Global equity markets once again in 2016 and early 2017 defied the so-called experts by shrugging off Brexit and Donald Trump's victory. The Dow Jones industrial average hit an all-time high just five days after Mr. Trump's inauguration, despite market pundits predicting Armageddon.
There is good reason for such exuberance. Purchasing Managers' Index in Europe and Japan are seeing multiyear highs while expectations for long-term U.S. earnings growth are over 12% and U.S. equities are scaling new heights fueled by a “good news” narrative; based largely on expectations of lower corporate taxes, fiscal expansion and the unleashing of so-called animal spirits as regulations are rolled back by Republican control of both the White House and Congress.
However, in such environments, it is important for investors to critically evaluate whether these consensus assumptions may either be unrealistic or be ignoring important risks that could undermine them; or that the post-election rally might have already brought forward the implementation of such earnings-boosting policies and thus are vulnerable to mean reversion.
For example, because they are expected to disproportionately benefit from corporate tax reform, small-cap stocks are now trading worryingly close to two standard deviations above their long-term average.
The industrials and materials sectors, as well as certain Latin American markets that are most exposed to these sectors, also have seen stratospheric appreciation from the combination of Chinese reflation (which is waning) and infrastructure spending expectations. Bank stocks have also benefited from the combination of a steepening yield curve and a rollback of the Dodd-Frank Wall Street Reform and Consumer Protection Act; although they still trade at reasonable levels relative to their long-term average.