Those old enough to remember Wimpy of Popeye the Sailor fame will remember the quote in the title above. Embedded in this quote is the concept relayed by Benjamin Franklin who said “Time is money.” In fact, time and money have been integral to the process of valuing free market transactions and are reflected everyday in financial markets around the world. Indeed, time and money are reflected in today’s equity market valuations as investors, it seems, believe that the Trump administration will successfully deliver on their campaign promises. Unfortunately, the monetary benefits of these policies are entirely dependent on legislative specifics and the timing of their passage. It is difficult to assess the final details of legislation, especially given the disparate constituencies needing to be served. However, it is possible to assess the amount of time it will take to achieve their passage.
Shortly after the election President-elect Trump released his plan to work with Congress “to introduce legislative measures and fight for passage within the first 100 days of my Administration” ten separate initiatives, including, tax reform, border tariffs, $1 trillion of infrastructure spending, repeal and replace Obamacare, and fully fund the construction of a wall on the Mexican border. While President Trump is nothing if not confident, he likely needs some perspective on the first 100 days. David Greenberg, Rutgers University professor of history and media studies, noted in a 2009 WSJ editorial, that new presidents tend to be clueless about governing. Greenberg went on to say that the 100 day yardstick for measuring presidential progress is misleading, arbitrary, and not nearly enough time for a president to go from “clueless to true mastery of the job.” JFK provided perspective as to the first 100 days in his inaugural address when he spoke of meaningful, if not, lofty goals for himself and the country, but then said the following: “All of this will not be finished in the first 100 days. Nor will it be finished in the first 1,000 days, nor in the life of this Administration…” Realistically, these words hold true for the Trump administration today as well.
Not unlike past presidents, President Trump faces significant social, economic, and geopolitical challenges and it appears that he also confirms Dr. Greenberg’s assessment of governing cluelessness. One might further argue that the current state of polarized political thinking and lack of legislative resolve in Washington will make it extremely difficult for President Trump to accomplish the campaign promises he made. Notwithstanding the GOP’s control of both houses of Congress, these campaign promises will likely face headwinds from nearly universal Democratic opposition and a politically fractured GOP. Suffice it to say that the current political and social landscape makes uncertain, at best, any debate, resolution and legislation relating to the Affordable Care Act, corporate and individual tax reform, infrastructure spending, etc.
Equity Market Valuations
As noted above, we believe that it is very hard to assess the net monetary benefits to the economy of the Trump agenda, let alone handicapping how much of it will actually get done. Furthermore, we think that the time frame to achieve this agenda has been significantly underestimated. In our opinion the Trump rally reflects investor hope rather than any real improvement in economic fundamentals. As such, we believe current market valuations not only misrepresent the current economic opportunity set, they are high relative to most historical references.
To wit, a look at various historical market valuations indicate that current market valuations are near the all-time highs reached prior to the Great Depression, the Great Recession, and the dot.com bubble. Exhibit 1 below uses Nobel laureate Robert Shiller’s P/E 10 Ratio (10-year average of inflation-adjusted earnings of the S&P 500 as the denominator) and plots the current P/E 10 as a percentile of the series. Today’s valuation is in the 96th percentile, just above the 95th percentile of the 2007 peak and just below the 97th percentile of the 1929 peak. This observation excludes the dot.com bubble.
However, Exhibit 2 below shows the P/E 10 Ratio relative to its mean and shows that the valuation of the S&P 500 today stands 87% above the historical mean, only behind the valuation prior to the Great Depression and the dot.com bubble.
Finally, Exhibit 3 shows what’s known as the Buffett Indicator, which compares the total market capitalization of the stock market divided by US GDP. Interestingly, the reading today is 125%, which has only been exceeded by the 130% reading in 2015 and 151% in 2007.
It is important to note that valuation measures are not particularly accurate in predicting market declines, but studies have shown that 10-year forward returns from higher historical valuation levels result in far lower returns. The chart to the right shows that the 10-year forward returns of the S&P 500 from the highest valuation quintile has resulted in a minimum return of -0.5% to 9.8%. Exhibit 1 above shows that current market valuations are well into the top decile of historical valuations, which indicates that 10-year forward returns are likely to be no more than 4%.
Discretion is the Better Part of Valor
Sir John Templeton said “Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria.” The confluence of a 30-year high in bullish sentiment among investment advisors, a 16-year high in consumer confidence, and investor sentiment pushing equity valuations to excessive levels must at least signal that we are far closer to euphoria than to pessimism. Another sign of optimism, if not euphoria, is the dramatic rise in retail investing. The WSJ reported last week that retail investors have been driving the most recent rally, with $124 billion of equity ETFs purchased since the beginning of the year. BlackRock reported that individual investors accounted for 85% of inflows to their iShares ETFs in the first two months of the year.
The recent postponement of the House vote to repeal Obamacare is further evidence of the difficulty faced by the Trump administration in accomplishing its legislative agenda. Next up is tax reform, which is universally believed to be a tougher task than reforming healthcare. The Trump reflation rally has been driven by the hope that the Trump agenda would be passed quickly and that it would be a catalyst for economic growth. We believe that the equity markets have priced in Trump legislative successes with little room for failure.
When all the facts above are combined with the fact that the economy is in the ninth year of recovery and the Fed has finally become more aggressive in raising rates, we can’t help but believe its time to exercise some caution on behalf of our clients. As such we have decided to take some profits in the domestic equity markets. We’re continuing to maintain our current exposure to international equity markets. Moreover, in addition to the recent Fed move on interest rates, we are beginning to see some inflationary pressures here in the U.S. as well as Europe and are keeping bond maturities relatively short to protect principal with a focus on higher quality holdings as credit spreads are tight by historical measures. We continue to maintain a healthy allocation to non-correlated strategies like reinsurance, longevity, managed futures, alternative lending, and real estate credit to better diversify our client portfolios. We have a small tactical allocation to cash for now, which has optionality value despite its near zero return.
The coming weeks and months will reveal if our concerns are legitimate, in the meantime our thinking is discretion is the better part of valor.