Directly reporting Mr. Trump words regarding a potential bubble, it’s worth to make an analysis on the current conditions of the economy.

We are very likely to be in a big bubble, but not as ugly as Mr. president mentioned during the campaign. Funny enough, the main driver of this bubble, that has lately grew further, was Donald Trump himself, in fact prices inflated dramatically due to his election and promised policies.
In April 2016, Trump said he didn’t have much faith in the stock market outlook, and that it was a terrible time to invest because a huge recession was coming. Moreover, Trump named Carl Icahn as a special advisor to his new administration. Icahn is a recognized investor, notably bearish on the stock markets at the moment. He also created a mini documentary warning on possible financial meltdown on the horizon, called “Danger Ahead“.  So Trump is clearly well aware of how risky is the current situation of financial markets.

The Dow Jones industrial average hit the 20,000 threshold for the first time, pushed by President Trump’s calls for massive infrastructure spending, lower corporate taxes and regulatory rollbacks. Equities, especially in the US, are expensive, suggesting confidence in the future growth of the country. However, the post-election euphoria may be temporary as analysts argue about Baltic Dry Index case, seen by many as a leading indicator of the state of the world economy. The index measures the demand for shipping capacity versus the supply of dry bulk carriers. The supply of cargo is inelastic as it takes years to build a new ship. While the demand for shipping, varies with the amount of cargo that is being traded or moved in various markets. Therefore, increases in demand can push the index higher quickly (and viceversa). The index that indirectly measures global supply and demand for the commodities shipped aboard dry bulk carriers, such as building materials, coal, metallic ores, and grains, has fallen 30% since Trump’s election win, dramatically plunging after his inauguration. That could be driven by “high fears of protectionist policies” according to Neil Wilson, of ETX Capital.

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Baltic Dry Index – Bloomberg

Another indicator moving in the direction of a “big” bubble is “The market cap to gross domestic product (GDP) ratio”, also known as the “Warren Buffett Indicator”, considered as a really good measures of stock market valuations. It compares the total price of all publicly traded companies (total Market cap) to GDP. A ratio of 100% suggests the valuation of the stocks is fair. The market cap to GDP ratio is currently at 128%. It has only been higher twice since 1950. However, In terms of real GDP growth, the current economic expansion has been the weakest since the end of the Great Depression.

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Therefore, if economic growth has been so weak during the past eight years, why has the stock market experienced such a strong boost? (The S&P 500 index is up 240% from the low in March 2009.) One reason could be that artificially low interests have been detrimental for retirement portfolios that relied on fixed income investments. Hence, many investors and retirees were forced to pour their money in riskier investments like the stock market.

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While we have ventured far into the monetary expansion, with a 400% increase in the monetary base since the Financial Crisis:

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It took nearly 100 years for FED monetary base to reach $1 trillion. Then, in 8 years following the most recent financial crisis, it has quadrupled the monetary base from under $1 trillion to more than $4 trillion. As a result of that, the money has been pumped up stock and real estate prices. However, history shows that when the liquidity is withdrawn, the gains in asset prices will not continue.

The last worrying valuations method is price to sales ratio. Sales are notably difficult to manipulate, and thus the price-to-sales is arguably a more robust measure of valuation. The following chart shows the price of the S&P 500 compared to its median price to sales ratio. The current level above 2.0 is one of the highest price to sales ratio investors have ever paid.

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At the same time, total corporate sales have flat lined for the past four years, so investors are not paying higher multiples due to a wide growth environment. Total business profits also are at 2012 levels. While the global economic outlook remains uncertain. Half of all S&P 500 companies relying on foreign sales, and the obstacles to free trade could have a negative impact on their earnings.

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On the other hand, Price-to-earnings ratios are elevated by conventional metrics, but they turn out to be close to the long-term historical average for periods of low interest rates as the current one.

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S&P 500 Index Valuations are on Historical Trend Relative to Interest Rates

Of course, as bubbles are not rational, it is extremely challenging to predict the timing of their burst. However, careful analysis of market data can indicate when a bubble is about to collapse. Hence, the prudent move for longer-term investors could be to carefully observe these valuation metrics, and be prepared for downside risks in the years ahead.
It’s not cautious to expect a return to Reagan prosperity based on Trump similar fiscal policies. The environment was not similar, Reagan started his presidency when stocks were trading at low P/E with high dividend yields, while interest rates where declining. We are in the precise opposite situation today, with high valuations and rising interest rates.

Author:
Luca Cartechini
Head of Financial Markets

*Based on analysis carried out by Investing.com and the Marketwatch.com

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