×

Here are the warning signals the market is flashing right now

Danger
Chris Kryzanek | Getty Images

One of my mentors, the late Dr. Bing Sung who managed the Harvard endowment fund, taught me that stock market rallies come in three distinct stages. It begins with capitulation followed by conviction then ultimately ending with euphoria.

He was very big on drawing historic parallels to show me the rationale behind his observations. As this was the late 80's, the recent Reagan years were a great example of how to read each stage. I find this as a classic case study for the recent market developments as much of the action seems similar in character to the early days of the Reagan administration.

The move in the market from the night of the last election until the recent move by the Federal Reserve last week can be considered the capitulation stage. It ended with a blow-off top which had all the characteristics of the end of a move. Many of the hard-core shorts finally threw in the proverbial towel and gave up on fighting the 'Trump Trade.'

For the last few months portfolio managers who found themselves sitting in too much cash or severely under invested kept waiting for the market to pull back, to no avail. Those that missed the signs in November finally came to the realization that they were wrong and bought stocks through the months of January and February. It was no longer a question of making money; it became a question of job security. A portfolio manager being left out of an equity market making new all-time highs day after day usually finds a direct path to the unemployment line.

This was a perfect example of capitulation; it took a couple of months and caused much pain and financial suffering to the bears. Now what?

Now it's time to look back and take another look at the Reagan years because of the similarities between the two administrations. Just as Reagan changed the course of the markets, so too do we see the Trump administration doing the very things necessary to refuel the economy, tax reform, regulatory overhaul and real fiscal stimulus.

"The question we should all be asking is can president Trump get his pro-growth agenda passed through congress this year? The promise of legislation is great but signed legislation is crucial, in fact it's the only thing that matters for the market."

But let's understand something. The Reagan tax cuts in August of 1981 were spread out and didn't take full effect until 1983. Corporate America held off on spending and GDP was suppressed. It wasn't until 1983 when we saw cap-ex pick up and we started to post GDP numbers of 4 and 5 percent quarterly. After Reagan was elected, the market had priced in faster change with a hard rally in stocks but was eventually disappointed by the timeframe of the legislation and pulled back.

The question we should all be asking is can president Trump get his pro-growth agenda passed through congress this year? The promise of legislation is great but signed legislation is crucial, in fact it's the only thing that matters for the market.

We've already been put on notice from the Republican leadership that there will be no tax bill until after the August recess. That means we probably won't see anything until 2018 at the earliest. What would that mean for stocks? The valuation of the market would change considerably if that were to happen.

Some of the high assumptions for forward earnings of the S&P 500 for 2018 were in the range of $140. Roughly $15 of the $140 was a direct result of tax reform and repatriation being factored into the numbers. With the S&P at the 2350 level that changes the P/E of the market from 16.7 to 18.8.

For the Trump rally to move to the next stage of the rally, the conviction stage, legislative print becomes essential. The Trump Trade is tired. Topping action in stocks, a flattening yield curve and the lagging commodity sector are warning signals that the market needs more.

If President Trump's agenda is pushed out another year, the market will be forced to reprice from its present levels. The 'conviction stage' needs to see results to be set in motion.

If the tired Trump trade is to find new life and energy it needs a shot of political adrenalin. Years ago, Dr. Art Laffer taught us that there are four prosperity killers: High taxes, inflation, government control/regulations and protectionism. The Trump pro-growth legislation has addressed three out of the four. Maybe it'll be enough. If so 'conviction stage' here we come.

Commentary by Jack Bouroudjian, CEO of Index Futures Group LLC, a registered independent broker, and CIO of Index Capital Partners, a registered commodity-pool operator. He was also a three-term director of the Chicago Mercantile Exchange and founder and advisor of UCX (Universal Compute Exchange). Follow him on Twitter @JackBouroudjian.

For the latest commentary on markets in the U.S. and around the world, follow @CNBCopinion on Twitter.