Holiday Fluff? (12/20/2016)

Since Donald Trump’s election victory, the stock market has risen in a significant way. At the same time, bonds have tanked! What does this mean?

Let’s begin with the easiest explanation. Bonds behave like a see-saw; when interest rates drop, bond values climb. When interest rates increase, bond values fall. What has been happening over the past two months is that interest rates have moved sharply upward. This appears to be happening for two reasons: the first is that inflation is becoming a factor in the economy again. The second is that the Federal Reserve is planning on raising its targeted rate on a more regular basis. The good news is that future bond purchases will result in higher earnings. The bad news is that most of the earnings received earlier in the year have been lost with the rise in interest rates. Bonds are still an important part of your portfolio; even with this slide, they are safer investments than stocks.

How about stocks at this time? Markets, as we have shown in the past, are not rational. To paraphrase Allen Greenspan, former chief of the Federal Reserve, markets can show unfounded exuberance. A year ago, the trailing price earnings ratio (P/E) was 22.65. That seemed high to me then. It has now increased to 24.98, and seems lofty by historical measurements. Perhaps more telling is that the estimated future earnings P/E ratio has gone from 17.19 last year to 19.06 now. As the prices of stocks continue to rise, and as it does not appear that corporate earnings can keep pace with inflating stock prices, these multiples make less and less sense.

When examining the stock market from a fundamental approach, we have some clear facts. The most likely reason for the stock market exuberance is that President Elect Donald Trump is filling his cabinet with pro-business appointees. This seems to signal that many of the restrictions on business will either be reduced or eliminated. The thinking is that this will make businesses stronger, more profitable and with a greater willingness to grow. Some serious headwinds will be facing U.S. business. The Federal Reserve has increased the discount rate and has indicated that they will do so again in 2017, taking the rate up another 0.75% to 1.25%. This is significant since the cost of borrowing will increase on mortgages, credit cards and business loans, to mention a few. The higher interest rates are out of sync with the rest of the world, where rates remain very low. To obtain the high rates found in the U.S., money from around the world is being invested into U.S. debt and bonds. All of this new money has driven up the value of the dollar. The higher dollar value means that international U.S. goods and services are more expensive than our competition. With interest rates rising, the consumer may find less reason to spend. This would slow the economy. Business earnings could also be hurt by a slowdown of US consumer spending and the high value of the dollar. Finally, inflation could rear its head in a dramatic way. With unemployment at a low, it is possible that any stimulus by the new administration could put considerable strain on wage increases while also increasing the national debt further.  

The above review of the current state of the stock market makes me wonder if current prices can be sustained. It seems to me that a correction might occur, taking stock prices down to a lower level. I also think that we might see considerably more volatility in the stock market going forward, with the new administration attempting to change rules, regulations and relationships. The bottom line is that broader portfolio diversification appears to be the answer.

Ed Mallon

December 20, 2016