This is pretty much all you need to know about markets right now, from the Wall Street Journal:
‘The Dow Jones Industrial Average climbed to a fresh high as investors bet that a tax-overhaul plan before Congress would pass, likely boosting profits for many U.S. companies.
‘Investor optimism over passage of a compromise plan propelled gains in shares of companies that are likely to see particular benefit from lower corporate tax rates, such as smaller companies and financial firms.
And the Financial Times:
‘US companies are expecting sharp increases in earnings next year as Republicans in Congress remove the final obstacles to their overhaul of the US tax system, with a bill likely to be passed into law this week.
‘Analysts and executives expect corporate earnings to be boosted by an average of about 10 per cent, with some companies set to see significantly higher benefits of up to 30 per cent, thanks to the proposed reduction in the main rate of US federal corporate tax from 35 per cent to 21 per cent.’
Yes, the promise of tax cuts and its impact on company earnings continues to drive US stocks relentlessly higher.
While that’s well known, the question to ask is whether the tax cuts are already priced in. Are investors now being too optimistic about the impact of lower tax rates on company earnings?
In the short term, the answer is most certainly yes. That’s because well-known investor behaviour patterns are behind this buying. What started out as a rational reason to push stock prices higher now has an irrational feel to it.
Let me explain. I’m not just giving you my opinion here. This is about well-understood investor psychology in action.
In short, anticipation of future gains gets investors excited. This anticipation releases feel-good chemicals, which results in a willingness to take on more risk and increased buying.
Market Psychologist Richard Peterson explained this process in a study called “Buy on the Rumor:” Anticipatory Affect and Investor Behavior
‘Investors often gamble both on an event outcome and on the anticipated price appreciation as a result of that positive outcome. Anticipation of reward generates a positive affect state. Positive affect motivates both increased risk-taking and increased purchasing behaviors. As the anticipated potential reward approaches in time, investors’ positive affect is increasingly aroused. Following the delivery of an expected reward, investors’ affect regresses to neutral. This post-event net decrease in positive affect leads to more risk-averse, protective investing behaviors such as selling (consummate with the new, less positive, affect-state).’
A sell-off on the horizon?
Based on this explanation, my guess is that when the government finally announces the tax cuts have made it into law, you’ll see a sell-off. That might not happen straight away, but if not, it will come soon after.
The tax cuts will take effect from 1 January, so it might ‘make sense’ for some investors to sell after this date. That would lock in a lower personal tax rate on capital gains for them.
If everyone thinks this way, then you’re going to see a reasonable sell-off. The mood of the market can shift very quickly. Especially since investors are currently buying based on ‘anticipation’.
This has been going on for a few months now. As you can see in the chart of the S&P 500 below, the surge above 2,500 points in September has really been all about the tax cuts. That’s the narrative driving the market higher.
[Click to enlarge]
But when everyone knows that everyone knows something, is there any money to be made?
No. And that’s when it’s time to take the opposite side of the trade.
While I don’t think you’re going to see a crash or the start of a new bear market, I do think the probability of a decent correction unfolding is quite high.
Looking at the chart, you can see that every time stocks moved too far away from the moving averages (red and blue lines) a correction unfolded. It will happen again…it’s just a matter of when.
I’m tipping it will be when the rumour of tax cuts becomes fact.
The other argument against the market rally continuing is valuation. There are many ways to value stocks, with the most common (and simplistic) being the price-to-earnings (P/E) ratio.
While it is simplistic, it is also useful. However it pays to keep in mind that an overvalued market does not mean a correction is necessary. A correction needs a catalyst, and overvaluation is not a catalyst.
According to data from the Wall Street Journal, the S&P 500 trades on a P/E ratio of 25.12 trailing earnings, or 19.82 times using estimates earnings for the next 12 months.
On both of these measures, the market is overvalued compared to historical readings. It wouldn’t take much in the form of a negative shock to knock the wind out of the market, at least in the short term.
My guess is that the ‘shock’ will simply be the realisation that the impact of Trump’s tax cuts is well and truly priced in. And that realisation will only dawn once the rumour becomes a fact.
Editor, Crisis & Opportunity