“Animal spirits are back,” says John Authers in the Financial Times. It feels like the dotcom era on Wall Street. And you can see why. Donald Trump’s election has caused a paradigm shift. After years of having to rely on liquidity from central banks to power equities amid lacklustre growth, investors reckon we now have some genuine economic momentum to do the trick: a major stimulus from Trump and a Republican-controlled Congress.
What changed in 2016
Until November, the theme of the year was a series of scares rectified by central-bank liquidity – pretty much what we’ve been seeing since the post-crisis rally began. Investors gradually realised that each nasty surprise would prompt more stimuli. In January, fears of a sharp slowdown in China caused a global stockmarket slide and upended forecasts of several interest-rate hikes. Similarly, the Bank of England restarted the printing presses after the Brexit vote.
In Trump’s case, the initial jitters soon subsided as investors pencilled in looser financial regulations, corporate and income tax cuts, and a $1trn spending boost for infrastructure. The S&P 500 has moved up a gear since the election, gaining almost 10% to new record highs – compared with an 11% advance for the year as a whole.
The trouble is, says Randall Forsyth in Barron’s, “expectations are so strong as to border on certainty” that Trump’s policies “will be enacted as he presented them, and promptly”. Wall Street’s forecasts are clustering around a mid-single-digit rise in the S&P 500. When all the experts agree, something else tends to happen.
The consensus is usually wrong
For starters, says Forsyth, a spat over a Supreme Court nomination could well delay the fiscal stimulus, and while both houses of Congress are in Republican hands, potential resistance from “staunch deficit hawks… falls outside the consensus”. Investors are relying on Trump to push through his stimulus, but at the same time “counting on [him] to forget about, or downplay, his protectionist rhetoric”, as The Economist’s Buttonwood columnist points out. Even if this pans out, don’t count on a sustained upswing.
Unlike in the early 1980s, the last time a new Republican president delivered a fiscal stimulus, the US economy has been growing for years and is close to full employment. The unemployment rate is down to 4.6% and wage growth is at a post-crisis high. Pouring more fuel on this fire could boost inflation and lead to faster interest-rate hikes than expected.
Furthermore, if wage growth does
keep growing strongly, it will nibble away at profit margins, as will a stronger dollar – S&P 500 firms earn around half their revenues overseas. So while the earnings recession is over, profits are unlikely to surge. Historically high valuations are a further potential headwind. The path of least resistance remains upwards. But, says Buttonwood, “bad news – in the form of political risk, falling profits or changes in monetary policy – may never be far away”.
Dow 20,000: a meaningless milestone
There has been a lot of fuss in the past few days about the Dow Jones Industrial Average reaching the 20,000 mark. Ignore it. The Dow Jones index is an anachronism that provides a skewed view of market movements. Most indices, notably the benchmark S&P 500, are weighted by market capitalisation: the share price multiplied by the number of shares available. So, quite reasonably, firms with a higher market value get a higher weighting in the index tracking that market.
The Dow, on the other hand, weights companies by price, not market cap. This is because equity indices were a new concept when Charles Dow constructed it in 1896. Back then, it comprised 12 companies, and adding all the companies’ share prices together and dividing by 12 produced the value of the index. It was a fairly simple calculation for people to remember.
But the problem with a price-weighted index is that if a share in company A costs twice as much as one in firm B, A will make up twice as much of the index even if B is actually a much more important company with far more shares available than A.
Fast-forward to today, with the Dow now encompassing 30 firms, and we have the absurd situation of Goldman Sachs being the top firm in the index simply because of its $240 share price. By market value Apple is America’s – and the S&P’s – biggest company. The fact that The Wall Street Journal handpicks the Dow’s 30 firms skews the picture further.