The Stock Market Makes No Sense

Trump’s cohorts are rolling over, and the odds are increasing that some real dirt may get revealed.

The China/U.S. trade war is on the verge of ratcheting up to DEFCON 11 or whatever. New home sales have been trending down, interest rates are heading higher… and the S&P 500 is breaking out to new all-time highs? What the…?!?

In the words of my man John Turturro: 

Yeah, OK, we’ve been over this before. The stock market often don’t make no sense. Or maybe it makes more sense to say that it’s sometimes hard to get a grip on exactly what sense the market is making. Does that make sense? 

I wrote last week about windows of opportunity. I still say it’s one of the best ways to think about the stock market. Traders and fund managers will push stock prices higher when there’s a good opportunity for them to do so. Because as much as you may want to see stocks drop or watch Tesla shares implode, the bottom line is that the money is made on the upside.

That’s really the whole point of capitalism. Capitalism encourages people to invest. To be owners. And the whole point of owning is that your piece of the pie gets more valuable over time. And the easiest way to be an owner is through the stock market. 

Our whole system is geared toward higher stock prices. 401(k) accounts, IRA accounts, pension funds, endowments, the Fed target inflation rate…

It should come as no surprise that the path of least resistance tends to be to the upside.

But… But… What About Valuations? 

Fair point. Valuations matter… at some point.

Pro Tip #1: When considering price-to-earnings (P/E) ratios, please include the forward P/E and not just the trailing P/E.

Think of a P/E ratio in terms of buying a business. How many years of that business’s profits will it take you to recoup your investment? A P/E of 10 means it would take 10 years.  

A trailing P/E measures earnings over the previous 12 months. It tells you where a company is profit-wise. The forward P/E measures earnings over the next 12 months. It tells you where a company will be. From an investment point of view, the expectation for what an asset will be worth in the future is what really matters. This is why analysts have jobs.

Pro Tip #2: Pay special attention to the disparity between trailing and forward P/E ratios. This is where you get the best sense of how expectations are changing.

Right now, the trailing P/E for the S&P 500 is 24, and the forward number is 17.6. That’s a 37% difference. Now, that doesn’t mean stocks are gonna run 37%. That’s just crazy. But it does tell us that sentiment is strong and expectations for stock returns are high. That’s an environment where you buy stocks. 

Now, of course, there always comes a point when expectations get out of whack (I learned this when I was seven and discovered that Marvel the Mustang didn’t actually let you ride around like you were on a real horse). At some point, we will be disappointed. At some point, analysts’ earnings projections will diverge from reality. 

When does that happen? Well, it happens when U.S. consumers suddenly feel they have to pull back on their spending. Sometimes that happens when certain expenses get really high, like gas prices. The U.S. has endured several recessions where gas prices have spiked and suddenly that dinner out looks less important than a full tank of gas. 

Price spikes like that can kick off the vicious cycle. They can lower demand for consumer discretionary stuff, companies cut back on workforce, people get worried about losing a job, and spending contracts more, etc.

Clearly, a prolonged trade war can accomplish this vicious cycle. And investors have been worrying about this. So it’s not a huge surprise that a little good news from trade talks with Mexico gets extrapolated out, and stocks rally.

Pro Tip #3: Regulations

Now, I wanna make a point about regulations that may not be popular. 

It is the job of capitalism to invest money in order to make money. Interest rates have an impact on this, because higher interest rates mean it’s harder to make enough money and justify an investment. That’s why higher rates tend to slow an economy down. 

Regulations accomplish the same thing, albeit in a different way. 

A lot of people complain that regulations under the Obama administration kept the U.S. economy from fulfilling its potential. Under Trump, some regulations have been lifted, and this has eased some investment, and we are seeing better GDP growth. 

But we can also look at that same scenario and say regulations kept the U.S. economy chugging along at 2% growth, and we enjoyed an eight-year bull market. Today, with fewer regulations, CAPEX spending is up, and GDP might be hitting 3% for the year. That’s great. But it also means we may be moving more quickly to the point where money is getting invested poorly. 

And if you want some poorly invested money to worry about, think about all the emerging market denominated debt out there, i.e., Turkey.

Don’t forget, back in 1999, times were good, and Congress was de-regulating. The Glass-Steagall bank regulations were reversed. And within 10 years we had the mother of all financial crises. 

Currently, the window of opportunity is getting opened very wide. A lot of good stuff is flying in. At some point, something nasty will fly in that window. And it will be too late to close it.

How long will that be? There’s no way to know. But history seems pretty clear on this. 

In the meantime, I’ve got my Real Income Traders in call options for both Twitter (NYSE: TWTR) and Micron Tech (NASDAQ: MU). We are taking advantage of this opportunity. 

Until next time,

Briton Ryle

@BritonRyle on Twitter

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A 21-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He is also the managing editor of the Wealth Daily e-letter. To learn more about Briton, click here.