By Colin Cieszynski, Chief Market Strategist, CMC Markets
The US stock market has been on fire since Donald Trump was declared the election winner. A clear result unleashed a massive sigh of relief among traders and sparked a huge relief rally that has carried the Dow from near 17,500 almost up to the 20,000 big round number. This rally appears to be nearing exhaustion and US stocks look vulnerable as the reality of winter sets in.
US Post election performance
Historically, US stocks have been mixed in the months after a new Republican president has been elected for the first time. It’s not unusual for markets to be choppy and traders to be uncertain when a new President takes over with people uncertain how the new administration is going to govern and which promises will actually be kept.
The positive reaction to Donald Trump’s election has been particularly strong. The Dow industrials rose in both November and December, the first time that has happened for a first-term Republican since Eisenhower over sixty years ago. The last four Republicans saw November and December split between wins and losses.
Source: CMC Markets
The lower half of the table shows, however, that the strength of the recent rally may be leaving the market vulnerable to a correction. A look at the four times since 1950 that a US election was followed by two months of gains to end the year shows that in two cases (Eisenhower and Nixon) initial gains were then followed by three months of losses in the new year. The one exception to continue into the new hear was the Kennedy honeymoon. The one example from this century was split two months of losses, one month of gains following George W Bush’s re-election.
For Republicans two months of post-election gains have been followed by 1% plus average monthly losses to start the new year.
Why could we see a correction in early 2017?
There are a number of factors that could cause the current rally to come to an end and a correction unfold in early 2017
1) Trump has been priced to perfection
A lot of the big rally has been built on the hope that the incoming Trump Administration will be friendlier to business and that increased infrastructure spending will help to boost the economy, consumer spending and corporate earnings.
It’s not unusual for the market to rally on anticipation of something happening and then see profit-taking on the event. In this case, the trigger could be the January 20th inauguration when the market stops guessing what Trump may do and has to start reacting to what he actually does.
The rally has also been powered by the assumption that with the Republicans in control of Congress, that they will be able to push through major initiatives quickly and without much opposition.
At this point, the market is still in the honeymoon stage and has forgotten the realities of governing. The market has assumed that the US can do whatever without any pushback from other countries, negative repercussions from their actions. Any bumps in the road, delays, or unintended consequences could quickly upset the apple cart.
2) US Dollar impact on earnings results and guidance
The most immediate unintended consequence that could impact stocks in 2017 is that the Trump election has sparked a huge rally in the US Dollar driven by speculation of a more hawkish Fed going forward.
The problem with this is that the negative consequences of a higher US Dollar on US exports and corporate earnings is likely to hit quickly while the positive impact of regulation/taxation changes and infrastructure spending may not arrive until late 2017 or even 2018 by the time budgets are passed and money works its way through the system.
A year ago, US corporations were whining about the high Dollar and the Dollar Index is higher now than it was a year ago. The upcoming earnings season which starts in January could see a lot of US companies cutting guidance due to the higher dollar.
3) Year-end Capital inflows winding down
Another major factor that drove the market higher was a rush to get capital into the market before year end. A lot of cash had been parked on the sidelines due to election uncertainty which was unleashed by the result. This turned into a bigger scramble when the market rallied and asset managers realized it would look really bad if the market went up 10% on the year and they underperformed because they were sitting on mountains of cash.
At the same time, individual investors were pouring near record amounts of cash into equity funds which also needed to be put to work in the markets.
This created an unusually strong demand for stocks before year end which could slow in January before retirement account deposits pick up in February and March.
4) Dow 20,000 round number effect
Once the Dow decisively cleared 19,000 it rallied straight toward 20,000 as though it had been caught in a tractor beam and was being drawn in. Now that 20,000 has been pretty much achieved, it appears that momentum traders have been taking money off the table.
Back in 1995-1996, the Dow took a big run at 5,000 then spent the next year consolidating the move between 5,000 and 6,000.
In 1999, the Dow passed 10,000 and drove toward 11,500 in early 2000 then traded in that range for most of 2000-2001 then 2004-2006 with a bear market in between.
The point is that while the Dow may clear 20,000 it may not get too much farther relative to how far it has already come and could be setting up for a bear market or a sideways trend that could last a year or two.
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