Tuesday night Donald Trump gave his address to Congress and re-emphasized many campaign promises. In light of that, I’d like to provide some thoughts on the investment landscape.
When it comes to making investment decisions, there are two primary schools of thought, the “macro” view and the “micro" view. “Macro” driven investors look mostly at the larger picture of the economy as a whole, paying special attention to interest rates, unemployment, tax rates, major political decisions, etc. Alternatively, investors driven by the "micro" view focus on specific companies or industries, paying special attention to details like profit margin, debt ratios, stock buybacks, corporate earnings growth, price to earnings ratios, etc. Both schools of thought have merit, and both are required in order to make truly informed decisions.
For many investors, it’s easier to focus on the “macro” (big picture) because that mindset dominates the news media. As such, tax policy, government spending, and interest rates are often viewed as the main drivers of stock performance. While that appears to be true in the current environment, there remains a danger in ONLY focusing on the “macro” view. Both the unemployment rate and interest rates are incredibly low; optimism is high, and tax cuts are likely on the horizon. These conditions provide an attractive backdrop for a healthy economic state. However, there are good reasons to consider the "micro" view as well.
Current valuations suggest that most of the good “macro” news is already priced into equities. Stocks have rallied strongly since the election in light of anticipated tax cuts and optimism over the promised additional spending on infrastructure and defense. Continued low interest rates and low unemployment are likely also reflected in valuations as well.
The current ‘price to earnings’ ratio on the S&P500 is 26.5 (according to multpl.com), which means that investors are paying an average of $26.50 for every $1 of the previous year's net income. Historically, over the last 75 years, the average has been about $15.70 per $1 of the previous year’s net income. The same story could be told for other ratios, including "price to sales" and "price to cash flow." In fact, most metrics we use to value the stock market are well above historic averages.
It's logical that investors are placing a current premium on stocks for reasons mentioned above, but should also give a good reason to pause and consider the potential longer-term outcome. Unless investors continue to pay a handsome premium to own stocks over the coming years, paying a premium today probably won’t yield great longer term results.
With that said, in the near term, we tend to agree with the crowd (i.e., don't fight the trend). Markets appear poised to move higher as optimism abounds over anticipated tax cuts and spending packages. Equities in the Financial and Defense sectors stand to gain most from the current administration's focus on deregulation and increased spending.
We remain invested in stocks, but probably more cautiously than most. Many investors may be wise to consider using “stop loss” orders on individual stocks to protect against a potential pullback. If the tide turns and “macro” optimism fades, there probably won’t be much on the “micro” side to steady the boat.