Stock prices are setting new records but could easily charge much higher. The U.S. economy is growing again—about 2.5 percent in the second quarter and going forward—and corporate profits are rising again.
After the Brexit vote, the dollar strengthened against foreign currencies but overall it remains well below levels recorded earlier this year and last. That should aid in the translations of U.S. earnings on foreign operations into dollars on corporate profits statements.
Naming of Theresa May Prime Minister should firm the outlook for UK growth and stocks. Although much uncertainty about Brexit persists and the British economy may flutter for a few quarters, its long-term prospects remain strong.
Anemic growth on the Continent and the stress imposed by the immigration crisis, half-hearted market reforms, a single currency and fiscal austerity compel the European Central Bank to continue its negative interest rate policies.
In Japan, a shrinking labor force, resistance to immigration and halting deregulation limit growth and compel accommodative monetary policies too.
In China, slower growth, the absence of competent financial market regulation, reliable accounting and limits on foreign ownership make U.S. bonds and stocks the best alternative for private investors around the world.
U.S. Treasury data on capital inflows indicate continued strong global demand for U.S. corporate stocks and bonds. Even if the Fed responds to a stronger job market by raising the federal funds rate a quarter point by December and further next year, the impact on 10 and 20 year Treasury rates will be minimal—mirroring 2004-2006, when the Fed last pushed up short rates.
The average rate of profits for the S&P 500, which comprises about 80 percent of the publicly traded U.S. equities, is 4.0 percent and compares favorably with the 1.4 percent paid on 10-year Treasuries.
At the same time, long-term sustainable price-earnings ratios for stocks are rising and make U.S. equities cheap.
Nowadays, economic growth is based much more on intellectual property—computer apps that create companies like Uber and artificial intelligence that power drones and robotics —and less on hard assets—industrial buildings and machinery. That greatly reduces the amount of financing businesses needs to create new and better products—the foundations of stock market wealth.
Google (NASDAQ:GOOGL) was launched with only $25 million in 1999 and grew into a $23 billion enterprise at its initial public offering five years later—the story repeated elsewhere in the tech sector.
As established powerhouses like IBM (NYSE:IBM) and Ford Motor Company (NYSE:F) rely more on software to create value in products sold, the demand for private finance for expensive purchases of physical assets becomes more limited.
This is an important reason why established companies are flush with cash, even as they invest to improve supply chains, expand product offerings and invest in promising new ventures and buy back stock.
Lower capital requirements coupled with an abundance of financial capital, thanks to flush balance sheets and foreign money coming into America, are pushing down the expected rate of profit needed to attract funds into equity investments.
In turn, that pushes up the price-earnings (P/E) ratio markets can sustain—even if uncertainties abroad create the wider fluctuations in stock prices as recently experienced.
The S&P 500 Index is currently trading at about 2137 with a P/E ratio of about 24.15. However, factoring in expected profit growth over the next 12 months the P/E ratio falls to about 18.00.
That’s well below its 25 year average of 24.94.
Assessed against alternative investments and history and given how much more efficiently digital technologies permit businesses to create wealth using investors’ cash, stocks are hardly overvalued.
A P/E ratio at 25 is reasonable and coupled with expected growth in profits that could easily push the S&P Index up another 33 percent and past 2800.