Watching the Stock Market Work

Over the last 14 months, we have had a compressed demonstration of how the stock market works. At any given point in time, the intrinsic value of equity investments roughly reflects two factors.

1. A discounted present value of expected future earnings.

2. The expected returns from competing investments.

When Donald Trump was elected President the expectations of future earnings rose dramatically because he promised, then delivered on, reduced taxes and government regulation. Both of these actions greatly increased expectations of future corporate earnings versus what they had been under the Obama administration and what could be expected from another Clinton administration. Hence the significant market run-up immediately following his election.

The second factor we've seen play out in the last week. The Federal Reserve has made it pretty clear that we can expect higher interest rates in the future. This affects expectations for bonds, the primary alternative to equity investments.

Traders trying to guess which of these two factors will be dominant create a lot of day-to-day volatility, but over the longer run, it is the battle between these two expectations that counts. If corporate earnings continue to grow faster than expected, Factor #1 will prevail. Otherwise, you can expect a major correction in 2018.