At this writing Donald Trump has won the election and control of the Senate is now in republican hands. The House is still being tabulated. However, as mentioned last month the financial markets will be driven by how Trump deals with the pressing issues of the day, from debt to international relations.
Typically, after a relief rally, the stock market declines in the first year of a new administration. While Trump has previously been president, he is not succeeding himself. The reasons given for the first-year decline include the need to acclimate the financial markets to the goals of the new government, the uncertainty surrounding the relationship between the White House and Congress, and external events that are thrust upon the government and subsequently test the same.
The US economy is currently the envy of the world, but no economy stays good forever. Imbalances work their way in, a need to reduce the budget deficit is taken more seriously, either taxes are raised, or spending is cut (both of which reduce demand), and those who are living on the edge (both company and individuals) suddenly fall off. Of interest is the fact that the Kiplinger organization is forecasting 3.5% growth in 2024, but only 2% in 2025. Some might consider this a soft landing. It is still a landing, with reduced growth as a result.
In terms of the market, a sense of complacency has been building up for some time. Each pullback is framed as a buying opportunity. Markets do not go up forever. People who study the stock market’s history, like Bob Farrel and Mark Hulbert, believe in what is called “regression to the mean.” This term implies that markets oscillate around a long-term number and that over-valuation is followed by under-valuation.
One proxy for the market’s valuation is its aggregate price-earnings ratio. This is the total of all company P/E ratios on a weighted average basis. According to data published by Barron’s, as of November 1, the P/E ratio was 24.49. According to the firm Birinyi Associates, the estimated P/E ratio for 2025 is 23.5. A year ago, the P/E ratio using the same methodology was 19.69. The cash return on the S& P 500 is 1.31%. A year ago, it was 1.7%.
Interpreting the numbers, of the 22.7% appreciation of the past twelve months, 20% was from rising stock prices unsupported by higher earnings. According to Birinyi, the index is projected to rise only 5% in 2025. Cash flow from investments has fallen 30% as yields on new investments earn less.
All this paints a picture of a market that is selling at far higher than historic valuations. Indeed, the average P/E ratio for stocks over the past 75 years has been 16. This number implies the overall market is about 50 percent above its mean.
Now markets can sell at premiums or discounts for a long time. The data does not preclude an imminent market contraction. What it does do is place the current overall market, in a historic context, at the far end of the over-valuation scale. In fact, one would need to go back to 2000 and the dot com bubble to find valuations this stretched. This would suggest, at a minimum, selling overvalued positions and replacing them with stocks of more reasonable valuations.
Those who invest primarily in packaged products like market index ETFs do not have this option. They can only sell the index. Given the lack of knowledge of the typical ETF investor as to what he or she holds, the sale of ETFs may wind up exaggerating any downward move.
A common response to the idea of selling at the top is, “Well, I will have all of these capital gains taxes to pay.” 70 percent of something is more than 100 percent of nothing. Besides, if congress ever does get serious about reducing the deficit, raising the tax on capital gains would be considered an easy target, especially for those whose income or net worth exceed a certain amount.
This time artificial intelligence (AI) may take the role previously assumed by the dot com stocks. Technology in general has been the leader in this upward run and some of the stocks show it. Nvidia, a company that makes chips for AI devices, has a value more than all the stocks traded on the German and Italian stock markets combined. Tesla has a greater valuation than General Motors, Ford, and Stellantis (nee Chrysler) combined. Those of us who have been around have seen this movie before. It does not end well.
The Economy
Economic activity is on the surface humming along. Below the surface, issues of housing affordability and a shrinking labor pool continue to hinder economic growth. Aggressive immigration enforcement will likely cause the pool to shrink further.
Data supports the fact that housing has become something out of reach for first time home buyers. New home sales are stagnant, while the age of existing home sellers continues to advance. This is an issue of utmost importance for the economy. As the Federal Government has little influence on lot size, it is limited in terms of what it can do to address the situation.
Inflation
Inflation is in remission but has the potential to heat up again. This will come in short order if interest rates rise in response to any indication of larger budget deficits.
The US dollar has strengthened against other currencies with Trump’s election victory. It is unclear whether this strength will be sustainable, especially if the tariff concept spoken on the campaign trail is implemented.
Interest Rates
Interest rates have risen sharply with the Trump victory. The expectation is that deficits will rise, and debt issuance will accelerate to compensate.
In the 1990s there arose a term “bond vigilantes” to describe those who would not buy bonds if the inflation rate increased, or the budget imbalance was not addressed. Should such a group be reconstituted it would mean a more restrictive course of action for the party in power to cut taxes or increase spending.
The Stock Market
Aside from the valuation issues mentioned previously, there is the existence of a great deal of new options which serve the role of speculation rather than investing.
Cryptocurrency has previously been mentioned. The fact that the SEC permits the trading of cryptocurrencies domestically which are made offshore to avoid the regulation that comes from being an investment is confounding to say the least. The SECs bowing to pressure from brokers to trade crypto ETFs will be subject to government hearings after they potentially collapse, a classic case of closing the barn door after the horses have fled.
Other objects of speculation include “zero-day stock options” in which someone buys a call and tries to forecast the closing price of a security that same day. Add to this the leveraged ETFs that promise double or triple the return of their less exotic brethren who do not inflate their portfolio by buying on margin.
The original purpose of the stock market was to raise capital for companies. Should the returns on the capital be sufficient, bonds and stocks are the beneficiaries. Now, there is such an element of the casino in what is being offered, the idea of long-term returns for many is almost problematic.
All this would be bad enough but add to this that people are using their retirement accounts to speculate. Not only was such not intended, but when the inevitable collapse happens, there will be a cry not just for vengeance but a political solution.
Warren M. Barnett, CFA
November 5, 2024
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