Stock Market Rout Is a Reality Check for Bulls – Barron's

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Amid all the hyperventilation about financial markets’ reaction to the latest installment of the revelations about the Trump administration, investors would be well served to take a step back from the news cycle.

If they do, they might consider how much markets have risen on the hope of faster economic growth based on policies that have not even taken on a coherent shape, much less having been legislated and enacted.

The major U.S. stock indexes shed about 1.8% Wednesday, the biggest one-day drop since Sept. 9, but after having set record highs in recent days while being confined to extraordinarily intraday trading ranges of less than 0.5%.

By Wilshire Associates’ reckoning, U.S. shareholders ended the day $525 billion lighter in their portfolios. That pared their profits since the Jan. 20 presidential inauguration to $825 billion and since the Nov. 8 election to $2.7 trillion, so they’re still way ahead.

Even before the latest buzz about former FBI head James Comey reportedly being asked by the president to back off investigating former National Security Advisor Michael Flynn, it should have been apparent the key Trump legislative initiatives were far from being considered. The repeal and replacement of Obamacare finally passed the Republican-controlled House of Representatives with a single vote to spare, but the Senate is likely to come up with its own version—when it gets to it.

As for the centerpiece of the Trump economic plan—tax reform and reductions—all the administration has produced is an inchoate, one-page list of talking points. Producing actual legislation and passing it will be a 2018 job, if then.

Anticipation of the positive effects of these programs lifted both so-called soft data and prices of equity and speculative-grade debt—aka “risk assets” to lofty valuations. Those better times would pave the way for the Federal Reserve to continue to lift its federal funds rate target. That, in turn, has given a big boost to banks and other financial stocks that could look forward to wider net interest margins.

That now appears to being unwound. The Financial Select Sector SPDR XLF -3.149937001259975% Financial Select Sector SPDR ETF U.S.: NYSE Arca 23.06 -0.75 -3.149937001259975% /Date(1495063800000-0500)/ Volume (Delayed 15m) : 137267424 AFTER HOURS 23.1 0.0400000000000027 0.17346053772766695% Volume (Delayed 15m) : 3925359 P/E Ratio N/A Market Cap N/A Dividend Yield 1.524770164787511% Rev. per Employee N/A More quote details and news » exchange-traded fund (ticker: XLF) tumbled more than 3%, more than half again as much as the overall market, as the expectations of rising interest rates faded sharply.

Treasury yields also plunged with the yield curve (the difference between short- and long-term rates) flattening markedly. The 10-year note yield fell to 2.21%, the lowest since just after last November’s election. Meanwhile, the two-year note yield eased to 1.24%, putting the spread between those maturities at just under one percentage point.

That is a classic harbinger of slowing economic growth—exactly the opposite of what the Trump agenda had promised.

In the process, odds of a second Fed rate hike in December have faded to less than even money. While the probability of a quarter-point increase (from the current 0.75-1% target range) at the June Federal Open Market Committee is still prohibitive (86%, albeit down from nearly 100% a week ago), the probability of another hike in December has slid to just 34%, according to Bloomberg calculations.

The signs on the monetary front have been flashing yellow long before the latest Comey news and loose talk about impeachment were bandied about. Financials, Treasury yields and the dollar all have been rolling over for two months or more.

During that span, the stock market’s gains have been concentrated in a shrinking number of megacap tech stocks that dominate the major indexes. And that effect worked in reverse today. Apple AAPL -3.3575609442336143% Apple Inc. U.S.: Nasdaq USD150.25 -5.22 -3.3575609442336143% /Date(1495054800464-0500)/ Volume (Delayed 15m) : 49418722 AFTER HOURS USD150.93 0.680000000000007 0.4525790349417637% Volume (Delayed 15m) : 1444867 P/E Ratio 17.573099415204677 Market Cap 810595686872.363 Dividend Yield 1.6772046589018303% Rev. per Employee 1894280 More quote details and news » (AAPL), the world’s biggest stock, lost 3.4%, a major factor dragging the SPDR S&P 500 (SPY) down 1.77%.

History further suggests that scandals don’t necessarily hurt the stock market. BCA Research’s Daily Insights looked back and found the Teapot Dome Scandal didn’t derail the Roaring ‘20s bull market while the Monica Lewinsky affair (their words) barely affected the 1990s dot-com bull run.

Of course, the Watergate scandal coincided with the bear market of 1973-75. But as I explained earlier this week, that reflected the oil shock and resulting inflationary recession of the time.

And finally, a check of the calendar shows that it’s the middle of May. Seems I’ve heard something about selling and going away during that month. And there’s another saying about selling high, which is where stocks still are.

Comments? E-mail randall.forsyth@barrons.com

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