This article was originally published on Forbes
April 27, 2017
When Trump’s presidential victory was announced last November, the U.S. equity markets took off and never looked back. From post-election day through the end of first quarter 2017, the S&P 500 finished up an impressive 11%. Volatility–as measured by the VIX–was stunningly down almost 40% over the same period. On the other hand, the 10-year U.S. Treasury yield sharply increased about 100 basis points, apparently signaling that a period of great growth was about to begin.
As we approach the end of Trump’s first 100 days, let’s try to see how much of a premium the U.S. stock market has built into a Trump rally, and what risk that entails. There are a variety of methods to explore this. I like to compare the actual year-to-date run-up in the S&P 500 to an average 6% expected return during a “normal” year of investing. The chart below shows the total return of the S&P 500 for year-to-date as of April 24, 2017. It has amassed an impressive $1.5 trillion in additional value over that time. I’ve also overlaid an annual 6% return, which I use as a proxy for long-term average market returns. On a year-to-date basis that turns out to be about 2%.
The gap between the two graphs–actual S&P 500 returns versus the average market return–represents the difference between average market returns and reality. In dollar terms, this equates to approximately $1.1 trillion in additional market capitalization.
Where does this additional value of $1.1 trillion come from? In my estimation, it is an amalgamation of many market-favored initiatives that investors are hoping for: tax reform, infrastructure spending and health care reform. But it also could include an improved outlook for the baseline U.S. economy’s continuing recovery in earnings. Let’s take a look at how that factors in.
First quarter earnings for 2017 look promising so far—the average reported year-over-year change is expected to be in the low double digit range. But according to Bloomberg, the expected annual earnings growth for the entire year is about half that. So if one expects baseline nominal earnings to come in around 7% for the year, and a dividend yield of another 2%, I calculate a “building block” return of 9% (denoted as “2017 Baseline Return” in the graph). Translating this to our graph for this first four months of the year gives us another straight line approximation of about 3% return YTD. This represents about a $900 billion gap in valuation versus the actual S&P 500 return.
My point: even if I account for strong baseline earnings, there is still quite a gap between the current S&P 500 return and what we would expect it to be from a baseline perspective. This gap must come from the “Trump Premium.” How much of the premium is at risk?
Using a fact-based approach, one can simply state that none of the new president’s initiatives has been successfully implemented yet. Perhaps a portion of them will be implemented during this year, but at this point, I conclude that the gap between the baselines in my graph and the actual YTD returns are based purely on hope.
Should the market translate the absence of policy adoption as a chronic issue, then this premium is definitely at risk. My worst-case estimates assumes a drop in returns to my baseline cases: between 2% and 3% returns year-to-date. Taking the differences between the current S&P 500 returns and my baselines produce a drop of 5% to 6%, which in turn implies that the market would give up anywhere between $900 billion to $1.1 trillion in a selloff.
While no one yet knows if Trump’s policies will be adopted, current earnings indicate our baseline economy appears to be doing well. If Washington approves some of the President’s pro‑business actions the “Trump Premium” would then be more logical and fact-based.
Disclosure: The general nature of this article has not been tailored to any particular investor’s need. The opinion of the author is as of the date of this article and subject to change.