Was The Trump Rally Really A Fed Rally?

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Includes: CRF, DDM, DIA, DOG, DXD, EEH, EPS, EQL, FEX, FWDD, HUSV, IVV, IWL, IWM, JHML, JKD, OTPIX, PPLC, PPSC, PSQ, QID-OLD, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWL, RWM, RYARX, RYRSX, SBUS, SCAP, SCHX, SDOW, SDS, SFLA, SH, SMLL, SPDN, SPLX, SPSM, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU-OLD, SPXV, SPY, SQQQ, SRTY, SSO, SYE, TALL, TNA, TQQQ, TWM, TZA, UDOW, UDPIX, UPRO, URTY, USA, USSD, USWD, UWM, VFINX, VOO, VTWO, VV
by: Bruce Carlson

Summary

The Fed is providing an unprecedented amount of stimulus for this stage in the economic cycle.

This stimulus is extremely supportive to stock P/Es and prices.

However, with the Fed beginning to tighten and warning signs appearing, the rally may be in the 9th inning.

The Federal Reserve is providing an unprecedented amount of stimulus for this stage of the economic cycle. The easiest way to see this is through a chart comparing real Fed Funds level vs. the unemployment rate (inverted), as intuitively the Fed should be tightening policy as the unemployment rate drops and easing policy as the rate increases. We can then distill that down to a Fed policy indicator that demonstrates the degree of stimulus/restraint the Fed is providing to the economy.

Source: Federal Reserve (FRED)

Source: Federal Reserve, my calculations

We can see from both the level and prolonged period that this magnitude of stimulus has never been injected into the economy before. While the Fed has been gradually hiking rates, the pace has been slower than the pace that the unemployment rate has been dropping and the level of inflation (CPI x food and energy) has been increasing.

So, implicitly, the Fed has been easing as the economy has been strengthening, and as opposed to "Taking the punchbowl away as the party gets started," the Fed has been continuously spiking the punch as the party grows. We all know how that ends - with the house being trashed and the police on the doorstep. However, until that point it can be a real good time!

We are currently at that stage where the party is rocking but the police haven't arrived yet. When we look at the Fed policy indicator compared to stock P/Es it is clear P/Es increase as the Fed is easy and then come crashing down as the Fed tightens up (although initially earnings drop precipitously and P/Es explode as the E goes to 0).

Source: Federal Reserve, Robert Shiller & Yale Economics

Into this mix we had added a U.S. presidential election. So, while the Fed was priming stocks to move higher, the uncertainty of a very rancorous and partisan presidential election was keeping both individual and institutional investors from deploying cash into the market. When the election ended and Trump was victorious, the uncertainty was removed and stocks moved dramatically higher. In the end it wasn't that Trump was elected but that the election was over.

Why does this matter? Because we need to identify the real catalyst for the price action, and because we are starting to see indicators that the underlying Fed stimulus is starting to unwind. The Fed has gotten more serious about removing this stimulus, as they have committed to (at least between the tea leaves) at least 2 more and possibly 3 additional tightenings this year. The money supply growth has been dropping and has turned negative, bank lending is slowing, and we have started to see high yield spreads begin to widen.

When we regress the Fed policy indicator against P/Es, it would point to another 7% stock price gain from this point as the Fed still remains stimulative. However, since we are starting to see underlying indicators deteriorating, it feels like even though the police haven't arrived the neighbors have already called them.

While in many cases we would stay at the party until the police actually showed up and skate out the back door, given the hyper-leveraged markets and economy (especially in China) it may be a case where the market turns very dramatically and those that haven't taken any risk off the table will get caught.

This is especially the case as there seems to be a growing political and geopolitical risk premium being priced into the market. The uncertainty of the election is now coming back into the market as the uncertainty of policy, as many of the pro-business policies look less likely to be achieved and the risk of a geopolitical or domestic political event (smoking gun) comes into play.

There will be some stock gyrations based on the probability of Trump getting his pro-business policy and tax cuts achieved, and at least one good rally left in the market but I would expect the fall to be unkind to the market.

For equity portfolios I would begin to lighten up or hedge S&P (NYSEARCA:SPY) and Nasdaq (NASDAQ:QQQ) positions and look to start entering into Short S&P (NYSEARCA:SDS) or Short Nasdaq (NYSEARCA:QID-OLD) positions on any sustained rally of 5% or greater.

In this case, it might be better to leave the party early than end up in handcuffs.

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.