What Can Go Wrong?

The market is hyperbolic in its bullishness which has no basis in anything tangible other than optimism that Trump’s presidency will bring GDP growth and reignite corporate profit growth. It’s natural to want to be optimistic, but this rally is too powerful. At some point, early in Trump’s term, speculators will recognize the obvious: Trump isn’t a miracle worker.

The chart below shows the Dow is the most overbought since late 1996 according to the relative strength index. The Dow Jones Industrial Average is the pinnacle of CNBC bullish hysteria. The index doesn’t represent the overall market, but it has a big number attached to it so commentators are ready to exclaim how great everything is because a few stocks are doing well. Goldman Sachs alone is responsible for over 20% of the rally since November 4th as the stock is very close to its all-time high. Either way the Dow hitting 20,000 will bring some new retail investors into the market at expensive levels.

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As I showed in an article a few days ago, the insider selling in banks is higher than before the financial crisis. This is against the backdrop of the BAML fund manager survey saying 31% of respondents are overweight bank stocks which is the most on record. Corporate profit growth expectations are the highest in 6.5 years and global growth expectations are the highest in 19 months. These expectations are based on hot air as there is no catalyst for growth to occur. Investors are putting a lot of Trump’s shoulders. Apparently, he will put the entire global economy on his back even though he’s advocating for protectionist policies. There doesn’t seem to be a middle ground as the market went from thinking he would be the worst president to thinking he would be the best. Even if he was the best president ever, I doubt these expectations can be met.

There’s many ways to look at the euphoria in the market. The SPX call demand is at an all-time high. There were many shorts in the market while the S&P 500 was hovering around 2100 in 2015 and the beginning of 2016. These shorts had to cover as they’ve been run over by this big rally. It’s a bearish indicator when there aren’t any left.

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Tomorrow is the Fed meeting which is widely expected to see the Fed raise rates. It’s tough to understand the market. Earlier this year, the market would crash at the mention of a rate hike. Now a rate hike is being ignored just because of a few positive data points in November and the negative corporate profit growth streak ending. This entire recovery has been lumpy, yet now that it’s been 7.5 years, investors believe it will accelerate.

This optimism is reflected in the Deutsche Bank chart below which shows the likely way markets will react to various Fed guidance. The two lines I am focused on are the equities and the credit spread. Every scenario is ‘risk on.’ This isn’t Deutsche Bank being glib. This is the reality of the market. It makes sense to be bullish on any one event, no matter what it is until the trend turns.

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I’m perplexed by the probabilities Deutsche Bank has for each scenario to play out. My difference in opinion likely comes from my viewpoint pertaining to what will actually happen compared to Deutsche Bank’s viewpoint which is what the Fed will guide. I do grant Deutsche Bank the possibility that the Fed will say it will hike more than 2 times in 2017. However, I don’t think it will act upon that guidance.

The CME Group website which shows what each Fed decision is pricing in to the market agrees with my assessment. The market is only pricing in a 36.8% chance of 2 or more rate hikes by November 2017. Deutsche Bank only gives a 5% chance that the Fed will say there will be less than 2 rate hikes. This puts in the same situation we were in last year. The Fed promises a few rate hikes and the market doesn’t believe it. Then the Fed threatens to hike rates which causes the market to sell off. Finally, the Fed listens to the market and hikes once and the market rallies. This one rate hike per year pace is not sustainable as the Fed will wind up with low rates right before a recession. Whether rates are at 75 basis points or 150 basis points before a recession is almost meaningless as the Fed will have little ammo to fight a recession in both scenarios.

In my past articles, I’ve mentioned that the Fed would do a dovish rate hike because the market had been crashing at every mention of a rate hike. I didn’t put a specific definition of what a dovish rate hike would entail because I was focused more on language. The Fed never has guaranteed any specific amount of rate hikes, so the Deutsche Bank analysis is too granular, in my opinion.

I no longer think the Fed will do a dovish rate hike because the market has rallied in the face of what it is expecting to be a rate hike tomorrow. This gives the Fed room to attempt to unwind its extremely dovish policies. I am not stuck in a box on my Fed forecasting. The only rule I have is the Fed will listen to what the market tells it to do instead of what is good for the economy. If the market sells off in the next few weeks because of a hawkish hike, the Fed will walk back everything it said.

Conclusion

            The market is ecstatic by a Trump victory and is rallying with reckless abandon. I am of the belief that the market may have rallied if Hillary would have won as the market was looking for an excuse to go higher. The Fed has still inflated this bubble with low interest rates even though the market doesn’t want to admit it. At some point in the next few months, higher interest rates will put a damper on this rally. It is unsustainable. But for now ,the Dow is about to reach 20,000 as the party continues.

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