Is the Stock Market Too High? (11/2/2017)

People are asking me lately whether the stock market is at or near a peak. Of course, I was also getting this same question at the beginning of the year.

Several elements appear to be pushing the market to ever increasing highs. The first and foremost is the economy, the second is low unemployment, and the third is a possible tax cut for corporations by year end.  During the second quarter the economy grew by 3%.  The Federal government has recently reported that the economy grew by 3% again in the third quarter.  Back to back growth of 3% shows that there is momentum in the economy. The growth in the third quarter was unexpected, given the serious weather and fire issues that impacted the southern and western parts of the country during the quarter. To understand what is happening to GDP, we need to remember what makes up GDP.

Four core elements together make up GDP. They are: personal consumption; business investment; government spending; and net exports. A very important part of GDP is personal consumption, which accounts for about 70% of total economic output. With very low unemployment, the median wage rising to over $58,000 annually, and the opportunity to change jobs, the consumer has been more willing to spend money and increase consumption. As the consumer has been more willing to spend, businesses have been using the cash that they’ve been hoarding for years, and are investing into new production and new real estate ventures. This accounts for about 14% of GDP. The U.S. Government continues to spend and accounts for about 18% of GDP. Changes in exports, the last element, has been negative for many years.  Because we are a service economy, and these services can’t be exported, we are importing more than we export. One of the big import items continues to be petroleum. During the last two quarters, this difference between exports and imports has shrunk, making this a net positive for GDP.  

Congress is attempting to reform taxes.  Such reform will be difficult to do for individuals, but is necessary for corporations, in order for the U.S. to remain competitive. The stock market is taking this into consideration in valuing stocks. Lower corporate tax rates translate into higher corporate earnings, thereby allowing corporations to make large investments, pay higher dividends to stockholders, and pay higher wages to employees. Because stocks are priced based on current and future earnings, such a tax reduction is bullish for stocks.

Above is all the good news. The bad news is that since so much of the “good news” is already priced into the stock market, a slip in earnings, a rise in unemployment, or the lack of corporate tax reform could trigger a correction in the market. A correction is a downward movement of the market by about 10%. We usually have one or two of these each year. We have not had one this year and the last one was for 7% last year. This is my way of warning everyone that the likelihood of a correction is getting greater.  Don’t worry when it happens. The fundamentals of the economy seem to be very good and should continue well into the future. In addition, a well-diversified portfolio is not reliant solely on just the U.S. stock market.

Ed Mallon

November 1, 2017