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Profound change swept across the electoral map on its way to upending Washington, DC, last week. But how much has truly changed for economic and investment conditions? In the last-minute anticipation and then immediate reaction to Donald Trump’s victory on Tuesday, nearly everything broke in favor of risk markets. A quick and decisive election result instantly released pent-up tension over the chance of a hung outcome. The apparent likelihood of a Republican sweep in Congress then engaged the old 2016 Trump Trade playbook of grabbing for cyclical, small-cap and financial stocks. The S & P 500’s eventual 4.7% jump for the week after briefly peeping above the 6000 threshold on Friday was almost perfectly set up by the market’s three-week internal digestion of the autumn rally, giving the average stock a chance to pull back even as the S & P 500 stayed just below record levels. Almost as an afterthought, the Federal Reserve trimmed short-term rates another quarter-point and Chair Jay Powell did nothing to downplay the chances of a further cut in six weeks. This in an economy that has been surprising to the upside and with inflation readings whose long retreat has paused a bit above the 2% Fed target. Even what looked like a reflex of tighter financial conditions lacked bite. The 10-year Treasury yield briefly shot above 4.4% Wednesday, but even this was below the springtime highs and is at a level that has not been shown to hold the economy back much. Ditto for the dollar index, popping but still below mid-year highs. It’s about as much bullish fodder as investors might dare ask for — and more than most bears would choose to fight, at least just yet. But, as ever, there are nuances and potential complications to consider. 2016 Trump redux? For one, the market was already in a sturdy uptrend, the S & P ahead by 20% in 2024 by October. Cyclicals have been consistently outperforming defensive stocks, with financials running ahead of tech since August. Even the small-cap Russell 2000 had made up more than half its year-to-date deficit against the Nasdaq 100 between mid-July and mid-October, once the Fed pivoted assertively toward rate cuts. .SPX .RUT YTD mountain S & P 500 vs. Russell 2000, YTD Leuthold Group chief investment officer Doug Ramsey recited a few of the crucial distinctions between November 2016 and the current moment: “Core inflation was just 2% when he won in 2016, and few feared any inflationary impact from tariffs. Today, core inflation is 3.3%. In 2016, the federal deficit of 3.0% of GDP was large, but not seen as an impediment to either steady growth in government or a big corporate tax cut.” The deficit now exceeds 6% of GDP. He adds, “While the investor mood before the 2016 vote was restrained, one component of our Sentiment Composite (consumer expectations for stock price gains in the coming 12 months) surged to an all-time high just one-month ago.” The S & P 500 before the 2016 election was at the same level as 18 months before and traded at 17-times earnings, with profit margins depressed after the 2015-’16 earnings recession. Now, the S & P is up 44% in the past 18 months and the P/E is above 22 on more elevated margins. The U.S. economy had been struggling with subpar growth and undershooting the 2% inflation target for more than half a decade by the 2016 election. Today we’re coming off an inflation shock with above-trend real GDP the rule for the past three years. Investment-grade corporate credit spreads then were twice as wide as now, leaving less room for improvement in financial conditions from here. In other words, when the reflationary Trump 1.0 policy mix of tax cuts and deregulation came into view following his surprise 2016 win, reflating was exactly what the economy needed. Now, expansionary policy (setting aside possible stiff tariffs and disruptive deportation programs for now) presents itself as a possible accelerant to trends well underway. Even then, value stocks and small caps only outperformed for about two months before growth stocks and defensive sectors took hold of the S & P 500 through a remarkably calm and strong 2017. Here’s the S & P 500 Value vs Growth relationship since 2014. As for small-caps, institutional players have been maneuvering to play a revival for the past couple of months, leaving positioning in Russell 2000 futures pretty elevated. Citi equity strategist Scott Chronert regularly computes the five-year profit-growth rate priced into equities at a given valuation, and on Friday said that with the election week rally, “Our implied growth estimate moved to 13.6% [per year] from 12.4%.” Chronert calculates that this move “fully prices a domestic-producers tax cut to 15%, which by our math is a +0.6% annualized FCF impact. That leaves the remaining +0.6% to deregulation and household tax cuts. This creates little room for incremental negatives from tariffs and/or higher rates tied deficit concerns, especially against a euphoric sentiment backdrop.” His call is for investors to fade any near-term rally that takes the S & P above his 6100 “bull case” target for year end. Tesla’s 30% week All fair and sober assessments. Yet even if the math pencils out to an unexciting fundamental return setup, bull markets also feed off of stories and feelings and the fund flows they embolden. If the reflationary policy prescription today is not needed to cure an impaired economy, perhaps it will be used by markets for recreational purposes? Certainly, this might have been previewed in the way that crowd favorite Tesla burst about 30% higher for the week, the way heavily shorted stocks were ripping, the vertical ascents in the likes of Goldman Sachs shares on expectations of a merger and IPO frenzy to be unleashed. TSLA 5D mountain Tesla, 5 days More concretely, the mere hope of a possible corporate tax cut and of industry empowered to tilt regulations more in their favor can sustain the feeling that earnings growth can improve by late next year and perhaps lengthen an economic cycle that not long ago seemed to be losing momentum. For sure, the S & P 500 is by some measures running a bit hot, pushing above the top end of its two-year bull-market path. This simultaneously means a pullback should be unsurprising but an ultimate peak isn’t likely at hand. Market breadth was also pretty underwhelming all week for such a strong index rally, a sign of how assertively the market took to sorting deemed policy winners from the rest of the pack. Investors had pared back exposures and hedged pretty aggressively into the election, so there is likely still room for the Street to “re-risk” portfolios further. Still, after the bounty of market-friendly news, it’s time to watch for investor sentiment and positioning to grow toward unstable bullish extremes — even if, near year’s end, such readings are not always much impediment to the upward seasonal bias.
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