US equities have hit 53 record highs in 2017, the equal highest streak in the 10-years since the financial crisis with some weeks still go to – 2014 also had 53 record highs. This boom in asset prices has resulted in a range of sentiments, with some respected pundits including Jeremy Siegel claiming that equities are still a bargain relative to bonds, while others such as Alan Greenspan declaring “we are moving into a different phase of the economy - to a stagflation not seen since the 1970s. That is not good for asset prices”.
Add to the mix Donald Trump, and it is little surprise the topic of market predictions are getting so many headlines. Yet, if Donald Trump’s one-year election anniversary has taught us any lesson, it must be the perils of forecasting. To demonstrate, we only need to reflect on his journey from an unlikely Republican candidate to an unlikely presidential nominee that eventually defeated Hillary Clinton to become president.
So Far, So Good for Trump’s Presidency?
With hindsight, the outcome was a declaration of both hope and frustration by the American public, and thus far, has seemingly resulted in improved prosperity, with strong consumer confidence, falling unemployment and growing asset prices. Yet, his election has similarly reinforced the danger of inference between politics and market returns.
The initial fears of a major market decline by respected economists were misjudged, and in some cases, blatantly wrong. Where many predicted that the market would crash by as much as 10%, it has instead increased by approximately 25%.
The relevance of this observation should not be understated. A prime example is the impact of the ongoing hostility between Donald Trump and Kim Jong Un. South Korean and Japanese equities are often considered to be vulnerable to the threat of war, and this naturally encourages investors to attempt to discount the cost of such an event into asset prices. Yet, we question whether this is this a rational response by investors as their efforts to discount such an extreme event will necessarily dominate their view of the attractiveness of the affected markets.
Moreover, our tendency to confidently infer market movements from such political events mean that behavioural biases get in the way of rational investing. We know that politics spark an emotional response among society, and emotions mean that we don’t act rationally all the time. When it comes to investing, this irrationality is further exacerbated by biases known as loss aversion; fearing loss more than appreciating gain, and temporal myopia; too great a focus on the short term, both of which are incredibly important as we think about Donald Trump and the prospects for the US equity market.
What Does it Mean for Equity Investors?
As tempting as it may be, predicting political outcomes and the commensurate market move has no place in the rational investor’s toolkit. Instead, we need to overcome our behavioural biases by sidestepping the political noise and focusing on investment fundamentals. This doesn’t mean ignoring topics as far-reaching as tax reform and sanctions, but it does mean focusing intently on corporate fundamentals and how much is priced into markets.
By using this framework, we need to determine two key variables. First, what the fundamental backdrop is for US equities; and second, how much of this is priced into markets. Regarding the fundamental backdrop, we can see below that both earnings and dividends have excelled in real terms since the financial crisis. This is generally supportive of long-term growth, although one must also be careful to extrapolate this into some sort of prospective trend.
By looking under the hood, a key driver of this expansion has been elevated profit margins, which have hovered around 8.5% to 9.5% for the best part of a decade. Therefore, one should be careful to expect these margins to be sustained, especially given they are meaningfully higher than the longer-term average of around 7.5%.
Furthermore, it has also become clear that the price growth has far exceeded any reasonable estimate of this fundamental growth.
Bringing these two variables together – fundamentals and valuations – we find the valuation-implied return could be closer to 0.1% in real terms the next 10-years and 2.9% over 20-years rather than the 5.7% we have become accustomed to from US equities when valuations are not stretched.
Therefore, we encourage looking through the recent positivity and Trump’s rhetoric and instead analyse reward for risk. In doing so, one is likely to find that better opportunities reside outside the US.
A version of this article appeared in Portfolio Adviser magazine
