You can call it cognitive dissonance or you can call it being blind to the numbers. Both terms are apt descriptions for today's lemming-like rush into U.S. stocks.
David Kostin, chief U.S. equity strategist at Goldman Sachs, prefers the term cognitive dissonance and uses it to describe the growing chasm between rising U.S. stock prices and falling profit forecasts.
Investors and managers are growing increasingly optimistic at exactly the same time as analysts are reining in expectations for 2017, he writes in a note. The result has been a 10 per cent increase in the S&P 500 index since the U.S. election despite a 1 per cent decline in consensus forecasts for earnings per share.
Mr. Kostin isn't the only analyst to be worried. In fact, many market gauges are signalling just how overheated Wall Street has become.
Of course, the biggest reason for the prevailing market fever is Trump-phoria – the belief that the new team in Washington will whack taxes and slash regulations, thereby igniting a new period of rising profits and surging growth.
Maybe so. But it's difficult to say exactly what the precise impact will be of yet-to-be-announced changes that may not even be passed into law.
So let's take a step back and try to place investors' high hopes in context. Anybody betting on a further Trump bump in stock prices should be prepared to answer at least one of three questions in the affirmative.
Can profits surge?
Analysts love to play games with earnings forecasts, setting predictions high at the start of the year then reducing estimates as the year progresses.
Rather than getting caught up in the usual rigged game of earnings beats and revisions, investors should focus on the big picture. Corporate profits usually amount to between 3.5 per cent and 7 per cent of the overall economy. They've recently been around 6.3 per cent, one of the highest levels in the past half century.
Sure, profits as a share of the economy could stay where they are now or even move slightly higher. But history says there's a better chance that earnings will stagnate or decline, relatively speaking.
Can the economy speed up?
The absolute value of profits could still grow at a rapid clip if the total economic pie were to suddenly swell larger. In such a case, earnings might still account for the same relative slice of the total pie, but the slice would be a lot bigger in dollar terms.
But where is that growth supposed to come from? The Trump team makes it sound as if too much regulation and too many bad trade deals have been holding businesses back from rapid expansion. They promise at least 3.5 per cent growth, a near doubling from recent levels.
Good luck with that. A likelier explanation for disappointing growth in recent years has to do with the aging of the U.S. work force. From 1980 to 1990, the working-age population expanded at 2 per cent a year. Growth been slowing ever since. In recent years, the prime-age work force – those between 25 and 54 – has barely increased at all.
If the work force isn't expanding, the only way for the economy to grow fast is to revolutionize productivity so each worker can generate far more output. Unfortunately, there is little sign of such an outburst, outside of a brief surge between 1995 and 2004 when businesses retooled for the Internet.
Barring another breakthrough of equal magnitude, you have to be a diehard optimist to expect a sudden surge in gross domestic product (GDP). John Fernald, a highly regarded researcher with the Federal Reserve Bank of San Francisco, says his best estimate of the sustainable pace of GDP growth in the United States is now just a little more than 1.5 per cent a year.
Could valuations increase?
If the profit share of the economy is close to its peak, and economic growth is unlikely to go on a tear, the only remaining way for stock prices to surge is if people are willing to pay more for each dollar of earnings.
The problem with this hope is that U.S. stocks are already richly valued. Measured in comparison to trailing 10-year earnings, U.S. stocks are at least 70 per cent above their historical mean, according to Jill Mislinski, research director of Advisor Perspectives.
Other comparisons also argue that stocks are trading way above normal levels. Perhaps this reflects abnormally low interest rates – there is simply no other place for investors to be.
However, there are other reasons to worry. Aswath Damodaran, a finance professor at New York University, points out that in 2015 and 2016, U.S. companies returned more money to shareholders in the form of dividends and share buybacks than the companies earned. This, he notes drily, is "an unsustainable pace even in a mature market."
Investors should keep that in mind as they contemplate what lies ahead for U.S. stocks. Mr. Kostin and other Goldman analysts expect "hope" to drive the S&P index to 2,400 – just above current levels – before fear brings it back down to 2,300 by year end. That sounds reasonable. In fact, it may even be a bit optimistic.