IS HONEYMOON OVER WITH THE ‘TRUMP RALLY’?
Don’t assume the U.S. president’s hot air will cause a market fail, writes Joe Chidley.
Is the Trump rally over? The minor sell-off in global equities this week might suggest that the honeymoon between U.S. President Donald Trump and stock markets has run its course. Trump seems to be running into roadblock after roadblock (some of which he installs himself ), most lately in the form of uncertain Senate approval of the Obamacare replacement plan he’s backing.
As his administration blames, shames, prevaricates and complains, Trump is looking weak, and his promises of tax cuts, infrastructure spending and deregulation seem increasingly uncertain. Investors who’ve been counting on that policy trifecta to boost growth and corporate earnings are now — with Trump’s approval ratings drowning in the swamp — having to temper their expectations.
That, at least, is how the political uncertainty storyline goes. Underlying it is an assumption that stocks have been rising on political pixie dust: take Trump’s hot air out of the markets, and they wither like a pin-pricked balloon.
Two things about this assumption: First, if the fate of the markets is inextricably tied to the political effectiveness of Donald Trump, then God help us all. And second, assuming that a Trump fail will lead to a market fail might be overdoing things a bit, at least when you look at metrics, history — and how low interest rates are.
Granted, on the surface, there are signs that stock markets entered unsustainably lofty territory this year. Didn’t the Dow Jones industrial break through 20,000? Didn’t the S&P 500 and, here at home, the S&P/TSX composite index hit record highs? Price-to-earnings ratios for the major indexes seem to strengthen the bubble case: the Dow’s P/E has risen to 21 from about 18 a year ago, while the S&P 500’s has been nearing 25 (it was 23.6 a year ago) and the TSX’s has already cleared that mark.
But you have to put your money somewhere, right? The real question isn’t whether stocks are risky at current valuations, but whether current valuations are likely to compensate you enough for the risk you are taking on by buying them, versus owning something that is less risky.
One back-of-the-envelope way to address that question is to look at earnings yield — the inverse of the price-to-earnings ratio. A higher earnings yield is, generally, better than a lower one, in the same way a low P/E is “better” than a high one. But looking at earnings yield alone doesn’t answer the risk question, really. Comparing it to the yield you could expect from a (nearly) risk-free asset, like 10-year U.S. Treasury bonds, gives you a much better idea of how risky owning the stock is.
So where are we at now? Let’s just look at the S&P 500, a reasonable proxy for North American markets. With a P/E of 24.89 (as of March 17), its earnings yield is about four per cent. By historical standards, that is pretty low. According to Aswath Damodaran, a professor at NYU’s Stern School of Business, last year the S&P 500 yielded 4.86 per cent; a decade ago, its yield was 5.62 per cent; way back in 1974, it was 13.64 per cent. In the late 1990s and early 2000s, during the dot-com mania, the S&P 500’s earnings yield was lower than it is now — yikes. It was also below five per cent in the early 1990s, as the U.S. was recovering from recession — but the market did not crash.
So by historical standards, there might be cause for pause. But these are not historically consistent times, at least when it comes to the pricing of risk. Interest rates remain at historic lows, and that makes even low yields from equities look more attractive.
With a 10-year Treasury yield at 2.4 per cent, investors in the S&P 500 are getting a risk premium of 1.6 per cent. Is that enough? Well, a year ago, the premium was higher — about 2.25 per cent — because the earnings yield was higher and rates were lower. But compared with other historical periods, the 1.6 per cent premium looks positively golden. In the mid-1980s and the late 1990s, Treasury yields were higher than S&P 500 earnings yields, so in a way stock market investors were earning less for taking on more risk. And through much of 2007, as the global financial crisis was taking shape, the S&P 500 risk premium was significantly smaller than it is today.
The difference between now and then is that even though earnings yields are low, so are bond yields — and they still will be even if the Fed raises two or three more times this year. By that measure, U.S. stocks don’t look particularly overpriced, and the same analysis suggests that Canadian stocks aren’t either.
That doesn’t mean they’re cheap, nor that investors shouldn’t consider looking elsewhere. European and Japanese markets currently have higher earnings yields and lower bond yields than either Canada or the U.S., which suggests there might still be value there.
In the end, though, the question of whether the price is right for stocks is a relative one, and metrics only tell part of the story (the part we’ve already heard, more or less). No one knows what’s going to happen tomorrow. Just ask Donald Trump.
Investors who’ve been counting on (Trump’s policies) to boost growth and corporate earnings are now ... having to temper their expectations.