Since the US presidential election in November, the US stock market has been riding a wave of enthusiasm. This rise has been followed by a similar rise in Australian equities. Part of this rise reflects better fundamentals but much more of this rise simply reflects better sentiment.
In 2016, the US economy was relatively soft. GDP grew at only 1.6 per cent for the full year. The reason for the weakness was a slowdown in non-residential construction. Low oil prices in the beginning of 2016 meant a much lower level of investment in oil drilling, gas drilling, and energy infrastructure such as gas pipelines. Improving energy prices in the second half of 2016 caused the beginning of a recovery in the same non-residential construction.
In 2017, our chief economist, Michael Knox forecasts the US economy to accelerate to 2.3pc. In 2018 he expects growth to pick up further to 2.7pc. This improving economic outlook has generated a remarkable scenario for US corporation earnings.
With stronger growth and the prospect of much better earnings, it is not surprising that the US stock market has risen. The question is has it risen too much? Michael models the US S&P500 index based on the level of operating earnings per share and US 10 year bond yields.
Based on the current level of earnings per share and bond yield, our fair value for the US S&P500 index based on Michael’s model in February 2017 is only 1916 points. At the time of writing, the market is way above that at 2351 points. In the future, growth in earnings will justify the level of the US S&P500. The problem is how far in the future it will be before earnings provide that justification.
Michael’s modelling tells us that even with the much better earnings expected in the future, fair value of the US S&P500 index does not reach a fair value of 2338 until the third quarter of 2018. That means that the US S&P500 index is currently trading at fair value based on earnings that do not arrive until the third quarter of 2018.
Why is this happening? We think the US market is receiving a flood of liquidity from the US corporate debt market. The difference between US corporate yields and US sovereign yields has fallen dramatically since February 2016. Where previously investors might have bought corporate debt, the decline in the yield on that debt is now leading investors to switch from corporate debt to corporate equity flooding into equity prices and driving equities to a level that the market does not yet justify.
In addition to liquidity the market is being supported by sentiment. Much of this sentiment is driven by the prospect that the new Republican administration will cut corporate tax rates. These corporate tax cuts are possible through elimination of most of the corporate tax deductions that currently exist in the tax code. In addition, revenue is raised through a border adjustment tax. The elimination of tax deductions for corporate imports provides an effective revenue tariff of 20pc, assuming a corporate tax rate of 20pc.
The problem is that even though these proposals have the support of the House of Representatives and the American President, they have yet to gain the support of the American Senate. US elections are much more open to the operation of lobbyists than in Australia. This is primarily because of the very large cost of running elections in the US. This in turn is due in part to the high cost of advertising to very large populations.
The stock market is banking on a cut in the corporate tax rate. Unfortunately the passage of the corporate tax cut through the US Senate is likely to be achieved only after much public argument. As the market sees US tax cuts at risk, it is possible that its reaction could be both volatile and negative.
The outlook for the US economy is good. The outlook for US earnings is even better. The US equities market is now pricing itself very fully on the prospect of better earnings in the future. Part of the reason for that optimism is the prospect of much lower corporate tax rates. These tax rates are guaranteed a noisy passage through the US Senate. This noisy passage could give equity markets a scare moving forward.
- Justin Still, Investment Adviser (Authorised Representative: 000279726) Morgans Financial Limited | ABN 49 010 669 726 | AFSL 235410.