Stocks were slammed this week as worries grew that the Trump economic agenda may be in peril. The SPDR S&P 500 ETF (SPY) dropped 1.5% on Thursday, registering its worst decline in three months. At the same time, the small-cap iShares Russell 2000 ETF (IWM) lost 1.8%, nearly wiping out all its gains for the year.
Year-to-date, IWM is now up 0.4%, compared with 9.6% for SPY.
YTD Returns For SPY, IWM
We've seen this before. Something happens in Washington, D.C., that causes investors to question whether the pro-growth policies espoused by President Trump―tax cuts primarily and infrastructure spending, to a lesser extent―will actually get implemented.
This week's controversy over Trump's reaction to a racially charged rally in Charlottesville raised doubts that the president can provide the leadership necessary to bring his policies to fruition.
Investor sentiment on the matter for the last few months has fluctuated between hopeful and skeptical, while largely staying near the former, as evidenced by the numerous record highs and all-time-low volatility seen in the stock market for most of the year.
This week, sentiment suddenly swung toward the skeptical side, hitting small-caps―which would be the biggest beneficiaries of tax cuts―the hardest. It's too early to say investors have thrown in the towel on Trump's agenda, but they are clearly getting antsy about it.
Investors have every reason to micro-analyze what's going on in Washington. Without Trump's pro-growth policies, the market looks downright expensive. Earnings growth this year has been good, but not great, and certainly not strong enough on its own to support the market's 15% surge since Election Day.
FactSet estimates that profits for companies in the S&P 500 may grow by 9.4% this year, and 7.2% if you strip out the energy sector.
That's a decent number, and much better than last year, when earnings didn't grow at all, but not necessarily something that would cause the market to spiral upward like it has for the past nine months.
A lot of the stock market's rally has come by way of multiple expansion, where investors pay an increasing amount for each dollar of companies' earnings. Earlier this month, the S&P 500 was trading at as much as 19x this year's estimated earnings, according to Bloomberg data. That's the richest level since 2002, and above the 30-year average P/E of 16.9.
Similarly, the Russell 2000 was trading at more than 30x estimated earnings, above the long-term average of 27.2, even with earnings expected to only grow 8% this year.
All that said, just because the market is historically expensive doesn't mean it's about to tumble. If tax cuts do pass, corporate earnings could surge. In that case, the "E" in P/E would rise, bringing the P/E ratio down.
For example, if tax cuts boosted earnings by 10%, that would bring earnings in line with historical averages. That's a tall order, of course, but not outside the realm of possibilities.
For small-caps, tax cuts may be even more crucial, as smaller companies tend to generate more of their revenues domestically than large-caps.
This is not to say that if the business-friendly policies Trump has promised do not come to fruition, the market is in trouble.
There's an argument to be made that even without forthcoming tax cuts, the market deserves a premium valuation because interest rates are so low. It certainly looks like rates aren't going to go back to where they were during the peak of the last economic cycle―above 5%―anytime soon. If that's the case, then each dollar of future earnings is simply worth more when discounted back to the present at a lower interest rate.
The market traded at extraordinarily low valuations during the ’70s and ’80s, when interest rates were sky-high; why shouldn't the flip side hold true as well?
Regardless of how one chooses to answer that question, at least a modest stock market sell-off seems overdue. As of this writing, the S&P 500 is still up close to double digits for the year and hasn't sold off more than 3.3% at any point this year.
That's highly unusual for an index that tends to pull back at least 5-10% every several months, even during bull markets. Small-caps have buckled under the threat of Washington dysfunction. Maybe large-caps will be next.
At the time of writing, the author held no positions in SPY or IWM. Contact Sumit Roy at firstname.lastname@example.org
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