Trump Rally Or Trump Mirage?

by: Eric Parnell, CFA

The U.S. stock market continues its post-election advance higher.

Beware the mirage.

Three important indicators raise legitimate concerns about the sustainability of the rally into the New Year.

The U.S. stock market continues its post-election advance higher. But beware the mirage, as three important indicators raise legitimate concerns about the sustainability of the rally into the New Year.

Breadth Is Lacking

A first point of contention about the sustainability of the current stock market rally is the fact that a degree of market breadth is notably lacking. A positive signal when stocks are in full rally mode is when an increasing number of stocks are trading above their long-term 200-day moving average. But during the most recent advance since the election last month, the percentage of stocks trading above their 200-day moving average on the S&P 500 Index (NYSEARCA:SPY), the NASDAQ and the NYSE are all notably below the previous peaks from earlier in 2016.

Focusing on the NYSE in particular, we see that just 67% of stocks are trading above their 200-day moving average. While this is positive from an absolute perspective, it is notable that it is well below the previous peaks of 76% from early June and 81% in early September. What this indicates is that despite the fact that the market in general is trading at new all-time highs, the degree of participation by stocks across the market to support this latest advance is measurably weaker than it has been during past rallies, bringing into question the sustainability of the rally going forward.

Money Flows Are Lacking

Second, a popular narrative surrounding the recent stock market advance has been the unleashing of animal spirits among investors who are enthusiastic about the pro-growth policies that are anticipated to come with the new administration. This all sounds great in theory and the new administration may very well meet these lofty economic expectations before it is all said and done. But unfortunately for the stock market, and fortunately for the bond market (NYSEARCA:AGG), the underlying money flow data does not necessary support that this is actually taking place.

We did see a positive first step for stocks (NYSEARCA:DIA) in the week after the election ended November 16 with more than $23.1 billion flowing into domestic stock funds and ETFs. Of course, more than -$228 billion had flowed out of these same domestic stock funds and ETFs from the start of 2015 through the week ended November 9, 2016, so while the first week inflow was a good start, stocks would need a whole lot more where that came from in order to support a continued advance. Instead, what we have seen in the two weeks since has been a rapid deceleration of money flows into domestic stock funds and ETFs. For the week ended November 22, inflows dwindled to just $6.9 billion. And for the next week ended November 30, they dropped off even further to just $2.8 billion. The slowing of money flows to a trickle is not at all what the unleashing of animal spirits looks like. Instead, what it suggests is that major financial institutions are driving the market higher for now, but for how long.

What about the bond market? Isn't money supposedly flowing out of bonds (NASDAQ:BND) to chase the pro-growth dreams implied by the stock market? This is also not at all the case, as bonds already stemmed the bleeding weeks ago from a retail and small- to mid-sized institution perspective. Sure, -$5 billion moved out of the taxable bond market in the first week after the election ended November 16. But since that time, we saw net inflows of just under $800 million back into taxable bonds in the week ended November 22 followed by a switch back to -$660 million flowing back out during the week ended November 30. This is stabilization, not a stampede. And given that $160 billion had flowed into the taxable bond market from the start of 2015 through the week ended November 9, it had some space to let off a little steam with these recent marginal outflows. Once again, this is not money flying out of bonds in the pursuit of animal spirits. Instead, any weakness in the bond market is a reflection of foreign countries and major institutions dumping some of their bond holdings to raise liquidity.

Both of these forces are short-term phenomenon, not the beginning of long-term trends, which brings into question not only the sustainability of the recent stock market rally, but also the further duration of the bond market (NYSEARCA:TLT) decline.

Risk Premiums Are Dwindling

A flippant take by many analysts is the following: the bond bubble has burst, so go long stocks! OK. But here's the problem. Even if you are completely jazzed up about the pro-growth policies that are supposedly coming with the new administration, it's gonna take a loooong time even under the most optimistic of timing scenarios before these policies actually generate results that are going to feed through to the bottom line for U.S. corporations.

Put simply, the outlook for the "E" in the P/E ratio in the coming year should not be much different than it was before given these pro-growth dreams in mind all else held equal. Yet the "P" in the P/E ratio has risen to new highs in anticipation of this potentially higher "E" at some point down the road maybe in mid-2018. Of course, a lot can happen between now and 18 months from now, so the realization of this higher "E" outcome remains to be seen, but I'll give the stock market the fact that it's supposed to be a predictive indicator (although it has been much more of a reactive indicator during the post crisis period, but we'll overlook this point for the moment).

At the same time, bond yields have spiked dramatically higher. This includes the yield on the 10-year U.S. Treasury, which of course serves as the risk-free rate for the discounted cash flow and capital asset pricing models that investors and analysts know and love so well. So not only would investors be receiving a far lower risk premium on their stock investments than before even if the stock market had remained unchanged during this time period, but also they are receiving an even smaller premium now that stock prices have surged higher at the same time that bond yields have spiked. Moreover, the accompanying higher borrowing costs along with the stronger U.S. dollar are generating a meaningful earnings deflating headwind going forward. Put simply, we may very well see the "E" in the P/E ratio either not expand as much as anticipated over the coming year if not shrink even further before we are able to even begin to benefit from the pro-growth policies that many are hoping will follow.

Putting this together, the stock market is already trading at a historically high multiple of 25.1 times trailing 12 month as reported earnings heading into a stretch in the coming year where the "P" is still rising and the "E" may fall short of expectations if not dwindle further in a broader market environment where bond yields are now meaningfully higher and investors are getting paid measurably less to take on stock market risk. And this does not even include the political and market risk presented by the populist wave currently sweeping across the planet, which has the potential to weigh on "E" even further. Such is not a supportive mix for the continuation of higher stock prices.

The Bottom Line

The recent stock market rally has been awesome. And it's likely that it will get even "awesomer" before 2016 draws to a close. While investors are right to take their seat at the table of post-election stock market gains, be careful out there, as such excitement is difficult to sustain when a number of key indicators suggest that it is built largely upon sand.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: I am/we are long TLT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am long selected individual stocks. I also hold a meaningful allocation to cash at the present time.