Building Upon The Sand

by: Eric Parnell, CFA


Au contraire, mon frere.

The market over the past three months has priced in something that was never going to happen.

This reality is becoming increasingly apparent, and stocks are bound to eventually respond to it in a negative way.

Such may be the catalyst for a -5% to -10% correction in the S&P 500 Index in the coming weeks.

Any such short-term pullback in risk assets should be viewed opportunistically.

"Certainly nobody ever said big tax legislation is easy"

- Gerald Seib; The Wall Street Journal; Amid Trump Controversies, Tax Overhaul's Uncertain Path

To the contrary, my friend. Investors all across Wall Street have been saying this for months now. And they are still saying it today.

The recent Wall Street Journal article mentioned above brings attention to a topic that should have been well known by the market but has been almost completely overlooked to date over the past several months. It has been boldly assumed by many experts and analysts beginning on the morning of November 9 through now that all of stock market investor hopes and dreams were set to start coming true once the calendar flipped to January 20. But as dreams give way to reality with each passing week into the New Year, we are now seeing that it just doesn't work this way, as many of these dreams may not come true for some time if ever at all. Presumably, the stock market might even wake up to this fact at some point soon.

Corporate tax reform, individual tax cuts, Obamacare repeal, Dodd-Frank repeal, and massive infrastructure programs. They were all set to come rapid fire once the new Congress was in session and the new administration took office. Analysts' earnings forecasts were raised and discounted cash flow models were adjusted in the early morning hours of November 9 as every investment expert on Wall Street and beyond began individually musing about how policy in Washington would play out exactly as they imagined it inside their own separate heads. How could these things not happen, after all, as they just make too much sense! And stock prices started rallying as a result.

But then the inauguration came and went. And so did Valentine's Day. And President's Day. And Saint Patrick's Day is quickly rolling around the corner. We are more than three months removed from Election Day and more than one month into the new administration, yet we really don't have any better idea of what these fiscal policy changes that were supposedly going to be well on their way to being enacted into law by now are even going to start to look like once they are completed. That's if they ever get completed.

Outrageous, you might say! The new administration has only been in place for a month and his cabinet picks have been slow walked by Congress in the approval process. The new leadership needs time to make things happen.

My response to this point is the following: Exactly my point! For my reason for saying then and continuing to say now why it's going to take longer, potentially a lot looooonger than any rational investor might currently think, for these fiscal policy changes to be legislated, passed into law, implemented and actually feed through to corporate earnings is because Washington DC is not Wall Street. It's Washington DC. I lived in Washington DC, and instantaneous transformational policy change is not how they roll in the nation's capital.

Little of this has anything to do with Donald Trump. I don't care if he was acting as quiet as Calvin Coolidge and had a laser focus on fiscal policy in his first 100 days. It still wasn't going to happen right away.

Why? First, let's consider the agenda. The folks in Washington are not investment bankers. They can't go into lock down for a weekend and work 72 hours straight with the common goal of pushing a merger deal through so that everyone involved can make a lot of money. Instead, they are politicians. They set their legislative agenda often one objective at a time, not all at once. And the reason they do this is because these things take time to effectively legislate and pass into law.

Second, let's consider the players. Politicians in Washington each have their own unique individual interests that often run in conflict with the politician that may or may not be in the same party sitting right next to them. And they also have powerful lobbyists and constituents in their respective districts and states with a lot of money (and influence) endlessly whispering in their ears about what they would like to see happen. These are wide and varying interests to try and juggle much less represent.

Third, let's consider the Republican players in particular. The Republicans in the House of Representatives struggled to get along before the White House was on their side and willing to pass the bills that they sent to the President's desk. So why should we assume that they would get along any better once the legislation they were putting forth actually started to mean something more? Let's also consider the Republicans in the House of Representatives and their counterparts in the Senate. These groups have also struggled to coordinate on various legislative efforts in recent years as well. The fact that the President might be distraction prone certainly does not help matters, but it just as easily could have been John Kasich, Jeb Bush or any number of other candidates from the GOP field in the White House and the same legislative bog would almost certainly have been happening. It has almost nothing to do with the players in the party. Instead, it's just how Washington works.

Fourth, let's consider the Democratic players, because they are no different than the Republicans at the end of the day. Some cite President Trump's penchant for controversy and potential lack of popularity for why things are not getting done. But I remember eight years ago at this time a wildly popular with the American public President Obama struggling to get one of the holy grails of the Democratic Party policy platform in universal health care passed through the Senate and House of Representatives that were also controlled by the Democrats. It was so challenging that in the end, the Democrats had to resort to reconciliation to pass the Affordable Care Act into law more than a year later in March 2010.

Put simply, the fact that legislation is not happening as quickly as some investors originally anticipated should come as no surprise. For regardless of who is president or what party universally controls the White House and Congress, passing legislation in Washington DC takes time. And in some cases, it takes a lot of time. That's just how it works. It always has and it always will. And it is surprising that so many on Wall Street seemed to once again forget this reality that has been repeated over and over again throughout history.

The Implications Of Time

The fact that legislation is not going to pass as quickly as anticipated is bound to have a notable effect on risk assets in general and the stock market in particular.

Let's consider the following. The stock market, as measured by the S&P 500 Index (NYSEARCA:SPY), closed at 2,139.56 on Election Day back on November 8. The market immediately rallied for five straight weeks with a +6.4% advance on gains in 18 out of the next 26 trading days driven by the investor dreams of what would come with the new administration and Congress. And on Tuesday, stocks reached new all-time intraday highs of 2,366.24.

Put simply, the S&P 500 Index has rallied 10.59% since Election Day driven primarily by the effusive optimism that pro-growth policies would soon be on their way. But it is becoming increasingly evident that they may not be on their way after all. Indeed, as Mr. Seib points out in his article, the new administration is falling behind its predecessors in bringing big economic legislation to Congress after inauguration. The more time passes, the more daunting it will become to accomplish even some of the legislative priorities that so many investors have been dreaming about and are still assuming to be given in many cases. And even once it gets underway, it is still going to take much longer to turn into law, to implement, and feed its way into earnings than what the market has already priced in.

By this logic and assuming all else held equal, if stocks rallied by 10.59% from 2,139.56 to 2,366.24 on the S&P 500 Index driven by the optimism of pro-growth economic legislation, it presumably should fall back to 2,139.56 or further if it turns out that this same pro-growth economic legislation is either delayed well into the future or ends up not happening altogether.

Of course, not all else is held equal. And pro-growth economic policy is not the only reason why stocks have rallied in recent months. Not only are the last two months of the year a seasonally favorable time for stocks, but we have also seen a solid improvement in corporate earnings finally take hold after a difficult stretch dating back to September 2014. But here is the problem with these other upside drivers. Seasonality is not transformational and does not provide fundamental support. And the recovery in corporate earnings is also not transformational, for despite their recent rebound, they are effectively no higher on a nominal basis than they were a decade ago in 2007. On a real basis, they are still much lower. And with stock prices 50% higher than they were a decade ago, this presents a big headwind from a valuation standpoint that continued corporate earnings growth in a still sputtering global economy cannot solve on its own.

Put simply, the dreams of pro-growth fiscal policies were the juice that justified the recent jump in stock prices. And that juice appears to be slowly draining through the fingers of legislators and subsequently investors with each passing week. Time still remains to get things up to speed, but the clock is ticking. Couple this with the fact that the Federal Reserve remains intent on tightening monetary policy sooner than the benefits of any expansionary fiscal policy might come later suggests the high probability that the upside catalysts in the form of pro-growth fiscal policy hopes may soon give way to the downside catalysts of excess valuations and tighter monetary policy and liquidity concerns.

The Bottom Line

Stocks have rallied since the election on pro-growth fiscal policy hopes that have failed to materialize at the pace investors originally expected. But these expectations were never realistic regardless of who was in power in Washington. At some point, the stock market will be forced to come to grips with this reality. And with liquidity already on the wane worldwide, this rationalization process may serve as a catalyst for a stock market correction of -5% to -10% some time in the short term over the coming weeks.

With that said, the fact that corporate earnings remain on the rise should provide an offset to any short-term decline in stocks gathering speed. And we should never forget that still dovish at heart policy makers at the U.S. Federal Reserve remain armed with microphones and podiums to help bring any sustained market correction to a screeching halt. As a result, any such near-term correction should be viewed both opportunistically and selectively to add risk asset positions at the margins.

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/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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 as part of a broadly diversified asset allocation strategy.