Disconnect on Wall Street Points to Stock Market Collapse
The NASDAQ topped 6,000 for the first time on April 25. Meanwhile, the NYSE, S&P 500, and Dow Jones Industrial Average (DJIA) are all at record levels. This is good news for investors! Or is it? A growing list of experts, like Robert Shiller and Paul Tudor Jones are warning that stock valuations are out of whack. At the same time, first gross domestic product (GDP) forecasts have tanked. If GDP can’t keep up with corporate earnings expectations, investors can expect sky-high stock valuations to come tumbling back to earth.
The bull market is now in its ninth year, making it the second-longest in history. That’s a bit of a dubious distinction; it’s been fueled by artificially low interest rates and is being supported by the slowest economic recovery since World War II.
However, the stock markets got an unnecessary jolt after Donald Trump won the U.S. election. Since November 2016, the NYSE has advanced approximately 11%, the NASDAQ 16.5%, the S&P 500 12%, and the DJIA 14.5%.
The broader markets rallied because investors believed that Trump’s economic policies, which included slashing taxes, (including corporate taxes), and increasing spending, would help kick-start the U.S. economy.
Recall if you will, during Barack Obama’s presidency, GDP growth averaged just two percent. In 2016, Obama’s last full year in office, U.S. GDP growth was 1.6%. During his entire residency in the Oval Office, GDP never hit three percent.
Chart courtesy of StockCharts.com
Essentially, the current bull market was weaned on abysmal GDP growth during Obama’s presidency. On the campaign trail, Trump even called out the bull market as phony. One year ago, in April 2016, Trump said he had little faith in the stock market, and that it was a terrible time to invest. Not only that, but he also said a huge recession was coming. During the first presidential debate, Trump said the bull market was “in a big fat ugly bubble.” (Source: “In a revealing interview, Trump predicts a ‘massive recession’ but intends to eliminate the national debt in 8 years,” The Washington Post, April 2, 2016.)
U.S. Economy Grinds to a Halt
If the stock market was in a big fat bubble in September 2016, the bubble has to be a lot bigger and more susceptible to bursting now. Especially when you consider that stocks have continued to soar in the face of weak U.S. economic data. That weak economic data being: tumbling U.S. housing starts, fewer jobs being created, falling retail sales, and stalling growth.
The Department of Commerce will be publishing its first estimate on the health of the U.S. economy in the first quarter of 2017; but it seems that most think the U.S. economy is standing still.
The Atlanta Fed has basically thrown in the towel and expects first-quarter U.S. GDP to come barreling in at 0.2%. This is a far cry from the 2.7% forecast the Atlanta Fed announced in early February. The Atlanta Fed said it lowered its forecast because of underwhelming consumer spending; which is wise, when you consider that consumer spending accounts for more than 70% of U.S. GDP growth. (Source: “GDPNow,” Federal Reserve Bank of Atlanta, last accessed April 27, 2017.)
Meanwhile, JPMorgan Chase & Co.’s (NYSE:JPM) outlook for the U.S. economy is equally as bad. The bank trimmed its first-quarter GDP outlook from 3.0% at the beginning of the quarter to 0.4% to just 0.3%. However, the bank left its outlook for second-quarter GDP at a robust three percent. (Source: “J.P. Morgan reduces U.S. Q1 GDP growth view to 0.3 percent,” Reuters, April 27, 2017.)
Despite years and years of barely-there GDP growth and weak economic data, the S&P 500 and broader markets continue to defy the odds and climb steadily higher. This can only continue for so long.
Since 1929, earnings for the S&P 500 have increased 4.9% annually; over the same time frame, GDP has advanced 6.1%. Earnings per share (EPS) is lower than GDP because business growth is not responsible for 100% of GDP growth.
Since the Great Recession however, earnings have not lagged GDP growth. Since 2008, earnings increased 10% annually; more than double the historical rate. GDP, meanwhile, has averaged 1.2%. Even if you remove the 2008 (-0.3%) and 2009 (-2.8%) recessionary GDP data from the equation, average GDP growth since 2010 is still only two percent.
In this economic climate, it’s not possible for EPS growth to trump GDP growth by nine percentage points. But analysts are still optimistic and investors continue to send share prices higher, sending valuations to levels not seen since 1929 and 2000.
Not even Trump’s recently proposed tax cuts look like they will be able to get the U.S. economy back up to four-percent GDP growth. On April 26, the White House announced Trump’s much-hyped tax reform package, one that proposes to slash the top U.S. corporate rate from 35% to 15%.
The problem is, tax cuts, no matter how great (and Trump’s tax cuts come a distant third to Reagan’s tax cuts in 1981 and the cuts in 1945 to the federal taxes used to fund World War II), will still cost the country. Reagan’s tax cuts cost the U.S. 2.9% GDP over four years while the 1945 tax cuts cost the U.S. 2.7% of GDP the year after they were enacted.
The odds that Trump’s tax cuts will boost U.S. GDP to four percent are remote. That is, if he can even get the proposed tax cuts, as they currently stand, passed.
Hedge Fund Manager Says This Chart Should Terrify You
Hedge fund manager Paul Tudor Jones II is known for his bets on interest rates and currencies. In late 1986, he famously said, “There will be some type of a decline, without a question, in the next 10, 20 months. And it will be earth-shaking; it will be saber-rattling.” (Source: “The Man Who Won as Others Lost,” The New York Times, October 13, 2007.)
He was right. On October 19, 1987, stocks took the “Acapulco cliff dive” Jones predicted. Wall Street was crushed, but Jones, who was just 32 years old at the time, returned 200% for his investors.
Jones doesn’t make his opinion about stocks, bonds, or currencies known because he understands how much his opinions can influence the markets. But the reclusive billionaire said recently in a closed-door meeting with Goldman Sachs that years of artificially low interest rates have sent stock valuations into nosebleed territory. In fact, stock valuations have not been this bloated since 2000, just before the NASDAQ plunged 75%. (Source: “Paul Tudor Jones Says U.S. Stocks Should ‘Terrify’ Janet Yellen,” Bloomberg, April 20, 2017.)
Speaking to a room full of bankers, Jones said, “That measure — the value of the stock market relative to the size of the economy — should be terrifying.” The chart he was pointing to showed the market’s value relative to the U.S. economy.
The market-cap-to-GDP ratio and the Wilshire 5000 Total Market Full Cap are two of the best ratios when it comes to stock valuations and GDP.
The market-cap-to-GDP ratio is referred to as the Warren Buffett Indicator because Buffett believes “it is probably the best single measure of where valuations stand at any given moment.” (Source: “Warren Buffett on the Stock Market,” Fortune, December 10, 2001.)
The market-cap-to-GDP ratio compares the price of all publicly traded companies to GDP. It currently stands at 132.4%. A reading of 100% suggests that stocks are fairly valued. The ratio has only been higher once since 1950. During the dotcom bubble in 1999, it was at a blistering 153.6%. It was only at 108% before the 2008 Financial Crisis.
The Wilshire 5000 is a market cap weighted index of the value of all stocks traded in the U.S. versus GDP.
The Wilshire 5000 is less well known than the market-cap-to-GDP ratio, but it is actually the largest index by market value in the world. Back in the first quarter of 2000, the index stood at 118% of the total economy. Fast forward to today and the index is at 140%.
High Stock Valuations Make Investing Dangerous
Yale professor and Nobel Prize-winning economist Robert Shiller maintains that stocks are overvalued, but he doesn’t think investors should sell the farm just yet. Shiller’s cyclically adjusted price-to-earnings (CAPE) ratio, which compares the current value of equities to inflation-adjusted earnings over the last 10 years, is at its highest levels since 1929 and 2000. The ratio currently stands at 29.35; the long-term average is 16. The CAPE ratio has only been higher twice: in 1929 it was at 30, and in 1999 it was at 45. (Source: “Online Data Robert Shiller” Yale University, last accessed April 27, 2017.)
This doesn’t mean there will be a stock market crash in the coming weeks. There is still a lot of optimism surrounding Trump. And first-quarter results have not been terrible. Therein lies part of the problem.
If stocks soared in the midst of weak economic data and during the earnings recession, why wouldn’t they soar even higher when a company reports one quarter of decent earnings? You might think investors would take a breather and let one modestly decent quarter of earnings close the valuation gap. But that isn’t happening.
As a result, stocks continue to march higher. Again, obscene valuations don’t predict when the upcoming stock market crash is going to happen. After all, the CAPE was at these levels back in 1998, and the markets kept climbing for two more years.
But these kinds of valuations should be flashing warning signs. It never ends well when valuations get to these levels. Ever.