Has Reality Set In On the Trump Rally?
For the first four months since the election, the stock market was looking as cheery as these Miss America contestants aboard Donald Trump’s yacht in 1988. Investors were quick to conclude that the Trump presidency would lead to a meaningful reflation. It became a consensus viewpoint that huge infrastructure spending, massive tax reductions, and significant deregulation of the financial industry would be imminent. But now it appears reality is starting to set in.
It is easier to make campaign promises than enact actual policies. For all the talk about great negotiation skills, in practice, politics is quite different from the boardroom. The Republicans’ inability to pass their long-awaited health care bill is a clear sign of trouble for the Trump trade. Since the Republicans could not maintain party unity on such a pivotal issue, it bodes poorly for the rest of the Trump agenda. That is bad news for the stock market, which had already priced in much of Trump’s rhetoric as though it were already law.
Immediately after the election, shares in the fifty American corporations paying the highest tax rate outperformed the broader market by as much as five percent. This was, presumably, on expectations that the Trump administration would slash corporate tax rates. However, with the failure of the health care legislation, which cost $1 trillion in savings, along with the increasingly troubled border tax proposal, and it appears the funds simply won’t be there for a dramatic corporate tax cut.
While stocks have stalled out since they peaked a month ago, the bond market is arguably the bigger tell. The benchmark 10-year Treasury bond yield shot up following the election. From 1.8% on election night, it reached as high as 2.65% earlier this year. This signaled belief that the American economy was finally pulling out of its stagnation. However, since the Fed’s last short term interest rate hike, yields have gone in the wrong direction, and the 10-year is now back to 2.35%. This indicates that the bond market increasingly doubts Trump’s ability to make his vision a reality.
The equity market finds itself in a no-win situation. A great deal of the market’s rally since November has come from the financial sector. Investors have bid banks up sharply in expectations that higher interest rates will lead to fatter margins. Since election night, the financial sector ETF has risen as much as 28%.
However, any reversal of the move in interest rates will threaten this trade. The Fed has made it clear that investors should anticipate more hikes this year. That will likely have the effect of driving up short-term interest rates, which in turn causes banks to have to pay more interest on deposits. If long-term interest rates don’t climb at least as quickly as the short end, banks’ net interest margins will actually decline. After a robust widening in the 2-10 year bond spread following the election, the spread has compressed as much as 25 basis points in recent weeks. Bank stocks won’t hold their recent gains if this keeps up.
On the other hand, if long-duration bond yields start rising again, it would also lead to trouble for the stock market. While banks would get their larger profit margins, the economy as a whole would suffer. Already, new commercial and industrial loan volume has dropped off sharply, and the decline is accelerating:
As you can see, the slowdown in lending growth has already moved well beyond what happened in 2012. Credit expansion is oxygen for the economy; without it, there will not be earnings or GDP growth.
For now, the stock market doesn’t seem worried. That could change. It’s worth considering that every time lending activity has outright contracted, the stock market suffered a major slump, and lending activity is perilously close to heading into outright contraction now. A surge in interest rates would likely be sufficient to tip lending growth into the negative.
How Much Downside Once Trump Trade Unwinds?
The market has traded up from 2,100 to 2,350 since November. That’s a more than ten percent move largely powered by hopes tied to Washington. Those gains could come right back off if that political optimism fades.
2,100 was a long-running trading level and could serve as technical support during the next correction. However, from a valuation perspective, the market would have to go quite a bit lower to get back to something closer to the historical median. Here is the S&P 500’s price-to-earnings ratio over the years:
The market’s PE ratio continues its ascent, as prices rise while earnings fail to keep up. Earnings, once adjusted for inflation, are actually lower now than they were in 2007. Yet, the stock market is almost 1,000 points higher. Shown below are inflation adjusted earnings for the S&P 500 historically.
Stock market bulls can try to explain the lack of earnings by blaming transitory issues, such as the collapse in oil and gas companies’ earnings in 2015. However, the market’s earnings problem runs deeper.
The strong US dollar has made earnings growth difficult for multinational firms. Consumer staples companies in particular are suffering mightily with the strong dollar making their goods less competitive in foreign markets. Trump’s reflation trade, if it plays out, should cause the dollar to become even stronger, slowing multinationals’ earnings growth further. It should be noted that approximately 50% of S&P 500 sales are in foreign countries, so currency rates matter significantly for S&P 500 earnings.
Low profit-margin tech companies have also lowered the market’s earning potential. Companies such as Amazon and numerous app-based firms have eaten up other companies’ margins without producing much accounting profits for their shareholders. Certain segments, such as mall retailers, have had their profits cannibalized without that lost income reappearing elsewhere within the S&P 500.
Wall Street analysts always assume the best because it sells well. While earnings have been stalled out for years, they predict improvement is right around the corner. Much of the current bull thesis lies in the contention that the market isn’t really at a 26.6x price / earnings ratio since forward earnings estimates are significantly higher. Before accepting that assertion, consider what’s happened to S&P 500 earnings estimates as time passed over the past few years:
Since 2011, analysts have without fail forecast double-digit S&P earnings growth. Then, inevitably, earnings fell far short of expectations. In 2015 and 2016, forecasts for double-digit gains turned into virtually no earnings growth whatsoever. Yet the analysts are back at it again, predicting big gains for 2017 and 2018, though 2017 is starting to rollover now.
Putting it altogether, the market is at 26.6x earnings despite the historical market median being just 15x. It would take a gut-wrenching 40 percent decline to get back to average. Sure, earnings growth may raise the floor a bit, but the market will get far less protection from earnings growth than the analyst community would lead you to believe.
The odds of the market returning to a sub-20 PE ratio, at a minimum, are quite elevated over the next couple years. Fed rate hike cycles almost inevitably lead to recessions. President Trump’s policy proposals, if enacted, would likely lead to a stronger US dollar, exacerbating current trade problems. However, if Trump’s proposals are not enacted, the proposed corporate tax cut will not happen. The rally in banking shares in particular looks troubled; the sharp slowdown in loan growth should be a warning sign.
While it is hard to forecast what exactly will come out of Washington, the general trend is clear. Investors became overly excited by political talk and are heading for disappointment as reality sets in. Political chatter aside, nothing much has changed. Prices are greatly extended and without a major corporate tax cut, earnings growth is unjustified. With markets still calm, this is a great time to hedge, raise cash, or otherwise prepare for more volatile conditions.