August 2018 Comments: Current Financial Markets

Victor Levinson Comments

US stock prices have continued to rise, reaching historic new highs last attained in late January 2018, while bond prices have stabilized, resulting in positive returns. These currently favorable financial market results have occurred in the context of the following presumed negatives:

  1. New tariffs (see July Comments) on China and other parts of the world;
  2. Expectations that the Federal Reserve will continue raising short-term interest rates;
  3. Problems in various countries, ranging from China, to Turkey and Greece, to Britain’s “Brexit” outcome;
  4. President Trump’s new and ongoing legal and political problems;
  5. Historically high Price Earnings Ratio (25, using trailing 12 month earnings; see article on the ongoing US bull market in stocks in The Economist, 8/25/18 print, page 62).

It is fair to ask how this combination of favorable current results in the US is taking place, even with all the negatives. As our regular readers know, we are highly skeptical of attempts to explain short-term movements in financial markets, but we think the current situation calls for some effort to explain.

While not answering the question directly, Jeff Sommer’s NY Times article (9/1/18, page BU3) sheds some light on the positives that might be supporting these market moves:

“While the stock market has been hot lately, warnings of trouble ahead have been multiplying….But what if the good times that are evident in important sectors of the markets and the economy just keep rolling, at least for a while? That bullish possibility has arguably been underplayed, given the strength of the current numbers… Consumer confidence has soared to levels unseen since October 2000, and the US economy’s annual growth rate, 4.2% in the second quarter, was the best in nearly four years, while the unemployment rate (3.9%) hovers near its lowest level in decades. That statistical snapshot depicts a stock market and an economy that are prospering.”

So perhaps this solid economic growth is one reason supporting the current favorable financial market results. Sommers’ article continues to discuss potential pitfalls to the favorable scenario, and also the political implications of the current apparently favorable economy. The article concludes with a quote from a well-known independent stock market analyst, Edward Yardeni, who describes himself as a “conservative-leaning fellow”: “On contentious issues, from tax cuts to trade disputes to deregulation, financial markets have been giving quite a bit of weight to the possibility that this will all lead to less protectionism and greater global prosperity.”

Two other articles appearing in the NY Times (9/8/18, Business Section), make different points regarding the strong US stock market. The more cautious view comes from another Jeff Sommer article (NYT 9/8/18, page BU4), which states that “there has been a disconnection between stock markets and economies around the world, with stock markets generally outperforming their economies…but the US stands out.  There’s a much greater degree of [stock] outperformance and disconnection from domestic economic growth.” The article observes that the US GDP grew 38% (unadjusted for inflation) from Dec 2007 through August 2018, while the S&P 500 index has nearly doubled, but “that does not mean the American stock market will necessarily fall soon. It is being supported by several macroeconomic factors, aside from cash inflows from foreigners. Corporate profits, supported in part by tax cuts, and relaxed regulations and low interest rates, have been rising more rapidly than GDP, while wage growth has been constrained.”

Our note: rising corporate earnings tend to support higher stock prices by essentially lowering the historically high Price Earnings (P/E) ratio closer to its long term average of approximately 15. On the website “Seeking Alpha,” projected S&P 500 earnings to year-end 2018 are $145, which would mean a P/E of 20 using the current S&P value of 2,900. The next twelve months showed a projection for earnings increasing to $155, suggesting further earnings support for current S&P levels. Of course, relying on projected earnings is a dangerous proposition, but is done regularly by Wall Street analysts and prognosticators.

The second article, written by Neil Irwin (NYT 9/8/18, page BU5), discusses the favorable possibility that the US economy may increase its productivity, “allowing for faster output growth and lower unemployment without serious inflation risks,” drawing a parallel to the mid-1990s, when a similar set of positive conditions converged.

Given all the countervailing factors impacting the financial markets, we stick by our usual advice to maintain your asset allocations, and consider re-balancing if one part of your allocation gets too high.