Today the market is playing out as I projected. The leaders of the market, the financials and small caps, are selling off. The KBW bank index was down 3.43% and the Russell 2000 was down 1.44%. The initial hype that Trump would cut regulations to help these stocks became overheated. The market was expecting these improvements to the operating environment to happen immediately without any compromise. The reality is the government has been slow to action for many decades and Trump may not get every policy he wants approved by Congress. While I have the opinion some regulations will be cut and taxes will be lowered, I know there is no certainty when it comes to government. This is why the market typically likes a divided government because it gets less done. When there is a unified government, there’s a high chance major policies will be passed. The market worries about the potential for these policies to be bad.

The small caps and financials were two groups I felt would underperform in the beginning of the year. It’s tough to put a timeline on this because it depends on their future performance and the changes to the business environment. Underperformance in this market is terrible because the market, as a whole, is poised to have a rough next few years because of how expensive it is. According to the five valuation metrics in the chart below, the market is only slightly cheaper than it was at the peak in the late 1990s. This tech bubble peak was the most expensive valuation stocks ever achieved in the 130 years of data I’ve looked at. These valuation metrics show the market is 120% to 150% overvalued which means it could fall 50% to 60% easily when the cycle ends.

The 10-year bond yield fell today which also is what I have been projecting. It was down about 3% today and is down almost 5% year to date. It’s fallen over 30 basis points from its December peak to 2.3235. I think the inflation that Trump’s policies are expected to bring won’t happen. I think the reason why yields rose so much in the second half of the year is because there was a correction in the bull market. This was combined with optimism about the Trump administration. The chart below shows the channel of lower yields was broken to the downside. I’m not a big proponent of charts, but it’s clear this was an exhaustion of the trend. This selling momentum was accelerated by Trump; the ball was already rolling and the new optimism pushed it further than would have otherwise happened. Now we’re in the situation seen below where almost everyone is bearish on the 10-year bond. Hedge fund net shorts are the highest ever as they increased 14.4%. The unwind of this trade may be starting today.

The final piece of the puzzle in the unwind of the Trump trade is a decline in the dollar bubble. The U.S. Dollar Index was down 0.83% today. It’s down about 2% for the year and about 3.5% from the December peak. It’s a weird phenomenon that the dollar rallying is combined with inflation because of their opposite nature. The trade was nominal GDP in America would grow while other economies would maintain their current trajectory. Traders are associating growth with inflation which I don’t agree with. This new short/medium term move is in concert with my long-term bearishness on the dollar because of ballooning deficits. The chart below shows the BAML fund manager survey which has about 50% of participants claiming the dollar is currently the most crowded trade. It’s an interesting survey because I would guess many of the people saying the dollar is a crowded trade are also long the dollar. The bulls recognize how much the dollar has rallied which could be a signal it’s near a top.

The optimism isn’t limited to America as you can see in the chart below which shows European business optimism is high. This fact goes against the dollar bullish narrative because trade protectionism is supposed to help America and hurt its trade partners. The jobs are supposed to be leaving other countries and heading to America. I disagree that protectionism helps anyone because the definition of trade is two parties freely deciding it’s in their best interest to exchange goods/services. There seems to be some car companies who are moving manufacturing back to America, but I don’t see this to be a trend which works at larger level. Lower taxes and less regulations make the business environment better, but it would be shortsighted for firms to move to America based on a political policy which can change in a few years if the GOP loses an election.

The European business confidence indicator has been the ‘kiss of death’ in recent history. The index hit high water marks one year prior to the past two major slowdowns. The current confidence is higher than the 2011 peak and lower than the 2007 peak.

The final chart shows the short interest in the NYSE. Typically, a decline in the short interest has been a bullish indicator because the market correction that the shorts had been predicting occurs and a new rally starts soon afterwards. First, the shorts cover because the economy can’t get much worse as the rate of decline starts to moderate. Then the bulls start buying stocks because the economy shows more signs of rebounding. This is the underlying reason why the market acts ahead of the economy. This time was different on a relative basis. As you can see from the chart below, there were almost as many shorts in late 2015/early 2016 as 2008, but market’s decline was minimal. I don’t see the current short covering rally as a reason for the start of a new bull market because stocks are expensive and the corporate debt as a percentage of GDP is near the same level it peaked at in the past two cycles.

Conclusion

The Trump trade is reversing. I expect this to continue into inauguration day. Perfection was priced in, but it’s not logical to expect that. In the next few months this reversal of the Trump trade will continue unless pro-business measures are passed. If this legislation is being passed and the market sells off, I will become less bearish. Because of how expensive stocks are, it would take a major crash for me to turn into an outright bull.