The Economy vs. Stocks

There have been louder warnings by market pundits of a possible global financial crisis. Up to this point, these doomdayers have had a terrible record on predicting when the next market calamity will unfold. Each market dip has been short-lived with markets eventually making a speedy recovery. This week markets cheered the news that the pollsters finally got it right in the French election. The populist backlash in Europe has subsided for the moment.

With this hurdle cleared, the market turned its attention on whether President Trump can pass sweeping tax reform. The major provision in this plan is that the U.S. economy will need to grow by 3-4% or the tax cuts will add to the deficit. Given that the Q1 2017 GDP increased only at a 0.7% annual rate, higher economic growth is likely to be short-lived.

Over the last year, the S&P 500 index is up 17.78%, while GDP growth has stalled around 2.5%. This divergence can only be explained one way. Stock valuations have climbed in value much faster than earnings. Artificially low interest rates have helped to boost equity returns. Moreover, low rates have caused a buying frenzy in the housing market and bidding wars are common, especially at the lower price points. I believe that housing supply will remain limited.

The number of licensed realtors hit a nine-year high in 2016. Just this week, I received five mailings from real estate agents who were prospecting for new business. House prices in many of the major U.S. cities are now higher than they were before the Great Recession.  Along with the rise in housing, the Nasdaq reached a record level to 6,032. In March 2000, the Nasdaq passed the 5,000 mark before losing 80% of its value after the bubble burst. As Mark Twain wrote, “History doesn’t repeat itself, but it often rhymes”. Housing and the Nasdaq are once again beginning to show signs of excess speculation.

I believe that the market is in the late stage of the economic cycle. This part of the cycle can be very lucrative and can go on longer than investors realize. The pro-business environment should continue, even though recent government statistics have shown little GDP growth.  The biggest risk remains that the economy might overheat.  The investment theme that I have written about often is also starting to look a bit stretched.

It’s that Innovative companies will drive growth regardless of government policies or government statistics. There are many large companies that have cornered parts of the market that I would now view as monopolist. A few of these companies reported earnings this week and these results exceeded expectations.

Most of the management teams on these conference calls have sounded up-beat. All in all, the stock market might be ahead of itself, but higher expected earnings growth is not that far behind.

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