Yes, I am a two handed economist. I use both hands when talking about the future, especially when there is so much uncertainty in the world.
U.S. stock markets in 2016 look like they'll finish at or near record levels.
Through much of the current economic recovery, the stock market has prospered under the generosity of the Federal Reserve.
When the U.S. central bank ended its third round of quantitative easing in late October 2014, the stock market moved sideways until the recent presidential election. In December 2014, the S&P 500 stock index was around 2090. Just before the election this year, the S&P 500 stock index was around 2090.
The Fed created uncertainty among investors because it could not decide when, and by how much, to raise interest rates.
After quantitative easing ceased, the "forward guidance" of the Fed was for four rate increases of 25 basis points each in 2015, but there was only one rate increase that year, in December. After that rate increase, the "forward guidance" of the Fed was for four rate increases of 25 basis point each in 2016, but there was only one rate increase, this month.
However, a new phenomenon occurred in November: the "Trump Bump." Only two days after the presidential election, the Dow Jones Industrial Average hit a new all-time high, and the S&P 500 and the Nasdaq followed soon after with their own highs.
On Nov. 11, the S&P closed at 2198. After reaching several new highs, the index closed last week at 2258.
Is the market overpriced? It is in terms of Robert Shiller's measure of the Cyclically Adjusted Price Earnings or CAPE. For December 2016, CAPE has risen to 28.26 where it was just 26.89 the month before. The last time CAPE was this high was in May 2002, when the index was at 28.13.
The point is that CAPE always returns to its mean level in the high teens. The return can either occur as earnings rise as, for example, an economic recovery produces more profits, or stock prices fall to bring the market more in line with historical performance.
Since September 2014, the corporate earnings of the S&P 500 index has been declining monthly. The current market's improvement is in the hope that corporate earnings will grow.
The source of the rise has been the proposed fiscal program that President-elect Donald Trump presented to the electorate during the campaign.
Through tax cuts and infrastructure spending along with regulatory reform, Trump promised a new day for economic prosperity. This optimism was transmitted almost immediately to the stock market. But major questions remain about when such a program might impact economic growth and corporate earnings and the size of the impact.
For the seven-and-one-half years of the current economic recovery, the U.S. economy has grown at a 2.1% compound rate. Many economists, including officials at the Federal Reserve don't believe that there will be much improvement, if any, over the next several years. These projections were made before any of Trump's ideas were incorporated in the forecasts.
However, one of the major discussions in the economics field is about just how big a role fiscal or monetary policy policies play in improving longer-term growth rates. The slow economic growth associated with this recovery has been attributed to a substantial reduction in the growth rate of labor productivity. It has been a supply-side problem.
For the Trump economic program to be successful in creating more growth and more jobs, it must produce improvements in labor productivity and capital usage, something that must be well designed and that takes a long time to work. Short-run programs aimed at stimulating aggregate demand have been less effective in recent years.
Furthermore, there has been a change in the world economic scene as the United States dollar has become stronger. Note that the U.S. dollar has become stronger because the U.S. economy has been stronger than other major economies.
Since the middle of 2014 when it became obvious that the Federal Reserve was going to quit its program of quantitative easing, the value of the U.S. dollar has risen dramatically. In July 2014, the Fed's Trade Weighted U.S. Dollar Index against major currencies was at 76.00. In December 2016, the index stood at 94.00, a rise of almost 25%.
Not only does this stronger dollar impact the ability of U.S. corporations to export goods and make profits, it also changes the dynamics of what the U.S. government can do in conducting monetary and fiscal policies. The government cannot just engage in programs that push up aggregate demand while failing to be concerned with the productivity of American business and the ability of U.S. corporations to compete worldwide.
Can Trump's economic programs overcome the slowdown in labor productivity and other supply-side issues, as well as the rising value of the U.S. dollar? Will the programs create the economic growth that will lead to improved corporate earnings and continued record stock prices?
Financial Times writer John Authers writes that "Animal spirits are back." The concern Mr. Authers expresses relates to the possibility that these animal spirits can "turn into a 1999-style bubble."
CAPE reached a high of 44.20 in December 1999.
Forecasts are still for the economy to grow around 2% over the next several years. The 3% to 4% pictured by some Trump enthusiasts is nowhere in sight. Inflation is still expected to be in the 2% range, right around the Fed's target level. Interest rates are expected to rise. The value of the U.S. dollar will remain strong.
How will corporate earnings perform in such an environment? They won't be bad, but they will not be at the level that can create exuberance.
Where will we be a year from now? Authers writes "if a year from now, market-friendly reforms are on the books and there is tangible evidence that Mr. Trump has persuaded companies to spend and invest more, then a bubble grows far more likely."