Apr 10, 2017

Have Investor's Expectations Gotten Ahead of Themselves?

By Gene Balas

Even if you are relatively optimistic about the economy, might you also think expectations have gotten a bit ahead of themselves? In other words, even if we expect the economy and earnings to grow, investors may have already priced that (and more) into the markets. As such, there may be reasons to be a bit cautious right now, particularly because valuations relative to both sales and earnings for many stocks are a bit stretched.

And investors need look no further than Federal Reserve’s minutes following its March meeting, which stated, “A few [Fed officials] attributed the recent equity price appreciation to expectations for corporate tax cuts or to increased risk tolerance among investors rather than to expectations of stronger economic growth. Some [Fed officials] viewed equity prices as quite high relative to standard valuation measures.” It is unusual for the Federal Reserve to comment on the stock market; the last notable time was in 1996 when then-Fed Chair Alan Greenspan noted “irrational exuberance” in the markets.

Hard Data vs. Soft Data

Sometimes that “exuberance” comes not from “hard data” on sales, earnings or employment, but on “soft data,” such as sentiment and the “animal spirits” described by some economists in decades past. Indeed, “hard data” has yet to catch up to “soft data.”

Consider auto sales and consumer sentiment. Consumer confidence surged to the highest level since 2001, as reported by The Conference Board, but auto sales dropped sharply in the past several months, according to tallies of auto sales by each manufacturer. And department and specialty store sales fell by the low single digits recently, in data released by various retailers.

Meanwhile, loan volume across several different categories, from consumer to commercial and industrial loans, contracted notably in recent periods in data from the Federal Reserve. This is despite small business optimism that is the highest in years, according to the National Federation of Independent Businesses. Even so, these positive survey data accompanied a drop in corporate investment in capital investments in February, according to the Bureau of Economic Analysis.

Corporate Tax Reform

The Fed, in its minutes, reflected upon some of these issues. What is of interest is whether the fiscal policies that so excite the market are actually even factored into the Fed’s equations. If they are not, perhaps we might be a bit more circumspect on whether they should factor into our own equations.

Consider the passage of the Fed minutes that state, “[Fed officials] continued to underscore the considerable uncertainty about the timing and nature of potential changes to fiscal policies as well as the size of the effects of such changes on economic activity. However, several participants now anticipated that meaningful fiscal stimulus would likely not begin until 2018. In view of the substantial uncertainty, about half of the participants did not incorporate explicit assumptions about fiscal policy in their projections.”

Why does the Fed not recognize an immediacy of fiscal stimulus, if at all? Well, for starters (when it comes to tax reform at least), all the pieces of the administration’s various policies need to fit together to pass Congress. For example, government savings on the health care plan would have funded some of the corporate tax break, but the health care plan did not pass. The Border Adjustment Tax is needed to generate revenues to cut the tax rate down to a lower level by taxing imports – a tax that would be paid by consumers, unless the dollar rallies sharply. Opposition to the Border Adjustment Tax from importers, such as retailers, and auto manufacturers (which have complicated supply chains) runs very high. This offsets arguments in favor of this tax from exporters.

Putting these puzzle pieces together is why it becomes difficult to lower the tax rate. When looking at the total plan, many in Congress will likely want tax proposals to be revenue neutral, so if we can’t generate funds from health care overhaul or a Border Adjustment Tax, it becomes difficult to pass this complex legislation.

There are many factions who will lobby over the details in the tax plan, squaring off against one another. As such, this complex organism may face considerable challenges in both the House and, especially, the Senate, given the smaller lead Republicans have in that chamber. Thus, this illustrates why the Fed isn’t baking in tax reform into its economic projections.

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But investors are.

Earnings Season and the Markets

That leads to our next topic. Whether measured on a price to earnings basis or price to sales basis, many stocks are overvalued, though not uniformly so. Some value stocks are attractive relative to book value, but some growth stocks are very dependent on getting that earnings growth. These multiples will need to be justified by higher earnings; after all, that’s why investors are willing to pay up for a stock.

Forecasts are for a surge in earnings in coming quarters – far beyond what would be typical of a modestly growing economy. We may indeed see that earnings growth, but if we don’t, the market could be vulnerable. The market’s run-up and higher valuations ties into the “soft data/hard data” issue: investors are paying based on soft data expectations. What we will eventually need to see is that confirmed with hard earnings.


Just because the markets are expensive, or that investors are factoring in things that may or may not happen in government policy, that doesn’t mean stocks will fall in value, at least not immediately. After all, former Fed Chair Greenspan’s warning about “irrational exuberance” was made in 1996. Stocks continued to rally massively for several years afterwards, peaking only in March 2000. And we know what happened after that. But, ultimately, as the saying goes, “The markets can stay irrational longer than an investor can stay solvent.”

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