The stock market has been on an impressive run as of late, continuing to hit new highs, highs that are met with praise by some investors, and anxiety by others. The S&P 500 gained 8 percent from the election through the end of the year, and another 5 percent from the start of the year until mid-April. What is contributing to this?
To start with, a portion of the gain is attributable to the “Trump Bump.” During his presidential campaign President Trump vowed to reduce costly regulations and drastically lower corporate tax rates. His proposal calls for a reduction in the highest corporate tax rate from 35% to 15%, a 15% tax rate for all pass-through business entities (partnerships, sole proprietorships, S corporations, etc.), a 10% tax on repatriated cash (stockpiled cash held abroad by large corporations) and even a small reduction in the highest personal income tax bracket. Even for a company with flat revenues and an invariable expense line, a corporate tax reduction would automatically increase their profits simply because the company is now paying less in taxes. Since the market anticipated that corporate tax legislation would pass through Congress with little opposition, and since stock prices are always a reflection of expected future earnings, we saw a rapid “Trump Bump” in stock prices.
Aside from Trump’s presidency, the unemployment rate has been in decline since Obama took office, peaking at nearly 10% in 2009, and then falling to 4.5% more recently. Even the U-5 unemployment rate, which is similar to traditional unemployment, but includes able-bodied individuals who have simply stopped looking for work, has followed the same downward trend. “We are basically at full employment” says John Williams, President of the San Francisco Federal Reserve. This is a potentially bullish indicator, as historically such levels of unemployment provide leverage to the working middle-class as it pertains to wages. Higher wages provide more to the consumer, therefore greater demand for the goods and services business supplies, and therefore offer the prospect of a virtuous cycle upward of economic growth (though higher wages can also eat into profit.)
If companies make their projected earnings, the P/E ratio of the stock market (a measure of that market’s valuation) is approximately 18 as of this writing. Historically, the market trades at a P/E of around 16. So, while the market is currently trading above historical levels, it is unlikely that we are in bubble territory.
P/E ratios cannot, and should not, be looked at in a vacuum as if nothing else matters. For instance, compare stock earnings to bond market yields. While historically the market trades at a P/E of around 16, the historical real return (return after inflation) of a 10-year treasury is around 2.4%. Presently, the market trades at a P/E of 18, but the real return on a 10-year treasury is just 0.3%. Historically, investors were enticed by an annualized return of 2.4% over the rate of inflation, but are much less so at 0.3%. The appeal for bonds simply is not there, and from that perspective one could argue that stocks are undervalued.
Will stocks go up or down from here? Whatever side of the aisle you fall on, arguably, you’re right. For those who believe that stocks have dramatically overreached and are due for a correction, you’re right. Corrections are happening all the time. Stocks drop 14% on average every calendar year. The real question is, if and when this happens, will you be prepared for it, able to withstand it, and perhaps even restore or add to your stock position to enhance your long term return.
On the other hand, if you are expecting the market to advance from here, you’re also right. Ultimately, the historical trend of the stock market is upward. Of course there are setbacks; corrections and bear markets are part of investing. Sometimes they last for days, weeks, months and occasionally years. For this reason, bonds will always retain their importance as a means of preserving capital through stock market downturns.
The upward trend of the stock market has always prevailed, and the most successful investors anticipate and prepare for both setbacks and for growth, investing for the long-term. Most who have hoped to outsmart the market by waiting for when the moment is just right before investing have instead positioned themselves for lasting disappointment.
Brian Rykovich, CFP, is a Wealth Manager with C.H. Douglas & Gray Wealth Management, a wealth management firm located in Indianapolis.