Market Melt- Up
The Dow Jones Industrial Average1 ended February on a negative note, snapping a 12-day winning streak of record closing highs. Looking back at market history, the Dow came up one day short of tying a record of 13-closing new highs achieved in January 1987 (Gluskin Sheff/Business Insider).
The latest run can be traced back to comments made earlier in February by President Donald Trump. Following a very restrained “affirmative” on tax reform during a pre-Super Bowl interview with Fox News’ Bill O’Reilly, Trump quickly shifted gears and said he expected a “phenomenal” tax reform proposal within two to three weeks. That remark occurred on February 9 (CNN, the Hill.com).
Details were lacking but the stock market rally gained new momentum.
But what about his combative nature? Could that create problems with shares? Well, so far it hasn’t, as investors have focused on the positives—expectations that fiscal stimulus will unleash the “animal spirits” that have been dormant and drive economic growth into a higher gear.
Fed Chief Janet Yellen offered a similar suggestion a couple of weeks ago when she was asked during her semi-annual testimony before two Congressional committees what she thought was driving stocks. “I think market participants likely are anticipating shifts in fiscal policy that will stimulate (economic) growth and perhaps raise earnings,” Yellen opined. Fiscal policy is simply a wonky way of saying tax cuts and infrastructure spending.
Her response fit neatly into some of the recent themes we’ve covered.
So, what happens if Congress deadlocks and nothing gets passed? Worries abound that investors are front-running changes in fiscal policy that may not occur.
Washington does not work like a well-oiled machine and compromises must still be hammered out. Odds are low at this point, but if the gears get gummed up and Congress fails to implement reforms, volatility is likely to ensue. What type of short-term fallout we might experience is difficult to forecast.
But let’s always remember that investors look to the future, using their collective wisdom (via buy and sell decisions) to discount potential events. It may not be a clear path, but at this juncture, there is the expectation reforms will eventually make their way to the president’s desk for his signature.
The 800-Pound Gorilla
Politics and the victory of Donald Trump (and a Republican Congress) have dominated the narrative since election day. Hindsight is 20-20, and it seems obvious today that investors would warm to his pro-business stance. His more controversial positions have done little to derail shares.
But if we look back over the last several years, domestic political themes that have cropped up from time to time held only a short-term sway over shares. The “fiscal cliff” at the end of 2012 created headwinds, until a last-minute deal took the issue off the table. And a 2013 government shutdown, coupled with the possibility the federal debt ceiling might be breached, cast a temporary shadow over markets.
Eventually, I suspect the political storyline will run its course and the longer-term driver of shares will once again take center stage. In fact, I’d venture to say it’s already playing a role.
Longer term, it is profits and the expectation of profits that drive stocks. Figure 2 highlights the close relationship between S&P 500 earnings and the S&P 500 Index.
Sure, there are times when shares sell at a discount to earnings, as we saw in the 1970s. At that time, interest rates and inflation were soaring, reducing the attractiveness of stocks.
Then came the late 1990s, when investors piled into almost anything with a “.com” after the firm’s name.
But by and large, it’s earnings that drive shares. In fact, the correlation between S&P 500 profits and the S&P 500 Index is an incredibly high +0.94, where +1.0 would mean the two variables perfectly mirror each other, and -1.0 would mean the two variables move in exactly the opposite directions. A zero simply means there is absolutely no correlation between the two variables.
In other words, Figure 2 is a graphic illustration that demonstrates profits are the biggest long-term driver of stocks. Sure, other factors can come into play in the short term, but investors buy and hold shares for a firm’s earnings and expected earnings.
1 The Dow Jones Industrials Average is an unmanaged index of 30 major companies which cannot be invested into directly. Past performance does not guarantee future results.
2 The NASDAQ Composite is an unmanaged index of companies which cannot be invested into directly. Past performance does not guarantee future results.
3 The S&P 500 Index is an unmanaged index of 500 larger companies which cannot be invested into directly. Past performance does not guarantee future results.
4 The FTSE Developed ex North America Index is an unmanaged index of large and mid-cap stocks providing coverage of developed markets, excluding the US and Canada. It cannot be invested into directly. Past performance does not guarantee future results.
5 New York Mercantile Exchange front-month contract; Prices can and do vary; past performance does not guarantee future results.
6 London Bullion Market Association; gold fixing pricing; Prices can and do vary; past performance does not guarantee future results.
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