Guessing What's Next: The Markets and The EconomySubmitted by S. F. Ehrlich Associates, Inc. on May 15th, 2017
May 15, 2017
You may recall reading about the VIX Index in this space, which many view as a type of fear gauge for Wall Street. According to a recent article in the New York Times1, for the first time in more than 10 years, it dipped below 10, which means investors don’t anticipate an imminent market decline. (The historical average of the VIX is around 20.) With the market near record highs, and the VIX near record lows, contrarians must be licking their lips in anticipation of the windfall they think they’ll make. Their logic: everyone is happy, so nothing good can come next. But contrarians are not always right; they just tend to take the opposing view.
Professional investors believe that Washington will ultimately take whatever action is necessary to cut corporate taxes, and the result will be a spike, or at least an increase in corporate profits. If investors are willing to pay $20 for a dollar of profits, then an increase in profits means stock prices should move higher. (If earnings for a particular stock are $3/share, and the price/earnings ratio is 20, that means the stock price is approximately 20 x $3, or $60. If earnings go up to $4 a share, for example, and the price/earnings ratio stays constant at 20, that means the stock price could move up to 20 x 4, or $80.).
Stock prices are ultimately driven by profits, whether current or anticipated. Continuing chatter about a corporate tax cut is helping to fuel the markets, and those who have bet against the market have not fared well (at least to date). Frankly, a corporate tax cut from 35% to 15% adds a lot of profits to corporate America, and to its shareholders.
There are headwinds, however, which can derail the profits express. As pointed out in Barron’s, those headwinds are the three D’s: debt, deflation, and demographics.
Barron’s points out2 that higher debt levels in government are usually associated with slower growth. In addition, increased debt puts “downward pressure on prices,” which is the deflation part of the three D’s. The Fed is trying to raise interest rates, and deflation is the exact opposite.
In terms of demographics, Barron’s notes that the first Baby Boomers turned 70 in 2016. When Ronald Reagan was president, that cohort was in its peak earning years, spending money and helping to fuel the economy. But the economy is slowing, and this large segment of the population is long past its peak earning days.
Per Barron's, the highlight number for the economy (Gross Domestic Product, or GDP) grew at a very sluggish 0.7% in Q1, 2017, far below the growth needed to propel the economy forward. The Fed is raising rates, and the economy is slowing; tough obstacles for even an overly optimistic stock market to overcome. But like the Energizer bunny, this market just keeps chugging along.
1 Thomas, Landon. “Political Risks Growing But Investors Stay Put.” New York Times, 3 May 2017.
2 Forsyth, Randall W. “Trump's Tax Challenge.” Barron's, 1 May 2017.