In our last quarterly letter, we noted that the combination of large-scale corporate deregulation, tax cuts, and infrastructure spending would likely provide a tailwind to domestic corporate earnings, resulting in a short-term increase in domestic GDP growth. This optimistic expectation was predicated on the pro-business campaign platform of President Trump, evidenced by the 11.6% increase in the value of the S&P 500 since election night (as of April 26). Now that Trump has been President for 100 days, however, markets are beginning to become skeptical that the policies he spoke of during the campaign will be implemented with the anticipated speed and magnitude. This possibility was put into sharp focus by Trump’s initial failure to rally his own party to repeal and replace Obamacare, which may serve as a harbinger of additional conflict over potentially more complicated taxation and spending issues in the future.
As domestic equity markets appear to have priced in a large economic reform package coming early in Trump’s presidency, the potential for a smaller reform package coming later than initially anticipated could have a large negative impact. This impact could be exacerbated by the high valuations of domestic equities, both on an absolute basis and relative to long-term averages. As illustrated by the chart below, the 12-month trailing P/E ratio of the S&P 500 Index (large cap) as of April 26 was 21.7, 28% higher than the 10-year average P/E of 17.1.
Small cap equities, as measured by the S&P 600 Index, appear to be slightly less overvalued, with a 12-month trailing P/E ratio of 27.4 as of April 26, 9.9% higher than the 10-year average of 24.9.
Relatively rich valuations in the US equity markets are of concern because, if anticipated pro-business policy reforms do indeed take a long time or are of less magnitude than markets currently anticipate, domestic equities have a rather long way to fall to meet long-term average valuations. Thus, we are lowering our recommendation on domestic large and small cap equities from neutral to neutral-to-underweight.
Of course, if the Trump administration is able to work with Congress to implement reforms as originally planned, the boost to domestic GDP growth could be significant, justifying high valuations. In an encouraging step for markets, on April 26, Treasury Secretary Steve Mnuchin announced plans for tax reform that included a decrease in the federal corporate tax rate from 35% to 15%, which would be a boon to corporate bottom lines. Additionally, the plan calls for a decrease in the marginal tax rate for the highest individual tax bracket from 39.6% to 35%. The Trump administration has indicated a goal of passing tax reform by the end of 2017.