Trader Talk

Markets grapple with tug-of-war between tax cuts and Trump's legal woes

Key Points
  • The Dow plummeted 350 points on reports of Michael Flynn's testimony against President Trump.
  • Stocks turned around midday when Sen. Jeff Flake announced he was supporting the Senate tax bill.
  • The markets reversed course, and the Dow recouped roughly half of its losses.
Stocks slash losses as tax bill vote gains momentum

Tax cuts versus potential legal troubles for the president: Which wins out in the markets?

The markets have been focused for months on global economic growth, record earnings and the premium in the market for tax cuts.

But traders have spent almost no time thinking about the risk premium in the market for President Donald Trump's potential legal troubles.

It was an issue earlier in the year. Remember, the Dow dropped more than 300 points on May 17, when reports of a memo from former FBI Director James Comey surfaced, saying Trump asked him to stop the investigation into former National Security Advisor Michael Flynn.

Comey had been fired just the week before.

It's important to remember that the rally in the past year has not been solely based on the global economic expansion and tax cuts, though they are the two most important factors. Another factor, more difficult to quantify, is the belief that this administration and this Congress would be particularly sensitive to business interests, everything from tax cuts to regulations.

"There is a strong sense that the administration is more business-friendly, and we have seen that with rising business sentiment," Joe LaVorgna, chief economist for the Americas at Natixis, told me.

Then there's the issue of Republican control of Congress.

CNBC contributor Larry Kudlow told "Fast Money: Halftime Report" earlier in the day, "If Trump is in trouble, that will damage the Republican Party in certain parts of the country."

Stocks are reflecting that concern.

Tim Graham | Getty Images

The initial ABC report came out at 11:08 a.m. ET, saying that Michael Flynn was prepared to testify against the president and that Trump directed him to contact the Russians, originally as a way to work together to fight ISIS in Syria.

The Dow dropped roughly 360 points in the next 25 minutes.

The markets turned around about 11:33 a.m., right after the European close. It's likely the proximity of the European close at 11:30 a.m. was a major factor in the size of the drop. Volume accelerated going into the close and lightened up shortly after.

Stocks rose again around noon ET, when Sen. Jeff Flake announced that he was supporting the tax bill, and they have continued to rise into the late afternoon. But volume has lightened up considerably.

Bottom line: The heavy volume around the reports of Flynn's testimony indicates the market has not priced in these issues, but the slow slog up on the increasing chances for tax cuts — even if on lighter volume — indicates that tax cuts still have some juice left.