After climbing the wall of worry over one crisis after another from the White House, the latest revelation about the Comey memo sent markets reeling on May 17 with the Dow dropping 373 points, the biggest drop since September of last year. Volatility came roaring back with the VIX jumping 46%. This comes after having closed at 9.77 on May 8, the lowest closing level of the VIX since December 27, 1993.
The market complacency surrounding Trump’s administration has been surprising in that even the firing of Comey on May 9th had virtually no impact on the stock market. The Nasdaq reached a historical high on May 16. It took the news of possible evidence of obstruction of justice in the Comey memo to finally reach a tipping point that caused markets to sell-off swiftly.
In our recent survey, impeachment was ranked the least likely risk scenario and the market’s reaction to the revelation that Trump had potentially committed an impeachable offense would suggest that it was indeed discounted until now. With the appointment of former FBI director Robert Mueller as special counsel to lead the investigation into ties between Russia and the Trump administration, this risk scenario needs to be given more serious consideration. The investigation alone puts potential tax cuts the market had been counting on at risk, along with the entire Trump agenda.
In an interesting parallel, the Ibovespa stock index dropped by 10% on May 18, triggering circuit breakers, after revelations surfaced that President Temer was recorded approving a payoff to Eduardo Cunha, who led the impeachment of former president Rousseff, and was sentenced to 15 years after being found guilty of corruption, money laundering and tax evasion. This comes after the Ibovespa rose more than 80% (in US currency) from the January 2016 lows through February of this year, during which time Rousseff was impeached. It is a telling example of how financial markets can perform well during a political crisis as long as investors believe that problems will be put in the past and the country can eventually climb out of recession. The possibility of another political crisis with the current President sent shockwaves through the markets.
One challenge in factoring in these type of risk scenarios is that the market can prove very misleading right up until the last minute. The Ibovespa was within 1% of the 52 week high on May 16. Looking back at the VIX or other measures of volatility gave no indication whatsoever that this type of event was being priced into US markets. If the reaction in Brazil is any indication, we may be in for bigger shocks ahead in the US markets, especially given the run-up since trump was elected. The Nasdaq has rallied by 20% since the election and 27% in the past year.
Consider this recent Bloomberg headline on May 12, only a week ago:
“Investors Celebrate Temer Austerity While Brazilians Lose Jobs”
It goes on to say that unemployment reached a record high of 13.7% in March while inflation dropped below the central banks target of 4.5%, down from 10% a year ago, 5 yr credit default swaps have fallen significantly and the Ibovespa Index was up 28% in local currency in the past year. In other words, things looked pretty good and were continuing to improve, yet the market dropped by 10% on the news of the tape about approving payoffs.
Five stocks account for more than 40% of the NASDAQ 100 (NDX) index which has gained 30% in the past year. Apple has gained nearly 70% in the past year and accounts for 12% of the index. With this concentration in a few names we should not be surprised to see markets fall by 10% if another big shoe drops on the Trump/Russia investigation. What an actual impeachment process might do is another kettle of fish, but I would venture to say we could be looking at a more serious correction.
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