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Market's margin of safety vaporises in Trump euphoria

Peter Warnes  |  25 Nov 2016Text size  Decrease  Increase  |  

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While there has been a meaningful change in circumstances since Trump's victory, there is little margin of safety in equities markets at current levels, Morningstar's Peter Warnes says.


As US markets surge to new peaks on Trump euphoria, not all are convinced the path ahead will be without a pothole or two.

The markets seem convinced the decisive move away from loose monetary policy to fiscal stimulus is a game changer.

All four major US indices--the Dow Jones, S&P 500, Nasdaq and the Russell 2000--have hit all-time highs, the first time since 31 December 1999 when the 1995-2001 dotcom bubble, led by Nasdaq-listed stocks, was nearing its peak. The Dow Jones was 11,500; the S&P 500 1,470; the Nasdaq 4,070 and the Russell 2000 505.

The party ended late 2000 and such was the extent of the collapse in technology stocks, the Nasdaq is now 32 per cent above 31 December 1999 levels, while the Dow is 66 per cent higher, the S&P 500 50 per cent and the Russell 166 per cent.

It goes to show the resilience of equities markets over the long term, given the calamitous events of the GFC culminating in the Dow touching 6,500 in March 2009.

While acknowledging there has been a meaningful change in circumstances since Trump's victory, I believe there is little margin of safety in equities markets at current levels. Hype and extrapolation abound and extreme fear readings have changed to greed within the space of three weeks.

Significant short covering also helped push markets higher, particularly infrastructure stocks like US Steel and Caterpillar, along with healthcare and drug companies fearful of the Democrat policies.

Some of these stocks are up 10-12 per cent, double the move of major indices. Short positions are likely to be reopened.

The S&P/ASX 200 price/earnings multiple is near 17, on an earnings yield of 5.9 per cent and a dividend yield of 4.4 per cent.

The 10-year bond yield at 2.7 per cent suggests an equity risk premium (earnings yield less bond yield) of a rather thin 3.2 per cent. The margin of safety has been vapour-like over the past three weeks.

US markets are more stretched than other markets in terms of investment arithmetic with a lot of good news around the benefits of the infrastructure spending proposal and the draining of the swamp reflected in prices.

The Trump presidency begins on 20 January 2017, but markets are moved and disappointed by expectations. Longer term, the implications of widespread isolationist trade and immigration policies could be far more damaging.

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Peter Warnes is Morningstar's head of equities research. Any Morningstar ratings/recommendations contained in this report are based on the full research report available from Morningstar.

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