May 19, 2017

Stocks recovered a bit of Wednesday’s 2% selloff as some of the more extreme talk in Washington (i.e. even whispers of impeachment) died down.

Let me start by putting Wednesday’s news and the subsequent market reaction into perspective.  First, I am not a lawyer, but I do recognize the facts.  Under the Constitution, the House indicts via impeachment and the Senate confirms.  We may not know all the facts yet, but there is no way we are anywhere near the point where a Republican controlled House is going to even consider the thought.  President Trump may be his own worst enemy and would be well served to find the mute button on his cell phone, but trying to make comparisons between this year’s events and Watergate are, at best, premature.  Now that a special counsel has been appointed, look for a lot of the near term commotion to die down a bit (unless, of course, the President keeps stirring the pot).  There are at least three investigations now ongoing, one in the House, one in the Senate and one at the FBI.  The special counsel will work to coordinate the three while beginning its own investigation.  What is not needed right now are a lot of public hearings that contaminate evidence.  Those can come in time.  If, for instance, Michael Flynn would be willing to talk privately to the special counsel, nothing would be gained by forcing him into an open Congressional forum under subpoena.  Simply said, look for the high profile clashes to be set aside until order is restored.  That will probably be good for everyone, and that might even include the financial markets.  President Trump is headed to Saudi Arabia where he is likely to announce a series of deals (arms for the Saudis; infrastructure funding for us) that will also reset the agenda, again good for markets.

As for the markets themselves, let us all remember that they don’t like sudden surprises.  I am not sure why the news this week was much more disarming than any other malapropisms of the past three months, but markets certainly acted like they were.  One must also remember that leading averages were up 10-15%, almost in a straight line, since the election and a pause was probably due to come anyway.  Before Wednesday’s drop, breadth had declined noticeably.  Most of the record gains for the leading averages were concentrated in a handful of high profile stocks.  The transportation averages, often looked at as a leading indicator for the rest of the market, have been rolling over and were in a short term declining pattern even before Wednesday’s big drop.

In other words, for all the headline news out of Washington, Wednesday’s decline shouldn’t be taken to mean anything more than the recent rally had sapped markets of their buying power, and it is time for some correction.  It wouldn’t be illogical for stocks to give up about half of their November-early May gains, the old two steps forward, one step back pattern.  That doesn’t mean markets are headed exactly for a 5-7% correction.  They rarely act exactly according to traditional historic patterns.  But a correction wouldn’t be a surprise.  With that said, many investors have been waiting and waiting for a correction that never came, missing out on some pretty good opportunities.  What this all suggests to long term investors is the following:

  1. Stick to your asset allocation. If you are overweighted in equities because of recent gains, readjust.  If you are sitting on too much cash, don’t let Wednesday’s dip worry you.  Take advantage.
  2. If we are headed for more volatility (hard to see how we might be headed for less), don’t try and pick exact tops or bottoms. If you like a stock, buy some now, but you don’t have to buy a full position.
  3. Nothing in this week’s price action suggests any rotation of leadership. On days that markets rise or fall sharply, traders buy and sell the most volatile names.  When volatility dies down, they buy their best values.
  4. The political mess has weakened the dollar. The dollar was already weak in Q1 and U.S. growth rates trailed those of Europe and other leading nations.  The dollar may rally a bit off of Wednesday’s lows, but if you are looking for dollar strength to resume, that requires better economic numbers here.  In the short term, nothing Washington does will improve our growth rate.

One prominent media headline explaining market weakness on Wednesday, is that all the political commotion was condemning the Republican fiscal agenda to the graveyard.  There is no way to connect those dots.  If anything, the House Ways and Means Committee and the Senate Finance Committee are going to become more focused on trying to move their agendas forward. They very much want to divert attention back to the fiscal agenda.  That is why, for instance, you saw Ways and Means Chairman Kevin Brady on several news shows yesterday.

With that said, Republicans have a difficult task ahead.  Let me start with healthcare.  President Obama passed Obamacare where he essentially inflated Federal support for Medicaid by roughly $1 trillion over 10 years in order to get as many of the 40+million uninsured Americans as possible onto the insurance rolls, paying for it via large tax increases.  House Republicans, pressed mostly by the right wing, essentially voted to undo all of the above, reducing Medicaid support and reversing the tax hikes.  The Senate, being both more moderate and more deliberative, are going to write their own version of healthcare reform.  With 52 Republicans and the near certainty of no Democratic support, Leader McConnell must bring forth a compromise bill acceptable to Senators Susan Collins and Rand Paul.  Ms. Collins isn’t the only Senate moderate, and Mr. Paul is not the only conservative.  In other words, the Senate has to find a common ground that moves far enough toward reducing Medicaid support without neutering the positives of Obamacare that moderates want to retain.  Then, assuming that can be done, the House Freedom Caucus members have to choose between half a loaf or no loaf at all.  If they wish to stand on principal, as they have for years, and insist on a whole loaf or nothing at all, we will almost certainly end up right where we started and Obamacare, for all its flaws will be the law of the land.  In that case, every incumbent, both Republicans and Democrats will own what is left and that will include a healthcare framework where few, if any insurers, will offer coverage at any price to those not covered by group plans.  This dilemma hardly changes with the political circus we are all witnessing this week.

After healthcare reform comes tax reform.  The safest bet at the moment is that unless Republicans can complete an acceptable healthcare reform package, tax reform’s best chance would be for a very watered down and simplified package that might include repatriation of overseas income at a reduced tax rate, some small infrastructure package, and a very modest reduction in the corporate tax rate.  Everything else would have to wait until after the 2018 elections.  Should Republicans retain both chambers of Congress, perhaps more substantive tax reform could follow.

What does all this mean to markets?  As I have said so many times, equity prices are a function of earnings and interest rates.  Earnings are up and better than expected.  Interest rates are down and lower than expected.  Hence a good stock market.  It’s that simple.  If anything in the news is about to change any of that, then I will have to adjust what I just said.  Earnings, going forward, appear solid.  The current dollar weakness will only help the earnings of multi-nationals and will only serve to improve our trade balance.

I know it is hard to not let politics creep into your investment thinking.  Regardless of one’s political leanings, it is hard not to be frustrated by President Trump’s inability to adjust to the political way of life.  While the media makes mountains out of ant hills, keep focused on the economic agenda.  Even if nothing substantive passes Congress, which was probable even before this week’s distractions, reducing regulations and a more business friendly tone in the capital helps.  Improving earnings overseas help as well.  This is still an intact bull market where dips should be bought within the context of maintaining one’s asset allocation.

Today, Sam Smith is 25.  Archie Manning is 68.  Grace Jones turns 69.  Pete Townsend is 72.

James M. Meyer, CFA 610-260-2220

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