Dont short new highs or buy new lows. That is the first commandment in the traders bible, and for good reason. Within the confining walls of capital markets, price dictates reality. If your perception isnt the same as the markets view on things, it just means you dont understand what is setting price. Best to step aside/not trade until reality shifts in your direction.
That brings us to the traders second commandment: Dont just do something, sit there. Except this isnt an invitation to sloth; it means do the work to understand the trade better. Early is the same thing as wrong, so use the time spent waiting for your version of reality to identify the catalysts that will eventually shift markets to your point of view.
Why the reverence for new highs and lows? Thats simple: someone (or, more likely, lots of Someones) is out there buying or selling at an extreme price level. That someone is doing so with information you may not have. To go counter to that signal means 1) you must be sure you have better information than anyone else and 2) the buyers/sellers arent going to show up tomorrow (and the next day, or week, or month) and keep pushing the asset in question to higher/lower levels.
With that we come to todays US equity markets, which are hitting new highs on an almost daily basis. I hear lots of skepticism about the 2017 Trump rally. Valuations are stretched. US equity markets are putting too much faith in an as-yet-unproven Presidential administration. Stocks are whistling past the proverbial graveyard.
For the trader – someone interested in catching short term moves in equity prices – none of this matters because their only choices are to participate or sit this one out. Realistically, that second option is barely a possibility. When there is money to be made on the long side, it takes a herculean level of willpower to stay on the sidelines.
Regardless of where you stand on the current bullish run for US stocks, it pays to understand exactly why we are here. With a thorough checklist in place you can then decide how much longer this ride might last and where you should pull the cord and make your exit. There will come a time when every-day-a-new-high becomes more of a churn. And thats when to get short (if you can) or reduce risk (if you cant exit entirely).
We asked a group of Convergex desk heads and senior traders to fill in the blank on the following statement: In order to stay long US equities, you have to believe that ______________. Here is what they came back with:
President Trumps recent troubles are just the typical teething pains of any new administration. It has not been a great week for the new President, between the Flynn resignation and the overturning of his Executive Order on immigration. Since US stock prices continue to rally, it seems clear that investors see these bumps in the road as temporary rather than a signal of systematic dysfunction. The new Presidents economic agenda will proceed largely as expected and ultimately be enacted.
The Street, for once, is too pessimistic on earnings. Currently, Wall Street analysts expect the S&P 500 to earn $131.65 in 2017 and $147.04 in 2018. That amounts to 10.5% earnings growth for this year and 11.7% for 2018. Valuations of 17.8x those 2017 earnings and 15.9x next year seem high for low double digit earnings growth, especially in an environment where interest rates are heading higher.
The real juice to the earnings story, therefore, is the expectation of lower individual and corporate tax rates as part of a reform of the US tax code. None of that has been baked into analyst estimates yet; they will certainly wait for legislation to pass and get some guidance on what new rate to include in their models from the companies they follow.
See here for the latest FactSet Earnings Insight report with more details on Wall Street earnings expectations: http://insight.factset.com/hubfs/Resources/Research%20Desk/Earnings%20Insight/EarningsInsight_021017.pdf
The Fed goes twice, not three times, in 2017 and the yield on the 10 year US Treasury stays at or below 3.0%. Forget the chatter about the Federal Reserve raising rates in March; thats not what the market is expecting at all. Fed Funds Futures ended today with only a 13.3% chance that the central bank increases Fed Funds by 25 basis points in March. You can see the latest odds for April (39%) and June (70%) with the CMEs FedWatch Tool here: http://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html
As for the 10 year yield, here we have a tight wire act to watch. The US 10 Year Treasury currently yields 2.48%, below the highs of 2.60% set last December. Equity markets expect long dated yields to rise for the remainder of the year, as the rally in financials partially shows (the remainder of the move there being expectations of less regulation). But how much of a good thing is too much? Our best guess: 3% is where equity investors will start worrying about higher rates crimping growth.
Tax rates go down. That FactSet note we highlighted above had a useful tidbit on page 2: half of all companies that mentioned Trump on their earnings call also mentioned Tax Policy. It is clearly a top-of-mind issue in corporate America. And, of course, the easiest way to increase corporate earnings and consumer spending is to lower Federal taxes. Simple.
Oil prices remain stable. With all the attention on the new administration it is important not to forget that analysts are looking for a meaningful increase in Energy company earnings in 2017. Consider that FactSet has the expected Q1 2017 earnings comparison for the group in at 39% year over year. The Energy sector of the S&P 500 is down 2.2% thus far in 2017 and crude, unlike stocks, hasnt made a new high in 2017. Bottom line: Energy doesnt need to be market leadership in 2017, but it cant fall out of bed either.
Nothing bad happens in the rest of the world. How does Brexit actually happen, and what effect does it have on the British economy and currency markets? Who will win the French and German elections? How is the Chinese economy doing? Whats going on in North Korea?
Look at the chart of the S&P 500 and youd be forgiven for thinking none of these questions matter. And they dont. Until they do.
Regulatory reform/Infrastructure spending is on the way (Obamacare, Dodd Frank, general trend to deregulation, first infrastructure Executive Order coming soon). Markets are still waiting on a lot of the details behind President Trumps economic program. As long as we get occasional updates, everyone seems content to believe they are all still in process.
I could add several more to this list, including:
There are no overtly protectionist trade policies proposed by the new President.
No geopolitical event either increases global energy prices or dampens US consumer confidence.
US GDP growth remains in the 2-3% range until the Trump economic agenda passes Congress.
But you get the idea… A lot has to go right. And not much can go wrong. But thats what equity prices discount at the moment. And if you disagree with the underpinnings of the rally, thats fine. Pick your objections, find the catalysts that will make the market see things your way, and then wait.
Your time will come. It just isnt tomorrow.
