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(The opinions expressed here are those of the author, a columnist for Reuters)
By James Saft
April 3 (Reuters) - The Trump reflation stock market rally has two inter-related problems: Trump and valuations.
The Trump administration’s inability to force through its healthcare bill underlines the risks of a similar failure to deliver tax cuts, infrastructure spending and deregulation. With stock market valuations at historically high levels, and with the Federal Reserve raising interest rates, this is a major vulnerability.
The central thesis, supposedly, behind the post-election rally in risk assets was that Republicans, controlling the executive and legislative branches, would force through policies which would not only raise growth but improve the way that growth translates into corporate bottom lines.
That may yet happen, but with the ratio of price to sales for the S&P 500 index at an all-time high, and with the price/earnings ratio on 10 years of earnings at a level not seen since the dotcom bubble was bursting, there is little room for error.
“These all are nose-bleed levels. However, they may be justified if Trump proceeds with deregulation and succeeds in implementing tax cuts. His policies may or may not do much to boost GDP growth and S&P 500 sales. Nevertheless, they could certainly boost earnings,” market strategist Ed Yardeni of Yardeni Research writes.
“The risk is that Trump’s victory activated a melt-up mechanism that has nothing to do with sensible assessments of the fundamentals or valuation.”
Certainly there has been a notable divergence between sentiment-based economic indicators, like consumer and small business confidence, which have surged, and those harder figures which record actual money changing hands. The GDPNow forecast from the Atlanta Federal Reserve sees first-quarter U.S. economic growth of just 1.2 percent.
To be sure, sentiment can create its own reality but analysts are revising earnings forecasts upward now at a slower pace then they were before the election, when a corporate tax cut and foreign cash repatriation holiday were little more than a fond hope.
Expecting corporate America to suddenly start a virtuous cycle of investment, employment and growth before they are encouraged to do so by policy change is simply silly. Expecting that policy change to happen under current management is risky. Expecting it to work if it does happen is a speculation.
There is also the fact that a growing number of Federal Reserve policy-makers are noting that valuations are high, indicating that perhaps, for once, they may actually start to figure them into their interest-rate-setting calibrations.
Boston Fed President Eric Rosengren last week said some asset markets are “a little rich,” citing “rich asset market prices” as a reason for the Fed to tighten more quickly. John Williams of the San Francisco Fed also noted that the stock market specifically “may be a little frothy.”
Williams, who like Rosengren is not a voting member of the Fed's rate-setting Federal Open Market Committee this year, also said the market “kind of got ahead of reality” on fiscal policy hopes.
It is possible that the market is confirmed and its rally extended by fiscal and economic policy, but also possible that the Fed surprises with faster tightening in part to keep markets from extending themselves too far.
No matter how things play out, one fact remains: valuations are at levels which in the past have delivered poor future returns.
On some measures median valuation levels are at all-time highs globally, and are in a zone which suggests future returns only very marginally better than bonds.
“Higher valuations do however have a very good record of predicting future returns,” Andrew Lapthorne, quantitative strategist at Societe Generale in London writes.
“If you think an excess total return over bonds of less than, say, 2.0 percent (i.e., less than the dividend) is sufficient compensation for holding much riskier equities then today’s valuations might be okay; if you think equities deserve a risk premium then you have a problem.”
That is the bet stock market investors are collectively now making, and it is hard to see it coming good without the Trump administration bringing to reality a substantial portion of its various promised or suggested programs. Given that the last comprehensive U.S. tax reform was carried out by the Reagan White House in 1986, a much different time with a much different and more cohesive Republican Party, this is a long-shot bet.
Expect tax reform to be piecemeal and designed to deliver easy wins like foreign cash repatriation. Much of that will find its way back into the stock market via share buybacks.
A reflation, a pushing higher of growth and inflation back towards 20th-century norms, is far less likely. Stock prices should, and ultimately will, reflect this. (Editing by James Dalgleish) )