U.S. President Donald Trump provided no new details on the proposed tax reforms and spending plans in his speech to Congress on this week, and yet, stocks surged to new highs.
02 March 2017
Equities analysts and strategists, including myself, have been arguing for some time that if no further details were provided on how and when the proposed U.S. tax reforms and spending plans will take place, the market rally should take a pause. However, U.S. President Donald Trump provided no new details in his speech to Congress on Tuesday, and yet, stocks surged to new highs.
The only surprise we received was Trump’s striking shift in tone which was hugely different from his inaugural address and regular messages on Twitter. But is it enough to justify this rally?
What’s even more interesting is markets now consider a tighter monetary policy a sign of confidence in economic growth and thus a reason to continue purchasing stocks, when for years post 2008 crisis it had been considered the most significant motive to dump stocks.
The most asked question we receive on a daily basis is whether this rally still ‘has legs’? Well, fund flows suggest that investors are still willing to take the risk that will potentially lead to higher prices. Sooner or later however, investors will realise that valuations are what matter most in the longer run.
When looking at S&P 500 Shiller’s cyclically adjusted price-to-earnings ratio (CAPE) which is currently trading at 29.5 x earnings. This takes us back to April 2002; from April to October 2002, S&P 500 dropped from a high of 1,174 to a low of 768, a total of 34.5 percent. Since then, the Shiller’s CAPE never re-visited these levels until just this week.
Low long-term interest rates do justify to some extent higher valuations. For example, back in April 2002, U.S. 10-year treasury yields were trading above 5 percent as opposed to 2.46percent today, but as the Fed tightens more - “probably three rate hikes in 2017” - then risk-free rates will go higher and investors will require more return on their investments.
If this is the case, then expected earnings and dividends growth will be the key metrics to look for going forward. There’s no doubt that improved economic conditions, consumer confidence, and higher inflation will all lead to higher earnings growth, but what markets are currently pricing in is more than just these factors. It’s mainly about tax reforms, and assuming a reduction in the U.S. corporate tax from 35 percent to 20 percent, although difficult to calculate its impact on earnings, is expected to lift net profits from 10 percent to 15 percent, and this is what investors are betting on.
If you still want to ride the current bullish momentum wave, pray that Trump’s tax reduction plan succeeds as soon as possible. Any opinions expressed here are the author’s own and should not be construed as investment advice.
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