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Economy in Brief

US Equity Market: An "Oasis" of Hope
by Joseph G. Carson ([email protected])  July 9, 2019

The strong gains in the US equity markets during the first half of 2019 were mainly driven by the "hope" of new policies than improving fundamentals. Equity investors have been "hoping" that policymakers will reverse course and lower official rates and also "hoping" international trade disputes would be settled soon and in a way bullish for growth and earning. All of this "hoping" has occurred against a deteriorating picture for earnings and as a result equity investors have pushed market valuations to the highest levels since 2000. How long can the "hope" equity trade last? And does the high level of equities pose a risk to the economy?

Equity investors nowadays have been a "hopeful" bunch as they have been betting on policy changes with bullish outcomes. Yet, the reasons cited for the "hopeful" outcomes are not fully persuasive. All leave room for counterarguments.

First, equity investors are "hoping" that policymakers will lower official rates to sustain the growth cycle. Yet, it is not clear if lower official rates are necessary at this time or that there would be any lift to economic growth or equity market benefit from a lower level official rates. Treasury yields out to 10 years are trading well below the target on official rates so even if policy rates are lowered its not clear that market rates would move any lower from where they are priced today or that there would be any incremental increase in overall liquidity.

Second, equity investors are "hoping" that if policymakers decide to lower official rates that the outcome will be similar to that of the mid-course reduction in official rates that took place in 1995, which was followed by several years of economic growth and double-digit gains in equities. Yet, there are a number of fundamental differences between 1995 and 2019 and the most important is the equity market valuation.

At mid year 2019, the market value of domestic equities is 2X that of nominal GDP (matching the peak), whereas in 1995, equities were selling at less than 1X nominal GDP. In other words, in 1995 equities were cheap relative to future economic growth whereas today equities appear to be very expensive relative to future economic growth.

Third, equity investors have been "hoping" that trade disputes are less harmful to the US economy and profits given the low share of exports (12%) relative to GDP. However, equity investors are ignoring the fact that roughly 40% of overall corporate earnings are earned outside the US so the impact on profits emanating from slower global growth linked to trade disputes will be significantly larger than any negative impact on the general economy.

Fourth, equity investors seem to be "hoping" that the suspension of the next round of tariffs on Chinese imports is a sign of progress on the trade front. Yet, the Trump Administration is seeking a trade agreement that is heavily tilted in the US favor, so too undo or reverse the large trade imbalance of the past two decades. And, China's is seeking a trade agreement that is fair (equal) to both sides. It's unclear if there is a middle ground here for both sides to claim a win-win outcome. How long will it take before equity investors lose "hope" that US-China trade dispute that may not be resolved soon or in a way that is not bullish for growth or corporate earnings?

Equity market gains often paint a bright and accurate picture of future economic growth and corporate earnings, but it also true that strong financial market gains pose a danger that an overreaction on the upside could be followed by an overreaction on the downside if events do not play out as expected, or "hoped". That is not a forecast or a prediction of what may occur, but merely an observation that equity investors are pinning a lot of "hope" on policy decisions and positive outcomes from all of those decisions and in the meantime are overlooking high valuations and a deteriorating profit picture.

Viewpoint commentaries are the opinions of the author and do not reflect the views of Haver Analytics.
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