Not surprisingly, I have had numerus conversations with clients who have asked the question: “Are US equities overvalued, expensive, rich, ect? “ My answer is yes…if you only focus on historical valuation, recent US growth, headwinds of stronger USD and higher rates. Not unimportant factors to be sure when looking at investing in US equites (Figure 1) Further, it is not unreasonable to expect little upside in US equities from current “rich” levels, all else held constant. However, what I say next is that all else is not going to be held constant and that I believe that US equities offer significant convexity to the upside driven by greater than expected earnings growth. More importantly, investors can buy this upside at historically low levels of vol. The factors that could drive this upside to equities are Trumpanomics and synchronized world economic growth.
First, is of course, Trumpanomics and the impact it could have on US corporate earnings and ROEs. The market is underestimating the potential positive changes from Trump polices, particularly on the back of the spectacular loss on health care reform. This is not surprising. Abenomics was discounted significantly after the election in 2012 as the market missed the populist mandate that Abe had for change then and what Trump has now ( I wrote about this in an earlier comment if you are interested, also read the latest 61 page tome on populism that recently came out of Bridgewater) The second factor that could drive US corporate earnings higher than current estimates is synchronized growth of economies around the world. For the first time since the GFC all major economies of the world are lifting off, even Italy. Investors have underestimated the potential impact this factor can have on US earnings. Earnings models as with any data driven methodologies have difficult time capturing the impact of changes in behavior versus historical data. Current world economic growth is basically a correlation one event, however models and estimates have been fit from historical data that reflects more disparate levels of economic growth and crisis across countries.
Let me briefly talk about Trump corporate tax reform, and focus only on the move of the statutory tax rate from 35% to 15%. ( I have substantially more to say on the larger topic of Trumpanomics that you can find on my web site.) This change alone could add roughly 16% more to corporate earnings, which is an increase of 21%, if fully implanted. Yes, I get it, he may only get the Ryan plan of 20%, but it does give and upper end to the potential benefit. And yes, I know that the effective rate is closer to 25% for C-corps. However, a couple of points. Domestic companies—regional banks—pay the full 35%, so it could underestimate the impact for domestic companies. Further, I take that into account in the analysis below in figure 2
Now what does it mean for equity prices. Below is the graph of S&P prices with increase in earnings from Trump tax policies. I assume a 19.3 PE, which is the PE based on 2018 earnings estimate of 122. That could put S&P500 around the 2700 level, and increase of 15% from current levels.
Certainly, the probability of Trump getting any tax policy change is less than 100%. But the potential that he gets it done is significantly greater than zero. That upside looks cheap given that implied vols are near historical lows, Figure 4 below. For example, a 2500 strike call on S&P 500 cost less than 16 pts. A 10% rally in S&P would give it a payout of over 5 to 1. Why buy the down side of being outright long, just buy the upside with options?
(Buying financials is an even better trade given the sell-off, but I will leave that to another commentary. If you are interested, you can go to my site and read the pitch.)
Now the second factor, which I think is under appreciated by investors, is the synchronized economic growth from around the world, not just in the US. Take a look at Figures 5 – 8, which show PMI for most of the GDP in the world. In my view it paints a more optimistic view of future world growth and, more importantly, US corporate earnings given the large percentage of profits come from none US sales. Something clearly is going on in the world despite all the headwinds, perhaps after 10 years, the world is finally shaken off the impact of the GFC? In of itself, the tail wind from non-US growth could provide the necessary push up in earnings and ultimately equity prices. You could also make the case that equity markets in Europe and Japan are cheaper. I am going to put out a piece on Japan in the next week or two that I will make that case of more Abenomics.
Figure 5. US PMI
Figure 6. China PMI
Figure 7 Japan PMI
Figure 8 EU PMI
Figure 9 Italy PMI
Ok, a pretty controversial view, I grant you. But, I am betting on something is changing and it is not just Trump. It is a bet on world growth. That means interest rates in the US and ultimately in Europe are headed higher. It means that equities are going to ratchet higher and, even with higher rates, credit spreads are going to tighten from here. I will also be coming out with a piece on credit after I finish the Japan piece—although I might get sidetracked with Europe given how much is changing over there.