What’s Really Driving This Stock Market Higher

Of course, the doughty Dow didn’t do it alone. The Standard & Poor’s 500 index also ended Friday at a record 2575.21, up 0.86% for the week. Even more impressive is that its winning streak has come with hardly a stumble. Through Thursday, the S&P 500 tied its longest streak without a 3% decline, gaining 22.9% since last Nov. 7, according to the tally tweeted by Charlie Bilello of Pension Partners. That matched the length of the 241-day run from Jan. 26, 1995, to Jan. 9, 1996, which still topped the size of the current skein with a 30.4% advance. But, as the philosopher Yogi Berra would remind us, the current run ain’t over till it’s over.

While records are being set for various stock market indexes in the U.S. and abroad in this global rally, the Dow also has benefited from some peculiarities of its own. Unlike most stock market measures, which typically are weighted by their component stocks’ market capitalization, the DJIA is weighted according to its 30 constituent companies’ share price.

Of course, nobody would put together an index that way today, but that was the state of the art in the late 19th century, when Charles Dow designed his eponymous average. What the Dow lacks in statistical rigor, it more than makes up for in historical continuity and familiarity.

That said, the Dow has benefited from the biggest winners being among the highest-priced stocks, which gives it a bigger boost, as our resident market maven, Andrew Bary, sagely points out. Boeing (ticker: BA) has been the Dow’s top stock, with a 70% gain so far this year, and also is the highest-priced stock in the index, at $264.75. Visa(V) and McDonald’s (MCD) are No. 3 and No. 4, respectively, with roughly 38% year-to-date gains, but Visa’s lower stock price ($107.55) means its contribution to the Dow is less than two-thirds that of Mickey D’s ($166.30).

Conversely, General Electric (GE) could be called the real dog of the Dow, but I like my pooches too much to do that. Luckily, the sole remaining original constituent of the Dow also is its lowest-priced member, at $23.84 a share, so its 25% decline this year has been only a minor drag on the blue chips. GE hit a 52-week low on Friday after posting an earnings miss, but managed to rebound for a 1.1% gain on the session. That may speak more to the huge volume of stock that GE bears have sold short (over $3 billion worth, as colleague Ben Levisohn relates on the Stocks to Watch blog at Barrons.com) than optimism over the turnaround new CEO John Flannery is tasked with.

Spurring the overall market’s advance was optimism on two policy fronts, fiscal and monetary. On the former, the Senate on Thursday passed a budget resolution that seemed to pave the way for debate on tax legislation to begin more quickly than expected. The budget opens the way for $1.5 trillion in tax reductions over the next decade with a simple 51-vote majority in the Senate, and may not require a conference committee with the House of Representatives. Bottom line from the legislative arcana: There’s a chance of a bill getting passed, if not by year end, then by early 2018.

There also seems to be some greater flexibility in discussions over the tax package. House Speaker Paul Ryan was talking about adding a fourth tax bracket for high earners. That might provide revenues to pay for maintaining the state and local tax deduction, a highly contentious issue that could cost Republican votes in high-tax states. The higher top tax bracket, and keeping the state and local deduction originally, had been declared nonstarters. But going into the 2018 midterm elections, getting a win on taxes is more important to the GOP after failing on health-care reform than any doctrinaire policy stances.

It’s also wrong to expect either a major tax overhaul or nothing, according to Strategas Research Partners’ Washington research team, led by Daniel Clifton. “[T]he key to this budget is it still allows Congress to move a significant tax cut if the larger reform fails,” they wrote in a client note on Friday. “This increases the probability of some tax legislation passing in [the first quarter of] 2018.…We wouldn’t be surprised if we see a draft of tax-reform legislation next week.”

For the stock market, the proposed corporate tax cut is the centerpiece of any legislation. RBC Capital Markets’ economists estimate that a reduction in the marginal corporate tax rate to 20%, from an estimated current 27% effective rate, would add $10.50 to the S&P 500 companies’ per share earnings. Assuming that investors are willing to pay 19 times forward earnings, such a tax cut should be worth 200 points on the S&P 500, they estimate. How much of that was discounted in the week’s market advance is another question.

FURTHER BUOYING THE BULLS was speculation that Federal Reserve Gov. Jerome Powell was the leading candidate to be the next chairman of the central bank. But later on Friday, President Donald Trump told Fox Business News that Stanford University economist John Taylor also was in the running.

Trump added that he hasn’t made a decision. “Most people are saying it’s down to two: Mr. Taylor, Mr. Powell. I also met with Janet Yellen, who I like a lot. I really like her a lot. So, I have three people I’m looking at, and there are a couple of others,” The Wall Street Journal reported, based on the FBN interview.

Wall Street was enthused about Powell’s chances given that “he’s viewed as a Yellen clone on monetary policy,” writes Greg Valliere, chief strategist at Horizon Investments. Trump has previously declared a preference for “a low-interest-rate policy,” which the Fed under Yellen has delivered, even with a total of four quarter-percentage point increases since lifting its key policy rate from near zero starting in December 2015.

Yellen’s term as Fed chair runs out early next year, and most observers had assumed Trump would want to name his own central bank head, especially given that Yellen is a Democrat. She also seemed to endorse financial regulations put in place after the financial crisis that the GOP has sought to roll back.

Powell has supported Yellen’s policies but hasn’t been outspoken on monetary policy. He reportedly has the support of Treasury Secretary Steven Mnuchin, who is leading the search for the Fed head. As a Republican with private-sector experience, says Valliere, Powell could easily gain Senate approval.

Taylor is favored more by conservatives for his criticism of the Fed’s easy-money stance, notably its expansion of the central bank’s balance sheet to $4.5 trillion. The policy rule formulated by and named for him would imply substantially higher short-term interest rates. That would worry Wall Street, which obviously prefers the accommodative Fed policies that have helped lift stocks.

The “couple of others” to whom Trump alluded would be former Fed Gov. Kevin Warsh, who also has criticized the Fed’s quantitative easing after departing the central bank, and Gary Cohn, director of the National Economic Council and the president’s chief economic adviser. Warsh is seen as a long shot, while Cohn fell out of favor after criticizing Trump’s failure to condemn white supremacists at Charlottesville, Va.

FBN quoted a client note from Beacon Policy Advisors, a Washington research outfit, which suggested that Trump could chose Powell as Fed chairman and Taylor as vice chairman, or vice versa. That could set up a team of rivals, but Powell and Taylor would be OK with either outcome, the firm wrote.

None of which is likely to matter much in the short term. The federal-funds futures market puts an 83.6% probability on another quarter-point hike in the key policy rate, from a range of 1% to 1.25% currently, at the Dec. 12-13 meeting of the Federal Open Market Committee. In addition, the Fed is slated to begin the process of paring its balance sheet this month.

Even as the Fed begins to trim its holdings of Treasuries and agency mortgage-backed securities (which is discussed in the Current Yield column, on page M9), the European Central Bank and the Bank of Japan continue to pump liquidity into the global financial system, which sloshes across borders. But the ECB this week may announce plans to begin to taper its 60 billion euro ($70.7 billion) monthly asset purchases.

Perhaps the biggest change in monetary policy won’t become apparent until the next financial crisis. Doug Peebles, AB’s chief investment officer of fixed income, last week suggested that the so-called put option provided by central bankers may be ended by the next Fed leader.

It began in earnest after Black Monday in 1987, when the Fed under Alan Greenspan cut rates to arrest the stock market’s collapse. The process was repeated after the Long Term Capital Management fiasco in 1998 and by Greenspan’s successor, Ben Bernanke, after the 2008 financial crisis.

Peebles suggests that central bankers may want to rescind this insurance policy for the markets, which would really be a profound change from the practice of the past three decades.