The major indices all hit record highs Thursday extending the valuations to even more extraordinary levels. The dollar has been increasing in the past few days which may be a result of the border adjusted tax being discussed. I’d consider it a fat tail event. If Goldman’s estimation that there is a 20% chance of it being enacted is accurate, then the dollar should increase 5% since that is 20% of the 25% rise expected. The fact that the dollar is only up 1% since its recent lows could mean Goldman’s estimation is too high or the estimation that the dollar will rise 25% is too aggressive. Another possibility is the market hasn’t priced it in yet. A final possibility is that there are other exogenous factors pushing it lower. As you can tell by the many factors I just described, figuring out how the dollar will react is difficult. Therefore, I am making the case that we don’t know where it will go when this border adjusted tax is put in place. The fact that such an assumption is made as a part of the plan is a flaw in my opinion.

As I mentioned, the multiples stocks are receiving continue to rise. In this article, I will discuss some of the bullish indicators from the credit markets and earnings reports. Before I do that, let’s look at the chart below which shows the Russell 2000 and S&P 500’s two years forward price to earnings ratio. As you can see, both are near their all-time highs. The Russell 2000 is less than one point off its all-time high and the S&P 500 is about 1 point off its most expensive measurement ever. The 2 year earnings estimates are, in my opinion, the best case scenarios. In the past few years, earnings haven’t met their estimates.

The accuracy of the estimates depends on the point in the cycle. Estimates made in 2006 for 2008 were too optimistic and estimates made in the early 1990s may have been beaten. Therefore, if you think the economic cycle still has a few more years of growth left, you should be cautiously optimistic because of how expensive stocks are. If you think the cycle is over, then you’d want to stay far away from stocks because they are more expensive than they appear.  The one thing I glean from the third chart which shows the relative PEs is that the bubble in the late 1990s was highly concentrated in technology; the small caps didn’t participate in the bubble.

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The chart below shows the trailing 12-month S&P 500 net margins. The peak in margins occurred in late 2014, but hasn’t cratered like I expected it to. Corporate earnings have remained resilient in the face of moderately declining margins. The chart below is how many economic indicators look. The recovery has chugged along at a slower pace.

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Considering the decline in margins, I find the overall Q4 earnings shown below to be outstanding. Earnings exceeded expectations by 1.5% while revenues missed by 0.3%. This led both to grow 4.6%. These results were last updated on Friday, so it’s not a complete depiction of the quarter. Financials drove earnings results. This is before the deregulation which is coming from the Trump administration. Lowering costs from regulations will help earnings in 2017. The negative for financials is their net interest margins won’t expand as much as expected because the Fed has been dovish. The negative standout this quarter was consumer discretionary which was flat. This missed expectations for 0.7% growth as the all-important holiday season was a dud. So far, 5 consumer discretionary companies had negative earnings pre-announcements and only 2 had positive ones for Q1.

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The chart below shows how the entire year of earnings is setting up. The estimates for energy earnings have come down dramatically since December 31st which goes against some other data I have reviewed. This is in tune with my negative predictions for 2017. Oil prices haven’t come down from the low $50s and earnings estimates have still dropped. Imagine how low they’d go if oil prices started falling like I expect.

If the 11.1% earnings growth that is expected is achieved in 2017, stocks will move higher even though they are expensive now. Revenues are only expected to increase 5.8% which implies margins are going to increase again. The peak in 2014 was historically high, so that seems like a stretch to me. It is possible, however, if regulations are cut. That would lower costs which means revenues would flow to the bottom line quicker. It’s tough to rely on this because it’s impossible to calculate what the effect will be. Trump’s executive order is for two regulations to be cut for every one new one implemented. That doesn’t tell us which industries will be the most impacted. Thursday, Trump met with the heads of the airline firms and said their regulations will be curtailed.

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Looking at the credit market, it’s easy to see why I predicted a recession last year because C&I lending standards were becoming more stringent. It’s impossible to know when the spike higher will occur, so whenever they tighten it’s rational to be on alert for a recession. As you can see at the end of the chart below, the standards stopped tightening. They are still worth paying attention to, but clearly the recession has been delayed a few quarters.

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Conclusion

 The reason I focus on the negatives usually is because stocks are extremely expensive and the recovery is long in the tooth. However, in this article I showed the bull case for the market. Earnings are still expected to grow double digits and the commercial and industrial loans are no longer becoming more stringent. One catalyst for this ease of standards is the improvement in the energy and mining debt market. The question investors must ponder is shown in the chart below. Do you agree with the implied default rate of 0.9% that the market is pricing for junk debt today? The turnaround has pushed the credit market to near the peak of this cycle.

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