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When the Inmates Start Running the Asylum

Last fall, the market sold off sharply as Federal Reserve Chairman Powell suggested that the Central Bank was intent on raising interest rates further. Bad views for the economy and the stock market.

At the end of July, President Trump tweeted that he was going to introduce tariffs on another $300 billion of Chinese goods. The 10-year Treasury yield promptly dropped to 1.70%. Lower rates, good news, right? Nope. The market dropped over 6% in a week.

So, what gives, and who is setting interest rates?

Bad Attitude

What’s the old axiom? If it’s too good to be true, it probably is. That might be fitting for how the market performed last year.

By the end of 2017, most forecasts were pretty optimistic. First, you had a tax cut approval, earnings for the year now look like they will come in about 24% higher, GDP saw two quarters of growth over 3% which is pretty rare at this stage of the business cycle. To top it off, unemployment remains very low at 3.7%. How could the market not be higher?

Structural Bond Bear?

Each quarter, we write a commentary about the stock market which generally has a pretty near-term focus. In our most recent piece earlier this month, we reiterated a positive outlook for equities as long as a recession or tight monetary policy can be avoided.

However, if you step back from the day to day barrage of facts, there are some longer term factors and issues which we’ve identified and explored regarding the direction of interest rates and are monitoring in the context of the direction of the Fed’s policies and the economy.

Hope for Rotation

We’ve said repeatedly that we believe the current bull market will continue until there is either a recession or a restrictive monetary policy.

So far, that position has been accurate as the S&P 500 recently hit a new all-time high and the length of this bull market, according to some, has become the longest on record, beating the previous bull market that took place between October 11, 1990 and March 24, 2000. However, there are those who say the market decline in the 3rd quarter of 1990 was actually a correction. If they are right, then the bull market of the 1990’s actually started on December 4, 1987. That extended bull market lasted 4494 days compared to about 3500 for our current run. That might lend some comfort to those trying to handicap how far we are into this cycle. Furthermore, the current economic expansion supports the market as it will become the longest expansion on record in July, 2019.

Handicapping The Future

Since the January high and subsequent 10% correction, the market has been in a relatively narrow trading range for roughly five months. However, earnings estimates continue to improve and the economy is reasonably strong. So, why the hesitation? In my opinion, it has to do with having a clear view of the future and what is fogging our lenses is the Federal Reserve policy and foreign trade negotiations. Markets don’t like uncertainty and until we get some resolution to these issues, especially the trade impasse, the market isn’t likely to make much headway.

Correction, Transition or Bear Market

Believe in the Easter Bunny? Then maybe you’re an April fool. Believe in foxes, as in “Crazy like One”? Then maybe Trump’s tariff strategy isn’t that bad. OK, my apologies to the foxes.

Nonetheless, tariffs and trade seem to be the latest issue to afflict this market which came shortly after an inflation scare in the form of a higher than expected January wage increase which sent the market to its first correction of over 5% in more than a year.

Although they may seem like uncorrelated issues, they are not. Both factors have an impact on profit margins. But I’ll come back to this shortly because it is the essence of the bear case for this market.
In the meantime, I wonder if this market is like the proverbial bug in search of a windshield; it is looking for a reason to correct and these are the most convenient excuses. Earlier, many thought the market was overvalued and should correct. But, with tax cuts and synchronized global growth, valuations have come back into the reasonable zone.

An Old Adage

There’s an old adage on Wall Street that says, “Buy the rumor, sell the news.” It’s a simple synthesis of how the market operates in that it reacts to expectation or forecasts, it doesn’t wait for them to be announced. And when there is an announcement, it’s often too late for an investor to take advantage of it because it’s already priced into the market. And for a trader, it’s time to sell.

We saw a good example of “buying the rumor” late last year as it became more apparent that tax reform legislation would be passed in the United States. When it was signed into law on December 22nd, that was the news. Time to sell? Well, we think not. In this case, tax reform is broadly considered positive, but the real impact will be company and industry specific. So, we think the “news” will be revealed in the fourth quarter earnings reports which will start in mid-January.

Chasing the Tax Cut Carrot

Although tragic, the nice thing about hurricanes Henry and Irma is that they took President Trump off the front page, temporarily.

Nonetheless, politics on both sides of the border have had an influence on the market. We shouldn’t forget we have our own tax drama going on here at home with Mr. Morneau’s proposed tax changes.

I’ll address the Trump effect, but first let me give you my conclusion.

Bottom line, I’m still positive on the stock market. The economy is growing as are earnings while the U.S. Federal Reserve maintains a modestly accommodative monetary policy. I don’t anticipate this stance changing until we get either the threat of a recession or much tighter monetary policy. The only concern I have is with valuation. The stock market isn’t cheap. Other forecasters however, have conflicting opinions about the market, but the reality is that the stock market is at an all-time high despite greatly reduced expectations about the Trump administration’s economic agenda.

Paraprosdokians

It doesn’t seem that you can have a conversation about the market without it becoming immediately dominated by a discussion on President Trump.

I must admit I like many of his policies. If effected, they could do wonders for the economy and the stock market, and I’ll get to that momentarily.

However, his deportment as the leader of the world’s most powerful country does leave something to be desired. But, out of respect for his office, I thought I might raise the bar and take the lead from one of the world’s truly great leaders, Winston Churchill. He was always good at a little misdirection when talking about someone else and used paraprosdokians to make his point.
These are figures of speech in which the latter part of a sentence or phrase is surprising or unexpected in a way that causes the reader or listener to reframe or reinterpret the first part. As I said, Winston Churchill loved them and I thought I might recount a few that he might use today

Reality Check

The best place to start this quarterly is probably where we left off with our year-end comments.
The market’s focus remains on President Trump and what he can accomplish. At year-end, we made two points.

First, there were a lot of things that had already changed in the market before Trump’s election such as the following:
1. Interest rates had bottomed;
2. The economy was improving;
3. U.S. fiscal policy had turned from austerity to stimulus;
4. Inflation was showing signs of picking up.

Second, his platform not only accentuated these trends but added two more.
1. Plans for deregulation;
2. A dose of optimism.