Gadfly

Trump's Magical Market Mystery Tour

It's tough to pin down what's driving the bull and even harder to figure out what will make it stop.
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Photographer: Drew Angerer/Getty Images

The market is threatening to have its first three-digit down day for the Dow Jones Industrial Average since early September. 

Even so, the market has been on a remarkable run recently. In the past 30 trading days, the market has been down just nine, the worst of which looks to be Wednesday, with the Dow off more than 140 points, or 0.6 percent, and the S&P 500 Index down about the same. Still, the market is up more than 14 percent this year, and roughly 19 percent since President Donald Trump was elected -- the Trump Bump. The president has not been shy about trumpeting the advance, citing it frequently as a barometer of the success of his administration.

As the market has marched higher, the question of what continues to propel it -- the president says he knows -- and how long it can last, is becoming louder. The most common question from clients, according to a team led by Goldman Sachs's top U.S. equity strategist, David Kostin, is “When will the rally end?" Kostin predicted last week that the S&P could fall more than 6 percent by the end of the year. Morgan Stanley, too, predicted a 5 percent short-term drop in the market. And yet, so far, nothing -- not North Korea, not Trump's tweet storms, not natural disasters -- has blown this bull market off course.

It's hard to pinpoint a reason for why what is normally the erratic embodiment of all our hopes and fears, about the economy at least, has been a growing oasis of calm recently, except that it's safe to rule out some of the obvious candidates as the chief driver.

Earnings

Let's quickly cross this one off our list. The most widely cited reason for the stock market rise is profits. Corporate earnings are up. But stocks trade on earnings expectations, not actual profits. And in November 2016, before Trump was elected, analysts had already expected profits would rise in 2017 by about 10 percent. They are on track to increase nearly 11 percent. Just looking at how much better earnings are than expected, and assuming all else stays the same, this year's better earnings should only have pushed up stocks a mere one percentage point. Something else much bigger must be going on.

Interest Rates

Another reason often cited for why stocks are so high is low interest rates. Lower interest rates typically lead to higher stock market values, among other things, because they signal lower future inflation. But interest rates, after a recent rise, are not all that lower than investors expected at the beginning of the year. A year ago, the 10-year Treasury bond was predicted to yield just 2.46 percent by the end of the year, according to a survey from the Wall Street Journal. Instead, 10-year Treasury notes now yield just 2.44 percent, or 0.8 percent lower than expected. The stock market and interest rates tend to move in opposite direction, though not over short periods and not in lock step. Nonetheless, assume the stock market got the full effect of the lower-than-expected interest rates, and you can credit interest rates with about a percentage point of the Trump Bump.

Taxes

Here's what most investors seem to be hanging their hopes on: A big juicy corporate tax cut. It would have to be really juicy to justify the stock market's advance, in fact more juicy than what analysts are predicting. On average, Wall Street strategists predict that a corporate tax cut would add about $11.50 a share in earnings to the S&P 500 next year. Stocks are now trading at 17.5 times next year's earnings. That translates to an S&P 500 that would be 200 points higher, which is pretty close to Wall Street's math as well. Last week, Goldman said it would raise its year-end S&P 500 target by 250 points if Washington passes tax cuts. But that's only if tax cuts actually pass, which the market presumably isn't fully pricing in. Put a 50 percent chance that Trump and Republicans get their tax cut passed, which seems about right, and the lift the S&P has received from the talk of a tax cut should be about 100 points, or just 4.4 percentage points.

Volatility

That leaves 12.5 percentage points, or roughly more than half the Trump Bump, unexplained. One genuine surprise was the big unexpected drop in volatility. Lower volatility should mean less risk and bolster the value of stocks somewhat. The VIX index, which measures volatility, is down 47 percent since early November. Volatility rarely has as much pull on the direction of the market as other factors. The VIX, for instance, also dropped nearly 50 percent in 2009. The market rebounded that year, but not nearly that much. What's more, it's impossible to know whether lower volatility is pushing the market higher, or if a rising market is pushing volatility lower. 

So that's probably not the satisfying explanation, either. The most likely reason is an amalgam of disparate factors in addition to the ones above: persistently high profit margins, resurging overseas markets, fewer worries about China. And none of this proves that stocks are indeed higher than they deserve to be. But what it does show is that putting your finger on what will stall the rally is nearly impossible, and using the market to measure anything other than itself is pure folly.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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