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Exuberance as the Dow stirs animal spirits

Wall Street is bathing in nostalgia. This week the cover of Barron’s, the bible of US retail investors, proclaimed “Dow 20,000”. Presenters on CNBC are wearing Dow 10,000 caps first donned in 1999. And each day the thinning crowds on the floor of the New York Stock Exchange have watched the boards to see if the Dow Jones Industrial Average, having passed 19,900, can top the 20,000 mark for the first time.

It is nostalgic in part because the Dow has long since been retired by serious investors. That Wall Street cares about a meaningless landmark says something about market psychology. Animal spirits are back. The enthusiasm is palpable, and is on a scale unseen since the height of the tech boom.

The long rally from 2003 to 2007 which preceded the credit crisis never created such enthusiasm. And the longer rally that tripled US investors’ money since 2009 has been history’s most hated bull market, distrusted and widely believed to rest solely on manipulation by the Federal Reserve and its quantitative easing programme.

Now, Donald Trump of all people is the stock market’s saviour. The president-elect’s ideas about protectionism are anathema to most on Wall Street. During the campaign, the stock market greeted every rise in his polling numbers with a sell-off. Investors now view the forthcoming Trump presidency through a positive “pro-growth” lens.

There is more to this than the collective American insanity that many outside the country perceive. The Republican “clean sweep” of the White House and both houses of Congress was unexpected and offers the chance for a genuine shift towards fiscal policy. Vacancies at the Fed allow Mr Trump to engineer a change of philosophy, while tax reform also promises to shake up the corporate sector. His deregulatory agenda could delight markets.

Most importantly, Mr Trump represents change, after a soul-destroying decade stuck in the paradigm of reliance on financial engineering and low interest rates. It is as invigorating as it is surprising, and the surge of excitement is understandable.

Whether this could or should bring the Dow, or more legitimate benchmarks, any higher is a different matter. History offers no good comparison. The arrival of Ronald Reagan in 1981 is similar politically; markets, however, were in a very different state. Bond yields were near a historic high, rather than the historic low they touched earlier this year. Stocks were almost as cheap as they have ever been.

Before the 2016 election, almost everything pointed to the start of a decline for US equities. For almost two years — since the Fed finished tapering off the QE bond purchases with which it was propping up asset prices — stocks essentially moved sideways. Profit margins had peaked and declined slightly. Corporate earnings and revenues had also declined, mainly thanks to the falling oil price. Bond yields were beginning to rise significantly. And valuations, comparing share prices to long-time earnings, are at roughly the levels seen at the top of the 20th century’s big bull markets — before a decline. The only exceptions were the euphoric bubbles that preceded the crashes of 1929 and 2000.

That leads to probably the best comparison we have to this moment. Almost exactly 20 years ago, with stocks looking similarly pricey, Alan Greenspan, then Fed chairman, warned of “irrational exuberance”. That brought a sharp sell-off, which turned into a 10 per cent correction once he followed up with a rate rise. But this was the era of the “new economic paradigm”, a notion that eventually seduced even Mr Greenspan. The early successes of the internet, and a global economy enjoying the post-cold war peace dividend, generated excitement. Stock manias need some basis in plausibility — a narrative that could work — and they had one 20 years ago.

Then it was the internet, now it is Trumponomics. Enthusiastic Wall Streeters are making Mr Trump’s sketchy programme sound almost as exciting as the advent of the internet. Then, Mr Greenspan gave up the fight. After crises roiled the emerging markets, he eventually cut rates after the Long-Term Capital Management hedge fund imploded in 1998, ushering in a period of market insanity.

This week, Janet Yellen, the Fed chair, administered what might have been a deliberate shot across the bows of asset markets, suggesting the US economy may be so strong that it does not need the fiscal stimulus that Republicans are about to administer (shades of “irrational exuberance”). Judging by the sell-off in emerging markets this week, a crisis there might yet put the brake on any attempts she makes to rein in markets, as happened to Mr Greenspan.

Two conditions must be met for these animal spirits to turn into a 1999-style bubble. First, plausibility: if, a year from now, market-friendly reforms are on the books and there is tangible evidence that Mr Trump has persuaded companies to spend and invest more, then a bubble grows far more likely.

Second, it needs a compliant central bank. Ms Yellen’s hawkish words were a big surprise — and delayed Dow 20,000 for at least a few more days. They may well have been inspired by her reading of Mr Greenspan’s fate when he faced animal spirits like this 20 years ago.

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Via FT