Speculative Blow-Offs In Stock Markets

Defying Expectations

Why is the stock market seemingly so utterly oblivious to the potential dangers and in some respects quite obvious fundamental problems the global economy faces? Why in particular does this happen at a time when valuations are already extremely stretched? Questions along these lines are raised increasingly often by our correspondents lately. One could be smug about it and say “it’s all technical”, but there is more to it than that. It may not be rocket science, but there are a few issues that are probably not getting the attention they deserve.

The stock market has blown widespread expectations out of the water by embarking on a seemingly unstoppable rally since Donald Trump was elected POTUS.

Cartoon by Frank Hanley

As you can see below, we have marked “Brexit day” on the chart as well, which was another noteworthy juncture. Not only was the success of the “Leave” campaign just as big a surprise as Trump’s election victory, but it was yet another occasion on which the market ended up fooling most observers by dramatically reversing course after a mere two days of relatively mild panic selling.

DJIA, daily. Since the US presidential election, the stock market has rallied relentlessly, after breaking through a long-standing resistance level with ease. The move since then is increasingly looks like a blow-off rally, and we think that is precisely what it is – click to enlarge.

Not to belabor the obvious too much, but it is actually a hallmark of bull markets that they ignore any and all bad news. In fact, bad news quite often end up extending the lives of bull markets, not least because they help with sustaining a certain degree of skepticism among market participants. To be sure, at times that is not the only reason. In the “Brexit” case we have little doubt that the reaction of central banks to the outcome of the referendum played a big role in the market reversal.

We have discussed the market’s post-election performance before, but here is a reminder of how deeply ingrained the views about the likely effects of a Trump victory on the stock market were. As the probabilities shifted toward Trump winning on election night, DJIA futures intermittently fell by more than 900 points in Asian trade. Many Trump opponents felt compelled to remark on this without awaiting further developments.

Paul Krugman for instance made an especially ambitious forecast that was shredded within a few hours:

“It really does now look like President Donald J. Trump, and markets are plunging. When might we expect them to recover? […] I guess people want an answer: If the question is when markets will recover, a first-pass answer is never.”

Admittedly we like poking fun at Paul Krugman. That is however not the point here, the opportunity to pick on Krugman is merely an agreeable side effect. The point is that his comment is an excellent illustration of the expectations prevailing at the time. Our own forecast was by no means better – we did map out possible near term paths for the market depending on the election outcome, but none of these assigned a very high probability to a blow-off rally, even if the possibility was at the back of our mind some time ago already.

We have previously stated that we believe the overnight reassessment of the market’s prospects after the election was inter alia motivated by the Republican party’s “clean sweep”, i.e., the fact that in addition to its candidate becoming president, it managed to win majorities in the House and Senate as well. That made it more likely that Trump would be able to enact his economic policies and wouldn’t have to face a hostile Congress. That was likely the immediate trigger, but not the main driver of what has happened since then.

The Fundamental Driver of the Blow-Off Rally in Stocks

Stock prices have been driven to valuations that seemingly make little sense from a fundamental perspective. We believe the main culprit was way above-average money supply growth over the past eight years. What we are seeing now are partly its lagged effects; its pace actually remains quite brisk, but it has begun to slow down noticeably and that seems set to continue. The recent market action displays a number of characteristics typically associated with a final rally phase.