The Dow Jones Industrial Average finally broke above the 20,000 level Wednesday, which has no fundamental or technical meaning, but it’s an interesting benchmark. The only real message from the new record is that traders continue to bet on the so-called “Trump rally.”
The gains in the market aren’t just based on expectations for spending, tax cuts and deregulation from the Republican congress and administration. Growth in earnings has been strong even when adjusted for the one-off windfalls in the financial sector. This quarter’s year-over-year growth rate will likely hit expectations for a 5% gain.
The real question isn’t whether there is continued improvement in the economy, but whether asset prices have gotten ahead of those reasonable estimates. Investors must be worried that evidence that the gap between asset values and what we actually know about the Trump administration’s plans is probably widening too much.
As you can see in the next chart, the adjusted price-earnings ratio (blue line) is above its 2008 highs. In fact, besides the “dot-com” bubble of the late 1990s, the adjusted P/E ratio hasn’t been higher since “Black Tuesday” in the early 20th century.
Traders should be careful, however, not to try and derive a timing signal from this ratio. What it really means is that future growth expectations are extremely elevated, which have historically been disappointed.
S&P 500 P/E ratio (blue line) versus SPDR S&P 500 ETF (orange line)
The reason we care about this measure is that is helps us to understand whether expectations may be gapping away from what we actually know or can reasonably estimate about the future, which creates higher levels of risk. It’s certainly not the case that the Trump administration can’t help the economy, but usually government intervention takes a long time to come to fruition, and congress hasn’t been that good at “picking winners” in the past.
Who is at risk? The fact remains that changes to international trade relationships carry uncertain risks. The Dow hit its new benchmark mostly because Boeing Co (NYSE:BA) reported earnings above expectations.
However, one-third of the company’s revenue and 40% of its backlog are international customers. This quarter’s earnings were really great, but can that continue if reciprocal trade protection strategies are deployed in Asia, North America and Europe?
Most of the risks posed by the gap between current expectations and what we actually “know” don’t translate very well into timing signals. Instead, what we can anticipate is that volatility will probably remain relatively high. This is not a bad thing for option traders.
Wider price swings are frustrating when they move against us, but the potential for bigger, faster gains in our favor should offset that issue. The breakout in the S&P 500
this week is legitimate. However, the likelihood that the trend will hit its price target this quarter is low.
InvestorPlace advisors John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.
