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Categorized | Capital Markets

Summer origins of ‘Trump rally’ suggests it’s serious

Posted on November 23, 2016

Can we believe it? The US has had two weeks to digest the fact that it has elected Donald Trump as its next president, and many on both left and right are finding it hard to swallow. The US stock market is just as hard to digest.

In those two weeks, US stocks have gone on a tear, with all four of the most widely quoted indices — the S&P 500, the Nasdaq Composite, the Dow Industrials and the Russell 2000 index of smaller stocks — simultaneously hitting new record highs on Monday and Tuesday of this week. This had not happened since New Year’s Eve of 1999, as the tech bubble was about to reach its climax.

It looks like a widespread breakout from a market that had been becalmed ever since the end of the Federal Reserve’s QE bond purchases at the end of 2014. Should we believe it? And if the indices are not quickly to slip back, is this the beginning of a solid final leg to the bull market, or the beginning of a speculative “melt-up” like the one seen in 2000?

First, it is as well to take this seriously. Investors have gripped hold of the idea that the new presidency, accompanied by unified Republican control of Congress, will mean a new move to fiscal policy after eight years of dominance by monetary policy. Until either the fiscal policy fails to happen, or there is emphatic evidence that it has failed to spark growth, it is best to expect that markets will hold on to that assumption.

The accompanying sell-off of bonds is startling, and suggests genuine belief that inflationary growth policies are coming. The turn came during the summer, and stocks have sharply outperformed since the election.

At the level of sectors, the same trend is in evidence. Banks, particularly prone to interest rates and benefiting from a steeper yield curve, had already started to outperform in late summer, after many dreadful years. Their rocket-like performance since the election — aided by the steepening yield curve, but also by the slightly incoherent hope that a president elected on a populist platform will deregulate them, is startling. Indeed, the S&P 500 excluding financials is still below its record high, providing at least one reason to distrust the rally.

The pattern is also clear from the sharp outperformance of smaller caps. Again, smaller stocks, as shown by the Russell 2000, had begun to beat the Top 50 mega-caps during the summer, but this has become a rout since the Trump victory. This is easily explained. They tend to be domestically focused, unlike mega-caps, and are less likely to be affected by the vagaries of Trumpian trade policy. Also, unlike mega-caps, they tend to pay their corporate taxes in full, so they should gain greater proportionate benefit from tax cuts.

The notion of a market regime that had already turned before the election is borne out further by the performance of yield substitute stocks. During the QE era, stocks that pay regular and growing high dividends have outperformed. Such stocks, labelled “defensive value” by Ed Clissold, US strategist at Ned Davis Research, have gone into eclipse, as shown by the underperformance of the S&P 500 Dividend Aristocrats index.

Meanwhile, other measures of value, such price/earnings and price/book multiples are performing superbly, having turned the tide in the summer. These are dubbed “cyclical value” stocks by Mr Clissold — companies that tend to be inflexible, and have high operating leverage, making it hard for them to cut back in hard times, and allowing profits to rebound sharply when good times return.

More broadly, cyclical stocks also started to outperform defensive stocks during the summer, in response to broadly more positive economic data from the US and China — and this process was accelerated by the election.

A rotation was also evident in the performance of factors, which make the backbone of currently popular “smart beta” portfolios. While value and momentum (the tendency for winners to keep winning and losers to keep losing) have both enjoyed a resurgence, the low-volatility factor has fared very poorly recently.

Andrew Ang, who heads factor investing at BlackRock, suggests that this, again, shows that market is calling for reflation and stronger economic growth. Economic conditions offer the best guide to shifting between factors, and the strong economic optimism would lead to relative overweighting of momentum and value while cutting back low-volatility — or, effectively, taking more risk when times appear good.

From almost any angle, the market suggests that a regime change started this summer, as economic data appeared to improve, and that the Trump election, following improved third-quarter earnings, was the catalyst for a further advance. After years in which the market continued to advance (albeit slowly of late) led by stocks that normally only outperform in a bear market, the pattern of performance is now typical of the late stage of a bull market at the end of an economic cycle. A melt-up or a firmer advance are both conceivable.

None of this means that the next few months will be without volatility. Much of the Trump programme is sketchy, and the response from Congress to his plans is also questionable.

High valuations give the stock market little room for manoeuvre, particularly with bond yields rising, and a pullback is in any case likely after such a swift move upward. The extent of the optimism smacks of desperation to break out of a logjam that had lasted for years and appears overdone. But for now this rally looks like a typical final stage of a bull market, and it should be taken seriously.