Are Equities Primed for a Fall?
My weekend reading included a number of articles arguing either that stocks were primed for a sharp decline, or were likely to continue advancing, sometimes within the same publication. (At least this did not occur in the same article.) Investors often ask how we see this question. In fact, we remain fairly positive on the outlook for stocks and quite bearish on the outlook for bonds.
Stocks are likely to advance because the economy, corporate profits, and profit margins should all improve over the coming quarters. Moreover, the risk of a recession appears to be quite low for as far out as we can see, (which is, admittedly, not very far). Solid economic growth, even if some consider it sluggish so they carp about it all the time, is more than sufficient to keep growing those corporate profits, which are one of the most important constituents, arguably the most important, in equity valuation. Stock multiples are slightly high because profits are advancing so nicely. And as long as that continues, there is little reason for any market setbacks to be anything other than mild and temporary.
Other lesser considerations are also heavily supportive of stock price appreciation. Economic growth prospects around the world have improved considerably over the last year or so, most importantly in the large advanced economies of Europe and Japan. More growth in these economies implies increased demand for U.S. exports. Similarly, ongoing U.S. economic growth spills over into increased U.S. demand for their exports. This is mutually self-reinforcing. Inflation and interest rates are also low and provide a solid tailwind for growth.
Yet despite all these positives, investors remain somewhat fearful and cautious either because they remember the damage caused by the credit crisis in 2008 or because they see new highs in the equity market seemingly every day. But as a direct consequence, investors have reduced their equity exposure, which appears as net equity sales in the Flow of Funds statistics, and hold plenty of cash. It is for good reason this market rally has been dubbed the most hated bull market in history. But, the equity market tends to scale a wall of worry and investors remain worried, which only sets the stage for more advances. It is very painful sitting on cash while the market is rising.
Due consideration must be given to the bear case in order to remain comfortable with a positive equity outlook. Most commonly, bears cite the Shiller CAPE (cyclically adjusted price earnings multiple), which is now just over 30, a level exceeded previously only in 1929 and 2000, as a reason for caution. This would be a more compelling argument if the CAPE were a respectable indicator of stock pricing. In fact, its history falls somewhere between dismal and atrocious. The only time the CAPE suggested stocks have not been overvalued in the last 25 years was in 2009, when it implied that stocks were fairly valued. Stocks have tripled since then. Any measure that works so badly over 25 years, which is roughly half a single person’s entire investment lifetime (assuming a person invests between 25 and 75), cannot reasonably be used to make investment decisions. Even so, the CAPE is likely to decline considerably over the next two years, since the depths of the 2008 recession will soon drop out of the 10 year calculation, which reveals its weakness. It is inherently backward looking, notably very far back, instead of forward looking. Moreover, the market trades at around 17 times 2018 earnings, the more traditional and battle tested valuation approach. The market may not be cheap, but it is also not blatantly expensive. And it will suddenly become meaningfully cheaper overnight if tax rates are reduced at all.
Prospects for tax reform could be very important for the stock market over the coming quarters, since any meaningful reduction in corporate tax rates will reduce market valuations. In round numbers, each 1% reduction in tax rates would increase S&P 500 profits by about $1.50, which at a P/E of 17 adds about 25 points to the S&P 500. That’s sizable. Moreover, any amount of tax reform would promote somewhat faster growth and larger gains in corporate profits. Such gains would be entirely incremental. On its current trajectory, without any tax reductions, the stock market should be fine, even if its gains are more modest.
The greatest risk we see for the market is the possibility of an overly stimulative fiscal policy that exacerbates labor shortages, raises inflation, increases the federal debt, and forces the Federal Reserve to hike interest rates faster. There is considerable opposition to unbridled deficit spending. But in general, politicians are not well known for being fiscally responsible. So this bears watching. Taking all considerations into account, a solid case can be made for equities with a symmetrically negative case for bonds.
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