Irrational investors are fueling the Trump stock market rally

The incoming administration’s unique ability to make major policy shifts without so much as a blink is turning out to be both a source of uncertainty and reassurance at the same time. We are accustomed to the fact that politicians routinely lie to us, but the idea that the lies can be true and the truth can be a lie has taken us to an entirely new place.

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Call it quantum politics if you like, but we seem to have gone through the looking glass and discovered that we like it there. Ordinarily the stock market hates uncertainty almost more than actual bad news, but in a reality where nothing is what it claims to be and mutually exclusive choices can exist comfortably side by side, it is easy to be seduced into believing that all important policy choices will be resolved in the most economically optimal ways.

This kind of irrational thinking is fueling the current stock market rally. It would be well for us to pause and reflect. Humans have a bias toward optimism. This may have served us well in earlier times, but it doesn’t equip us very well for dealing with the abstraction and complexity of a modern market economy. In fact, it means that we are very often attracted to irrationally optimistic interpretations of the available facts.

The main premise behind the rally does have some appeal. The core idea is that a combination of deregulation and a lower corporate tax rate will produce substantial gains in corporate profits. With the executive and legislative branches of government finally on the same page, the government will be in a position to undertake a comprehensive fiscal stimulus program for the first time since the financial crisis.

This would further boost corporate profits, giving rise to more hiring and at the same time taking some of the strain off of the Federal Reserve and providing the central bank with much needed new policy options, such as the ability to raise interest rates without inducing an immediate crisis of confidence. Meanwhile, all the increased profits would find their way into the hands of employees and shareholders, who will also be facing lower tax rates. The result would be an increase in consumer discretionary spending, as well as more investment in innovative new business ventures, thereby re-engaging the virtuous cycle that has driven American prosperity and produced strong economic growth in the past.

However, there are many potential points of failure in this scenario and it is unlikely that it will deliver all that the market is expecting. If that is the case, the rosy outlook that has fueled the recent rally is based on overly optimistic assumptions. We can expect that to become clear to investors in due course.

Consider deregulation, for example. Even with one party holding both the legislative and executive branches of government, it will be very difficult to accomplish all that has been promised. After all, even if we don’t like some of the provisions of the Dodd-Frank Act Wall Street Reform Act, we have not forgotten the circumstances that gave rise to it, so what emerges from the deregulation effort is likely to come together more slowly and with more compromises than the version that is envisioned in the current euphoric market view.

Add to that the risks and complications of a potential trade war, a very real possibility if the incoming administration delivers on any significant proportion of its protectionist promises. Let’s not forget that it will take a long period of smooth sailing to extricate the Federal Reserve from the commitments entailed by the activist role that it has taken in order to maintain market stability in the years since the financial crisis. If we don't get an extended period of smooth growth, it will be difficult to move the economy back into a legitimate position of strength. For all of these reasons and more, it is unlikely that the very optimistic scenario that has now been priced into the market can be sustained.

As this situation plays out over the first half of 2017 and we get into the post inauguration era, Trump will have to move beyond rhetoric and begin to make some of the difficult choices that confront any new administration. It will no longer be possible to pretend that mutually exclusive possibilities can be true at the same time.

The best that we can hope for is a more serious national debate about actual policy objectives and the economic tradeoffs involved in achieving them. That is the debate that should have taken place during the campaign.

David Louton, Ph.D., is a professor of finance at Bryant University.


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