The International Monetary Fund, echoing increasingly gloomy sentiment in Washington, has concluded that the Donald Trump administration and Congress probably won’t succeed in enacting tax reform or even significant tax cuts. The Republican chairman of the Senate Foreign Relations Committee calls the White House “an adult day care center” and says he fears that the president’s reckless bluster may lead us into World War III. The president, meanwhile, says he wants to compare IQ test scores with his secretary of state.
Stock market investors do not appear to be worried about any of these things. The Dow Jones Industrial Average set a new closing record Tuesday. The Standard and Poor’s 500 Index and the Nasdaq Composite Index didn’t quite do that, but they did both close at all-time highs last week. The overall performance of the stock market so far in the Trump era — measured either from election or inauguration — is undeniably impressive. I briefly considered updating my exercise of two months ago, in which I considered stock market performance under every president since William McKinley, but it didn’t really seem worth the effort. Stocks have done well in the Trump era. Period.
Up, Up and Up
Dow Jones Industrial Average closing price
So what are we to make of this juxtaposition between a seeming train wreck in Washington and a booming stock market? I’ll leave aside the possibility that stock market movements over a nine-to-11-month stretch are random and meaningless — not because it’s necessarily wrong but because there’s not a lot to say about it. Three other explanations spring to mind:
Trump is actually doing a good job for investors. While the media and Washington fixate on every new outrage and absurdity emanating from the president’s Twitter feed, investors may be sifting out the noise and focusing on what’s actually happening. Environmental and financial regulations are being rolled back or delayed. The Supreme Court has kept its business-friendly majority. The president and Republican congressional leaders have so far proved remarkably incapable of accomplishing anything legislatively, but hey, political gridlock sure was good for markets in the late 1990s.
It’s not about Trump, or even the U.S. The U.S. economy is continuing to grow at about the same slow pace it has for most of the now eight-year-long expansion, but economies elsewhere in the world are picking up speed. That same IMF World Economic Outlook report that discounted the chances of tax reform and predicted U.S. gross domestic product growth of just 2.2 percent in 2017 and 2.3 percent in 2018 upgraded global GDP growth estimates to 3.6 percent in 2017 and 3.7 percent in 2018. The companies in the Standard & Poor’s 500 Index got 43.2 percent of their earnings from outside the U.S. in 2016; that percentage will surely be higher this year, and it’s probably higher for the Dow companies, too. Recent analyses by the Wall Street Journal and ETF.com found that corporations with the highest foreign-earnings percentages are driving the market’s gains. The “America first” president may be basking in a market boom driven mainly by overseas economic growth.
Markets are just wrong. One issue is that broad financial markets aren’t great at pricing tail risks (low-probability, high-impact events so named for their position on the tail of a statistical distribution). World War III would be a terrible thing, but the probability of it or some other market-crashing disaster happening is (1) small and (2) really hard to calculate. More generally, stock markets tend to overshoot, a phenomenon that Richard Thaler, awarded the Nobel prize in economics on Monday, played a key role in documenting.
At the annual meeting of the American Finance Association in 1984, Thaler and former student Werner De Bondt asked “Does the Stock Market Overreact?” They answered the question by assembling “winner” and “loser” portfolios of stocks that had performed especially well or poorly over 36-month periods, then examining their performance over the subsequent 36 months. The winners underperformed the market during the second period; the losers outperformed. Three years earlier, Robert Shiller (co-winner of the 2013 economics Nobel) had asked a similar question of the market as a whole — “Do Stock Prices Move Too Much to Be Justified by Subsequent Changes in Dividends?” — and also answered in the affirmative. In a 1989 essay titled “A Mean-Reverting Walk Down Wall Street,” De Bondt and Thaler cited numerous other studies that delivered evidence of overshooting and concluded that this appeared to refute the then-widely-held belief that “financial markets are ‘efficient’ and that the prices of securities in such markets are equal to their intrinsic values.” Decades of debate followed over what drives the overshooting, and I don’t think the matter will ever really be settled, but there is now at least a consensus that, as John Cochrane put it in his presidential address to the American Finance Association in 2011, “high prices … forecast low returns.”
So are prices high? The S&P 500’s price-earnings ratio, at 21.8, is higher than its average since the mid-1950s, but it’s not much higher:
Expensive But Not Exorbitant
Standard & Poor’s 500 Index price-earnings ratio
Use Shiller’s cyclically adjusted price-earnings ratio, which divides the price by average earnings over the previous 10 years, and things look a little pricier:
Yeah, That’s Pretty Expensive
Cyclically adjusted price-earnings ratio*
Source: Robert J. Shiller
Still, those 10-year earnings currently include the terrible earnings years of the Great Recession, and even with that the cyclically adjusted P/E is way below that of the dot-com years. So … I really don’t know if the stock market is currently overshooting or not. Neither, by the way, does Thaler, who, when asked to explain the stock market’s run on Bloomberg Radio on Tuesday, said, “I don’t know where it’s coming from.”
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
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