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Eight Years Into A Bull Market: How Much Longer Do We Have?

An amusing video has recently made the rounds on social media of an MSNBC interview by Ali Velshi and Stephanie Ruhle interviewing Brad Thomas. Velshi and Ruhle have had long careers as financial journalists, with Velshi spending time at CNN and Ruhle at Bloomberg prior to pairing up at NBC. Thomas used to be a real estate developer and wrote a 2016 book praising Donald Trump’s business record called The Trump Factor. He contributes to Forbes magazine and was on the advisory board of Donald Trump for President. Obviously, all three people have more than a superficial knowledge of markets.

Velshi and Ruhle challenged Thomas when he touted the stock market gains that have occurred since Trump’s election as well as his claim that Trump has created a million new jobs. You can watch the full exchange here:

In fairness to Mr. Thomas, he is an advocate to the President and was invited on the show as such. Calling him a liar is like calling a Defense Attorney a liar for not mentioning all the things that point to his client’s guilt. That is not his job. Having said that, it does get annoying after awhile when guests on news shows are never challenged and context is never provided.

The truth of the matter is that the stock market has appreciated considerably from its 2009 lows – both before and after Trump’s election. It is also true that there has been no meaningful economic acceleration since Trump has become president. Here is the data. First, the S&P 500 going back to the year 2000.

Second, here is the average number of jobs created (or lost) each month in thousands for the years of 2007 through 2017 year-t0-date.

Current estimates for GDP growth for the year center around 2.2%. That is an improvement from last year’s 1.6%, but not materially different from the post-recession average.

Although you will always find disagreement among economists and “experts,” I do not personally believe that there is much Trump or anyone else can do to significantly raise the long-term growth of the American economy. I’m persuaded by Robert Gordon’s argument that we are in a period of weaker long-term productivity growth. His thesis is straightforward: we were lucky to have in our past a period of unimaginable human progress in which the house was electrified, indoor plumbing became common, urbanization moved people from isolated areas, jet travel emerged, killer diseases became eradicated, and so forth. It is unlikely that we will ever again see such progress within the span of a generation or two. Despite the information technology revolution having real and measurable benefits on productivity, having electricity just does not compare to having Google or Facebook.

The evidence is proving Mr. Gordon correct. During the second quarter, productivity rose by 1.1% over the prior year and the five-year average growth is sitting at 0.7%, compared to the post-WWII average of 2.4%. With population growth relatively stable at 0.7% per year, it is just not feasible that long-term growth can rise about 2% per year if productivity growth does not improve measurably. The chart below depicts long-term productivity changes as well as the five-year average change in the United States.

Does that mean that policies are irrelevant to economic growth? No. A country that, for example, refuses to enforce property rights will have little innovation and little long-term growth. Tax policies can also influence private investment, which in turn can influence productivity growth. But, the fact remains that our standard of living primarily depends on how inventive we are. Most political policies influence cyclical growth and not secular.

That brings up a very good question: if the investors in the stock market are rational and if it is unlikely that long-term economic growth can rise above the 2% range at most, why have they bid an already expensive stock market so much higher since Trump’s election (by nearly 16%)?

Sometimes it is hard to divine the reasons markets move in the way that they do. In this case, I think it is not that hard. Markets were cheered by the possibility of corporate tax reform and deregulation.

The United States has a relatively high corporate tax rate, but businesses pay an effective rate that is relatively low because of numerous deductions that have made their way into the tax code. This includes a very ineffective means of taxing corporate profits on international earnings. If a multi-national company, say Apple, earns money in a foreign country, it pays U.S. taxes on those earnings only if it brings that money back to the United States.

Statutory (top) and effective (bottom) corporate tax rates in selected countries.

Deregulation has also been hoped for, particularly in the financial sector where banks have been under tighter scrutiny since the financial crisis. It is possible that tax reform and deregulation could lift business investment and raise long term growth, but it seems unlikely that it would do so by a meaningful amount.

If that is the case, then Wall Street apparently feels as though corporate America will be taking a larger slice of the pie rather than swimming in a larger economy.

Is there a point at which following through on these objectives will no longer be believed? Strikingly little has been accomplished of the president’s legislative agenda. No health care reform, no infrastructure bills, no tax reform (yet). Instead, each day there seems to be another controversy and even congressional Republicans seem to be at odds with the president.

There is no known answer to the question. Trump is expected to give a speech today on tax reform which may raise confidence in its enactment, but nothing so far has shown that the odds are high of that happening.

By most measures the stock market is expensive and that is rational only in the context of low-interest rates. Consider one gauge of the risk premium currently in the stock market by comparing the earnings yield of the S&P 500 over time with the 10-year Treasury rate. That spread is currently 108 bps compared to a historical average of 208 bps.

It could be logical to argue that because the absolute level of interest rates are so low, you would expect to see some compression of the risk premium. And, indeed, if you compare the ratio of the earnings yield and treasury yield the picture is more encouraging. That ratio is currently at 1.5x versus a historical 1.8x.

The trouble is, that while valuation levels can tell you a lot about future returns, they give little hint to market timers as to when inflections could take place. Most likely, we would need to see a disruptive event, recession, or continued increases in the Fed Funds rate to also see a sharp correction in equities.

In the meantime, investors might want to show some caution as they attempt to play this now very long bull market.

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