so powerful? Will the exuberance be ‘tamed’ by the fed, so that perhaps there will be some dampening of these outcomes?

One thing that we all learnt in the 2008-2009 Bush debacle, was that short of pumping in something like 10 Trillion dollars into the economy i.e. almost 50% of US GDP, the Federal Government, under normal circumstances, has very limited power to control market outcomes. They can boost things, dampen things, but NOT dictate outcomes.

If the market ‘correction’ happens before the next mid-terms (which it might), then we can all expect a war (with Iran no less). Because, short of war, Trump won’t have the economic support to get his base out to vote for him.

The huge rise in the S&P index since Trump was elected, makes the risks inherent in the U.S. economy much greater. There is some good news though, the global economy is growing at a much faster clip than the U.S. economy, so for now, many of the S&P 500 companies’ earnings are moderated by business performance outside the U.S. But this reality is NOT sustainable.  If there isn’t some sort of near term buffering in the system; otherwise we could see a crash like 2008. Markets are supposed to factor all this into prices, otherwise Trumpian exuberance might lead us all to hell.

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