A year ago, when the market was rallying, US President Donald Trump seemed sure stock prices were an accurate measure of his presidency. Now with the Dow Jones Industrial Average off more than 4,000 points from its peak, the president is not so sure about the market’s efficiency.
Last week, Trump said stocks were a good buy, effectively endorsing the notion, long-held by many economists, that markets are inefficient. And given companies’ earnings, in Trump’s view, stocks have been oversold.
“They have record kinds of numbers,” he said. “So I think it’s a tremendous opportunity to buy.”
If stocks overshot on the way up a year ago, which it seems clear they did, the question of whether the recent plunge has also been overdone is still uncertain. A day after the president’s comments that seemed to be the case. The market soared on Wednesday (December 26), with the S&P 500 Index rising 5 per cent.
Nonetheless, a volatile market, like the one recently, can itself create more volatility and feed a sell-off by sapping investor enthusiasm to own stocks, justifying their lower prices. What’s more, slumping stocks can slow the economy by making people less confident, creating a double-whammy in bear markets, or nearly bear markets, like now.
In February, I wrote after the market’s first big plunge of the year that looked at some key factors to try to determine whether that earlier Trump Dump had gone too far. I found that it nearly had, and soon thereafter stocks rallied. The market is even lower now.
Even after Wednesday’s gains, the S&P 500 is down 14 per cent from its early October peak. So stocks should be even cheaper now? Not quite.
One of the main things pushing stocks forward in the first year of Trump’s presidency, and propping them up until recently, was sharply climbing earnings, juiced by Trump’s tax cut. The bottom-lines of the companies in the S&P 500 are expected to be up 24 per cent for 2018.
That’s not likely to be the case next year. Earnings will still be up, but only 8.4 per cent, according to current projections. Investors, of course, given the one-time boost from the tax cut, which I estimate made up about 50 per cent of the earnings growth this year, should have seen the drop coming.
Still, it’s turning out to be steeper than expected. In early October, when the market peaked, analysts were looking for a 11.5 per cent rise in profits next year at S&P 500 companies. Stocks typically trade at about 1.2 times their growth rate. So a 3 per cent drop in expected growth means stocks should be down 4 per cent from where they were in early October, based on earnings alone.
The problem is that even that lower projection of earnings growth looks overly optimistic. That’s because it’s based on the assumption that profit margins not only remain stable but rise slightly next year from 12.1 per cent to 12.4 per cent.
That’s not likely to happen. Increasing interest rates, labour costs — fuelled by a low unemployment rate — as well as higher input costs driven by rising tariffs are all likely to dent margins. If profit margins remain the same rather than rise slightly, then earnings growth will drop to about 5 per cent, snipping an additional 4 per cent off the stock market, or a total of 8 per cent.
A trade war puts even that earnings growth in jeopardy. The biggest problem is not next year, but long term. Over the past decade, the S&P 500 has had an average price-to-earnings ratio of about 15.
That implies a long-term expected profit growth rate of about 12 per cent. The S&P 500 gets about half of its sales from overseas, where those profits are rising much faster. A trade war won’t impact all of that growth.
Assume a 50 per cent chance that 50 per cent of that growth is impacted, that brings your expected long-term growth rate down to 7.5 per cent, and could imply that the S&P 500 should be worth an additional 5.5 per cent less. So we are now at 13.5 per cent.
Here’s the big one. Volatility makes stock investors less interested in holding stocks. It also increases the risk of owning stocks in the future.
Both of those things translate into a lower P/E ratio. How much? The VIX index, which measures stock market volatility, averaged 11 last year. This year the average has risen to nearly 17, though it has been about 35 recently.
The VIX is measured in percentage points. So, all else being equal, a 6 percentage point higher VIX should translate into a stock market that is 6 per cent lower.
Add it all up, and stock market values could have reasonably been expected to fall about 19.5 per cent since mid-September. After Wednesday’s rally, they are 5 per cent above that level. Like sell-offs, stock market rallies do feed on themselves.
So stocks could continue to rise, but there is no reason to count on that. The stock market does not appear to be undervalued, and it certainly couldn’t be considered a “tremendous buy”. That also means that in this as in so many other things, Trump’s judgement is flawed.