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Wall Street Looks Stunning: A Bumpy Road Ahead?

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Although the domestic market looks stunning now with the Wall Street extending its marathon run and corporate profits consistently rising, are there threats ahead?

The bull run has taken the S&P 500 index near a 10-year high mark, resulting in stretched share price valuations. Moreover, the tax cut could not help corporates pump in more money in future business projects. Instead, the buyback frenzy is enhancing corporate profits to a large extent. U.S. firms are authorizing massive share buybacks and are on track for record repurchases in 2018.

Overall, if corporate profits in America improve in the coming quarters, it will mostly be because of share buybacks diluting the number of outstanding stocks.

Bull-Run Leaves US Market Stretched

In Twitter, Trump congratulated America after Wall Street saw its longest bull run last month. On Aug 22, the elite S&P 500 index completed the marathon run without registering a fall of 20% for 3,453 days at a stretch.

The turnaround of Wall Street since 2008 financial crisis — when the stock market suffered the most since the Great Depression of 1929 — was primarily backed by the massive quantitative easing (QE) program of Federal Reserve. It is to be noted that the bull run started on Mar 9, 2009 when the S&P 500 touched its lowest mark in more than 20 years. 

However, the rally has left the S&P 500 valuation stretched. The index’s current trailing-12-month (TTM) price/earnings (P/E) multiple of 20.10 is higher than the 10-year median ratio of 17.16 and is near to the 10-year high mark of 21.99.

Tax Cut Extends Rally

From 2008 to 2014, the easy monetary policy has significantly fuelled the bull run. To support the massive turnaround, the Fed lowered the interest rate to an ultra-low level.

However, since 2014, the Federal Reserve is slowly diverting from the QE program. In fact, since December 2015, the federal funds rate has been increased seven times.

Although Fed is moving away from monetary easing, the corporate tax cuts in America have been aiding the extension of the index’s marathon run. In other words, the Republican tax cuts have been boosting corporates’ bottom lines and domestic economy that have powered the Wall Street.

As per our Earnings Preview, total second-quarter 2018 earnings for the S&P 500 as a whole were expected to record year-over-year earnings growth of 24.9%. Importantly, earnings growth for the June quarter steered past 24.6% growth recorded in first-quarter 2018 to mark the highest quarterly growth since 2010.

Also, per the U.S. Department of Commerce, gross domestic product rose 4.2% through the April-to-June quarter of 2018, marking the highest pace in almost four years. Notably, the economic strength of the domestic market was broad-based and hence was definitely not dependent on any particular sector’s performance. In other words, almost all sectors, starting from Energy, Construction, Retail, Technology and others, contributed to the S&P 500 index’s earnings outperformance.

Massive Buybacks in Store Instead of Business Investment

The higher corporate profits owing to tax reforms should get allocated to long-term business investments. However, companies are focusing more on stock buybacks instead of allocating capital for businesses. In fact, according to The Goldman Sachs Group, Inc. (GS) estimates, American firms will buyback an enormous $1 trillion worth of shares in 2018.

The escalating trade war between the United States and China and the gradual rate hikes by the Fed have made things difficult for investors. Per Reuters, uncertainties like the tariff war will likely push corporates to execute more buybacks instead of allocating money for long-term business investments.   

Time to Focus on Undervalued Stocks

It seems that the bumpy ride ahead following the intensifying trade war is not giving enough confidence to U.S. firms for making long-term business investments. Hence, without capital investments, share repurchases are bound to create an illusion of impressive profits.

Overall, although the tariff war and the gradual rate hikes are impeding the aging bull run, there are stocks that are less pricey and have strong fundamentals to boost portfolio returns. 

Employing our proprietary Stock Screener, we are picking stocks that are undervalued as compared to the S&P 500 index. All the stocks flaunt a Zacks Rank #1 (Strong Buy) or 2 (Buy) along with a solid VGM Score. You can see the complete list of today’s Zacks #1 Rank stocks here.

Here, V stands for Value, G for Growth, and M for Momentum, and the score is a weighted combination of these three scores. Such a score allows you to eliminate the negative aspects of stocks and select winners. However, it is important to keep in mind that each Style Score will carry a different weight while arriving at a VGM Score.

Headquartered in Deerfield, IL, Caterpillar Inc. (CAT - Free Report) is the world’s leading manufacturer of machinery equipment.

With a VGM Score of A, the company has a TTM P/E ratio of 14.03, lower than the S&P 500’s 20.10. The stock is also trading below its 10-year median ratio of 15.45 and has significant upside potential with a 10-year high ratio of 31.39.

Presently, the company carries a Zacks Rank #2.

DISH Network Corporation (DISH - Free Report) , headquartered in Englewood, CO, provides services related to digital television entertainment.

The #2 Ranked firm with a VGM Score of B has a TTM P/E ratio of 13.97, lower than its 10-year median ratio of 15.40. The less pricey stock has significant potential for upside with a 10-year high ratio of 44.36.

Headquartered in Memphis, TN, International Paper Company (IP - Free Report) is among the leading producer of containerboard.

The Zacks #2 Ranked firm with a VGM Score of A has a TTM P/E ratio of 11.42, below its 10-year median ratio of 14.73. With a 10-year high ratio of 33.68, the stock has substantial upside potential.

Headquartered in Columbus, GA, Aflac Incorporated (AFL - Free Report) is among the leading providers of life insurance products.

The company, with a Zacks Rank of 2 and a VGM Score of B, has a TTM P/E ratio of 12.27. The stock with 10-year high ratio of 17.56 reflects upside potential.

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