20,000 Reasons to Love Donald Trump

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pst_trump snl


Due to the Trump Rally, the Dow Jones Index recently crossed the 20,000 mark for the first time. This has provoked a great deal of excitement from the talking heads on TV. Suddenly it seems everyone wants to get long the market for what is being hailed as a new era of prosperity. Even before taking office, the market started to price in Donald Trump as though he were an economic magician. The S&P 500 has rallied almost 10% following his victory. Certain sectors, such as financials and industrials surged even farther; big US banks are generally up 25% or more since November.  Will Trump defy gravity?  Can this man single handedly keep the stock market afloat after 8 years of positive returns?


This hyped-up market is losing touch with economic reality in various ways, and the Dow serves as a distraction that misleads investors. For one thing, the Dow Jones is a rather outdated indicator of marginal use. The Dow tracks just 30 stocks; offering less than a complete read on the economy.


Compounding matters, the Dow is price-weighted, meaning that higher-priced stocks have much more impact on the index than issues with lower stock prices. Goldman Sachs, due to its $229 stock price, earns an 8.3% weighting in the Dow index. Apple, despite being the US’ largest company, only makes up 4% of the Dow, since its stock price is merely in the 120s. This sort of system may have made sense in the early days of the US market, when rapid computing was not available to tabulate a more complex index. But with the S&P 500 available now, there is no reason to keep treating the Dow as it if were of special importance.


Humans, however, are drawn to big round numbers. It is in our psychology. A figure like 20,000 strikes people as important, and gives the market’s cheerleaders an opportunity to promote equities in general. Forget that the market has already tripled since 2009, the media says, we are hitting new highs and you have to get in or risk missing out.


It can be a powerful temptation; a new milestone often sucks in new investor money from the sidelines. In March of 1999, the Dow crossed 10,000 for the first time. Less than six weeks later, the Dow topped 11,000 as investors reached a state of jubilant optimism. The market would top out at 11,600 a few quarters later, and begin a sickening fall. By October of 2002, the Dow would be back to 7,300, leaving those who got caught up in the Dow 10,000 hysteria seeing 27% losses.


Do not fall for the bulls’ sales pitch here at 20,000 blindly. There are mounting risks to the increasingly overbought market. It may feel like there is easy money to be taken, but both political and economic headwinds are mounting.


On the institutional side, we face at least two significant challenges. The first of these is the Fed. For almost a decade now, the Fed has given endless ammunition to market bulls by providing a seemingly unlimited line of easy credit. Now, however, the Fed has entered a clear hiking cycle. While rate hikes can occur without upsetting markets, in general, tightening cycles tend to get messy. Consider this graph:


pst_fed causes events


As you can see, most major market shocks occur after extended periods of Fed rate hikes. Generally, long periods of Fed easing plant the seeds for mal-investment and credit bubbles. At some point, the Fed awakens to the mounting threat of inflation or asset bubbles. It raises rates, putting out the inflationary fire, but triggering a major credit event in return. Given the unusually low interest rates and long duration of the recent easy money policy, we should expect a more serious than normal series of credit problems as the Fed tightens policy this time around.


The market also faces political risk now that Trump has taken power. The market just rallied 10% on hopes that Trump would put business-friendly policies in place. Investors were hoping for huge infrastructure plans, more hands-off banking regulation, and corporate tax cuts. These things may still happen; however, Trump is spending a good deal of his political capital engaging in a border spat with Mexico and pushing controversial immigration policies that could hurt the tech industry. If he gets bogged down in these sorts of issues, his mandate to enact business-friendly policies would erode. And the market rally his victory caused would go with it.


Even if Trump gets his business-friendly agenda back on track, the market faces a more fundamental risk. It is really expensive. On a cyclically-adjusted basis, the market’s PE ratio has shot up in recent years:

pst_cape ratio 2017 2


The two other times the market got this elevated, we got the Great Depression and the implosion of the dot-com bubble. Notice that in 2007, as overheated as the market was then, it was still cheaper than it trades at today. Given that corporate profits, as a portion of the economy, are at elevated levels, it is particularly difficult to see acceptable equity returns coming in the next couple of years.


Simple reversion to the mean suggests the market has a major correction, or worse, ahead of it as well. This chart shows the peril of buying after strong bullish moves:


pst_precedent not reassuring


The only times the market moved up this much over a six-year period were in the late 1920s and late 1990s. For investors that bought the market in 1929, they would have to wait 25 years for the market to finally reach new highs. Investors in 2000 who bought at that high would not see nominal new highs until 2006. And, of course, the market collapsed again shortly thereafter. In inflation-adjusted terms, an investor in 2000 had to wait more than a decade to show a meaningful profit.


It is also worth considering just how lopsided sentiment is at the moment. One clear way to see this is by looking at a long-term chart of market volatility, as measured by the VIX index:


pst_vix chart


Readings below 12 are fairly uncommon and indicate a high level of complacency. The volatility index has only rarely made it over 20 since 2012. Historically, the two other periods of extended low volatility ended with substantial market routs. We should expect the same coming out of this period.


The chorus of bullish analysts can be hard to ignore. The market just topped 20,000 after the election, and it seems like everyone wants to throw a party. But do not forget what happened to the market in the past when it has reached similar valuation and excitement levels. The odds are very much against equities earning their traditional 8%/year returns over the next few years. In fact, another “lost decade” is more probable.


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