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Ignore the 20,000 Dow — watch global reflation

Dow 20,000 is here at last. No regular reader — or indeed, any sentient and sensible human being — should base any investment decision on the Dow. Its methodological flaws are irremediable. And in any case, round numbers should not matter.

One brief illustration of the Dow’s primitive methodology will suffice. Just five of its stocks — Goldman Sachs, IBM, Boeing, UnitedHealth and JPMorgan Chase — account for fully half of the Dow’s rise since election day. Thanks to its ludicrous weighting by share price rather than market capitalisation, Goldman accounts for eight times the weighting in the Dow of General Electric, even though GE has roughly triple the market cap. IBM, according to the Dow, is still a much more important and weighty company than Apple.

This explains why the Dow has become detached from the S&P 500, which it has been reverse-engineered to track, since election day. Excitement about Goldman Sachs has powered it forward, and the negative reaction to GE’s disappointing earnings has had almost no impact at all. The Dow’s overemphasis on financials has taken it to the landmark. No sensible person should care two hoots about it.

However, the S&P 500, a far more important index to which trillions of dollars are tied, either directly or indirectly, is also at an all-time high. And Donald Trump has a point about the media. In an example of groupthink and circular logic, every major news outlet has treated the Dow landmark as a big story, largely because everyone else is treating it this way. Yes, the Financial Times is also guilty of this. With the media treating Dow 20,000 as a major story, it will be perceived as a major story, even it is really “fake news”. And in markets, perceptions can create reality.

So, where lies the Trump trade? Why did the market stall for a month, and what has driven it forward again?

It is easiest to answer this in terms of the new tug-of-war in markets between “reflation-on” and “reflation-off”. The initial excitement about the election reflected a belief that a Trump presidency would mean reflation and growth. This was reflected in many markets.

Some of the clearest symptoms involved a sharp rise in industrial metals compared to precious metals, a steepening of the bond yield curve — meaning that longer-dated bonds’ yields rose relative to shorter-dated bonds — and a rise in inflation expectations derived from bond markets

These indicators stabilised and began to wobble a month after the election. Indicators that reflation was “on” would help move the US stock markets upwards. Reason to fear that it was “off” would lead to a decline.

What changed this week? Mr Trump moved ahead with the promised attempt to boost US manufacturing using protectionist policies (generally feared ahead of the election), and made a clear gesture that he will proceed with rolling back environmentalist regulations by announcing that two planned pipelines will go ahead. But the greatest hopes attached to his plans to cut corporate tax, on which the administration has yet to make an announcement.

Earnings data helped. After Boeing, over-represented on the Dow, published earnings on Wednesday, it rose 4.5 per cent. But the critical factors were the world reflation trade, and pure sentiment in the US. Metals prices have rallied, led by copper. Globally, cyclical stocks have begun to outperform defensives again, judging by the FTSE indices. Bond yields are also rising again. In the case of German Bunds, yields are as high as they have been in almost a year. US 10-year inflation break-evens rose above 2 per cent.

Finally, simple measures of confidence showed that the Dow was ready for the landmark. The American Association of Individual Investors’ weekly survey of whether its members feel bullish or bearish has long been a reliable contrarian indicator. By early December, bulls exceeded bears by 28 percentage point. This was overdone. By inauguration day, bulls outnumbered bears by only 4 percentage points. With sentiment back to reasonable levels, it took only fragments of positive news to pass the landmark.

For the future, the Trump trade will continue to involve erratic market moves in response to erratic communications from the White House. The element governing whether US stocks — measured by a decent yardstick, not the Dow — rise further is global reflation.

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