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Equity bulls enter 2017 ignoring high valuations

After seven years of stock markets climbing ever upwards, investors found a new reason to buy in November: the shock election of Donald Trump.

One oft-repeated anecdote is how the billionaire investor Carl Icahn left Mr Trump’s victory party to buy US stocks. A few days later Stanley Druckenmiller, who earlier in the year told a conference for fellow hedge fund managers to “get out of the stock market”, announced he had sold all of his gold on election night and liked sectors of the stock market tied to economic growth.

Republican control of the executive and legislative branches of the Federal government will mean tax cuts, infrastructure spending and higher interest rates, in the snap market assessment of a jumble of campaign promises and nominations set to produce the richest cabinet in history.

The shift sparked one of the biggest post-election rallies since at least 1952, according to the Stock Trader’s Almanac. The S&P 500, Dow Jones Industrial Average, Nasdaq Composite and Russell 2000 of small capitalisation stocks have all hit fresh highs since November 8.

The yield on the 10-year US Treasury, meanwhile, jumped from a low of 1.32 per cent in July to more than 2.5 per cent, as bond investors contemplate faster economic growth and higher rates ahead.

Yet is it too much, too soon, for a stock market many had judged to be expensive?

“We are cautious because gains have come so fast. In the first 100 days, will we have a clear plan for all the chatter on fiscal spending and tax cuts? If we don’t, the market will get skittish,” says David Mazza, head of ETF and mutual fund research at State Street Global Advisors.

We are cautious because gains have come so fast. In the first 100 days, will we have a clear plan for all the chatter on fiscal spending and tax cuts? If we don’t, the market will get skittish

The question does not just matter for US investors. Japan’s Topix index has matched the post-election leap of the Russell 2000, as investors anticipate a strong dollar will boost the country’s exporters.

Meanwhile, emerging markets have slumped. A strong dollar makes it harder for developing countries and companies to service hard currency debts, and has tended to be associated with weaker prices for commodity exports.

Then there is Mr Trump’s antitrade rhetoric. David Donabedian, chief investment officer at Atlantic Trust, says: “There are some unquantifiable risks that may come out of the new administration that are not so positive. The whole issue of trade policy, protectionism and diplomatic policy toward China is a huge deal and a complete unknown at this point.”

Protectionism, even if it does not impede growth, also suggests a potential shift in the economy which highlights what may be an under-appreciated aspect of the stock market boom: most US-listed companies have not been thriving.

“The average profitability of the average listed business is quite poor,” says Andrew Lapthorne, quantitative strategist for Société Générale.

Performance of the S&P 500 is dominated by about 100 very large companies. When profits are set against the value of a company’s assets, the so-called return on equity for the top five listed companies in each industry is double that of the rest (see chart).

In a sense the effect is similar to that often said to have propelled Mr Trump into office, a great number of Americans left behind by globalisation while the elite has thrived. It may be as true for businesses as it is for Midwestern metalworkers.

The whole issue of trade policy, protectionism and diplomatic policy toward China is a huge deal and a complete unknown at this point

Corporate indebtedness has also been rising, which impacts valuations. A company’s enterprise value includes both its net debt and its market capitalisation, and this figure can then be compared to a measure of profits known as ebitda — earnings before interest, tax, depreciation and amortisation.

On such an EV/ebitda basis, “the US stock market has only been this expensive during three or four months of the tech bubble”, says Mr Lapthorne.

What many investors focus on is earnings growth, which quietly resumed in the third quarter after a five-quarter streak of declines. Profit growth provides a fundamental underpinning to rising stock markets, and Wall Street analysts may soon start raising estimates for 2017 to account for fiscal stimulus.

Still, more increases to interest rates are expected from the Federal Reserve next year, which at the very least is likely to support the US currency. “The earnings recession has ended but guess what? We are going to start to hear from companies hurt by the stronger dollar,” Mr Mazza says.

And earnings growth is even more pressing to justify valuations in an environment of higher interest rates, particularly when the assumption appears to be Mr Trump can make good on his pledge of stimulative policy.

BlackRock, for example, remains cautious. “It does feel that there is a lot of work that needs to be done in the first half of 2017 to meet current expectations,” says Kate Moore, chief equity strategist at BlackRock. “The market has gotten a little excited — there is probably room for a little consolidation.”

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