By Paul R. La Monica
Hear that? It's the sound of Wall Street exhaling after Election Day.
Fears of nightmare scenarios, such as a long wait for final results from key battleground states or a legal battle contesting the outcome, were all the rage as voters went to the polls. Nothing came of them. Donald Trump's presidential victory was readily apparent by Tuesday night, Kamala Harris conceded, and stocks surged to new all-time highs.
The S&P 500 index gained more than 4% this past week, while the Nasdaq Composite rose nearly 6%. The Dow Jones Industrial Average climbed 4% after experiencing its largest post-Election Day gain since 1896. Even better, the Cboe Volatility Index, or VIX, declined 32%, its largest weekly drop since December 2021 -- a sign that all the pent-up worry in the market's fear gauge had evaporated overnight.
A little relief certainly goes a long way. But while many investors are dusting off their first-term playbooks as they prepare for Trump's second term by buying financials, oil stocks, industrials, and small-caps, the sequel might not go as well. When Trump succeeded Barack Obama in 2017, inflation was lower, with the core consumer price index near 2%. The federal deficit as a percentage of gross domestic product, now at 6.3%, was less than half that. And the S&P 500 traded at an undemanding 16.5 times earnings before the election in 2016, versus nearly 22 times now.
And despite the relatively benign backdrop, "the investor mood before the 2016 vote was restrained," write Doug Ramsey and team at the Leuthold Group. That's not the case now with the Dow, S&P 500, and Nasdaq all hitting new peaks. "High expectations are an underappreciated burden, and a new thing for Trump," they add.
That means Trump's policies are likely to have a different impact than they did the first time around, even though the policies themselves aren't all that different than they were eight years ago. The once-and-future President wants to cut the corporate tax rate to 15% from 21%, impose tariffs of 60% on Chinese goods and 10%-20% on everything else arriving in the U.S., and dial back regulations. In today's environment, the combination has the potential to increase economic growth but also boost inflation in a way that was unlikely in 2017, when deflation was a bigger concern.
Few expect a return to the peak CPI increase of 9.1% annually from mid-2022 due to supply-chain disruptions lingering from the pandemic and an oil price spike after Russia invaded Ukraine. But getting to the Federal Reserve's desired target of 2% may be a challenge. Core CPI, excluding food and energy costs, was up 3.3% annually as of September.
"It's hard to imagine inflation shooting back up to 2022 levels, but it's likely a higher target of around 3% as opposed to 2%," says Marta Norton, chief investment strategist at Empower, a retirement services provider. "That could be a weight around the economy's neck."
The problem would be exacerbated if the combination of lower taxes and greater fiscal spending causes the U.S. deficit, already double where it was in 2016, to blow out even further. That could bring out the so-called bond vigilantes, who have tasked themselves with keeping the U.S. fiscally responsible and inflation under control. Investors have been dumping long-term government bonds during the past few months, pushing yields, which move in the opposite direction of prices, higher. Yields on the 10-year Treasury have spiked from around 3.6% just before the Fed's September rate cut to above 4.4% the day after the election, before pulling back later in the week.
"[This] raises the question whether rising yields could, at some point, create problems for the U.S. economy and U.S. stock markets," writes Gavekal Research CEO Louis-Vincent Gave.
Jim Lebenthal, chief equity strategist at Cerity Partners, says that if the 10-year Treasury's yield cracks the 4.5% threshold, investors may start to worry more seriously about how high long-term yields could go. Sébastien Page, head of global multi-asset and chief investment officer at T. Rowe Price, adds that a 5% yield for the 10-year could be the proverbial magic number that could impact economic growth expectations.
Higher bond yields could be a problem for a stock market that is already very expensive. The S&P 500 is trading above its five-year average of 19 times earnings estimates and just below its recent peak of 23. That leaves the index with an "earnings yield" -- the inverse of the price/earnings ratio -- of 4.54%. If the 10-year trades above that level, it means investors are getting no premium over the risk-free rate.
That would be worrisome if earnings weren't expected to rise 15% next year and another 13% in 2026. Estimates could even head higher if analysts start to factor in how possible deregulation, lower taxes, and increased federal spending would impact corporate profits, which would reduce the market's P/E ratio. Still, valuations on an absolute level are high enough to remind some of the famous phrase from former Fed Chairman Alan Greenspan during the 1990s tech bubble. "Irrational exuberance? We're not there yet, but we're fast approaching it," says Joe DaGrosa, chairman and CEO of Axxes Capital. "P/E ratios are near historically high levels. How much further can multiples expand?"
But it may not be time to back away from the Trump trade just yet. After all, he doesn't take office until Jan. 20, so what he will -- or won't -- do remains something of a mystery. That means looking for value stocks, those that come from economically sensitive sectors and trade at lower P/E ratios than many of the Magnificent Seven momentum darlings in tech and communications services. The iShares S&P 500 Value exchange-traded fund (ticker: IVE) has an overweight position in financial stocks, plus big stakes in healthcare, industrial, and consumer-staples companies -- and trades for 17 times 2025 earnings estimates. The iShares S&P 500 Growth ETF $(IVW)$, meanwhile, has a P/E of 28, well above its five-year average of 23.
"We expect cyclical leadership to continue in the coming months as the market anticipates stronger economic growth and better earnings," writes Jeff Schulze, head of economic and market strategy at ClearBridge Investments.
Financial stocks have already responded. Goldman Sachs Group was a leader in the Dow on Wednesday, with its stock hitting a record high, as did shares of the bank's Wall Street rival Morgan Stanley. Shares of other megabank stocks, including JPMorgan Chase, Wells Fargo, and Bank of New York Mellon, notched fresh record highs as well.
Financials had already been benefiting from lower short-term interest rates, even as long-term bond yields spike, a combination that makes lending more profitable. A Trump administration is likely to dial back regulations on financials and bring a more relaxed antitrust regime, which should boost merger and acquisition activity and provide a healthy boost for the nation's largest banks.
Valuations for banks remain relatively attractive, too. The Financial Select Sector SPDR ETF $(XLF)$ trades at about 17 times 2025 earnings estimates. Regional banks are even cheaper, at a P/E ratio of just 13 times next year's profit forecasts. Chris McGratty, a managing director at KBW, says he expects multiples for the regional banks to expand, partly due to the prospect for deregulation and more mergers in the sector.
Other value stocks have also responded -- and could continue outperforming through year end. Insurer UnitedHealth Group was one of the top stocks in the Dow on Wednesday, with investors betting that the Trump administration will take a more positive outlook toward Medicare Advantage plans and possibly pare back the Affordable Care Act. Construction giant Caterpillar was another Dow winner following the election. Steel stocks Nucor and Steel Dynamics were leaders in the S&P 500. Jim Worden, chief investment officer at the Wealth Consulting Group, an investment advisory firm, says he also likes industrial giant 3M, a Barron's stock pick, and thinks defense giants RTX and Lockheed Martin are good buys on bets that Trump will look to boost military spending.
Smaller stocks should benefit from protectionist trade policies, such as the ones that Trump enacted in his first term. In addition to more tariffs against China, he might seek ones against economic allies such as Europe, Japan, Canada, and Mexico. Trump will clearly be pushing an America-first economic agenda. That, in addition to lower taxes for businesses, could boost small-cap stocks.
"The small-cap rally is a reflection that they are more domestic-oriented and could get more of a pure benefit from protectionism," says Tom Graff, chief investment officer of Facet, a financial-planning firm. "A corporate tax cut may also help small-caps more directly."
These stocks should continue to enjoy a boost heading into the end of the year. But worries about too much of a good thing could come back to haunt Wall Street. "The initial Trump optimism may fade," says Angelo Kourkafas, a senior investment strategist at Edward Jones.
The reckoning could come in the first quarter of 2025 if potential Trump tariffs -- and retaliatory moves by China and other tariff targets -- hit tech companies, retailers, and other sectors. Higher long-term yields could also lead to a premature end of the small-cap surge since it could boost borrowing costs. As Todd Walsh, CEO and chief technical analyst at Alpha Cubed Investments, puts it, "We're in the middle of a big sugar rush...what happens after the euphoria?"
We may soon find out.
Write to Paul R. La Monica at paul.lamonica@barrons.com
This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.
(END) Dow Jones Newswires
November 08, 2024 11:55 ET (16:55 GMT)
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