Stocks Advance Amid Policy Uncertainty

The stock market’s love affair with the Republican agenda endured the rocky start to the Trump presidency, and finished up 5% for the first quarter. The Dow Jones Industrial average breached two milestones – crossing 20,000 for the first time ever on January 25, then topping 21,000 on March 1. In surging to that record close, the market looked past a number of events that most Americans found unsettling – massive protests against the new President, the courts’ rejection of his unpopular travel ban, the resignation of the National Security Adviser under suspicions of colluding with the Russians in the 2016 election, and the recusal of the Attorney General a day later from that investigation. Whew!

A look at the chart for the quarter, however, reveals that stock market momentum stalled in March as questions arose about Republicans’ ability to push through their policy agenda. Doubts stem from two underlying issues. First, the President’s ability to use the power of the bully pulpit now seems compromised, by suspicions about his involvement with the Russians in the hacking of the 2016 campaign, by his own erratic behavior – most notably accusing his predecessor, without any evidence, of wiretapping his Manhattan apartment and most of all, by his record low approval ratings.

The second set of doubt stems from Republicans’ inability to push through repeal and replacement of Obamacare, their single biggest campaign issue of the past seven years. The debate highlighted the fact we wrote about last quarter, that Republicans have nearly as many disagreements amongst themselves as they do with Democrats. It is entirely possible that the market can shrug off an ineffective Trump presidency. But we have a harder time seeing how U.S. stocks prices can maintain current levels without legislative successes, especially on tax reform. The S&P 500 trades at nearly 22 times trailing 12-month earnings, a premium of about 20% to the long-term average multiple. While lower corporate and investment taxes would help justify current valuation, a repeat of the healthcare debacle would almost certainly suck the air of this market.

This is not to suggest that all of the stock market’s recent gains should be attributed to policy. For one, corporate profits are rebounding due to steadying oil prices and related investment. Global economic data has also been improving, especially in Europe and China. In fact, overseas markets outperformed the U.S in Q1, with stocks in Europe and Asia advancing 8%. There are still risks. In Europe, upcoming elections in France, Germany and Italy threaten to undermine commitment to the Euro currency at the same time that Britain begins its negotiations to leave the EU. In China, the banking system looks increasingly shaky, with a rise in bad loans reminiscent of Japan in the early 90’s and the U.S. before the financial crisis. But in most overseas markets, economic fundamentals are clearly improving and stocks are not as expensive (see chart), so the downside risks may be lower.

In this country, there has been a somewhat curious divergence between “hard” and “soft” economic data since the election. On the one hand, consumer, business, and investor surveys (the soft data) indicate the highest levels of bullishness since the dot com era. On the other hand, hard data on consumer spending and business investment indicate barely any improvement at all. This suggests that the surveys of sentiment reflect optimism more than confidence. Investor Sir John Templeton famously said that “bull markets are born in pessimism, grow on skepticism, mature on optimism and die on euphoria.” That this bull market has lasted eight years probably reflects the fact that most of it has been spent in pessimism and skepticism. There’s little doubt that dysfunction in Washington contributed to such persistent negativity. Now that Washington is back in the hands of a single party, the public expects effective governance. But continued dysfunction could destroy this optimism and kill the bull market long before it ever gets to euphoria. For Templeton, that would be an unnatural end; for investors, an unfortunate one.