Range Bound Markets Post 2016 Election – What’s Going On?

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Why are we stuck in the 2260 range?

Post election 2016, traders find themselves in a low volatility and range bound market. Here our traders talk about what is keeping the markets range bound and what we can expect to get out of the 2260 range; how do we resolve and in what direction?

Full Transcript:

Good morning SizeTraders, how is it going? Amos here with Gary, head trader, at SizeTrade. As you probably all know, the markets have been rage bound for quite some time now with low trading volatility. So Gary, I wanted to ask you what is your take on this? What’s going on right now? Why are we in such a tight range? When do you think we’re going to break out of this?

Hey SizeTradors! Just wanted to touch base with you guys while the markets are so slow here and kind of break down what is going down with the market because they are acting a little bit unusual. They’re really range bound. We’ve been in a 10 days consolidation range when the market is closed in the 2260 level. Every single day, there has been false breakouts and false breakdowns so I just wanted to touch base on what I think is going on, what I think is going to happen long term and when I think this low volatility situation is going to resolve itself.

So firstly, let’s talk about the reasons why we’re in this low volatility area. We just had this major election upset with Donald Trump and the market had to readjust itself for that resolve. So basically what ended happening, when the market realized that Donald Trump would have the house in the Senate, he put together and said, what are the republican’s and Donald Trump’s agenda to do. His first agenda was infrastructure. He spoke about that one the day he won the election and that’s seen as positive for the overall economy and GDP because people are talking up to one trillion dollars stimulus over the next two years, which they already have projects that will come into the infrastructure. So that was immediately priced in on the day of the election when the results were given. The market was down around a thousand points overnight and reversed when he gave a speech talking about infrastructure to become positive.

Secondly, we looked into tax reforms. Right now the markets are pricing a high probability that he’s going to do a quick tax reforms for corporations at least. Lowering corporate tax rates to make then more competitive with the rest of the world. A 5% to 10% drop in corporate tax rates or effective corporate tax rates should increase bottom line earnings by 5% this year, 5% next year and so on. So once we start pressing in these new scenarios, we start seeing that earnings per share should actually rise. The problem with this scenario is that nothing has been written out yet. Nothing has been enacted onto law and nobody knows how long it’s going to take.

So, currently, the earning per share are trading at a level consistent with the fact that we don’t have new corporate tax rates and that there’s no infrastructure package. So the market, based on that, is looking very expensive because it’s using a model that analysts don’t know how to properly predict in the future. So they’re not raising estimates for the year, but they’re saying that estimates are most likely conservative.
If you look at it in a historical PE ratio, the market is trading at a very high multiple and is higher than would make sense historically or would be called faire value. Now in the other hand, the market has priced in a high probability that all this stuff is going to get done and get done quickly. So, the market ran up at the election; I believe it’s an 11 or 12 percent and basically is stalled here because the market is pricing at a high probability, around 80% chance, of getting tax reform and an infrastructure build through, but unfortunately, it can’t continue to go higher to that extra 20% until enacted into law.

On the other hand, it’s not going to go higher either because corporate earnings are still low since it’s not incorporating the potential of a corporate tax rate. So what’s happening is that the market is too expensive to continue to go higher without anything being done by congress and the president. However, it won’t go down because there’s still a higher probability of these corporate tax reform and infrastructure projects being built in. So nobody want to short the market because if that’s announced, you’re going to see the market pop a little higher and nobody want necessarily to get long the market because it’s really expensive and there’s a high probability priced in already that these things will get done.

So basically, the two weeks leading to inauguration, the market began to stall and stay in the 2260 level, where you have basically a fight between the bulls and the bears. The bears are saying everything is priced in and it’s going to take longer than you expect. The democrats have fewer than 60 votes in the senate so, unless they can pass some parts of the budget through and that democrats are on board, they might block or filibuster it. On the other hand, if you cut taxes and rise spending, the fiscally responsible republicans who ran on the Tea Party concept are going to have an issue getting that through. So now, we are getting to the point where people are actually taking a look and really trying to come down to when these laws are going to be enacted and when these bills are going to get passed. I think that the bears are betting that either they’re going to take longer than expected or are not going to be as powerful or potent as the bulls are pricing in. There’s also a negative side of Donald Trump that markets are kind of looking at which is all of this protectionism and free-trade battles that he’s about to enact.

Sorry Gary if I can interrupt you for a second. How do you think all the trade deals that he wants to sign or get rid of are going to be priced in the market?

Yes, I think the market is over-looking that personally. I don’t know when the market is going to take a look at it. I think he has made it pretty clear on his agenda that renegotiating some of the Free Trade deals particularly NAFTA, the North American Free Trade Agreement with Mexico and Canada is going to be one of his first things he wants to do. The question is, how does it play out? What kind of tariffs does he put on? How does that affect corporate earnings? We’ve heard a lot about companies wanting to stop developing plans in Mexico and create jobs here. He’s talking about that it is great for headlines and mainstream, but on a more bigger macro level, a thousand jobs here and there is not going to affect overall employment and wages in the United States.
My personal opinion is that a renegotiation of some of the Free-Trades agreements will be good long term for America. It’ll bring back jobs to America. It will hurt corporate earnings so in the near term, you’re probably going to see some corporate earnings being affected. However, in the long term, it’s going to push wages higher and create innovations as wages go up. One of the reasons why robotics has been innovating in a slower past then we’ve seen in the past with new technologies is because there is no need for it. As jobs go to China and Mexico and wages there are around $2 to $3 per hour, big spending innovation into robotics doesn’t make sense because it’s too cheap for labour.

If you start bringing those jobs back to the US, when the unemployment rate is at 4.7%, even though minimum wage will go up and it’ll stay around 10$/h, the lack of labour will push up the price of wages. So as wages start going to $12 to $15 per hours versus what they’re being paid for in Mexico and China, you’re going to see companies starting to invest much more money into the innovation of robotic to figure out how to decrease the wage aspect. Now since the average wage goes from $3 to $15, it makes sense for companies to do that. On the company side, yes, the earnings will get affected, but wages for the majority of US companies don’t make a huge portion of their margins and what will happen is if you do get a corporate tax pre-cut, it’ll probably be beneficial to corporate earnings.

So basically what is happening is that because all of these unknowns are in the air, you don’t know how to price future earnings.

So Gary, the major competing factor here is corporate tax cuts versus what’s going to happen with these trade deals?

I think so. I think that at the end of the day, the market cares about earnings and growth rate, right? So, if the earning’s picture could stay stable, then we are probably over priced. If the earning’s picture can increase because we have GDP growth because of an infrastructure project, which will create more spending, which will trickle down into the corporation, which should trickle down to salaries because you need to hire more people due to the fact that now you have more demand for you product.

So that should create a better GDP growth rate, which has a very good correlation with earnings growth rate. So if you take everything stable and we grow at 2%, which is roughly what we’ve been doing for the last couple of years, and you don’t get any hiccups or recession, you’re probably going to be around $120, give or take for S&P 500 earnings by the end of the year. So that’s your base case. So now traders and money managers are starting to price in different aspects. The aspect is that if we can get in an infrastructure package past through quickly and it’s a big one, then maybe we’re going to see an increase from 2% to closer to 3% in the GDP for the second part of the year. This should increase earnings per share growth rate and you’d go from $120 to closer to $130 per share on the S&P 500.

Then, you have the potential of corporate tax rate cuts, which would right away help bottom line earnings as if they’re playing an effect of about 30% and you get it down to an effective rate of about 20%. That increases your growth margin by 10% without really doing much. So if you could increase 10%, you would go from $120 to $130 right away because there’s so real cost when you get that type of benefit. Then, there’s also the speak of potentially repatriating money from overseas. We have, I believe, a trillion dollars of US corporate earnings overseas that haven’t paid taxes on. If you could bring that in at a lower tax rate or convince the companies to bring it in into an infrastructure build where they have to tie up the money for five years, but give it to the government at a very low interest rate, like 0%. Basically all of these things need to prices into earnings.

Now, the negatives are that you have a potential Free-Trade agreement that is going to cut. You have a potential trade war with China. A lot of US corporations have pushed globalization and moved a lot of wages and employees over seas because of how US policy has been over the last 15 to 20 years. Now, they’re going to have to be able to bring that back effectively, efficiently and quickly if Trump acts on it and makes it difficult for these companies to use workers overseas. How does that negatively affect earnings per share? So you kind of have to put it all into a formula and come up with a number. I believe that at $120 to $130, the market is probably overpriced here. Between $130 and $140, it’s probably fair value. I think that’s where people are probably taking a look at it. They’re probably looking at $130 to E140 earnings. Then, you have people who are very optimistic and are looking at $140 to $150 of earnings.

That’s basically what’s going on right now. We have this big fight and usually, fights happen all the time on a lower level when you have basically how much is growth rate going to go this year? We typically take a look at interest rates to see how that’s going to affect the market. Then, we can say that we’ll grow, 1.5%, 2.5% or 3.5%. You can base off earnings per share on that and some people can be a bit more optimistic and some people can be a bit more pessimistic. That’s how the market moves. You have the bears who say the market is overvalued because people are not pricing in the negative effects into the market that are going to hurt earnings per share. Then you have the optimistic that say that everything is great and that we are underestimating because the companies typically do better, we have buy-backs etc. This all passively could affect our earnings and earnings could be higher. Then, basically, the market decides who believe in what numbers more, puts a faire estimate on it based on the growth estimates and says what we believe a faire estimate is of the market. The market typically trades are on there until we get more news. It’s easier to predict so the market doesn’t have these hiccups like it does right now.

Right now the biggest take-up is that we don’t know how long these speculated moves are going to take and if they’re going to be passed.

So, inauguration was just this past Friday and what you’re saying is that we’re kind of in a holding pattern at this point?

I think we’re coming to the end of that holding pattern because I think we’re going to see how quickly he’s able to move and how well the senate and congress are going to have his back. So, we’re kind of waiting and seeing. I think everyday that passes by that we don’t get any type of sign that infrastructure project or some type of reform taxes is a negative for the market and I think that the markets were expecting it to happen pretty quickly. There were even rumours that it would happen last Friday on inauguration day. I think that’s why the markets swooped when he spoke; they were hoping that would talk a little bit about infrastructures and taxes. I think when he didn’t speak about that in his inauguration speech, the market took a dive and when down around half a percent and then, later on, rebounded. I think that every day that passes buy that he doesn’t talk about infrastructure, corporate rate taxes, that the senate doesn’t move on that, will make the bulls who are pricing it at 70% to 80% chance of this stuff getting done relatively quickly, get cautious and taking a lot of their profit.

On the other hand, if he does start talking about it, that it seams to be a part of his agenda, and we see now that he has the back of the republicans at least and the democrats are okay with at least some portions of it and we feel like he could actually get it through, the market is going to start pricing that other 20% to 30% that’s off the table because the market is a 70% to 80% chance that this stuff gets done. So, people are reticent to get short too much here because they know that there’s, at least, one leg higher if he starts talking about this stuff and they can get really hurt. I think the bulls are reticent to buy more and they wouldn’t buy the pullback because I think that no matter what, they’re optimistic about the future with Donald Trump and some of his policies. However, I think they also understand that if stuff doesn’t get done quickly, the market is a bit overpriced. So, they’re not necessarily buying right now.

The longer it takes to do it, I think some of the weaker longs are going to start getting nervous and start selling especially if the market drops a little and you have someone who got involved at 2250 or 2260 level here for that last leg up, that little breakout. If the market drops at 2230 or 2240, you might see acceleration from does guys who want to get out and say: ‘’Hey, I want to take a small loss and get out’’. I don’t think some of the long-term guys will sell but I think they might wait for a better buying opportunity. I think that they know that the market is a bit expensive here. I think that in their opinion, earnings per share are probably going to go up no matter what. The question is to what degree. Like I said, is it $120 to $130 or is it 130$ to $140 or is it $140 to $150. Obliviously, you have the people who don’t care what happens and are going to say the market is going to go up because earnings are going to be $150 or $145 no matter what. The bearish people who says that we are going into recession and the US dollar is strong, this is bad for US manufacturing, the Free-Trade agreements are really what Trump is going to look into and that is going to negative for corporate earnings in the short-term at least. Wages are going to go up and that’s going to force the Federal Reserve to raise interest rates at a faster trajectory than the market’s pricing in.

So you have both of those sides, which we call prober-bulls and prober-bears, which are always bearish or always bullish, but within 80% of the market, I think the majority of those people think that earnings per share are going to go up this year. Are they right or wrong? Who knows, but that’s the feeling. The market is always right until it’s not. So, basically, you could be right and say we are going into recession at the end of the year, but the market still could go much higher before the rest of the street catches up to that. So I feel like the majority of the people of the street right now think the earnings per share should go up. Question is at to what degree will they go up and so on. So, I think that at any pullback, you’re probably going to get some type of floor where these buyers are going to come in.

Now, that can all change if we get some retiring from Trump, the congress and senate, which shows that maybe this tax reform will be a little hard to get and maybe it’s not going to as positive as we first expected. The filibuster is still there and it’s going to be interesting to see how many democrats cross the isle with Donald Trump. You know, Donald Trump is seen as the villain is the left liberal side of the country. So even if some democrats might agree that we need a spending bill and that it’s okay to lower corporates taxes to get it, I’m not quite sure that they’ll agree to vote with Trump kind of like what the Tea-Party did with Obama where their idea was that whether they liked it or not, to vote against it.

Again, the republicans have this nuclear option, which is called conjuncture, and allows the republicans to pass stuff with 51 votes. The problem is that, by using the nuclear option and killing the filibuster, you can’t put them back later. So if later on, you have a democratic president, a democratic house and a democratic senate, that gives the opposition, in this case the democrats but in that case it would be the republicans, the inability to stop anything. One of the reasons why the republicans were so successful at stopping a lot of Obama’s legislations was because they had the filibuster and were willing to use it. The democrats decided not to use conjunction and basically, Harry Reed, which was the head of the majority leader, decided that it was better to get some republicans over the isle, which at the end of the day, never happened because the republicans hated Obama so much.

Now, you have quite the opposite with Trump being the villain and we’re going to have to see how this all plays out. My personal feel is that when we do resolve, we’re going to resolve to the downside right now. I’m not saying that a masse crash is coming. I’m saying that the market has gotten a little bit ahead of itself. The Pe ratio is really high right now on a historical basis and they’re pricing on a lot of positives and not looking at a lot of the negatives at this point.

Gary, thank you so much for your time. For all SizeTrador subscribers, we’ll keep you updated. Until next time, this is Amos with Gary, head trader at SizeTrade.com. Thanks so much Gary.

Thanks a lot Amos. Have a great day.

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