By Peter M. Lupoff
Hyperbole may be the “new normal” in political discourse. Fake news, exacerbated by our beloved gadgets, is an emerging factor driving popular opinion. The investment community and market pundits still smarting from missing the signs leading up to Brexit and Donald Trump’s victory were looking to understand the equity markets rally post-election when they read this Christmas tweet from then-President-elect Trump: “The world was gloomy before I won – there was no hope. Now the market is up nearly 10% and Christmas spending is over a trillion dollars!” Many market strategists and business news media have accepted the idea that Trump’s win caused recent equity market performance and are running with it.
For market participants, understanding the drivers of the year-end stock market rally is valuable in considering the possible outcomes going forward. If, for example, it is plausible that the market’s year-end climb was more about economic factors and less about a Trump victory, then it may be the case that markets will be more buoyant in the face of the new administration’s inevitable pivots, capitulation, or delays. Alternatively, any pullback in U.S. equities on such political “disappointment” may portend attractive entry points into a market that may continue its ascent despite the person in office.
U.S. equity markets’ outperformance in the fourth quarter in 2016 appears to be largely a consequence of 1) robust U.S. corporate earnings, 2) the financial sector’s rise as impacted by rising interest rates, and 3) oil stocks, with their outperformance driven by the 20 percent increase in the price of a barrel of oil. None of these factors were influenced by the presidential election results.
It is my view that the U.S. stock market rally was chiefly a function of U.S. corporate earnings reported around the time of the presidential election. Third-quarter reporting was in full gear the last two weeks of October and through November—the same time that U.S. election developments dominated our attention. Increased election uncertainty more than offset a strong quarter for company earnings (often discussed by market participants as company earnings divided by total company shares, or earnings per share, “EPS”). To put it into perspective, S&P 500 earnings jumped 6 percent quarter-on-quarter in the third quarter to solidly break out of the flat-to-down trend in place since 2014. The S&P 500 Index revisions were also less negative through third-quarter reporting and turned positive the last two weeks, led by financials. It would appear to me that a 3.3 percent S&P 500 rally in the fourth quarter is justified by the 6 percent rise in U.S. corporate third-quarter earnings.
Third-quarter EPS rose to an all-time high, supporting a fourth-quarter rally. Source: Factset
Of the 4.6 percent S&P rally from Election Day through the end of 2016, the financials sector was responsible for nearly half of it—2.2 percent of the move. In my view, the relative outperformance of financials reflects the broader rise in interest rates. Industrials accounted for about 15 percent of the S&P rally, followed by energy at 13 percent. Oil prices are about 20 percent higher since the U.S. election, underpinning the 9 percent rally in the energy sector. Those three sectors accounted for nearly 80 percent of the total rally, with the other eight sectors contributing just 1 percent to the S&P rally since the election.
The weightings by industry in the S&P 500 Index change as the market values of the constituent industries change. At year-end 2016, the industry weightings looked like this:
Source: Standard & Poors
Financials, considered together as an industry for the Index’s purposes, include banks, insurance companies, and other financial services organizations. (The S&P 500 Index Financials Industry’s largest 5 constituents are Berkshire Hathaway, JP Morgan Chase, Wells Fargo, Bank of America, and Citibank.) These organizations are the greatest beneficiaries of rising interest rates, as their profit margins rise as interest rates rise. Energy and financials combined comprise about 22 percent of the Index.
The sector composition of the equity rally outside the U.S. is even more pronounced. In a recent research piece, Barclays noted that financials accounted for 60 percent of the rally in the ACWI, the global markets index. Adding in energy and industrials would explain 93 percent of the global equity rally. Financials were clearly the largest sector contributor to global equity markets returns worldwide. It would take some creativity to construct a theory for how the U.S. presidential election impacted financial sector outperformance worldwide.
With oil prices up 20 percent since the election, U.S. energy stocks were up 9 percent through year-end. The historical correlation between oil prices and energy stock performance would, in this case, be difficult to associate with an independent event like the election. As with financials, energy was also a key component to global equities gains in the fourth quarter, and not just in the U.S.
Energy sector performance and oil prices. Source: Datastream
With the Federal Reserve comfortable that the U.S. economy is on firm footing, Fed tightening commencing in December had been considered market participants’ base case, and rising rates were expected to be a near-term consequence. The combination of the imminence of rate hikes in the U.S. and the expected costs of both presidential candidates’ stated initiatives helped drive the 10-year U.S. treasury bond rate from 1.40 percent pre-election to over 2.50 percent.
Financials accounted for half the post-election rally. Source: Barclays Research
… And financials outperformance tracked rates. Source: Haver Analytics
Financials’ outperformance is logically in line with the increase in U.S. interest rates. Rates rose largely as a consequence of the very well telegraphed intention of the Fed to raise rates starting in December (and likely twice more in 2017).
A gentle rise in rates has historically been good for equity markets, in part because it suggests the Fed is comfortable with the underlying strength of the U.S. economy as borne out by recent data presented by both the Bureau of Economic Affairs and the Federal Reserve Bank.
There are historical data (rear-view mirror driving, but data nonetheless) that suggest that while rate hikes have led to greater volatility in equity markets, they have not marked the end of equity bull markets. On average, six months after the first rate rise, equities have risen 3.7 percent, according to research generated by Credit Suisse in 2014. In fact, Credit Suisse found that after three of the four monetary policy turning points they studied, within 18 months, the S&P 500 rose by at least 10 percent from its initial level when rates rose (with the S&P gaining around 10 percent in just one month following a rate rise in 1986). The one exception was 1977, when it took two years to achieve a 10 percent gain.
Equities tend to continue to make gains post-Fed rate increases. Source: Thomson Reuters
In the end, the prospect that U.S. equity markets outperformed in the fourth quarter due to U.S. economic strength, rising rates driving the equity securities of financials higher, and oil prices driving energy stocks up provides an alternative explanation to the knee-jerk explanation you might hear from investment professionals or financial media pundits suggesting this was a “Trump rally.” Rationally recognizing the plausibility that Trump’s win and the markets’ rally were coincidental can help us properly weigh all the factors that contribute to market outperformance and underperformance. To the extent we can “get it right,” we can better situate ourselves to see the clues that lead to better, more flexible, and more dynamic economic, political, and investment decisions … which would be Yuge.
Peter M. Lupoff is a fellow at World Policy Institute.