Monetary and fiscal ­stimulus fueling asset valuations

James Quackenbush, BridgeTower Media Newswires

It’s hard to ignore the renewed optimism on investor sentiment since the presidential election. President Donald Trump has invigorated growth expectations with hopes from potential tax reform, infrastructure spending, deregulation and a pro-business administration. These anticipated changes have ignited stocks to all-time record highs, pushing valuations to heightened levels on a number of metrics.

Beyond the Trump effect, and thanks to monetary actions (e.g., low rates and quantitative easing programs), the current state of the economy, and stock valuations have been building momentum for years. Looking forward, Trumponomics will undoubtedly have an impact on the future of the economy but growth expectations have become overly optimistic as there is increased uncertainty in Washington as to which policies will be implemented and to what degree.

To review one of the primary forces behind today’s elevated valuations, monetary policy has been ultra-accommodative since the financial crisis. The Federal Reserve (Fed) has kept short-term interest rates at record-low levels and initiated multiple rounds of quantitative easing programs to infuse money into the economy to spur growth. Although these actions have only been able to produce below-average growth thus far, the long-term benefits have been trickling into the economic data as of late.

Indeed, the unemployment rate is near pre-crisis levels at 4.5%, new job numbers are steadily increasing, consumer confidence is at levels not seen since the late 90s, and ISM manufacturing data is showing strength in the economy. It has been years of action by the Fed that has contributed to the improved fundamentals we are witnessing today and should not be forgotten as we move into the next stage of this economic recovery. Although the Fed has moved away from its ultra-accommodative stance and short-term interest rates have been increased to 0.75, rates are still low by historical standard and should still be viewed as unrestrictive and healthy for long-term growth and the stability of the economy.

Turning to fiscal policy and what has been coined as Trumponomics, there will be a transition from monetary stimulus to fiscal stimulus. The next stage of the business cycle and future of growth will be dictated by how Trump’s agenda will actually be implemented and if his policies are able to build off the progress initiated by the Fed.

However, there is a lot of uncertainty as to how Trump’s policies will develop. For example, there has already been resistance from Congress regarding health care reform. But if some variation of his tax reform and infrastructure spending is approved, it will prove beneficial for long-term corporate earnings, consumer spending, job creation and GDP growth.

Regardless of the uncertainty, there seems to be a sense of confidence by the investment public that fiscal policy change will be accomplished in the near term. Realistically, any advancement out of Washington will take time to be approved and the benefits won’t improve economic data and GDP growth until sometime in 2018. This is causing concerns that growth expectations are too optimistic, which could result in short-term volatility.

From a stock valuations standpoint, the price-to-earnings, price-to-book, and price-to-sales metrics are all stretched. The most commonly used valuation multiple, the price-earnings ratio (P/E ratio), is currently at 22, compared to its long-term average of 16.5. A company’s P/E ratio measures a company’s current share price relative to its earnings per share. At 22, the P/E ratio indicates that stocks have moved toward being overvalued. Although valuations are expensive relative to historical norms, they have not reached extreme levels as they did during the tech boom and it’s not unusual for valuations to stay elevated for a lengthy period of time.

While these high valuations do warrant caution, low bond yields from Treasuries are contributing to the rationale as to why P/E ratios have become elevated. The Fed model, which looks at earnings yield on the S&P 500 relative to the 10–year Treasury yields, is suggesting stocks are currently a better value relative to fixed income. The forward earnings yield on stocks is above 5%, compared to the yield on the 10-year Treasury of 2.3%, indicating low bond yields are attracting more investors toward stocks, which has contributed to high valuations.

With improvements in the economy and anticipated fiscal stimulus causing stock valuations to become stretched, investors question what the best investment approach is for the future. During times like this, when risk-averse investors may be tempted to reduce risk and risk-seeking investors might want to take advantage of the market momentum, investors should adhere to their long-term strategic asset allocation and not try to out think the markets.

Investors should take this time to review their asset allocation, market expectations and rebalance asset classes that may have drifted from their optimal weightings. Monetary policy is still accommodative by historical standards and potential fiscal stimulus should prove beneficial for long-term economic stability, but given valuations of stocks, a cautious investment stance is warranted.

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James Quackenbush is a Senior Domestic Equity Analyst for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees.  Offices are located at 183 Sully’s Trail, Pittsford, NY  14534  (585-586-4680).

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