- The market looks overvalued but there are three main factors that could push it even higher.
- A repatriation tax holiday could make $2.1 trillion available for dividends, buybacks, and M&As.
- Economic growth and inflation could push earnings higher, further inflating stock prices.
It seems that everyone agrees on the fact that this market is overvalued and borderline irrational. However, there is no correction in sight and the only question to be asked is “how high can this market go?”
The S&P 500 has jumped 5.4% since Trump won the elections, and is 12.1% higher year-to-date. By adding in the 2% dividend yield, we arrive at an excellent 14% return for 2016. This year’s positive return will make it number eight in a row for the S&P 500 as it has been rewarding investors since 2009.
Figure 1: S&P 500 in the last 10 years. Source: Yahoo Finance.
John Maynard Keynes said it best:
“The market can remain irrational longer than you can remain solvent.”
Today we’ll analyze what’s fueling this bull market, how long can it last, and what the short and long term catalysts and risks are that we have to consider.
There are three main positive market drivers to consider, a repatriation tax holiday, growth, and inflation.
Many expect, now that Trump will become president, that a tax holiday will be voted in allowing corporations to repatriate the cash stashed abroad at a much lower tax rate than the current 35%. You can read more about repatriation and tax holidays in our article available here.
The more than $2.1 trillion abroad, if and when repatriated, would surely give a boost to buybacks and dividends pushing the market even higher. Given that S&P 500 corporations have been buying back around $130 billion of their own stock and paying out $105 billion in dividends per quarter in the last few years, the additional $2.1 trillion could push the S&P 500 further up and also increase M&A activity. It’s very difficult to say how much farther this could push stocks, but it would surely postpone a bear market.
Economic & Earnings Growth
The trend in economic growth has, thankfully, changed. After a few quarters of slowed growth, we have seen a pick-up in economic activity.
Figure 2: Annualized U.S. economic growth. Source: Trading Economics.
The forecasts are also positive and with the economy expected to grow at 2.5% in the next few quarters, it should push stocks higher or at least keep them at the levels we’re seeing today.
Figure 3: Economic forecasting survey. Source: Wall Street Journal.
Improved growth should make earnings grow which should allow for greater buybacks and higher dividends. Earnings are expected to grow at double digit rates in the upcoming quarters as economic activity is picking up and oil prices have increased.
Figure 4: Analysts earnings growth estimates. Source: FACTSET.
For the S&P 500 to grow further, it’s extremely important that these very positive expectations are met because, if not met, stories about market overvaluation, high PE ratios, shrinking dividends and dim economic outlooks could soon take over.
The third driver for stocks is inflation. Inflation is supposed to be good for stocks as in theory, stocks provide a kind of hedge for it. Corporations can transfer increases in input costs into higher prices.
Inflation also increases the value of the underlying assets and inventories corporations own.
Figure 5: U.S. inflation rate. Source: Trading Economics.
However, inflation is still below the FED’s target of 2% and below historical levels from before 2015. Similarly to economic and earnings growth, inflation—or better, the expectation for higher inflation—pushes stocks higher.
The main explanations of the current S&P 500 jump are increased positive expectations. This is perfectly normal as we don’t invest for the present, but instead invest for the future. This bull market will continue as long as there is enough liquidity to fuel it, be it coming from repatriation or low interest rates, as long as economic growth expectations aren’t refuted by hard economic data leading into a recession, and as long as inflation levels keep rising. Therefore, as long as things remain as they are, you have nothing to worry about with your portfolio.
The issue comes from the fact that nobody can predict how long the situation will remain like this. Things could change tomorrow or two years from now. But as I’m constantly reminding our readers, it’s very important to understand the risks you are running by holding onto the market and compare those risks to the potential benefits.
You might want to analyze investments that don’t offer a sharp potential 20% correction based on bad news, or a potential 50% decline if a U.S. recession comes along. Sectors to look into are commodities, which have been battered in the last 5 years and are a great inflationary hedge, and the agricultural industry.