Can the Stock Market Possibly Do Any Better?
The S&P 500 has rallied more than 16% so far this year and many investors are now suffering from acrophobia with the market now at all-time highs, fearing that a major decline lies ahead. While a “correction” could come at any time for any reason, or for no reason at all, economic fundamentals provide excellent support for the stock market. We are quite confident, even certain, a bear market lies in our future. But with no recession on the horizon, it is our judgment that any sudden market decline would be a buying opportunity. For the moment, we believe stocks will continue to perform well, especially if some version of the various tax reduction bills is passed by Congress. In contrast, we still view the bond market as overvalued and ripe for significant declines.
Stocks have performed very well over the past few years, not just in 2017, but they merely reflect the solid performance of the economy and corporate profits. Although politicians love to disparage the performance of the economy, especially when they are out of power, the truth of the matter is the unemployment rate is now down to 4.1% and it’s headed even lower. If a declining unemployment rate doesn’t reflect good economic performance, nothing else would. (And we all know that politicians are not the most truthful characters around.)
Corporate profits have also hit all-time highs. According to FactSet, S&P 500 profits are expected to hit $131.20 share for 2017 and rise to $145.40 per share in 2018. Yet, most analysts make no allowance for the possibility that corporate tax rates might decline. It seems reasonable to us that some reduction in corporate tax rates is likely, even though the precise outcome must await the political wheeling and dealing taking place behind closed doors in Washington. A 10% cut in tax rates, if applied to 2018, could easily increase after-tax profits by close to $15 per share. So we think 2018 profits could come in higher than is currently expected.
Historically, bear markets are caused by economic downturns. To use an extreme example, the major stock market decline of 2008 occurred as part of the severe recession of the same period. In the absence of recession, when corporate profits routinely take a serious tumble, market declines tend to be brief, even if they are sharp. You can think of the sharp decline following the Brexit vote in the U.K., which only lasted a few weeks before being totally erased. So the critical question for investors is whether the U.S. economy is ripe for recession?
It remains our judgment that economic growth will continue at around 2.5% annually, with commensurate positive effects on corporate profits. There are no disturbing imbalances visible at this time in our economy, like the housing market in 2007. Overseas, economic recovery has taken hold in Europe and Japan, with positive effects for U.S. exports and increased profits for the foreign operations of domestic companies. In fact, all top 10 economies of the world are sharing a globally synchronized expansion, even if the U.K. and India’s economies are taking a few hits. It is a safe bet this will not continue indefinitely. In fact, it is a certainty. All good things come to an end. But it is unproductive to fret whether the end will come in 2019, 2020, or 2025. Without a trigger or some imbalances or high and rising interest rates or a surge in oil prices, an end to the market rally in 2018 seems unlikely or visible right now. No doubt, this will change at some point. But right now, the road ahead seems clear and stock prices should continue to rise.
In contrast, the road ahead seems darker than is commonly perceived for the bond market. The low unemployment rate cited above suggests that the risk of inflation should not be dismissed, even though that seems to be the fashion of the day. Rising interest rates are needed to contain these expected inflation pressures. As long as inflation increases slowly, interest rates can also rise quite gradually. But the game will change quickly if inflation picks up more sharply. Fed officials understand this and they are likely to hike rates slowly until inflation becomes more visible. They have even suggested they could postpone some rate hikes if inflation doesn’t worsen. So it remains our judgment that the bond market is at more immediate risk than the stock market, even if a falling bond market eventually creates problems for stock valuations. Until then, it seems like sticking with stocks remains the place to be invested.
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