Valuations, Interest Rates, and Future Returns
This bull market has lasted eight years as the S&P 500 index has returned more than 300%. US stocks sell today at 29x its CAPE ratio vs. its long-term average of 17x. That’s a 70% premium. Pricey. Some of this is due to low interest rates forcing money to chase returns. Some is due to expectations that new policies will accelerate economic growth and corporate profits and justify higher stock prices. In the first quarter, international stock markets showed strong relative performance to their US counterparts. The US market currently sells at a 60% premium to other developed markets. Pricey. The price you pay for an asset ultimately impacts your returns. Therefore, it’s reasonable to expect international returns will eventually reverse their under performance of the last 10 years.
Will the Trump Tweets Lose Steam?
The pundits on Wall Street have been telling us that the market’s sudden meteoric rise is the result of the so-called “Trump Trade.” This translates into an expectation that companies and individuals will soon be paying fewer taxes, be burdened by fewer regulations, leading to higher profits and greater prosperity. Add a trillion dollars of promised infrastructure spending and we’ll have an economic boom across virtually all sectors.
However, as yet there’s no sign of a boom; just a continuation of the slow, steady recovery that the U.S. has experienced since 2009. The latest reports show that the U.S. gross domestic product—a broad measure of economic activity—grew just 1.6% last year, the most sluggish performance since 2011. The U.S. trade deficit widened in January. Consumer spending and construction activities are weakening from slower-than-average growth rates.
The good news is that corporate profits increased at an annual rate of 2.3% in the fourth quarter, which shows incremental improvement. However, the previous three months saw a 6.7% rise in profits, suggesting that the trend may be downward.
Hope Deceives More than Cunning and Vice
It’s possible to read too much into the recent failure of health care legislation, and imagine that we’re in for four years of ineffective leadership. Markets are more concerned with the tax reform debate that will ensue in the coming months, but the surprising aspect—as with the healthcare legislation—is that there seems to have been no pre-prepared plan for Congress to vote on. We know that the Republican President and Congress want to lower corporate tax rates and simplify the tax code. In the past, this meant adding thousands of new pages. We know that there is general opposition to any form of estate taxes, but nobody is proposing which deductions would be eliminated in order to make this package revenue-neutral. There you have the battle lines: politics vs. economics.
Similarly, there have been no details about the infrastructure package, which means we don’t know yet whether it would be a budget-busting package of pork barrel projects or a real contribution to America’s global competitiveness.
Time and the Pendulum
More certain than policy outcomes is that as the US bull market ages, we are closer to a period when stock prices will go down, perhaps as dramatically as 20% or more. This is a good time to ask yourself: how much of a downswing would I be able to stomach either before panic sets in or my lifestyle is endangered? If your answer is less than 20%, or close to that figure, this might be a good time to revisit your stock and bond allocations.
On the other hand, if you’re not fearful of a downturn and your investment time horizon allows, then you should look at the next bear market the way most successful investors do: a time when stocks go on sale for the first time in a decade. People go to the mall to buy when items go on sale, and do the opposite when the investment markets go down. Applying this simple logic can be an advantage to your future wealth; if history is any indication the next downturn will be followed by another bull run.
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PLEASE NOTE: You can’t invest directly in an index. Past performance does not guarantee future performance. All investments are subject to risk, including possible loss of the money you invest. Diversification does not guarantee profit or protect against a loss. Nothing herein or elsewhere on this site constitutes investment, legal, or tax advice. For details please see Disclosure.