The Spark

Here is what's really behind the record-breaking Trump rally and why it may be far from over

Things in place for Trump rally to continue: Spallanzani
Things in place for Trump rally to continue: Spallanzani

The stock market has been on a record-breaking tear in the wake of Donald Trump's election, and the rally looks far from over.

That may seem hard to swallow, now that the Dow Jones Industrial Average has vaulted above 21,000, just tied the record for number of consecutive record highs, and matched the dotcom-era record for swiftest climb from one "round number" (20,000) to the next.

Is this market, as many traders warn, "overbought," "overstretched," "overextended"?

In the very short term, sure.

But here's the bigger picture:

"American business — and consequently a basket of stocks — is virtually certain to be worth far more in the years ahead," wrote Warren Buffett last week in his Berkshire Hathaway Co.'s annual shareholder letter.

"Investors who avoid high and unnecessary costs and simply sit for an extended period with a collection of large, conservatively-financed American businesses will almost certainly do well," he wrote in a letter published as the Dow was sitting above 20800.

Buffett: American dynamism 'overwhelms' everything else
Buffett: American dynamism 'overwhelms' everything else

Of course, the devil's in the details, and Brian Reynolds, the chief market strategist at New Albion Partners, is happy to explain how this stock market rally "is likely going to persist…another 3-6 years," as he told his clients in a late February letter.

Getting Credit

For now, there's simply "bearish macro trades being called in," Reynolds says. He's referring to the stock market and to the much larger credit market, where pension funds and other big institutional investors have been pouring money in.

In one recent example, a California county replaced its 5 percent commodity target with a 5 percent target for private credit. That may seem small, but in total, public pensions have put more than $300 billion, by Reynolds's estimate, into credit funds (which then amplify that sum using leverage) over the past decade.

The credit funds selected commonly take bearish short positions, which are lately getting mauled in this market. The "short squeeze" is leading to ever more bullish conditions in the credit market, which in turn creates ever more bullish conditions in the stock market.

Getting Bullish

As this process plays out, investors replace short positions with long ones. Meaning, there are vast sums of money rotating into all types of credit products and new money being added as more pension funds look for ways to hit their lofty return targets.

"As these monies get invested, they will end up on corporate balance sheets, and likely be used to fund even more buybacks designed to boost share prices," according to Reynolds.

(In fact, Buffett is already pushing back against the buyback boom, warning corporate boards in his own letter that "repurchases only make sense if the shares are bought at a price below intrinsic value.")

This process, aided by municipalities committing taxpayer money to underfunded pensions, is likely to continue until the yield curve inverts, says Reynolds.

The government bond yield curve inverts when shorter-term bonds have higher yields than long bonds. It last happened in 2005-06, and the opposite is true today. The yield curve is now quite steep, and has helped fuel the related run-up in financial companies' stock prices.

Getting Out?

"This credit-led bull market is likely going to persist until two years after" the curve inverts, or "another 3-6 years" from now, says Reynolds.

That would make the current stock-market rally, and implied economic expansion, one of the longest ever experienced. It means the credit boom may be even more powerful than the last one, in the early 2000s. It may also fuel bubbles in places like commercial real estate where valuations already look frothy.

And then what?

Even if a panic ensues, and pensions have to pull money out of the market, and companies stop their share repurchases, Buffett suggests retail investors should take a page out of his 2008-09 playbook, and be buying.

"During such scary periods, you should never forget two things," Buffett wrote in his letter. "First, widespread fear is your friend, as an investor, because it serves up bargain purchases. Second, personal fear is your enemy."