Authored by Nicholas Colas via ConvergEx,
The stock market may not be a casino, but 21 is the game of the day. That’s how many House votes the Republicans can afford to lose from their own party and still pass the American Health Care Act on Thursday. The cause of today’s sell-off is simple: there seems to be more like 25 “Nay” votes coming from the right wing of the GOP. For what it’s worth, our two best sources in DC both think the bill will pass on Thursday and today’s Beltway theatrics were just par for the course.
Regardless, equity investors know they aren’t positioned for even a faux-drama in DC. High valuations and (until today) low volume/low volatility melt up markets are always susceptible to shocks.
Our view is that today marked the official end of “Trump Trade 1.0” and it will take some time to ship Version 2.0. Washington, after all, does not work in New York minutes.
I’m not much of a gambler, but I know that “21” typically has better odds than most games at a casino. Providing you follow a few basic rules, you can get pretty close to 50/50 odds. Take a card when you have 16 or less… That kind of thing. And if you can find a casino where blackjack pays 2:1 instead of 3:2, all the better. (Here is a link with many of the common permutations of house rules and their effect on your odds, if you are curious)
In “21” drawing cards that sum to more than that number is a “Bust”, and so it is with the pending American Health Care Act currently slated for a House vote on Thursday. Republicans cannot afford to lose more than that number of votes, assuming Democrats vote en masse against the legislation. News reports today had 25 GOP members of Congress set to vote against the ACHA. DC newspaper The Hill has their own running tally (20 solidly against, 7 leaning against) here.
We asked our two best DC sources what they thought about Thursday’s vote. Both said they thought the Republicans would pull together enough votes to pass it. That’s (sort of) the good news. The bad news is they feel that the House bill has little chance in the Senate. And whatever the Senate would find palatable has little chance back in the House. The old Mark Twain quote comes to mind: “People who love sausage and respect the law should never watch either one being made.”
So if the legislative process is actually running to historical norms, why did equity markets respond so poorly today? I can think of three reasons:
1. US equities have been priced for perfection since the start of 2017 and today was a rude reminder that the legislative process is imperfect on even its best days. It’s not just a current year multiple of 17.9x that makes valuations feel toppy. It’s also that analysts have been cutting numbers of late. Earnings momentum is the bedrock of most equity rallies, but the drip-drip-drip of negative revisions has eroded that foundation.
2. The low volume/low volatility melt-up for US stocks had lulled traders and investors into a temporary complacency, now shattered. Immediately after the US Election last November, many market observers thought we would see the dawn of a new era of market volatility based on the unpredictability of the new President. After some sector rotation that accompanied the initial rally, however, the “Trump Trade” began to resemble the sleepwalking “Fed Put” market of much of the last 8 years. All that came to an end today with the realization that the Trump economic agenda will need to pass through Washington’s political process and (worse yet) we will all have to watch and worry as it does so.
3. All that complacency also translated into a lack of interest in options-based risk management. The most common measure here is the CBOE VIX Index, which as of yesterday was 11.3 (more than 1 standard deviation away from its long run average of 20). You can also see this phenomenon in the “VIX of” options chains for the 11 sectors of the S&P 500 and various other asset classes like small cap stocks, corporate bonds and precious metals. We’ve attached a chart that shows this. Of the 20 sectors/asset types we track, 17 saw declines in their “VIX” measures over the last 30 days.
Looking at the “VIX of” the 11 S&P 500 sectors in particular shines a bright light on this problem. As of yesterday, every sector save 2 (Telecomm and Energy, the only groups down on the year) had VIX readings either on their 52 weeks lows or within 1 point of those lows. Market complacency had managed to soak through not just the major indices (like the S&P 500) but all the way through to risk pricing in almost every industry sector. Given that sector correlations have declined notably since last November, that is remarkable.
It is always hard to call major turns in the market, but we’re willing to ring the bell today on “Trump Trade 1.0”. This move started the night of the election and carried us all the way through yesterday. It’s had a good run, anchored on the belief that tax reform, infrastructure and deregulation would lift most boats higher. In addition, the accompanying steepening of the yield curve would both send money flows out of bonds and into stocks and finally buoy the long beleaguered Financials sector.
After all it’s not like today’s sell-off was actually “Caused” by the angst over the ACHA vote. We’ve known for weeks it would not be a slam dunk. Rather, the volatility today is the result of a rethink about the timing of any eventual legislation on corporate/personal taxes, regulation and infrastructure investment. Health care reform will take time. Then tax reform will take some more time. Then everything else.
Do not fear: there will be a “Trump Trade 2.0” at some point this year. Either valuations will retreat to the point where they reflect the reality of a legislatively-driven set of catalysts, or Washington will (in its own time) deliver on a pro-growth agenda as the market treads water.
Just remember: Washington doesn’t work in New York minutes.