Supply, Demand, Exuberance may be the Real Rally Drivers
With the Nasdaq hitting a new high and other US indexes within range of following it, investors will have to be unusually contrarian to resist the temptation to join in the buying. But the reasons behind the rally may not be as clear as some believe.
By Vikram Rangala
Wednesday, February 8, 2017 - 00:00
For the second day in a row, the Nasdaq 100 (Nadex US Tech 100) index hit an all-time record high. Historically, the Nasdaq has often been in the lead in making major moves, with the other, more broad-based indexes following it days later. The Dow and S&P 500 are both just one ordinary rally away from their records, but haven't yet made the run upward.
Since the election of Pres. Donald Trump, many analysts have suggested—and some investors and fund managers have concurred—that the rally in US equities is based on expectations of tax cuts for corporations and wealthy individuals, new infrastructure spending, and massive deregulation. How the new administration will both cut taxes and increase spending without raising the deficit is an unanswered question, but that didn't seem to matter to investors doing the buying.
Three weeks into the new administration, we've seen executive orders on immigration and other issues, as well as some freezes on hiring and regulations, but investors are beginning to ask publicly for information on these major tax and spending initiatives. They would have to be done by Congress. Many businesspeople who support those policies also support free trade, unlike the president. For them, seeing actions that reduce immigration and abandon free trade agreements without any similar moves on taxes and spending is creating a growing sense of uncertainty.
A new report by analysts at JPMorgan suggests, as part of a broader market guide, that the so-called "Trump Bump" may have less to do with speculation about Trump policies and more to do with basic supply and demand of equities, bonds, and cash to spend on them. Simply put, the supply of stocks (and bonds, but let's focus on stocks for now) has shrunk in the last several years. At the same time, investors have a healthy supply of cash and are eager to invest it in things like stocks and bonds.
In other words, demand for equities is rather high and the supply is rather tight. That's a recipe for higher prices.
Could it really be as simple as a healthy demand for a scarce product? It seems at least as plausible as the story that investors have reached a broad consensus about policies we haven't seen yet. Moreover, markets rarely ignore outright supply and demand ratios. They might go out of balance for a short time, but eventually they line up because that's what markets do.
Exuberance about tax cuts and infrastructure spending might make for splashier news stories, because you get better quotes from billionaires and pundits. Not to mention cute catchphrases like "Trump Bump." The real news may well be boring, but it's backed by math.
Why are stocks in relatively short supply? You may recall that, beginning with the bailout and continuing as companies regained share value and positive cashflow, many firms engaged in large stock buybacks. Some firms even went back to private ownership, buying back all public shares.
Many economists warned that such actions would slow the recovery. Instead of reinvesting their profits (and government sweet deals) to expand their operations and hire more workers, the companies spent the cash to buy their own stock, driving up shareholder value, but not necessarily wages. Given that wage growth only took off in 2016, years into the recovery, that warning may be correct. It's also consistent with the current supply of equities.
All of this is simply to point out that the first explanation you read in the news may not be the whole story. The whole story is complicated, evolving, and pretty messy. Seth Klarman, the influential head of Baupost Group, which manages $30 billion, said in a recent private letter to his investors that he was wary of "perilously high valuations."
He pointed not only to "exuberant investors" who have ignored the risks of "America-first protectionism and the erection of new trade barriers," but also "the sweep of automation and globalization," which Klarman says can only be temporarily staved off. Some companies have already stated that if they are forced to move manufacturing from Mexico and elsewhere back to the US, they are more likely to buy more robots than hire more US workers.
Longer-term worries like these, about automation, trade, and immigration, tend to cause short-term ups and downs. Short-term traders, whether day traders or swing traders or even those who invest on a quarterly time frame, tend not to think about larger patterns like business cycles or the rise of robots and artificial intelligence. They should, however, because those big moves happen in pieces and those pieces create the short-term moves that traders focus on.
For example, the big trend of stock buybacks that helped fuel the Obama-era bull market happened in pieces over several years, with dips along the way where investors sold off underperforming stocks and snapped up bargains. That's why so many traders keep one eye on the news and one eye on the charts. And the smartest ones remember to stay a little skeptical of what both eyes are seeing.
Bloomberg published a chart which represents a larger trend in both perception and fact. They tracked the number of news stories that contained the word "uncertainty" since 1992 and found that number reached a new high in 2016. If nothing else, that probably reflects some accurate reporting.
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