The Trump economy is cracking—GDP growth is on track to top 3% for three quarters running. We haven’t seen that since 2004, and the Dow Jones average has just pierced 24,000.
Privates businesses are optimistic and poised to invest with passage of the tax cuts. They have broken free from the Obama era pessimism about free markets and capitalism.
This has big consequences for ordinary investors. Even with stocks up overall more than 20% , this is no time to sell.
Here is a broader look at the economy and what it means for you.
In the new millennia, the U.S. and global economies have undergone radical change. Bellwether companies like GM, Proctor & Gamble and GE have endured wrenching adjustments but American businesses remain well positioned to profit from the next wave—robotics, artificial intelligence and electric vehicles.
For 2018, the global economy and international commerce are poised for a strong year. Most of the highly sought global brands—and most robust high tech businesses—remain American. Firms like Apple and Netflix will profit.
Much has been made of the Trump effect but so far, the economy has been in a policy neutral environment. Mr. Trump’s promises on taxes, infrastructure and immigration reform have yet to materialize and deregulation is still in its nascent state.
Most fundamentally stock market gains have been paid for with profits growth. Currently, the S&P500 is trading at about 25-times earnings—just about what it was a year ago and roughly in line with its 25-year average.
Analysts are forecasting earnings growth exceeding 10% over the next three quarters. That puts the 1-year forward P-E ratio at only about 18 and makes another jump in stock prices wholly possible, especially if the Senate and House can agree on a tax bill with a significant cut in corporate rates.
Importantly, inflation remains in check. Federal Reserve Chairman designate Powell is expected to continue Chairman Yellen’s policy of slowly raising interest rates and shrinking the Fed balance.
Even with somewhat higher interest rates, the P-E at 25 implies a rate of return on stockholder invested capital of 4% on shareholder equity, and investors can’t get anywhere near that on long-term Treasuries or CDs.
Over the last 25 years, the return on the S&P 500 has averaged 11% but long-term Treasuries only about 3%. With double digit gains forecasted for earnings, the fundamentals support stock performance relative to bonds in line with those metrics—perhaps a lot better.
In this century, new value creation is premised much more on intellectual property—for example, computer apps that create companies like Lyft and artificial intelligence that make physicians more productive and support labor saving innovations in factories and across the services sector. Hard assets—in particular, industrial buildings and factory equipment—are less important.
Google was launched with only $25 million in 1999 and grew into a $23 billion enterprise at its initial public offering five years later. Whereas Henry Ford had to build out a network of factories and dealerships—requiring a lot more capital and time to accomplish similar growth.
This is an important reason why established companies are flush with cash—they simply need to spend less on new buildings and hardware to improve productivity, expand product offerings and launch new ventures.
Lower capital requirements coupled with an abundance of investable funds are pushing down the rate of return needed to attract new capital into business ventures. In turn, that pushes up the P-E ratios equity markets can sustain.
For stocks overall, a long term P-E ratio of 35 now seems reasonable. However, in the near term, markets are driven by psychology as much as economic fundamentals, and the success of the Trump Administration at implementing a pro-growth tax cut and deregulation are critical to establishing a positive tone for 2018.
Asking me how the stock market will do—near term—is akin to asking whether Senator McConnell can cobble together a tax bill that satisfies 50 Republican senators and a majority in the House. Issues like the future of deductions for state and local taxes and the size of the personal income tax loom as large as prospective P-Es.
All this said, a P-E ratio of 30 to 35 would support an S&P of 3100 to 3500 even at current earnings.