January 23, 2017

Stocks posted healthy gains on Friday as Donald Trump was inaugurated as the 45th President of the United States.

Over the weekend, once again most of the attention was on the Trump persona as opposed to issues and facts that might be market moving.  In typical Trump fashion, the focus quickly turned to minutia such as inauguration head counts, and the veracity of comments both he and the media have made in the past few days.  It is hard not to get distracted.  We can expect a rash of executive orders this week, some likely controversial.  But few are expected to have any immediate economic impact.  Actions that will likely move the economic needle mostly require Congressional approval.

Meanwhile, earnings season continues and results to date have had a positive tone.  Economic data has supported a positive point of view and has been reflected by a bounce in long term interest rates.  Most of the major banks reported solid results with good loan growth.  Bellwethers like GE# and IBM# reported results roughly in line with expectations.  But few companies so far have exceeded forecasts to the extent that investors had to raise earnings estimates.  As a result, stocks continue to trade within a narrow range.  In the end, it is earnings, earnings expectations and interest rates that matter to the market and not media nonsense about inauguration crowd size.

With that said, this week will be important as we watch initial policy action in Washington.  While it would seem that with Republicans in control of the White House and both chambers of Congress, the party has the ability to dominate and control the political agenda.  On the surface that is true, but it also presupposes that Republicans can or will act as a unified whole.  History shows that when one party controls both the White House and Congress that is not necessarily the case.  Two of the biggest items dominating the agenda early on will be tax reform and the rewriting of ObamaCare.  Neither is as simple as the White House suggests.  One side of the agenda, cutting the top tax bracket and repealing ObamaCare, is relatively simple.  However, closing loopholes or generating offsetting revenue sources are key issues of tax reform and deciding how to replace ObamaCare could tie Congress up in knots, at least for a while.

What we will look for this week are three things.  First, what actual proposals will come out of the White House with regard to these two agenda items in particular?  Second, is there room for compromise?  And third, is the tone conducive to compromise?  President Trump’s Inaugural Address was dark and combative.  It left no prisoners, attacking Congress and Republicans and Democrats alike.  It was more similar to his campaign stump speeches than to past Inaugural Addresses.  While the Address was aimed at the public and not directly to Congress, in order to get legislation passed, the White House and Congress have to work together.  So far, all we have heard are words.  Lots of words.  This week, game time begins and the clock starts running.  Will there be shots fired across the bow as both sides stake out their positions or will the verbiage set the stage for compromise?  We don’t know yet.  What we have seen to date is the exact same Donald Trump we saw in the campaign.   If his combative statements go a bit too far, he and aides pull them back a bit.  Both sides are clearly going to have to learn how to react in a very new world.

It isn’t just Congress.  Later this week, Mr. Trump will meet with Great Britain’s Prime Minister Theresa May, the first foreign leader to visit the White House.  No allies over the years have been closer than the U.S. and Britain.  But Britain has its own populist movement underway as it seeks to exit the EU, and its relationship with us is going to either help or disrupt that process.  Ms. May has also expressed some concern with some of Mr. Trump’s statements and actions regarding women.  Whether they can be ameliorated or drive a wedge between the two is something to watch.  After all, these are two leaders who should logically be strong allies tied at the hip.  If Mr. Trump and Ms. May develop any tension between them right away, it wouldn’t be a very positive omen.

It might be easy to say that the relationship between these two leaders has little to do with earnings and interest rates and, thus, nothing to do with the stock market.  But that would be a short sighted conclusion.  Europe faces several very important events in 2017.  France has a series of important elections this spring.  Germany has elections in the fall.  Italy is a financial mess.   One only has to remember back to 2010 and 2011 to see what uncertainties in Europe can do to financial markets.  In 2011 ECB President Mario Draghi stepped in and said the ECB would stand behind the debt problems of member nations.  But this time, the euro itself might be in jeopardy as the UK seeks a clean break and should right wing leader Marine Le Pen win the race to be France’s new leader.  The U.S., should that happen, would no longer be a disinterested party.  Mr. Trump’s personal relationships with Ms. May, Angela Merkel and whoever wins in France will be an important ingredient that will impact Europe’s destiny.  Right now, given the stark change in Presidents in the U.S., we are the dominant focus.  We also possess the strongest economy.  But over the next few months, a new rhythm will evolve here just as change threatens to explode in Europe.  Unlike the U.S., Europe doesn’t have a strong economy, doesn’t have a strong currency, and, with Merkel under pressure at home, may not have strong leadership.

It could well be that stock markets peak early this year if the U.S. can’t move legislation forward early and turmoil increases in Europe.  It could also be that events in Washington move smoothly on the ground (allowing for plenty of Trump flash points with the media!) and Europe finds a steady path forward including a conservative win in France and a rather steady U.K. exit from the EU.  The uncertainties are what make 2017 so hard to predict.

But as I have stated often, bear markets, the kind that long term investors really need to be concerned about, develop because either equity prices are driven up way too far by massive exuberance or economic imbalances occur that cause a recession.  Neither is in place now and neither appears likely to be in place later this year.  European uncertainty may rise but it likely won’t be enough to derail our economy.  Markets are fully priced today but not so dramatically overpriced that a 20%+ correction is inevitable.

Instead, what I expect this year are periodic bouts of volatility that disrupt a market headed modestly higher.  P/E ratios tend to expand throughout a bull market until it rolls over into a bear market.  That usually requires a final, and sometimes lengthy, euphoric stage, one that hasn’t even begun.  That stage would contain an IPO boom and a wave of giant mergers.  In the meantime, markets will celebrate key legislative successes and despair over legislative gridlock.  They will celebrate calming events overseas and worry should populist extremists win high offices in key European nations.   I haven’t even mentioned the obvious world stages in the Middle East, Russia or Asia.

Earnings will rise and so will interest rates.  They represent two opposite pulls on stock prices, once again adding to the volatility.  Legislative moves will help some companies and hurt others. The same goes for regulatory changes.  This may be the first year in many where equity performance by sector will be quite divergent.

Obviously, this is going to be a year of change, one that may force most of us to be more active within our portfolios.  With so much uncertainty, there isn’t a whole lot to do now other than to watch and react.  Markets have already priced up banks and beaten up healthcare names.  We can’t look back; we have to look forward.  This week will give us a few clues.  Those clues will pile up quickly in the weeks ahead, and then we can react with more certainty.  It’s the big changes that matter, not the waves of noise.  With Trump the noise levels will be persistently high; that’s one truth I can almost guarantee.  Our job is to resist the temptation to react to irrelevant noise like headcounts, and focus on what really matters.  The path of legislation matters.  Key regulatory moves matter.  Europe matters.  Chinese growth and its ability to handle an immense debt load matters.  It is going to be hard to stay focused.

Today, Mariska Hargitay is 53.  Pilot Chesley Sullenberger is 66.  Richard Dean Anderson, the original MacGyver, is 67.

James M. Meyer, CFA 610-260-2220

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