If I had to guess earlier this summer, I would not have expected most major U.S. stock indexes to have reached all-time highs before any concrete results in trade negotiations with China were evident.
In fact, there have been records in both the Dow Jones Industrial Average DJIA, +0.12%[1] (the retail investor’s favorite index) and the S&P 500 SPX, +0.05%[2] (fund managers’ favorite index). Small-cap stocks and the Nasdaq Composite Index COMP, +0.02%[3] didn’t make fresh new highs last week, but they were outperforming all year and hitting records into late August, so the advance in the market is much broader than one might have anticipated in a late-stage expansion.
What is driving this push in share prices to all-time highs? Earnings.
At the beginning of the year, analysts expected earnings per share (EPS) to increase in the range of 10% to 12% for 2018, depending on whether analysts used top-down or bottom-up estimates. Right now, after first-quarter and second-quarter EPS growth came in at 20% and 25%, respectively, 2018 EPS growth is estimated to be 20%.
Naturally, if EPS is growing by 20%, share prices should follow suit.
Clearly, quantitative tightening by the Federal Reserve, global trade frictions and a rout that started in emerging markets’ (EM) currencies (soon spilling into local bond markets and later into emerging markets’ stocks) had the potential to create another crisis, but the crisis is contained at the moment. As we witnessed from 1997 through mid-1998, the U.S. stock market could ignore the Asian crisis — until it didn’t. So the current contrast between a strong U.S. stock market and weak Chinese (and other emerging) stock markets can continue for a while, but ultimately either the EM space will rally or the U.S. market will sell off.
While there was a small recovery off of an all-time low in the J.P. Morgan Emerging Markets Currency Index last week, the situation in the emerging markets space is precarious. Both the Turkish lira and Argentine peso have been cut in half in 2018, and we are still very much in the contagion phase of this crisis. Since the J.P. Morgan EM Currency Index is not widely available other than on a Bloomberg terminal or through FactSet, a good rule of thumb is to keep an eye on the Brazilian real, where forex reserves are ample and interest rates are high. The real, or reais as Brazilians...