Three reasons why this Trump rally won’t last

Donald Trump
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Donald Trump

The market continues marching upward on torrid pace defying prognosticators that predicted economic collapse should Donald Trump be elected. In fact, the market continues to hit all-time highs seemingly daily.

This euphoria flies in the face of a rising interest rate environment as well as the unprecedented record expansion now approaching 8 years and is already the fourth longest in the last 150 years. Given the cyclical nature of economic expansion and contraction, it is reasonable to ask: How long this market will rally?

Markets have rallied because the expectation is that tax rates will fall and President-elect Trump will bring a de-regulation perspective to the business environment. Trump's rhetoric during the campaign suggested that he was going to focus on easing business regulations to help the United States compete more effectively on a global basis. Additionally, Trump's proposal to lower taxes on businesses to bring the U.S. more in line with global competitors has been warmly received by market participants.

"A couple of bad headlines and a higher than expected inflation report could turn this market around in a heartbeat."

The focus on a form of trickle-down economics is, at least in the short-term, deemed to be positive in terms of freeing up more capital for reinvestment.

I know what you're thinking: "What about the $20 trillion U.S. deficit? Isn't that important?" Yes, but that doesn't seem to be a concern; the proverbial can continues to be kicked down the road.

Tax and deregulation issues, combined with a still low interest-rate policy by the Federal Reserve, have provided an environment which has boosted equity values in the United States. Why one might be tempted to embrace the euphoria as a long-term phenomenon, we think this would be misguided when looking at an intermediate and long-term timeframe. While short-term markets may continue to receive a bump based on proposed policies, we believe caution is warranted for three reasons:

1. These are merely proposals – nothing has been implemented yet. There will be pushback from some in the legislative bodies that the proposals suggested are not neutral taxation balanced. In other words, the proposed policies will likely increase deficits and that is not a popular course of action especially among Tea Party legislators

2. Stronger economic growth through reduced tax rates could trigger inflation. Higher inflation increases financing costs for companies and individuals and is a headwind for economic growth

3. The strength of the dollar could negatively impact U.S. corporate profits. Already, companies are beginning to warn about the earnings impact from the strength of the dollar. When the dollar strengthens, goods and services become more expensive to buyers from outside of the United States and this is a negative to corporate profits

Despite these headwinds, it's reasonable to expect in a legislative vacuum that hope will remain in the market and there will be continued upside volatility – until a sober reality sets in. This could be sometime in the second quarter of next year when legislative agendas are proposed and potentially implemented. Additionally, in Q2, we should begin to see the real impact of higher dollar value on corporate earnings and I expect to see significant warnings from companies in the first quarter and moving into the second-quarter. Simultaneously, rates will likely continue to rise beyond the virtually assured December rate hike which will increase costs for consumers and businesses period and we expect at least an increase of a quarter percentage point in the first 6 months of 2017.

We are long-term investors and we don't invest on the short time horizons that I'm highlighting here. Still, it doesn't mean that one should necessarily ignore short-term price movements as that could very well guide one's investment strategy when implementing or liquidating a portfolio strategy. Remember: The long-term is made up of lots of short-term time periods strung together. It pays to pay attention to trends regardless of whether they or long- or short-term.

Here's the bottom line: Enjoy the current rally but don't expect it to continue. I believe there are simply too many headwinds including U.S. dollar strength and higher interest rates that will likely overcome a more muted tax reduction policy implemented by the Trump administration. A couple of bad headlines and a higher than expected inflation report could turn this market around in a heartbeat and we believe the likelihood of the pullback becomes greater the more the market races higher on unbridled enthusiasm.

Commentary by Michael A. Yoshikami, the CEO and founder of Destination Wealth Management in Walnut Creek, California. Follow DWM on Twitter @DestinationWM.

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