Trump the candidate did not like bankers or financial markets. In his view, the rise of stock market indexes was nothing more than “a big fat ugly bubble“. Trump the president’s vision has changed significantly since and the Dow Jones’ 20,000 point milestone reached last week was celebrated by a jubilant presidential Tweet: “Great!”
This milestone has since been the focus of many other comments. Those most critical have pointed out that the Dow Jones is not representative of the broader market (containing only 30 stocks) and that it is skewed (as one of the few indexes weighted by price rather than market cap(1)). Still, these initial remarks did not dampen the jubilant euphoria coming from the trading floors.
A trip back in time would thus seem in order. When did the Dow Jones hit 10,000 points for the first time? 1999 (a date I remember). And 1,000? 1972 (this I don’t remember). And at what pace !
Indeed… at what pace? The answer: 7%. By applying a 7% rate of interest to one’s initial investment over 45 years one reaches a multiple of 20 for this entire period.
Is this coherent? One way to answer is verifying that a stock index’s growth is consistent with the earnings growth of the constituent stocks over a very long period. This method of verification is complex; Charles Gave’s research team tried to put it to the test(2). A basket of stocks valued at 100 in 1958 reached 4900 compared to 4844 for growth in earnings: results which are not so far apart. And in both cases, average annual growth was 6.9%.
Over the short and medium term in contrast, comparison between the growth of the stock index and earnings is less meaningful: the price of an index is the reflection of expectations regarding profits and interest rates. A convergence in profits and performance is only achieved over the long-term. However, recent divergence from this trend was so pronounced that questions are warranted: while earnings remained stable over the last four years, the Dow Jones was up 43% in the same period.
“This is due to the interest rate effect” respond all sophisticated investors. To which is added presidential measures, and in particular, the corporate tax cuts promised by Donald Trump. Discounting the rise of future flows (by means of the lower tax rate) in relation to a lower interest rate (declining regularly up to last summer) has thus provided a twofold boost to the index’s present value.
Last November we emphasized the degree of caution that would be required with respect to the rise of US markets. And so here we are today. The gap between corporate earnings and stock prices cannot go on indefinitely. Ultimately earnings must catch up to the stock indexes… and this is just one of the parameters: if the inflation and interest rates rise too fast, the discounting effect will be reversed, pulling indexes down. We will pay close attention to bonds which, as has often been the case since the crisis, will set the tone for financial markets.
Didier Le Menestrel
(1) Accordingly Goldman Sachs, whose share traded around US$230, accounted for 8% of the Dow Jones for a market capitalization of US$97 billion whereas General Electric trading at around US$30 represented only 1% of the index though with a market capitalization of US$265 billion.
(2) “The Dow 20,000 Conundrum“, Charles Gave, 26/01/2017