As of 10/26, the S&P 500 climbed 15.5% YTD and 2.6% in the last month. Global economies are growing in unison. Oil is over $50/barrel, allowing the energy sector to profit again, particularly following extensive cost reductions in the last two years. Many commodity prices are increasing rapidly. The weakness in the dollar, driven by improvement in other economies, is boosting emerging economies and benefitting the bottom line of U.S. multinationals. It appears that a corporate tax cut will pass in some form, including reduced rates for accumulated profits held overseas, an estimated $2.6 trillion according to CNBC. All of this has put the market in a very positive mood.
However, there are risks out there – namely that valuations are meaningfully higher than historical norms. The forward P/E ratio for the market is now 18.1x versus the 25 year average of 16.0x. The only measure by which the market is not overvalued is the spread between debt market yields and equity earnings yields. High valuations increase the risk in the market, particularly if market participants are using an assumed discount rate that is too low. This may turn out to be the case if interest rates spike higher, keyed off of rising inflation.
In the 10/18/17 podcast linked below, Larry McDonald of The Bear Traps Report discusses his short-term market concerns with All Star Charts. The podcast is an hour long but it lays out very clearly some of the near-term risks. Here is what I took away:
- The balance of economic activity inside U.S. versus outside has changed dramatically over the last twenty years from about 50/50 to 25/75. This means that the recent drop in the dollar is stimulating emerging markets in a very powerful way.
- In 4Q, the impact of the weaker dollar plus tax cuts plus storm stimulus point to an interest rate shock in the next 60-90 days in his opinion.
- A Federal Funds rate hike in December is expected but the market is not anticipating rapid Federal Reserve rates hikes to follow. A change in perceptions around a March rate hikes and subsequent hikes will be a shock.
- China is being juiced by weaker dollar plus internal stimulus. China just completed its 19th Congress, which established power structure for the next five years. Larry McDonald thinks it is likely that Chinese government stimulus continued in the lead up to this 19th Congress to prop up growth but that necessary deleveraging will commence now that the meeting has ended.
- Gold is trading with bonds so it is not a good inflation indicator as it was in the past. A year ago there were $14 trillion in negative yielding bonds. Investors would rather buy gold than negative yielding instruments. As bond yields have crept back up, only $4-$5 trillion in negative yielding bonds remain, reducing the appeal of gold. So gold sold off as interest rates rose, an unusual pattern.
- In the next 30-60 days, he anticipates a stock market drawdown (>5%) from some combination of: 1. China delevering, 2. Uncertainty around a leadership change at the Fed, and 3. Reduction of the Fed balance sheet.