Is the Market Broken?

The stock market is reaching extreme levels in terms of the lack of volatility and high valuations. However, given the market’s ability to shake off bad news last year, it’s not surprising to see it rallying in the past few weeks. Earnings are finally growing again, the Fed is promising to remain dovish, and Trump is promising tax cuts. If at the end of all credit cycles the Fed decided to not raise rates like it usually does and tax cuts were passed, the market wouldn’t fall. This is the ultimate experiment in policy. As I’ve said in a past article, this scenario is equivalent of one discussed in a college classroom. The question is if monetary policy and fiscal policy had the single goal of keeping stocks high, how high would they go and when would the rally end?

The answer to that question is coming in real-time every day the market opens. Personally, I think pushing the stock market higher leads to unintended consequences. The biggest one is that tax cuts and rate cuts steal growth from the future. If growth is barley reaching 2% with these extra boosts, imagine how bad the economy would be without them. Firms can borrow at low rates and buyback their stock. Therefore, it’s not surprising the earnings recession has ended. With these phony positive results, the S&P 500 traded within a 1% range for the 38^th consecutive session on Thursday which is the longest streak on record going back to 1978. The stock market isn’t much of a market anymore. The chart below shows the length of time without the S&P 500 falling 1%. It’s now been over 80 days since a 1% fall which is the second longest streak since at least 1996.

One of the reasons the stock market is overinflated is interest rates on government bonds are low; stocks are the only game in town. The chart below is a long-term measurement of mainly government bond yields. The 10-year bond yield increased 2.50% today to 2.3948%, but it still hasn’t been able to make a new 52-week high since December 15^th. I think if the 52-week high of 2.64% is broken, it signals an end of the secular bull market in bonds. Once yields move higher, stocks will be less attractive. Bulls believe if Trump’s fiscal policies are passed, rates will rise, but so will earnings, so stocks can still rally.

This brings us to Trump’s economic policies which is why stocks rallied today. Stocks reached new all-time highs and the VIX hit the 10 handle again. Trump stated the government is ahead of schedule and will announce a plan to cut taxes in the next 2 or 3 weeks. I don’t believe that’s possible given the problems with the plan that I discussed in my last article. By rallying today, the market is pricing in the best-case scenario, which is that the plan passes Congress, isn’t stopped by the World Trade Organization, and the dollar moves up 25% after it passes. That sounds like too many obstacles to get around in just 3 weeks. While Trump is a new face, the politicians in Congress are almost all the same ones who have been there for years. I don’t see how the plan will come about that quickly.

In the CNBC news article discussing Trump’s announcement, Peter Cardillo, chief market economist at First Standard Financial, stated the market would be 3% to 4% higher without the political uncertainty. If the market rallies 3% to 4%, it would reach the Shiller PE seen in the 1929 bull market peak which proceeded the Great Depression. It does seem like the market can go up endlessly, but eventually it will stall out. It won’t stall because of a political squabble. It will crash because central bank intervention has made it not real.

As I mentioned in my introduction, the Fed is likely going to keep interest rates low. We received more confirmation of this policy by St. Louis Fed President James Bullard. Bullard stated the Fed would keep interest rates low throughout at least 2017 as there is no clear understanding yet of whether the Trump administration's fiscal policies will cause higher inflation or growth. This answers the question I have posed previously. As a reminder, I asked whether the Fed would raise rates preemptively or wait until we have a clear understanding of how Trump’s policies will affect the economy. This is a dovish response. It’s important to understand that this is only Bullard’s opinion. It also depends on whether Trump follows through on his promise that tax cuts will be proposed within 3 weeks.

The chance of a rate hike increased by 1% today for the June meeting. Usually the chance of rate hikes increase when the market rallies. I think the chance increased moderately because of these comments from Bullard.

The final charts I have below compare the stock market and 10-year bond yield to Trump’s approval rating. I think they are correlated because Trump’s approval rating is the equivalent of the population’s satisfaction with the direction of the country. When optimism is prevalent, investors buy stocks and sell bonds because inflation is expected to increase.

Conclusion

The market has a tag team of support from fiscal and monetary policy which is now more helpful than expected. Instead of the Fed handing off the baton to fiscal policy to drive growth and support the economy, both are acting in coordination. Therefore, we are seeing the S&P 500 break records in terms of being stable. It’s amusing to see an analyst have to explain why the market isn’t even higher than the record high it has already achieved. It’s the equivalent of a baseball analyst seeing Ted Williams’ .400 batting average and explaining why it’s not .500. If tax cuts and reforms aren’t proposed in the next three weeks, I expect the market to correct. It was a bold decision for Trump to give such a strict timeline for tax reform, since he doesn’t control it; the Congress has the power of the purse.