INSUBCONTINENT EXCLUSIVE:
By Stephen GandelA year ago, when the market was rallying, President Donald Trump seemed sure stock prices were an accurate measure of his
efficiency.
On Tuesday, President Trump said stocks were a good buy, effectively endorsing the notion, long held by many economists, that
of whether the recent plunge has also been overdone is still uncertain
The market soared on Wednesday, with the SP 500 Index rising 5 per cent
Nonetheless, a volatile market, like the one recently, can itself create more volatility and feed a sell-off by sapping investor enthusiasm
to own stocks, justifying their lower prices
whether that earlier Trump Dump had gone too far
I found that it nearly had, and soon thereafter stocks rallied
The market is even lower now
The bottom lines of the companies in the SP 500 are expected to be up 24 per cent for 2018
Earnings will still be up, but only 8.4 per cent, according to current projections
Investors, of course, given the one-time boost from the tax cut, which I estimate made up about 50 per cent of the earnings growth this
year, should have seen the drop coming
In early October, when the market peaked, analysts were looking for a 11.5 per cent rise in profits next year at SP 500 companies
Stocks typically trade at about 1.2 times their growth rate
So a 3 per cent drop in expected growth means stocks should be down 4 per cent from where they were in early October, based on earnings
alone.
PROFIT MARGINSThe problem is that even that lower projection of earnings growth looks overly optimistic
If profit margins remain the same rather than rise slightly, then earnings growth will drop to about 5 per cent, snipping an additional 4
per cent off the stock market, or a total of 8 per cent.
INTERNATIONAL TRADEA trade war puts even that earnings growth in jeopardy
The biggest problem is not next year, but long term
Over the past decade, the SP 500 has had an average price-to-earnings ratio of about 15
That implies a long-term expected profit growth rate of about 12 per cent
The SP 500 gets about half of its sales from overseas, where those profits are rising much faster
Assume a 50 per cent chance that 50 per cent of that growth is impacted, that brings your expected long-term growth rate down to 7.5 per
cent, and could imply that the SP 500 should be worth an additional 5.5 per cent less
Volatility makes stock investors less interested in holding stocks
It also increases the risk of owning stocks in the future
Both of those things translate into a lower P/E ratio
How much The VIX index, which measures stock market volatility, averaged 11 last year
This year the average has risen to nearly 17, though it has been about 35 recently
The VIX is measured in per centage points
So, all else being equal, a 6 per centage point higher VIX should translate into a stock market that is 6 per cent lower
Add it all up, and stock market values could have reasonably been expected to fall about 19.5 per cent since mid-September
Like sell-offs, stock market rallies do feed on themselves
So stocks could continue to rise, but there is no reason to count on that.
