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Index Month / Year to Date
Dow Jones -0.36%/+11.39%
S&P 500 +0.05%/+10.69%
10-yr Treasury 2.29% yield at the end of July and 2.12% at the end of August
For the most part, Wall Street continued clinging to its optimism over Donald Trump’s economic policies in August despite another tumultuous month for his administration. At the same time, we did see signs of worry creep in that Trump’s entire domestic agenda—including his tax plan—could be jeopardized by all the turmoil and distractions. Following the North Korea crisis and the fallout over Charlottesville, the Dow had its biggest one-day fall in over three months.1 We saw a similar slide back in March when Trump’s healthcare plan hit a brick wall. These are signs Wall Street knows it ultimately needs real reform to sustain its optimism, not just hope and promises.
For that real sustained growth to occur, Trump likely needs approval of his ambitious tax reform plan, but that’s hardly a guarantee given its many critics and the continued partisan divisions on Capitol Hill. Why is the tax plan so crucial? Think of it this way: If a company has $1M in profit and pays 35 percent in taxes currently, its net profit shrinks to $650K. If Trump can get the tax rate down to 20 percent, that same company will instantly see its net profit increase to $800K, a jump of about 22 percent. That would almost instantly align corporate earnings with overinflated stock prices and justify current price-to-earnings ratios.
In other words, the most likely reason the markets soared with Trump’s election is that institutional traders think that if his tax reform can increase corporate earnings with the snap of a finger, stock prices can go up accordingly. The problem is, they’ve put the cart before the horse, which means if Trump’s tax plan fails or even stalls, the market could just as quickly fall by 22 percent—or much more.
So, this is going to be a very interesting fall, and I believe Wall Street will have a very close eye on both Congress and the Federal Reserve, which is reportedly planning to announce an “unwinding” of quantitative easing that involves selling back the $4.5 trillion in U.S. Treasuries it purchased through QE1, QE2 and QE3.2 This could be a last-ditch effort by the Fed to solve the yield-curve dilemma that is hampering its ability to continue raising short-term interest rates. But, this “unwinding” process is just as experimental as every other aspect of QE, and it may have the potential to create a stock market tipping point whether it succeeds or fails.
1 Fred Imbert, “Dow posts biggest one-day fall in 3 months; concerns over Trump agenda grow,” CNBC, last modified Aug. 17, 2017
2 Martin Crutsinger, “Fed Leaves Rates Alone but Moves Closer to Selling off Bonds,” U.S. News & World Report, last modified July 26, 2017
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