US stocks: Why things don’t always have to give

<p>There are so many reasons why the stock market, the US market in particular, looks overbought right now. The RSI – the relative strength index […]</p>

There are so many reasons why the stock market, the US market in particular, looks overbought right now. The RSI – the relative strength index – is at its highest level for twenty years and is above 80, P/E valuations are rocketing, and the Fed Fund Futures market is pricing in an 88% chance of rate hike from the Federal Reserve when it meets in the middle of this month. Now is a good time to remind us’ why overbought signals do not always lead to a market sell off.

What we can learn from history

Firstly, let’s look at history. Bloomberg has done some good analysis regarding the RSI. Back in December 1996, the S&P 500’s RSI also moved above 80. The index did sell-off, it dipped 5%, however, after that temporary blip it roared back to life and the bull market lasted another 3 years. Bank of America also did an empirical analysis that found markets tended to rally by 15% in the last 6-months of a bull market, so closing your long position too early could be a costly mistake.

Why valuation measures can be misleading

Now for a quick word on P/E ratios. The S&P 500’s P/E ratio is currently above 18, so the current price of the S&P 500 is based on 18 times its per-share earnings. This may sound like a lot, but in this era of stock buy backs and M&A activity the P/E ratio can easily be driven higher by factors that don’t necessarily mean a stock is over-valued.

The Donald and his message of hope (for the markets)

Thus, just because the RSI is above 80, P/E ratios are sky high and the Fed Fund Futures market is pricing in a large chance of a rate hike from the Federal Reserve this month, this does not mean that the stock market rally is about to end. The market loves certainty, but, as we have found out since November, it also loves hope. Donald Trump may be an unlikely bearer of a message of hope, but the markets are thriving on it right now.

Trump’s performance on Tuesday when he addressed Congress for the first time may have been short on detail, but his tone ended up being more important than any fiscal pledge. As we mentioned in the run-up to the speech, this address was merely a Presidential laundry list. Whether or not he gets what he wants will depend on Congress. His “Presidential” tone on Tuesday was seen by some as a way to win more Republicans to his side, hence no inflammatory talk about protectionism or immigration bans. So, far, there have been no signs that Republicans will get in his way, so the market is assuming that a large tax cut and spending programme will be delivered in the coming months. Trump’s message of hope is dominating financial markets once again.

Evidence Trump is driving this rally:

Why do we know that Trump is driving this rally? Financials, energy and materials were the top performing sectors on Wednesday, while utilities- the ultimate safe haven – was the weakest performer. These three sectors are thriving on the back of hope that President Trump can boost their prospects through de-regulation and fiscal spending.

The Fed: the punchbowl stays

Not even a Fed rate cut can stop this party. Even if a hike does happen, a third rate hike in 10 years is not a sign that the Fed is taking away the punchbowl prematurely. In fact, a prospective rate hike from the Fed gives the market even more faith in the ‘Trumpflation’ trade, as it suggests that even the world’s most important central bank is taking notice. These factors, along with the lowest level of initial jobless claims since 1972, are giving rise to another optimistic start on Wall Street. The decline in volatility on Wednesday, and the hesitation in the 2-year Treasury yield to breach the key 1.3% level, is also helping to boost sentiment ahead of the US open on Thursday.

Back to November 2016?

To finish, the market rally won’t last forever, not even Trump can orchestrate that. However, it doesn’t look like it is over yet, and with stocks, bond yields and the dollar rallying once more in unison, this Thursday’s price action looks very much like November 2016 to me, so there could be further fuel in this risk rally.

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