Fundamentals or euphoria? Both fueled post-election stock surge

On Tuesday, as debate on the American Health Care Act (AHCA) health care bill was heating up, the S&P 500 fell by more than 1 percent for the first time since October 2016.

This market decline shattered a historically abnormal calm which coincided with the very strong stock rally since President Donald Trump’s election. Some wonder how much the market has to fear from politics and the Trump administration.

{mosads}It is commonly accepted among most professional investors that, over the long run, stock returns should reflect the earnings growth of the underlying companies. The short run is much more difficult to predict as many factors come into play, including both fundamental factors that could affect the long-term earnings power of the companies and human emotion that is, at its extremes, called the “madness of crowds.”

It is fair to note that political decisions have the ability to affect both elements for better or worse. For example, a corporate tax cut could increase the after-tax earnings of most companies and hence could affect the long-term earnings outlook.

Alternatively, fear of government action (or inaction) might cause market participants to assume earnings will be lower in the future even though this may never come to pass.

History does seem to indicate that there is reason to be wary of increased volatility at the start of a new administration. Looking at S&P 500 returns following the election of a new president, going all the way back to Herbert Hoover in 1929, stock returns in the February following a presidential election averaged -4 percent.

Why would returns be negative in eight out of 11 instances? Let’s be clear that, statistically, this could just be noise, but it is certainly reasonable to posit that the reality of governing and passing actual legislation does often catch up with the larger positive expectations following an election.

For presidential scholars, I must note that both Hoover and Franklin D. Roosevelt were not inaugurated until March, but I believe our hypothesis is still reasonable. Certainly the market weakness on March 21 was attributed to worries that the energy spent on the health care bill may delay or sideline some of the more pro-growth policies of the Trump administration like tax reform and deregulation.

In analyzing our current situation, it makes sense to consider how much of the market returns since the election were in anticipation of pro-growth policies, like corporate tax cuts, versus what can be attributed to other fundamental drivers that are not at the mercy of Washington.

One of my favorite economic indicators is the Institute for Supply Management™ (ISM) Manufacturing Index. The ISM Manufacturing PMI gives a monthly snapshot of economic strength rather than waiting for the quarterly GDP data. A PMI reading above 50 is viewed positively, while a reading below 50 is a reason for concern.

The U.S. PMI stood at 52.0 in October, before the election and hit 57.7 in February. A large move like this has only occurred 12 times since 1970 and every time it has been accompanied by positive market returns, according to an analysis by Empirical Research Partners.

So while the S&P 500 has gained about 10 percent since the election, fundamental drivers seem to account for a good portion of those returns rather than the rise being propelled solely by the euphoria surrounding the anticipated tax cuts or other pro-growth policies.

This is not to suggest that some part of those expectations of a corporate tax cut are not priced into the market; we would anticipate stock weakness if those possible changes were called further into question. In addition, the S&P 500 has now gone over three times longer than normal without a 5 percent pullback; investors should be mindful that these declines are normal and are certain to come eventually.

The Trump administration has signaled that, win or lose on the AHCA, the top priority is their economic growth agenda, including tax reform, which should provide salve to the markets. In the end, we believe that most investors would do well to generally ignore the political noise, along with any additional volatility, and focus on the long term.

We think a well-planned investment strategy, tailored to the needs and risks of the individual, remains the best roadmap for superior long-term performance. Political vagaries do not alter this advice.

As Warren Buffett, paraphrasing Benjamin Graham, stated in his 1993 shareholder letter: “In the short-run, the market is a voting machine — reflecting a voter-registration test that requires only money, not intelligence or emotional stability — but in the long-run, the market is a weighing machine.”

Bill Stone is the Chief Investment Strategist for PNC Asset Management Group.

The views expressed by contributors are their own and not the views of The Hill.