Financial markets 2018: P/E ratios are great again.

AuthorNeal, Robert S.
PositionPrice-earnings

The most remarkable development over the last year is the disappearance of volatility in the financial markets. The most-followed measure of stock market volatility is called the VIX, which is a technical combination of option prices.

It was created in 1993 and it represents the market's forecast of volatility over the next 30 days. It has been at its lowest levels in its history throughout 2017. The steady decline of the VIX started just after the election last year. Investors appear not to care about the difficulty that Republicans have passing major legislation, not to mention the turmoil in the White House.

Last year, we commented on how the market seemed to be discounting the campaign rhetoric. We speculated that the market treated both campaigns as if they were sales pitches that neither candidate believed or really thought they could implement. We thought we were an outlier in this view. We were not. The drivers of the stock market appear to be solely earnings forecasts and valuation ratios. Certainly, the lightly covered economic news of deregulation in almost every sector helps boost returns, as does the talk of a tax cut. But until we get a tax cut or any major legislation, Washington news appears more irrelevant than ever to the financial markets.

On the other hand, we were thankfully wrong in our forecast that the stock market returns would be below their long-run average return. Between October 30, 2016 and October 30, 2017, the S&P 500 index increased about 21 percent. This is far above the long-term average of about 7.5 percent and in line with the memorably high returns in 2012-2014. It certainly is quite an improvement over the low returns in 2015-2016. The returns to the Nasdaq Composite and Dow Jones indices were even better, coming in at 29 percent and 31 percent, respectively.

We certainly believe that the agendas that appeal to the base supporters of each party, if fully implemented, would not be good for the stock market. The unlikely Democratic agenda of higher taxes and regulation to ostensibly help the middle class will discourage business investment and startups. The somewhat more likely, Steve Bannon--promoted, Trump agenda of sharp restrictions on trade and immigration will likely hurt much more than a tax decrease will help--especially if it sparks a trade war--but the threat at this point seems unlikely.

We don't see the growing deficit causing dramatic movement in the bond market. With the economy jogging...

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