As we enter the brave new world of Donald Trump, it is useful to assess what still makes sense and what does not. This graph shows the PE ratio since 1900.
The PE is the market price of a share of stock divided by the earnings-per-share of that stock. Stocks with a high PE ratio are considered “expensive” while those with a low PE ratio are considered “cheap.” It is widely used and often discussed.
Looking at this graph, we see that the stock market has moved above the red line, making stocks at today’s prices expensive. Should you sell some stocks or just get out of an over-priced market altogether?
There are a couple of things that skew this discussion. First, it is based on earnings-per-share over the last twenty months. But, that was during the earnings recession that we are now exiting. In addition, Trump is promising a stimulus program and will probably deliver, which should increase earnings-per-share. At this point, it is problematic whether his tax cuts will boast GDP like Reagan or just add to the deficit like Bush II. Either way, corporate profits should benefit for the foreseeable future. Reducing regulation should also improve corporate profits.
Importantly, stocks should benefit from rising interest rates. This is a rare circumstance where stock prices rise with interest rates, but little has been normal since our economic collapse in 2008. Bond prices are incredibly inflated, due to the low interest rates. As those rates rise, the value of those bonds will fall. As money flees bonds, the vast majority will move into stocks. This is often called The Great Rotation from bonds to stocks and will drive the price of stocks up even more.
I have written often about the risk of another derivatives blow-up like 2008. Considerable progress has been made by regulators to lessen this risk but it still remains. Because most of this regulation has been an international negotiation, I don’t think Trump can abrogate or un-do much of this regulation but will be watching it closely.
All of this reminds me of the sales pitches we heard prior to every economic collapse — “It is different this time.” Take PE ratios as an example. The higher the ratio, the more expensive the stock is. That doesn’t change! Following the economic collapse, we have been a one-armed fighter with only monetary policy, which has literally saved us. Finally, we may have the the other arm, i.e., fiscal policy. These economic times are not normal, and things are indeed different . . . for awhile. The importance of PE ratios will remain, but let’s look forward a year or two but no more. It is different only in the short term, not the long term.
This economic recovery has been a slow and ponderous, like a 6-hour marathoner, since 2008 but may finally be picking up speed over the next few miles. Enjoy!