Originally posted at Briefing.com
We said last week that something big was about to happen for the world and our stock market. That "something" was going to be borne out of the election results, and, boy, were we right despite being wrong about the expected catalyst for the relief rally.
An Upset of Conventional Wisdom
Actually, the news from the election wasn't big, it was "y-u-u-u-u-g-e!"
Donald Trump did what just about every political pundit claimed he wouldn't do. He defeated Hillary Clinton in the race for president by way of the electoral vote (Mrs. Clinton actually edged him out in the popular vote).
In turn, the Republicans (GOP) retained control of both the House and the Senate, effectively securing a political mandate for the GOP.
We don't want to spend much time looking back at election night, yet it would be remiss not to chronicle here just how big the market reaction was that night and the next day.
When it became apparent that an upset of conventional political wisdom was in the making, the Dow futures tumbled as many as 800 points and both the S&P 500 and Nasdaq 100 futures went limit down with a 5.0% decline.
By the time the stock market closed on Wednesday, November 9, the Dow Jones Industrial Average was up 257 points, the S&P 500 was up 24 points, and the Nasdaq 100 was up 20 points. In percentage terms, the Dow, S&P 500, and Nasdaq 100 ended Wednesday up approximately 6.3%, 6.1%, and 5.7% from the lows seen in their respective futures contracts.
It was a move that was as much of a surprise as the election outcome. The stock market did what just about every market pundit suggested it wouldn't do in the wake of a Trump victory, never mind a GOP sweep of the executive and legislative branches. It rallied.
A Rally of Disbelief
Why did the market rally like it did? From our vantage point, we felt the bullish price action was oriented around the following factors:
- Short-covering activity
- A bandwagon trade of momentum as traders chased a gain that few, if any, people expected
- Strong leadership from the financial and healthcare sectors, which was paced by the major bank, biotech, and major pharmaceutical stocks, all of which are seen as beneficiaries of a Trump Administration
- Newfound attention in the media on the "pro-growth" initiatives that could come into play now that the GOP controls both the executive and legislative branches
- Personal and corporate tax cuts
- Fiscal stimulus for infrastructure upgrades
- Rolling back increased regulatory actions; and
- Depending on one's perspective, the repeal of the Affordable Care Act
- The S&P 500 plowing through technical resistance at its 50-day simple moving average
- Memories of the post-Brexit trade, which was accented by sharp declines at first but an even sharper rebound later
The market rebound, we thought, was also driven by an underappreciated factor, which is the recognition that it was not a contested election — something that was very much in the realm of possibility as the election results unfolded Tuesday night.
There is no telling for sure what the market will look like by this time next week. Bandwagon trades can be a finicky thing. It is fair to say, however, that the post-election rally was an astounding development driven as much by disbelief as it was by belief.
A Bullish Case
Can this bullish bias be maintained? The short answer is yes, but there is an asterisk attached to it.
The rationale for an overall positive bias into year end boils down in our estimation to the following factors:
- With the election uncertainty removed, the market's focus will shift to the pickup in earnings growth
- Because economic growth has been lackluster for so long, market participants will embrace the idea that economic growth should be accelerating in 2017 with the GOP adopting what it deems to be pro-growth policies in President Trump's first year in office
- A lot of cash was reportedly sidelined in front of the election and will be put back to work
- Money managers underexposed to the equity market will be in a position of chasing returns in an effort to beat their benchmarks and secure bonuses
- Big banks, major oil companies, biotech companies, major drug manufacturers, and companies with large cash holdings overseas are expected to be beneficiaries of a Trump Administration that favors, among other things, less regulation, lower taxes, and tax repatriation leniency. That grouping of companies carries some relatively heavy weight in the market, so if they trade well, the broader market stands a good chance of doing the same.
- There is still plenty of negativity among investors, which leaves the door open for a contrarian advance
- This is typically a seasonally strong time of year for the market
- To the extent that the market accepts the notion that the recent spike in long-term rates reflects a positive view of the growth outlook more than anything else, it could be the beneficiary of an asset allocation shift out of government bonds and into stocks
We want to pick up on that last point, because the behavior of long-term rates is the asterisk that accompanies the current market view.
On the night of the election, the yield on the 10-yr note dropped 13 basis points to 1.72%. Like stocks, it too experienced a "y-u-u-u-u-g-e" turnaround on November 9. A huge turnaround in this instance, though, was a bearish move, not a bullish one since price and yield move inversely in the Treasury market.
When the Treasury market settled on November 9, the yield on the 10-yr note stood at 2.05%. That marked its highest level since January and it has subsequently bumped up to 2.13% as of this writing.
The commensurate rally in the stock market has been construed as a validation of the idea that the backup in yield is a reflection of the newfound optimism surrounding the growth outlook. Accordingly, money is being shifted away from bonds and into stocks, the latter of which would benefit from stronger growth and the higher inflation that should come with it, whereas the former would not.
There is another element in the mix, however, behind the jump in rates that is also a function of the pro-growth initiatives the market expects the Trump Administration to adopt. That element is the expectation that debt issuance is going to increase, along with the budget deficit, so that a fiscal stimulus package can be implemented.
In turn, the recent remark from Fed Chair Yellen that there could be some merit in allowing the economy to run hot temporarily has heightened inflation concerns in the Treasury market now that a fiscal stimulus package looks to be in the offing.
While the stock market is understandably more tolerant of letting an economy run hot temporarily, the fixed-income market isn't so keen on the idea. There is legitimate concern that the Fed, should it let the economy run hot "temporarily," will not get its timing or its measurement angle right when it comes to making sure inflation doesn't get out of hand.
This backdrop of rising long-term rates needs to be watched closely. It all fits neatly now in the pro-growth narrative that has taken over following the election result that very few pundits and polls projected.
At some point, an equity market that has feasted on the persistence of ultra-low rates is going to get anxious about the spike in long-term rates — perhaps sooner rather than later if they continue at their current pace.
What It All Means
The past week or so has been one for the ages.
First, the Chicago Cubs won the World Series for the first time in 108 years, destroying the conventional wisdom that they were destined to be lovable losers forever. Then, Donald Trump won the presidency, destroying the conventional wisdom that said he would not.
The political pundits, the market pundits, and the pollsters were all losers this week. We'll leave it up to you to decide if you still find them lovable.
Whether the stock market ultimately finds Donald Trump and the GOP lovable as drivers of national policy for at last the next few years remains to be seen. Based on the stock market's very recent behavior, it's fair to say they are off to a good start — and they haven't even done anything officially.
That is the anticipatory nature of the stock market at work. It seems to be embracing the belief that better things lay ahead because the political road ahead is being paved with seemingly good growth intentions.
That mentality should serve as an underlying source of support for the stock market in the near term, yet the cost of pulling forward future growth — and there will likely be a sizable cost — is going up in the long term. How the Treasury market handles that reality will ultimately dictate just how far this "y-u-u-u-u-g-e," post-election rally can run.