By Professor Ricardo “Rick” Ulivi, Ph.D.
Since before and after Trump’s election, I recommended you remain cautious, and in most cases, to reduce your stock exposure. I thought prices were too high, and that a correction was necessary to have stock prices reflect current facts.
Yet, right after Trump won the election, and until now, stock prices roared, setting new records. I am very surprised. It was not my forecast. Why has this occurred?
The role of facts and expectations
Valuation is affected by two key variables: facts and expectations. Facts are such things as current earnings, debt levels, interest rates, sales growth, etc. Facts are numbers; they are real and measurable. You can check them out.
Expectations, on the other hand, are subjective. They are based on one’s view of the future; somebody can expect things to get worse, and so they become pessimistic; others can expect things to get better, and are optimistic.
When you try to determine the value of a stock, or real estate, facts play a role, but a larger one is played by expectations. After all, the true value of an asset is based on what you expect future facts to be. Let’s take Tesla as a case study. It only makes two models of cars at the moment, and it produced a personal record 25,000 cars in the first three months of this year. It has also lost huge amounts of money since day one.
Ford, in contrast, makes many models, in every possible vehicle category, and it sold ten times more cars in March alone than Tesla did in the first three months of 2017. Ford also makes money–billions of dollars. Yet the market value of Tesla is greater than Ford’s. That’s totally crazy, if you expect market value to reflect facts.
But if you take into account expectations, you can see why the stock market can justify valuing Tesla more than Ford. The valuation implies that Tesla will soon be selling more cars and making more money than Ford. Will this happen? Only time will tell. If future facts do not match the current expectations, you can assume Tesla’s stock price will plunge at some point.
What were the economic and financial facts when Trump took over? The USA has been running a $500 billion federal deficit for too long, it has a comparable trade deficit, and it has accumulated trillions of dollars in debt. To a fiscally conservative person like me, these facts suggest that we are in trouble, and we need to get serious if we are to avoid the consequences of our irresponsible economic management.
Is Trump a magician?
Trump became president and the facts are still the same. The country continues to run huge fiscal and trade deficits, etc. The economy has not grown any faster than it has for the last few years; in sum, nothing has really changed. Why then did the stock market take off just after he won the presidency? The answer is simple: expectations. Investors seem to believe that Trump, like a magician, will wave his magic wand, and the economy will improve immediately.
Magicians exist but don’t really make magic; they just make us believe. Is Trump a magician?
Let’s go back to my advice. In urging you caution, and in recommending you reduce your exposure to common stocks, I was obviously wrong. Why? What I failed to see, or understand, was the huge wave of enthusiasm that Trump’s election created with a large percentage of the general public and with perhaps an even larger percentage of the investment community.
But I’m still a conservative guy. I still see what’s wrong with America’s finances, and I believe strongly that we need more than a magician to fix our problems. Eliminating the fiscal deficit, reducing the trillions of bonds the Fed has bought since the 2008 crisis, reducing our trade deficit, improving our educational standards, and so on requires a bi-partisan approach in Congress that I don’t see happening in the near future.
Where do we go from here?
In sum, my belief is that financial enthusiasts have become a bit too optimistic, and if their high expectations are not met, we will see more realistic valuation of stocks, bonds and real estate.
Where do we go from here? I recommend we take a wait and see approach. That’s because I am concerned about the consequence of lofty expectations not being realized.
Let me know if you have any questions.