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. 

Stock Market Risk -- Reversion to the Mean

As the stock market reaches new highs and optimism grows, it is worth considering a couple of charts that should give caution. The first one is the ratio of corporate profits to GDP. It's currently at an all-time high of 10%. That isn't going to continue. At some point it will revert to more historically normal levels. Ultimately, share prices have to be related to earnings. 

The second is the Shiller PE Ratio between share prices and trailing 10 year inflation-adjusted earnings. The Shiller ten-year P/E Ratio also suggests the market is expensive. In 2000 the ratio was 44, the highest level on record. At the top of the market in 2007, the Shiller was 27. The long-term average is 16.5. By that estimate, the stock market was 63% overvalued in 2007. Right now the Index is at 25, which suggests an overvaluation of 50%.

Overvalued assets can become even more overvalued as we saw in the 90s, but the more expensive stocks become, the higher the risk of a big drop.  About the only thing you can say with any certainty is that over the next few years there’s more risk on the downside than on the upside. Of course, you could have said that in 1997 as well. Bob Shiller did, and he missed out on a couple more years of share price inflation. Investor psychology seems to fear losing out on a big upswing more than experiencing a big loss. Certainly that was what drove real estate in the mid-aughts. But history suggests that reversion to mean is an even more powerful force.