Tarriff Policies

It is true that tariff policies have made things volatile…on and off again…different carve outs…different countries…phone calls that change things.  All of this clearly has had an impact on the markets.  I’m not surprised to see stock market volatility.

However, it isn’t all about tariffs.  Many major models of the overall stock market valuation show that the market is expensive.  The so-called Buffet Indicator, which measures the market cap of the S&P 500 as a percent of GDP, says the market is overvalued.  The Shiller CAPE PE Ratio, which measures stock prices compared to trailing 10-year inflation-adjusted earnings, shows the market is overvalued.  In other words, compared to history, stock prices are on the high side.

The Fed Model, which compares the earnings yield of the S&P 500 (the inverse of the PE ratio) to the 10-year Treasury yield or to a corporate bond yield, shows that stock returns relative to bond returns are the lowest since 2000 – the dot-com bubble. The Capitalized Profits Model, which discounts current profits by the 10-year Treasury yield, shows the same thing.  We are overvalued relative to past relationships of earnings and interest rates.

However, as the saying goes, it is a market of stocks and not a stock market.  Just because these models say the market as a whole is over-valued does not mean all stocks are over-valued.  But because the S&P 500 is so top heavy, with just 10 stocks making up over 1/3rd of its total capitalization, it is hard for the other 490 stocks to offset declines in these very large cap companies.

I think the policy changes that are underway will be positive for long-term growth.  Keeping tax rates low, cutting regulations, and reducing the size of the government bureaucracy will boost the underlying growth rate of the economy in the future. Unfortunately, the US economy has been artificially boosted in last 20 years by massive deficits and a very loose monetary policy.  Reducing that artificial stimulus is like having the painkiller wear off.  I expect the economy to grow more slowly this year, which means corporate profits are unlikely to grow faster than the consensus expects.

In other words, what is good for the long-term makes the short-term look worse.  This is much like what happened with Ronald Reagan in the early 1980s.  Even though his policies led to a boom in the economy, the fix was a painful process.

I am not surprised to see the stock market reaction of the past few weeks.  Investors have been so used to “buying the dip” because the stock market has been a one-way trade. Seeing it fall toward correction territory feels worse than it really is.  This compounds negative feelings and people start looking for scapegoats. I get it.  But tariffs are just the catalyst, not the full explanation.  When Reagan moved into the White House, the PE ratio of the S&P 500 was about 8 and the budget deficit was non-existent.  When Trump moved back into the White House (50 days ago) the PE ratio of the S&P 500 was 28 and the budget deficit is close to $2 trillion.

Smart investors should not abandon stocks.  The valuation models mentioned above are not meant for trading. They are indications of overall value. But there are still opportunities in undervalued sectors and through diversification. At times like these you have to be diligent and patient.