After a torrid start to 2019 for stocks, many investors are questioning if stocks can maintain this momentum or if they are expensive and due for a pullback. As the bull market enters its 10th year, this isn’t the first time that question has been asked. The “stocks are expensive” argument is one frequently cited by bears as a reason to sell stocks, especially after a period of tremendous gains. The price-to-earnings (P/E) ratio is a popular metric for investors to use when valuing stocks – it measures the price investors are willing to pay for a dollar of earnings. Since price equals P/E multiplied by earnings, changes in a stock or index price can be attributed either to changes in its valuation (P/E) or profitability (earnings). This week’s chart suggests 2019’s rally in the S&P 500 Index has been driven by P/E expansion more than earnings expansion. Therefore, in a purely mathematical context, stocks have indeed become more expensive.
The formulaic assessment that stocks are more expensive this year is not particularly helpful without understanding what compels investors to pay more or less for stocks. While individual stocks face idiosyncratic factors specific to each company, the actions of policymakers can influence valuations for the broader stock market. The past several years provided some good examples of how actions from the Federal Reserve (Fed) and White House can influence stock prices.
For the first six weeks of 2016, as oil hit the mid-20s and high yield credit came under pressure, stock valuations were strained over fears of a global slowdown. Furthermore, the Fed had signaled at the December 2015 FOMC meeting that it wanted to raise the federal funds rate 1% in 2016, which added to investors’ worries. By March, the Fed had not raised rates, while reducing the projected increase for the year to 0.5%. The Fed held off until December, when it hiked rates only 0.25%. The election results in November – with the president-elect’s agenda including deregulation, infrastructure spending and lower taxes – added to the constructive environment for stocks.
In 2017, stocks saw rising corporate earnings and few surprises from policymakers. As a result, the S&P 500 Index returned almost 20% as the backdrop for equities was benign. Although widely anticipated, the signing of the “Tax Cuts and Jobs Act” into law on Dec. 22 propelled stocks even higher through the first month of 2018.
Policymaking in 2018 flipped from serving as a tailwind for the stock market, to becoming one of the most prominent risks to owning stocks. Early in the year, rising wage inflation brought about fears that the Fed would continue to hike rates and end the economic expansion. Meanwhile, the Trump administration’s implementation of tariffs, combined with escalating trade tensions, undermined stock performance despite rising corporate profits. After recovering in the summer, stock prices fell dramatically in the fourth quarter. The start of the sell-off coincided with Fed Chairman Jerome Powell indicating the Fed could raise rates much quicker than the market was expecting.
Stocks were very unloved at the start of 2019. Valuations declined considerably the previous year, and other areas in financial markets were signaling low expectations for equities in 2019. On Jan. 4, Chairman Powell reversed course on rate hikes and reaffirmed the Fed would take a “patient" approach to raising rates during the January FOMC meeting. On the political front, trade tensions have declined and an agreement with China is expected. The easing from policymakers, coupled with a low bar for corporate earnings entering 2019, set the market up for its strong start to the year.
The stock market is impacted greatly by policymakers’ ability to inhibit or promote corporate profitability. Stock prices have historically reacted strongly to changes in policy, particularly when policy expectations have been set at an extreme, and then those expectations change course. Policy uncertainty can also undermine stocks’ valuations. UnitedHealth Group (UNH) is a good example. Despite continued strong earnings, UNH’s stock price has struggled this year with the emergence of 2020 Democratic candidates who support government-run universal healthcare coverage.
While policy headwinds from 2018 have largely abated, there are already several policy-related developments on the horizon for this year, including the Fed’s stance on inflation, the conclusion of a trade deal with China, and who emerges as the top Democratic candidates for the 2020 election.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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