As long as the stock market continues to be earnings-led rather than P/E-led, we can all sing Bobby McFerrin’s 1988 song “Don’t Worry, Be Happy.” Actually, the lyrics for stock investors should be “Don’t Worry, Be Wealthy.”
Consider the following:
(1) Trickle up. The S&P 1500’s market capitalization has increased by a whopping $6.6 trillion to $27.2 trillion since Trump was elected (Fig. 1 and Fig. 2). It is up 73.5% since the prior bull market’s peak on July 19, 2007. Yes, the rich have gotten much richer, but so have working stiffs with 401(k) accounts invested in stock.
(2) Trickle down. On Friday, Adam Shell wrote an article in USA Today titled “Did your company pay you a bonus with tax savings? Check the list.” By his count, “[m]ore than three dozen of the biggest American companies have shared their tax-cut windfalls with employees, mostly through one-time bonuses but also with hourly wage increases and bigger 401(k) matches following the new tax law passed in December. ….
“As of Friday, at least 39 companies in the Standard & Poor's 500 index—comprising 500 of the nation's largest companies—have said they are providing additional financial rewards to workers, citing benefits from the new tax law, according to a USA TODAY analysis of corporate press releases and company statements, as well as other forms of publicly available communications tracked by multiple sources, including Americans for Tax Reform, FactSet and S&P Global Market Intelligence.”
Most of the cash payments are one-time bonuses rather than wage increases. So they won’t lift wage inflation. The bonuses won’t boost the widely watched average hourly earnings (AHE) because irregular bonuses are not included in this measure of wages.
(3) Bullish squiggles. The good news is that this meltup might be sustainable. Granted, valuation multiples are high. However, most of the gain in stock prices over the past year has been attributable to rising forward earnings rather than rising forward P/Es, as clearly shown by our Earnings Squiggles analysis (Fig. 3).
Over the past six weeks since passage of the Tax Cuts and Jobs Act through the 1/25 week, industry analysts have raised their 2018 consensus earnings-per-share estimate by $7.16 to $153.42. Their 2019 estimate is now $168.94, up $7.87 over this period (Fig. 4). This year’s quarterly estimates have increased $1.63 to $35.83 (Q1), $1.81 to $37.90 (Q2), $1.83 to $39.33 (Q3), and $1.93 to $40.52 (Q4) since the tax cut (Fig. 5).
(4) Bullish sentiment. On the negative side, from a contrarian perspective, is that everyone is bullish, or so it seems based on the latest readings of the Investor Intelligence Bull-Bear Ratio (Fig. 6). The ratio rose to 5.25 during the 1/16 week and edged down only slightly to 5.05 during the 1/23 week. Both are the highest readings since the start of 1987. The good news is that this ratio works much better as a contrary buy signal when it is down to 1.00 or lower. It can stay quite elevated along with levitating stock prices when it is at 3.00 or higher. We don’t have any experience with readings this high since 1987, which started out great, but then got hit with Black Monday on October 19.
1987 All Over Again?
Last year, in the 10/9 Morning Briefing, we wrote: “By the way, a meltup followed by a meltdown won’t necessarily cause a recession. It might be more like 1987, creating a great buying opportunity, assuming that we raise some cash at the top of the melt-up’s ascent. Our animal instincts will have to overcome our animal spirits.” As noted above, the Bull-Bear Ratio was very high in early 1987. Back then, it was 4.92 during the week of March 3. By the end of the year, it was down around 1.00.
(1) Tax reform & takeovers. Back then when Reagan was president, as now under Trump, investors were excited by a tax reform package, which cut taxes significantly for individuals. It was enacted on October 22, 1986. There was also a wave of takeovers funded by junk bonds issued by Drexel Burnham during 1987. The DJIA soared 50.5% from the passage of the tax reform plan to peak at 2722.42 on August 25, 1987 (Fig. 7).
(2) Interest rates. The government bond yield was relatively low at 7.18% at the beginning of 1987 (Fig. 8). Yields rose on inflationary concerns to peak at 10.23% on October 23. Contributing to the upward pressure on bond yields is that Alan Greenspan, who became Fed chairman on August 11, 1987, raised the federal funds rate by 50bps on August 27 (Fig. 9).
(3) Stock valuations. The S&P 500 forward P/E rose from 10.1 at the start of 1986 to peak at 14.8 during August 1987 (Fig. 10). It then plunged to 10.5 by the end of that year. The rising bond yield, Greenspan’s first policy action at the Fed, and relatively high valuations certainly set the stage for Black Monday. But the triggering event was a proposal in the House Ways & Means Committee the prior Wednesday to eliminate the deductibility of interest expense in takeovers.
(4) Forward earnings. Despite all the commotion, analysts’ consensus earnings estimates for the S&P 500 continued to move higher during 1987 (Fig. 11). There was no recession. Stocks were deemed to be a bargain once the House committee killed the tax proposal in early December.
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.
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