Just keep looking up.
The International Monetary Fund, echoing increasingly gloomy sentiment in Washington, has concluded that President Donald Trump’s administration and Congress probably won’t succeed in enacting tax reform or even significant tax cuts. The Republican chairman of the Senate Foreign Relations Committee calls the White House “an adult day care center” and says he fears that the president’s reckless bluster may lead us into World War III. The president, meanwhile, says he wants to compare IQ test scores with his secretary of state.
Stock market investors do not appear to be worried about any of these things. The Dow Jones industrial average has set a slew of new closing records. The Standard & Poor’s 500 index and the Nasdaq composite index also have been reaching all-time highs. The overall performance of the stock market so far in the Trump era — measured either from election or inauguration — is undeniably impressive. I briefly considered updating my exercise of two months ago, in which I considered stock market performance under every president since William McKinley, but it didn’t really seem worth the effort. Stocks have done well in the Trump era. Period.
So what are we to make of this juxtaposition between a seeming train wreck in Washington and a booming stock market? I’ll leave aside the possibility that stock market movements over a nine-to-11-month stretch are random and meaningless — not because it’s necessarily wrong but because there’s not a lot to say about it. Three other explanations spring to mind:
• Trump is actually doing a good job for investors. While the media and Washington fixate on every new outrage and absurdity emanating from the president’s Twitter feed, investors may be sifting out the noise and focusing on what’s actually happening. Environmental and financial regulations are being rolled back or delayed. The Supreme Court has kept its business-friendly majority. The president and Republican congressional leaders have so far proved remarkably incapable of accomplishing anything legislatively, but hey, political gridlock sure was good for markets in the late 1990s.
• It’s not about Trump, or even the U.S. The U.S. economy is continuing to grow at about the same slow pace it has for most of the now eight-year-long expansion, but economies elsewhere in the world are picking up speed. That same IMF World Economic Outlook report that discounted the chances of tax reform and predicted U.S. gross domestic product growth of just 2.2 percent in 2017 and 2.3 percent in 2018 upgraded global GDP growth estimates to 3.6 percent in 2017 and 3.7 percent in 2018. The companies in the S&P 500 got 43.2 percent of their earnings from outside the U.S. in 2016; that percentage will surely be higher this year, and it’s probably higher for the Dow companies, too. Recent analyses by The Wall Street Journal and ETF.com found that corporations with the highest foreign-earnings percentages are driving the market’s gains. The “America first” president may be basking in a market boom driven mainly by overseas economic growth.
• Markets are just wrong. One issue is that broad financial markets aren’t great at pricing tail risks (low-probability, high-impact events so named for their position on the tail of a statistical distribution). World War III would be a terrible thing, but the probability of it or some other market-crashing disaster happening is 1) small and 2) really hard to calculate. More generally, stock markets tend to overshoot, a phenomenon that University of Chicago behavioral economist Richard Thaler, awarded the Nobel Prize in economics on Oct. 9, played a key role in documenting.
At the annual meeting of the American Finance Association in 1984, Thaler and former student Werner De Bondt asked “Does the Stock Market Overreact?” They answered the question by assembling “winner” and “loser” portfolios of stocks that had performed especially well or poorly over 36-month periods, then examining their performance over the subsequent 36 months. The winners underperformed the market during the second period; the losers outperformed.
So are stock prices high? The S&P 500’s price-earnings ratio, at 21.8, is higher than its average since the mid-1950s, but it’s not much higher:
So … I really don’t know if the stock market is currently overshooting companies’ earnings or not. Neither, by the way, does Thaler, who, when asked to explain the stock market’s run on Bloomberg Radio on Tuesday, said, “I don’t know where it’s coming from.”
Justin Fox is a Bloomberg View columnist and the author of “The Myth of the Rational Market.”