The S&P 500 gained 2% last month and is now up 14% for the year. According to finviz.com, every sector registered gains, with financials and technology leading the way.
Third quarter “earnings season” is off to a strong start. According to FactSet, with 6% of the S&P 500 reporting as of October 13, about 80% of companies have reported EPS and revenue results above consensus. Even with earnings and revenue growth, it is very hard for corporate fundamentals to keep pace with this long, relentless “melt-up” which has produced uncomfortably high valuations. According to multpl.com, the S&P’s estimated trailing P/E ratio is up to 25.6. Historically, the index P/E has only been higher during periods where earnings were artificially depressed, such as 2008, and during the two years leading up to the technology bubble which peaked in 2000.
We should note that continued low interest rates are consistent with high stock valuations. Interest rates have risen only slightly compared with their rock bottom lows from mid-2016. The 10-year Treasury currently yields 2.34%. This feels paltry compared to historical norms, but it is actually quite generous by global standards. German 10-year debt yields 0.34%. Japanese 10-year rates are only 0.06%. Swiss 10-year rates are slightly negative.
Those low global rates are acting as an anchor for U.S. rates. There are many reasons why we should expect U.S. interest rates to be moving higher. After four quarter-point increases, the Federal Funds Rate currently sits at 1.25% with more tightening to come. The Fed has started “tapering” its balance sheet—buying new bonds more slowly than old ones mature. This process has only barely begun. As reported by Bloomberg’s Christopher Maloney, the current pace of tapering is $4 billion per month, a drop in the ocean. By our math, it would take over 80 years for the Fed’s $4.5 trillion balance sheet to return to its pre-crisis norms. Tapering will have to accelerate. Maloney reports that by this time next year the Fed is expected to accelerate its pace of tapering to $20 billion per month.
Currency markets seem to think the Fed has it about right. Compared to a basket of foreign currencies, the U.S. dollar has declined steadily throughout most of 2017 but perked up starting in early September. The September inflation reading was only 0.1%, exempting food and energy. We can’t live without food or energy, but September was an especially good month to ignore them due to effects of hurricanes Harvey, Irma, and Maria. Harvey was especially significant for energy markets because it directly hit Houston, a major energy-producing area. Gold has also been sluggish recently, further evidence that inflation remains tame.
Are economic growth and low interest rates sufficient to explain the market’s current valuation? There is a third possible leg of support. Perhaps corporate tax reform is coming. A tax reform package that reduced the average corporate rate for S&P 500 components from approximately 26% to, say, 20% would lower the S&P’s aggregate P/E from 25.6 to 23.6. Eliminating the tax on repatriated foreign earnings could produce a wave of available capital that could be invested domestically or returned to shareholders. Presumably, tax reform would also provide ancillary, second-order benefits to economic growth. This economy could really get going if its recent momentum were further enhanced by long-hoped-for reform that brought U.S. tax rates in line with world averages. With respect to these second-order benefits, there is a question whether corporate tax cuts would need to be balanced with tax increases elsewhere, and whether these increases might sap some of the benefit of the overall reform package. This matters long term—nothing matters more than growth in the long run—but the fact that tax reform could be a double-edged sword for economic growth does not counter the argument that lower taxes would absolutely increase corporate earnings, easing concerns over stock valuations.
The administration calls tax reform its number-one priority. Priorities seem to change quickly, and disputes around the Affordable Care Act are competing for attention. A tax reform optimist might say that the President is currently using the ACA as a bargaining chip to advance his tax reform agenda. Some would say this gives the administration too much credit. The stock market is not sending clear signals, although we note that smaller stocks have outperformed larger stocks, with microcaps performing the best over the past month, and mega-cap stocks scoring the lowest gains. Smaller companies tend to be less global, with fewer opportunities to shift their profit recognition overseas. They stand to benefit the most from lower corporate tax rates.
Absent a meaningful tax reform package, the administration has expressed its desire to, at the very least, push through a modest tax cut. A simple tax cut might help economic growth a bit but would also add to the deficit. In theory, an expanding deficit would give interest rates one more reason to increase, although (surprise!) economists are split on whether budget deficits are inherently inflationary or deflationary, which means the interplay between deficits and interest rates is complicated.
Stocks feel high, but valuations must be viewed in the context of continued low interest rates and the improving cadence of economic growth. There is also a possibility that meaningful corporate tax reform could produce a step-up in earnings, justifying current valuations. The question is whether investors can bank on any of these market-supportive forces going forward? “Cautious optimism” is a stock market cliché, but it is also typically the right perspective to bring to investing. We currently lean toward caution, but that is not a reason to be pessimistic. There are always opportunities out there. The trick is to find them.
Miles Putnam, CFA