The S&P 500 is hitting record highs, but it’s not done yet.
Stock prices may be setting new records, but those could still push much higher. The economy is poised to grow faster and new technologies will support higher valuations for the long term.
As the economic recovery continues to unfold, the energy and manufacturing sectors have learned to be more efficient. With oil prices rising to the low-$50 range, oil and gas drilling has been increasing since May. And manufacturing is posting more gains — to supply that industry and elsewhere — despite a stronger dollar.
Consumer spending remains robust and private investment appears to be picking up. A mismatch in the availability of housing — more starter homes are needed than are available for interested buyers — will power up home construction. Overall, the economy is expected to grow at 2.4% this year as compared to 1.9% in 2016, and corporate profits for the S&P 500, which encompasses about 80% of the U.S. equity market, are expected to rise about 14%.
All this is powered forward by conditions in China — both economic and new efforts for Beijing to exert more social control — which are driving money out of the country despite government controls. Along with Europe still only accomplishing moderate growth and Brexit casting a pale over European unity, America remains the best place for investors to place their bets.
Bonds remain an unattractive alternative to stocks — longer yields remain low. Even with the Federal Reserve pushing up the fed funds rate 0.5% to 0.75% this year, the rush of foreign capital into U.S. markets will likely keep rates long rates low — as it did when Ben Bernanke pushed up short rates in 2004 to 2006.
Optimism that Gary Cohn, chairman of the White House National Economic Council, is poised to push ahead on taxes, infrastructure, financial deregulation and a less-restrictive health-care law, only adds more flavor to the sauce.
At the same time, sustainable price-earnings ratios for stocks are rising and U.S. equities are cheaper than they look.
In this century, new value creation is premised much more on intellectual property — for example, computer apps that create companies like Uber and artificial intelligence that power the robotics revolution — and less on hard assets — in particular, industrial buildings and factory equipment.
Speaking at a meeting with governors, President Donald Trump said on Monday his first budget will include a "historic increase" in military spending. He said the proposal will focus on public safety and national security. Photo: Reuters
This trend greatly reduces the amount of financial capital businesses need to create new and better products — the foundations of American wealth and higher equity valuations.
Consider that Google was launched with only $25 million in 1999 and grew into a $23 billion enterprise at its initial public offering five years later — the story is repeated at ventures like Amazon, Facebook and many others.
Similarly, as industrial-era enterprises like Ford and IBM rely more on software to create value in products sold and innovations like 3D printers and flexible robots make machinery investments more versatile and productive, the demand for private capital to finance expensive purchases of physical assets becomes more limited.
This is an important reason why established companies are flush with cash. They simply need to spend less on hardware to improve the efficiency of production and responsiveness of supply chains, update and expand product offerings, and launch new ventures.
Lower capital requirements coupled with an abundance of capital, thanks to foreign funds coming into America, are pushing down the expected rate of profit needed to attract funds into equity investments.
In turn, that pushes up price-earnings (P/E) ratios that markets can sustain — even if political uncertainties at home and abroad create the wider fluctuations in stock prices as recently experienced.
The price-to-earnings ratio for the S&P 500 is nearing 27, but expected profits can justify these high prices.
That’s well below its 25-year average of 25.
Assessed against alternative investments and history and given how much more efficiently digital technologies permit businesses to create wealth using investors’ cash, stocks are hardly overvalued.
A P/E ratio approaching 35 is reasonable. Coupled with the expected growth in profits, that could easily push the S&P Index to 3200 over the next two or three years.