Bang! Zoom! To the moon! Just how far can stocks go? Just how fast can they get there?
A growing economy. A tax reform (cut) bill that was just signed into law. An infrastructure build. A lot of budgetary strings attached, but a build none the less. Maybe.
Increased defense spending. You know there are still a lot of bad guys out there, right? North Korea is not going anywhere. All ready on the left? All ready on the right? All ready on the firing line? Is there anyone downrange? With a ten-round magazine... Lock and load. When you see your targets.
What is quite obvious as we slide on into the last week of 2017, is that equity markets have built up a nice head of steam. Some call it the Trump Train. I think that the market's 2017 gains were built on earnings growth. But the president does get some credit for boosting confidence, both on the individual side as well as the business side.
That this confidence (as well as some nicely placed deregulation) did propel, to some degree, the earnings growth that we have seen this year is undeniable.
Waiter, My Soup Is Cold
That is all well and good. However, this year's gains are the second story of a four-bedroom colonial. The foundation, and the first floor were laid by perverse monetary conditions that forced investment dollars into riskier assets. Now that the economy appears to be able to stand on its own two feet, such accommodation no longer seems necessary.
The FOMC has already been gradually increasing the federal funds rate for two years. The Fed has also been allowing the balance sheet to roll maturing product to do just that... to mature. This monthly amount that the Fed does not re-invest will grow; until sometime next spring, the central bank is a net extractor of liquidity.
How much does that change the environment? Does it shake the already mentioned foundation? Will this create, along with increased deficit spending on the fiscal side, greater yields on the long end of the curve?
Let's crunch some numbers. Admittedly, we are going to do this in simplified fashion, so we do not lose anybody, and because this is an article meant for a broader audience, not a thesis on investment.
The S&P 500 now stands at or close to 2,690. That index has experienced a 20% run in 2017, and now trades at 19.8 times projected 2018 earnings.
Expectations for S&P 500 earnings were projected at an aggregate $146 per share prior to tax reform. The reduction of corporate taxes is expected to push S&P 500 earnings in a northerly direction of about $1.40 per headline percentage point cut.
35% - 21% = 14%.
14 x $1.40 = $19.60.
$146 + $19.60 = $165.60.
Wow. Is that even possible? S&P 500 earnings of $165.60? Seems farcical. Analysts are going to have to upgrade their earnings projections, and do it broadly. I am even almost afraid to write this. At current valuations, $165.60 x 19.8 = 3279. So, in a constant ballpark (not possible), we are talking about a potential 21.9% move for the S&P 500 on top of this year's 20%.
Now, this is simplistic, mind you, but apply a similar 21.9% potential move to the last sale of the Dow Jones Industrial Average, currently 24,821, and poof!! You end up looking at a gain of 5,435 points, and land above the golden number .. at 30,256. Again ... 30,256 !!
Obviously, this is not an apples-to-apples comparison. The two indices do not even weight their components in the same way. They do, however, correlate quite nicely over time.
The DJIA has run 25% in 2017, so we can certainly see the blue-chip index beating the broader market index, particularly after tax reform kicks in. The Dow Industrials are trading at 20 times next year's earnings, so valuations are comparable.
Should we talk about liquidity? I guess we have to.
The Big Ugly
For years now, the Fed has been forcing investors to be aggressive. We have already discussed this. Now, just how aggressive the Fed itself is under Jerome Powell is going to be key.
Most folks think that the FOMC will look to raise the fed funds rate three times in 2018. Seems reasonable. What if wage inflation finally kicks in? I would think it very possible that competition on the demand side of the labor market might finally hit stride. What if that provokes an unwanted level of consumer level inflation?
If the FOMC is put in the position of having to raise rates when the economy is not ready, or disproportionately to external central bank behavior (already kind of there), then that will put downward pressure on economic growth, as well as upward pressure on dollar valuations -- also bad, despite what the media tells you.
Even if these negatives do not develop in this way, you will, in the best-case scenario, still have to deal with reduced liquidity. I'm thinking P/E ratios closer to what traders are more comfortable with. Try 17.5 times? That would put the S&P 500 around 2,898 in 12 months and the Dow around 26,740.
My Formative Years
My formative years in this industry all came during the 1980s and 1990s. One thing folks said back then was "Don't count out the U.S. consumer."
For much of the past decade, the consumer was not a factor. The consumer had been damaged by painful experience. What if that consumer believes in this economic expansion? What if that leads to small business success? See where I'm going here? Been a long time since we've rock and rolled, and baby, I think Middle America is almost ready to roll.
Oh, higher yields, and reduced central bank interference will produce volatility, and I bet there will times that it scares the stuffing out of us. Know what? Those early years of mine were volatile -- and they produced winners year after year.
Two positives here. When the consumer sees his or her retirement accounts at year's end, they will be emboldened. When the banks see higher long-end yields, and an actual gap between what the two-year, and the 10-year Treasury pay, those banks might just provide some of the liquidity that will go missing on their own.
Operation Market Garden
Energy matters. Yup. Will OPEC stay disciplined? Will the kids in the Permian crank up production? Does the $58 gateway to the $60s fly open for WTI Crude? Can natural gas climb out from the dungeon? So many questions. So much impact.
I've got a feeling. It's only a feeling, that energy prices, even after adjusting for economic growth, earnings growth, and changes in both monetary as well as fiscal conditions will decide for us if Dow 30,000 is just a bridge too far. Too far for 2018 anyway.
(This article originally appeared Dec. 22 on Real Money, our premium site for active traders. Click here to get great columns like this from Stephen Guilfoyle, Jim Cramer and other writers.)
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