The U.S. economy and the stock market have come a long way since the financial crisis in 2008. Now that the election is over and Donald Trump will be taking over in the White House, investors are trying to figure out what a Trump presidency will mean for financial markets.
The Standard & Poor’s 500 index is up more than 200 percent since March 2009, and it hasn’t made a deep correction at any point in nearly eight years. That type of extended run understandably has some investors uncomfortable about the future.
The S&P 500’s cyclically adjusted price-earnings ratio sits at 27.2, its highest level since 2007. The CAPE ratio is a long-term market valuation metric that incorporates a decade of corporate earnings to smooth out short-term cyclical fluctuations. The higher the CAPE, the more expensive stocks are. The S&P 500’s CAPE has only been higher than 28 two times in history – just prior to the Great Depression in 1929 and during the peak of the dot-com bubble in 2000.
Even Trump himself has raised concerns about the likelihood of stock-market bubble.
“When they raise interest rates, you’re going to see some very bad things happen because they’re not doing their job,” Trump said of the Federal Reserve during the first presidential debate in September. “We’re in a big, fat, ugly bubble.”
Trump isn’t the only person that sees a link between a record-high stock market and the extended period of record-low interest rates. Some investors believe that the S&P 500 bull market has been driven in large part by the Fed’s policies. The argument is that investors haven’t been buying stocks simply because stocks are cheap. They have been buying stocks because there are few reasonable fixed-income investment alternatives out there.
The yield on 10-year U.S. Treasury bonds is only 2.35 percent. Ten years ago, it was 4.45 percent. Twenty years ago, it was 6.26 percent.
Savings account and certificates of deposit rates are even worse. The current national average interest rate for a five-year CD is only 1.73 percent.
When Japan, Switzerland and other nations opted to drop interest rates below zero, even more international investors were left with no good options. Yields on 10-year German government bonds even dipped below 0 percent in 2016.
According to Trump, the money that low interest rates have driven into the equities market has created a stock bubble. Fortunately for investors, not everyone agrees with Trump’s take.
“There is no doubt low rates have encouraged investment in stocks and pushed prices up,” says Brad McMillan, chief investment officer for Commonwealth Financial Network.
“Whether or not this is a bubble is questionable,” he says. “While valuations are high by historical standards, you can make a reasonable case that under current conditions they are still supported.”
Thomas Lee, head of research portfolio strategy at Fundstrat, says there doesn’t seem to be an obvious bubble in stock valuations.
“I don’t think the S&P 500 is in a bubble – it is simply not reflected in valuations (16X forward [earnings]) and in earnings power. Margins are not at all-time highs,” Lee says.
Rithholtz Wealth Management portfolio manager Ben Carlson also stops short of using the B-word. “Valuations are far above average, but I don’t think you could call this a bubble,” he says.
Unfortunately, there’s no way to know for sure whether low interest rates have artificially propped up the S&P 500 until the prop is removed. More than 80 percent of recently-polled economists expect the Federal Reserve to resume raising interest rates by the end of the year.
“Rates for the 10-year are in line to approach 3 percent by the end of 2017 and move to 4 to 5 percent by the end of Trump’s term,” McMillan says.
For investors worried that Trump’s prediction of a stock market crash is accurate, Lee urges investors to avoid bond-like stocks in sectors such as utilities, consumer staples and health care.
“In fact, the factors behind Fed tightening indicate a stronger economy, and in such a scenario, one wants to own banks, technology, energy and cyclical stocks broadly,” Lee says.
McMillan says investors should focus on Trump’s campaign promises of corporate tax cuts, infrastructure spending and deregulation. “Within the U.S., businesses that would benefit from less regulation, such as financials or energy, are likely to do better, while those that depend on consumer spending are also likely to benefit,” he says.
Investors certainly can’t ignore the potential negative impact that rising interest rates could have on the stock market, but Carlson says…
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