WASHINGTON, January 1, 2018: The value of the U.S. stock market as measured by the Dow Jones Industrial Average, has increased more than 25 percent in 2017. As 2018 begins, it looks very much like the bull market will continue, possibly posting a yearly gain possibly similar to that of the year just concluded. Although analysts have mixed views, another strong gain seems most likely at this point.
Analysts generally focus on evaluating specific industries or specific company performance. My analysis looks more at the overall market performance. After examining what fundamentally influences stock prices, the conclusion of another substantial increase in the price of common stocks in 2018 makes sense.
What determines stock prices?
There are a number of variables that influence the price of a share of stock. One factor is the overall demand for stocks. That, in turn, is influenced by the amount of new capital created. As households earn more after-tax income, they generally accumulate more income that can be invested.
Because the new GOP tax law cuts taxes for almost all Americans, households will be able to create new capital that can be used for investment purposes. This helps increase the demand for stocks, which in turn causes stock pricse to rise. While most new capital comes from the highest income earners, even the average taxpayer may choose to add to his or her retirement account.
New capital will also be created because the corporate tax rate was cut dramatically from 35 to 21 percent. Corporations may use this new capital to invest in the growth of their business. Or, as some analysts have said, the stockholders, who are the owners of the corporations may decide to increase the dividend paid out by the company. In other words, the shareholders could use most of the dividend increase to re-invest back into the stock market. Either way, demand in the stock market will increase and stock prices will rise.
The primary determinant of a company’s stock prices is the earnings per share.
Since stocks are investments, purchasers look for the anticipated return on their investment when deciding how much they are willing to pay for a share of stock. Because of the tax cut and the anticipated GDP growth in excess of 4 percent annually, corporate profits are about to soar. That means, in turn, that earnings per share will soar, which generally results in an increase in the price of common stocks.
The new tax law’s 2018 reduction in the corporate tax rate will increase corporate earnings by more than 20 percent. If nothing else changes, this alone could help increase stock prices by more than 20 percent. Add to that the increase in earnings brought about by the growth in GDP and stock prices could increase by as much as 25 percent in 2018. It is possible that the Dow Jones, currently standing at just under 25,000 points, could hit 30,000 by year’s end.
What are stock market factors that could slow the growth of equity prices?
The level of interest rates also has an impact on stock prices. In fact, as interest go up, stock prices will experience downward pressures. This happens because investors who have capital must choose between buying debt securities like bonds, or equity securities like stocks. Part of the reason the stock market has performed so well since 2009 is that bond interest rates were at nearly historic lows. That made bonds a poor investment while stocks became more attractive.
In 2018, the Federal Reserve will likely raise interest rates three time, as they did in 2017. The higher rates will attract capital away from the stock market which could hold stock prices down.
Geopolitical events could also have a negative impact on stock prices. Since there are a number of areas in the world where military action could be needed, investors may worry about the outcomes of conflict. This usually causes investors to pull their money out of volatile stocks and into safer investments like government bonds.
In 2017, interest rates were raised three times and still the stock market performed exceptionally well. It is therefore unlikely that interest rate hikes will have a significant effect on stock prices in 2018.
While it is very difficult to predict exactly what will happen with the conflicts in North Korea, Iran, and perhaps China, Russia, the Ukraine and Syria, anything short of full military action will not have much of an effect on stock prices.
It is always very difficult to predict with any degree of certainty exactly how the stock market will perform. But the indications are that 2018 will be a very good year. I recall that some time ago, economist Milton Friedman was asked for his prediction about the stock market for the coming year.
Statin he was very confident about his conclusion, Friedman answered, “The stock market will fluctuate.”