Since President-elect Donald Trump and the Republican Party scored a decisive victory in last Tuesday’s elections, equity markets in the United States have soared. Even the Russell 2000, an index of riskier, smaller-capitalization stocks, is participating in the broad equity rally. Last week the S&P 500, the benchmark equity index, rose over 4%, more than 270 points.
Investors cheered the Republican sweep because Trump and the GOP are seen to believe in capitalism, low taxes, and dismantling the regulatory state. Investors know that the U.S. economy will grow faster with Trump as president and Republicans in control of Congress. Investors are right to believe that productivity growth will accelerate under the Trump administration because the president-elect and Republicans will fully embrace the artificial intelligence revolution.
Moreover, the market correctly understands that the new Trump administration will introduce laws and policies that will encourage the nation’s oil and natural gas producers to invest in new production that will keep energy prices low. Abundant low-cost energy helps both households and businesses. Energy is a critical comparative advantage of the U.S. economy. Under a Republican government, the regulatory state will no longer strangle innovation and impose unnecessary costs on households.
But the traffic lights are not all green on the highway of America’s equity markets. Valuations are stretched. With the exception of the COVID-19 pandemic, since 2000, the S&P 500 earnings multiple, the ratio of price to earnings that investors are willing to pay to invest in the index, has trended around 18. For the past two years, since the AI revolution began to unfold, the earnings multiple has expanded to over 20 times. But now, after the so-called Trump Rally, the earnings multiple has gone parabolic. Stocks are trading at more than 23 earnings projections for 2025.
Things can go wrong.
Inflation, for example, remains above the Federal Reserve’s 2% target. Monetary policy remains restrictive, which means that interest rates are a constraint on economic growth and earnings growth for businesses. The economy, markets, and investors don’t like uncertainty. Trump has promised to introduce policies that will create uncertainty. At the moment, his team is preparing to deport millions of illegal immigrants. That will cause significant short- to medium-term economic disruption. Trump also wants to cut taxes at a time when the federal government is running a deficit equal to more than 6% of GDP. Tax cuts for individuals don’t pay for themselves.
Higher deficits are inflationary and push interest rates up. The cost of investment and buying homes increases. Of course, Trump also promises to raise tariffs on U.S. imports. Tariffs raise the price of goods, consequently increasing inflation. Tariffs are an implicit tax on consumption. That matters because household consumption makes up almost 70% of GDP. Tariffs would be a drag on the economy. The Trump administration will bring a lot of uncertainty to equity markets.
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U.S. equities over the short term are all about momentum, and right now, equity momentum is strongly positive. Occasionally, however, irrational exuberance takes hold of investors. As stocks rise into the year-end period, caution is warranted. Assessed on a historical basis, stocks are very expensive and investor sentiment is becoming extreme. This means any bad news could have a pronounced negative effect.
Going up, stocks climb the stairs. Going down, stocks use the express elevator. Excessive risk-taking is not warranted.