Washington lawmakers appear trapped in gridlock, while the Trump administration suffers from daily political crises that threaten its legitimacy and weaken any hope for the policy changes for which it was elected. Yet the equity market has set new highs. This is alternately attributed to complacency or the unrealistic expectations on the part of investors.
Rather, investors seem to have a good grip on market valuation, while critics of the Trump administration and the media seem to relish promoting a pejorative narrative that refuses to recognize the sound basis for the market's valuation. As the most hated bull market ever, by investors, media and critics alike, there is still a vast pool of cash sitting on the sidelines just hoping for any kind of retrenchment to be able to buy into a market that they have missed.
First and foremost, stock prices are driven by corporate profits. If businesses make more money, their shares will become ever more valuable. Thus, the 13.9 percent surge in first-quarter 2017 profits (the highest since 2011) despite a modest 0.7 percent expansion in gross domestic product demonstrates unambiguously that corporate operations are lean and highly leveraged to even small gains in the economy.
As always, the truth is more nuanced. The corporate sector suffered from five consecutive quarters of declining corporate profits, which was simplistically taken by many to suggest stocks were overvalued. In fact, profits nearly disappeared in the energy sector following the massive decline in crude oil prices from $110 per barrel to $25. Other sectors, though, experienced consistent profit growth. So energy stock prices fell sharply, but there was a sound basis for the rest of the market to advance. Instead, it also weakened, making many stocks cheaper. Now, with oil prices recovering to about $50, profits have rebounded in the energy sector, while other sectors continue to plow ahead.
Investors are well aware of the contentious and shocking news flow out of Washington, but mostly appreciate that it matters to equity valuations only to the extent it undermines the ability of companies to grow. The truth of the matter is the global political scene has been awful for decades, even centuries. Was the global news flow any better around World War I? During the interwar years when inflation exploded in Weimar Germany, leading to the rise of Nazism? During World War II? During the Korea, Vietnam and Cold Wars? It doesn't get any better if you go further back in history.
Domestically, we had massive population shifts off the farm into factories early in the 20th century, followed by a Great Depression that elevated unemployment to 25 percent, recurring recessions in the 1950s after World War II, a surge in inflation to double digits, random crises that killed off the savings and loan industry, major failures in commercial real estate (causing Donald Trump, among other real estate tycoons, to suffer massive losses and bankruptcies), failing emerging-market debt, a residential housing crisis, and on and on.
These were real economic shocks that mattered vastly more to the equity market than the political battles that captured our attention, whether it was Jimmy Carter's inability to get our embassy hostages out of Iran, the riots that occurred at the Chicago Democratic convention in 1968, Richard Nixon's impeachment and resignation, Vice President Spiro Agnew's resignation (to avoid impeachment), the Iran-Contra scandal, Bill Clinton's Monica Lewinsky scandal, gridlock in Washington, some of which led to brief government shutdowns. We also experienced the assassinations of John F. Kennedy and Martin Luther King, the shooting of Ronald Reagan, the assassination of presidential candidate Robert F. Kennedy. Yet, despite all of this political theater and violence, the U.S. economy has grown, living standards have increased, corporate profits have risen, and stock prices are rightfully at record highs because so are profits.
It's not that these events don't matter. Domestic and international politics are important for how we live, for our environment, for our social activities, and our social well-being. But that's quite different from whether political developments affect stock valuation, real-estate valuation or bond pricing on a sustainable basis. We may react, or even overreact, in the short-run, but valuations quickly revert to underlying fundamentals.
The market has it essentially right: U.S. economic growth is continuing at a moderate pace, an economic recovery is finally under way in Europe, inflation is under control, corporate profits are rising, and there is some prospect for tax reform and deregulation, even if whatever gets implemented is less than is really needed. These conditions imply continued growth in corporate profits. Investors holding cash who remain fixated on Washington's wild machinations are missing one of the all-time great bull markets in history and they are understandably quite frustrated. They may yet reluctantly jump in.
That's when we should really start to worry the market might be getting vulnerable.