Trader Talk

The risk to stocks is rising because the political risk story is changing

President Donald Trump arrives for the U.S. Coast Guard Academy commencement in New London, Connecticut, U.S., May 17, 2017.
Brian Snyder | Reuters

U.S. political risk is rising because the story is changing.

I've said for months that the rise of the stock market is not a mystery, if you understand what drives stocks. Earnings—guidance forward earnings—are the main driver of stock prices, and they have been improving. The global economy is improving, though there has been some weakness in China recently. Geopolitical risk in Europe is lower.

What about the Trump agenda of lower taxes, less regulation, and infrastructure spending? Investors have been willing to believe that the markets can withstand a certain amount of political drama from Donald Trump.

But what's happening now is different. Most of Trump's tweets in the past, while odd, were not actionable.

This is actionable: talk about obstruction of justice or an impeachment fight is another story altogether. It is a new level of uncertainty. Here we are faced with the prospects of a President derailed by months of potential fighting.

The risk is even if he survives he loses so much political capital that the only thing he can get through is something everyone wants, like infrastructure. But corporate tax reform could be in trouble.

This is what the markets are reacting to today.

And don't be too clever: those who say, "Hey, if Trump leaves and Michael Pence becomes President the Trump agenda will still be intact," may be accurate in the long run, but there is an awful lot of potential chaos that will likely precede that outcome.

Still, the other positives are so strong that I'm doubtful that this will lead to a sustained pullback, absent more headlines. Has the potential for a more notable 5 percent to 10 percent pullback increased? Sure, it's higher, but it's about time. Bank of America noted today that 5 percent pullbacks typically occur three times a year. That hasn't happened in a long time!

The bigger question is, if we see more drops for the next couple of days, will an underlying bid for the market materialize? The pain trade—the trade would inflict the maximum amount of pain to the trading community—has been higher for a long time. How many times have we heard that volume is lackluster because buyers are waiting for a 5 percent to 10 percent pullback so they can buy lower?

Bottom line: traders finally have a downside story with a little meat to it. It's not insipid "valuations are too high" whining (valuations are often higher when earnings are expanding), or "the economic upcycle is long in the tooth," it's a more substantial story.

Where do we go from here? Anything that closes off a path to obstruction of justice or impeachment talk would be market positive. But if this picks up steam, and the prospects of Watergate-style hearings emerge, it could be a long summer.