The Trump Rally, while rooted in ideology and investment theory, is not necessarily rooted in reality. While tax reforms, reduced regulation and fiscal stimulus could make for a powerful combination stoking the economy and inflation it is not certain this combination will actually happen and if it does happen it will not happen for some time. Expectations are running a bit too high and this is still Washington DC after all. The roots of the Trump Rally are bound to get stuck in the mud of the Swamp.
Interest rates and the US dollar are rising which can be a dangerous combination. The market can rally with rising interest rates and we believe that it is healthy for interest rates to rise from here and that low interest rates were actually inhibiting growth in the economy. Some semblance of higher interest rates are good for the economy. But for the stock market the current high level of valuations were predicated on TINA (There Is No Alternative). At some point, bonds, real estate or other asset classes become an alternative. The high levels of asset valuations were predicated on low interest rates as all investments are evaluated versus the risk free rate of the 10 year Treasury. A rising ten year means that models may have priced assets too richly.
As you know we follow certain financial leaders and Jeff Gundlach at DoubleLine is one we find most open with his thoughts. Gundlach is on record saying that the 10 year could go to 6% in the next 4 or 5 years. We are of the same thought although not as drastic. In the near term we believe that yields have gone too far too fast along with equities in the post Trump win world. Gundlach spoke to Reuters this week and caused markets to pause as he said much the same. Gundlach feels that the bond selloff has seen its low for now and stocks will take a breather before Inauguration Day. After he spoke bonds rallied and stocks fell. Evidently we are not the only ones listening intently to Gundlach's views.
Another one of our favorite investing legends is Stanley Druckenmiller. He spoke this week at the Robin Hood Conference in NYC. Druckenmiller does Gundlach one better. He believes that the yield on the 10 year will rise to over 6% in the next year or two!! Druckenmiller is shorting the Euro and the Yen and he believes that if the 10 year rises above 3% then the stock market could see a 10% correction. Let's face it. The stock market can face a 10% correction if someone sneezes in the Middle East. A 10% correction is not something to be feared but anticipated. I think that the real takeaway is that at some point the yield on the 10 year becomes more enticing to investors than being in the stock market. The pendulum will swing and bonds will usually give you the correct signals. Keep an eye on the 10 year for hints as what stocks will do.
This Sunday's referendum in Italy is the market's next boogeyman. Journalist and pundits are predicting the next great financial calamity if there is a "No" vote in Italy. Where have we heard this before? Italy has had 67 governments formed in the last 70 years. Why should 2017 be any different? We don't mean to diminish the battle that is going on with bad loans at some of Italy's biggest banks but somehow after seeing the predictions that Brexit would be bad for markets and Trump would be bad for markets we have a hard time believing the next great financial calamity follows the next populist regime change. The Italian Referendum should be another interesting vote. It might be time to become familiar with the name - Beppe Grillo.
The market is working off its collective overbought and oversold conditions. The 10 year closed Friday at 2.39% and should see resistance at the 2.5% level. Stocks have relieved some of their overbought condition but the Trump Rally is seeing some buyer's remorse at 2200 on the S&P 500. Keep an eye on Italy this weekend.