James Bevan: Trump, stocks and signs of a ‘melt-up’

Is the US about to see a ‘melt-up’? Rising expectations after the election of Donald Trump and bullish stock markets are signs that it may be underway.

Equity markets are anticipating that president-elect Donald Trump has an economic plan that is bullish for stocks, so long as measures that damage trade are not taken. They also expect that with Republican majorities in both houses of Congress, Trump will lower tax rates and reduce business regulations, and these measures should be helpful for business.

For some while we have talked about a melt-up scenario, with a 30% probability for US equities, as against a 60% probability of just rational exuberance, and a 10% probability of a sustained mark down in prices, and there are signs that the melt-up scenario is underway.

Thus last Friday, the following major indexes in the US rose to record highs: Russell 2000 (up 16.1% since Election Day), the S&P 500/400/600 (5.6%, 11.9%, and 18.1%), and the Nasdaq Composite (4.8%). The Dow Theory is very bullish, with both the Dow Jones Industrial Average and the Dow Jones Transportation Average at record highs, rising 7.8% and 13.0%, respectively, since election day.

Tax and buy backs

Of all Trump’s economic proposals, the easiest to implement quickly may be a reduction in the corporate tax rate on repatriated earnings from 35% to 10%. By some estimates, that could bring back $2.4tn parked overseas and it’s noteworthy that the current bull market has mostly been fuelled by corporate equity buybacks and dividends, which totalled $3.1tn and $2.2tn, respectively, from Q1 2009 through Q2 2016.

Corporations have had an incentive to buy back their shares with funds borrowed in the bond market because after-tax yields have been below the forward earnings yield of their stocks – so the S&P500’s valuation multiple may be determined mostly by that after-tax yield. With the backup in bond yields, the after-tax yield might be up to 4%, which still provides the buyback incentive and leaves plenty of room for the S&P500 forward P/E to rise as high as 25.0 as against the 17.2x on Friday.

Meanwhile, the comparable valuation multiples for the S&P400 and S&P600 are 19.2x and 20.5x respectively. If the S&P500 traded on a forward P/E of 25.0 today, the S&P 500 would be at 3290, or 46% higher than Friday’s close.

That’s not a forecast, just an illustration. One problem is that Trump’s policies could mean a bond yield that is much higher than today, leading to a valuation melt-down. Another challenge is that much of the cash that may be repatriated is held in bonds which need to be liquidated to fund buybacks, dividends or genuine investment, and the selling of the bonds could drive yield up too.

On a straight yield relative basis, the S&P500 dividend yield is now around 2.00%, while the US Treasury 10-year yield is up to nearly 2.50% but clearly absolute yield is not important in that the initial reaction to Trump’s victory was to sell dividend-yielding stocks and move into stocks that benefit from economic growth and inflation – so instead of pursuing ‘yield’, investors looked for stocks that would benefit from a steepening yield curve. Thus we have S&P500/400/600 Financials up 18.5%, 19.6%, and 26.8% since Election Day.

Sentiment is certainly stronger, with the investor intelligence survey of US investment advisers (BBR) at its highest since July 2015 (although further strength could be construed as a contrarian sell signal). US retail investors are apparently interested in equities rather than bonds but there is a risk that markets over-discount a successful first year of policymaking under Mr Trump’s administration, requiring us to focus on what actually happens to corporate earnings.

Certainly, US economic indicators were improving before election day, with the recession — which ran from H2 2014 through H1 2016 — in the energy sector seemingly over due to the rebound in oil prices since the start of the year. The US oil rig count seems to have bottomed during late May, while oil field production remains high, so far not dropping much along with the rig count.

The Citigroup Economic Surprise Index has risen from this year’s low of -55.7 on 5th February to 30.2 on Friday. The S&P500’s total aggregate earnings (not EPS) rose 10.8% year on year (yoy) in Q3, its first positive reading following seven straight negative you comparisons. Aggregate S&P500 forward earnings, which had been weighed down by the plunge in the energy sector’s earnings last year, have been rising to new records this year.

Tax cuts would boost corporate earnings – the published numbers suggest that the effective tax rate on the S&P500 was 27.5% during 2015 and during the past decade, S&P500 earnings slowly benefitted from lower interest expense and share buybacks.

A cut in the tax rate to 15% would yield an immediate and permanent benefit to S&P500 earnings. The consensus currently estimate that S&P500 earnings will be around $132 per share in 2017. Using 2015’s effective rate of 27.5%, each percentage-point cut in the effective corporate tax rate would add $1.82 to consensus 2017 earnings. A 5ppt reduction in the tax rate would add $9.10 to earnings, and a 10ppt reduction would add over $18, or nearly 14%, to earnings.

Melt-ups and melt-downs

The bottom line is that a tax-rate cut could drive the S&P500 index even higher – and importantly whilst the S&P500 has risen 5.6% since election day, it could move higher even without a valuation melt-up if the effective corporate tax rate is cut.

Any melt-up carries a risk of subsequent melt-down and the richer the valuation, and the more vertical a market rise, the greater the risk. We will look for any guidance from the Federal Reserve at the FOMC meeting on 14th December as to whether it is concerned, and we may see a more aggressive dot plot of rate hikes for 2017.

We will also watch for trouble in the yield spread between corporate High Yield bonds and the 10-year Treasury. At the end of last week, it was down to 378bps from a recent peak of 844bps on 11th February, and the lowest since 3rd June 2015. There’s no sign of a recession in this spread.

On the other hand, the US economy may perform better than expected. Analysts are raising real GDP forecasts from circa 2.5% next year to circa 3.0%. Core inflation rate forecasts have risen from 2.0% to 2.3% in 2017 – with the US Treasury 10-year bond yield rising to 3.00% by the end of next year or sooner given that it is already at 2.50%.

If Trump does succeed in accelerating US economic growth, it may be attributable — to an important extent — to the stimulus that his plan will provide to small business owners, with lower taxes and less regulation.

Small businesses are hugely important for US jobs – the ADP private payroll survey reveals that small companies (1-49 employees) accounted for 40.6% of total employment during November, with medium companies (50-499 employees) accounting for 37.6%, and large companies (over 500 employees) accounting for 21.8%.

Meanwhile, the latest Wells Fargo/Gallup Small Business quarterly survey, conducted 11th-17th November, measuring the optimism of small business owners, shows them to be the most optimistic that they have been since January 2008. The overall index score of 80 in November is up 12 points from July and up 26 points from a year ago. Optimism is all about thoughts on the future, and we will need to keep a beady eye on the extent to which facts end up substantiating the hopes.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla

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