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Market Rally Confounding You? Mystery Solved

By: Royce W. Medlin - Chief Investment Officer

Market Rally Confounding You? Mystery Solved

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The stock market continues to reach new highs and seems impervious to bad news or political rancor. Is the market trading on sheer euphoria? The answer is: Strong fundamentals are driving stock prices higher, both here and around the globe.

Global economies are growing at a pace not seen since 2007 which supports optimism. Stocks continue to trade at the high end of their historical valuation ranges which ratchets up risk, but earnings growth has supported recent price increases.

As you can see below, aggregate expected earnings per share (black dotted line) of the companies that make up the S&P 500, have seen strong growth lately. What is striking is the surge in expected earnings that occurred simultaneously with recent passing of tax reform. This makes sense as every dollar not paid in taxes drops straight to the bottom line. Even more striking is the drop in the expected price/earnings ratio (blue line) from over 20x to roughly 18.5x.

sp500

Stocks clearly began to discount the increased likelihood of lower taxes and the positive impact that would have on forward earnings in advance of the legislation actually passing. You can see that in the multiple expansion (blue line increasing) that occurred in the weeks leading up to the tax cut.

While markets have been on fire this year, there is an easy case to be made that some upside still exists. Getting back to a 19.5x P/E, which is where the market traded only a few months ago, implies upside of another 6%.

Again, the market is trading at historically high multiples which brings with it elevated risks and stronger reactions to disappointments, but with a positive domestic and international economic backdrop that seems to be accelerating, not faltering, higher stock prices are being driven by stronger fundamentals… which is what you want as an equity investor.

royce-sig
Royce Medlin
Chief Investment Officer