PMC Weekly Review - March 24, 2017

A Macro View: Should Investors Dump the Trump Bump?

Since the surprising presidential election results in November, domestic equities have enjoyed a relatively smooth ride to historical highs in recent weeks. Both the Dow Jones Industrial Average and S&P 500 indices are up more than 10% since Donald Trump won the election, and, until Tuesday, neither had experienced a single-day setback of greater than 1%, going all the way back to October, which was the longest stretch of this nature since 1993. This bull run has been dubbed as the “Trump rally,” “Trump bump,” and “Trump trade,” after the President, whose election theoretically initiated it. On Tuesday, for the first time in more than 100 days, Wall Street reversed course, and major US indices retreated by over 1%.

During the last few months, the market’s steady rise has been attributed primarily to investors’ optimism surrounding President Trump’s pro-growth policies aimed at stimulating the sluggish US economy. Most notably, the President has promised an agenda to support domestic businesses, which includes rolling back regulations, cutting corporate taxes, and promoting infrastructure spending. Given the backdrop of improving unemployment, healthy consumer spending, and relatively low interest rates, any further boost to corporate bottom lines should promote an extremely business-friendly environment. As pointed out above, investors responded favorably to these pledges, and the market prospered.

The first indication of a pause this week was on Tuesday, when equities retreated, and traditional safe haven assets, such as US treasuries and gold, benefited. For the most part, the market commentariat blamed the drop on the increasing likelihood that the Trump administration will face challenges to pass proposed reforms and corporate tax cuts, even from within the Republican Party. Despite the headwinds to President Trump’s ability to make good on his pro-growth proposals, the market faces a steep, uphill battle to fulfill investors’ ambitious expectations of fundamentals. In short, US equities are pricey, and the recent run-up has exacerbated their relative cost. A Bank of America Merrill Lynch survey revealed that more than one-third of fund managers believe stocks are “overvalued,” which is the highest reading in the survey’s nearly 20-year existence. Additionally, according to FactSet, the S&P 500 has recently traded at almost 18 times forward earnings, which is well above the five-year average of 15 times forward earnings, and the highest figure since 2004. These numbers point toward the reality that corporate earnings will likely need to increase to validate the market’s optimism.

Although it appears the Trump trade has been driven by optimism and expectations rather than by fundamentals, whether or not the rally is at its end remains to be seen. The market decline dominated financial news on Tuesday, but by historical standards, the pullback was relatively modest in nature, and the market has been fairly stable for the remainder of the week, so it is possible this was just a false alarm. Salil Mehta, a Georgetown University finance professor, highlights a simple observation, that “Stock markets normally decline by at least 1% once every six sessions.”

Furthermore, Bespoke Investment Group strategists conducted a lookback on returns, following a period of more than 100 days without a 1% decline, dating back to 1928. Upon analyzing the 11 times this has occurred, the strategists discovered that on average, during the week, month, and quarter subsequent to the initial decline, the broad market tended to end higher. We do express a note of caution, however: Although the technical data are not as unprecedented as they may seem, it is difficult to dispute that investors have recently priced in high hopes for corporate growth. If the administration fails to push through polices to meet these lofty expectations, a market correction of greater magnitude could result. 

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