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Trumped-up Equity Markets?

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Jeff-PantagesStocks have rallied strongly since Donald Trump’s election with major US stock markets reaching record highs during November. Earlier concern about the unpredictable businessman’s policies evaporated literally overnight and gave way to a realization that with the Congress and White House in Republican hands, enacting policies to revive the economy were likely to be job number one.

Lower taxes, less regulation, more infrastructure spending and a decidedly more business friendly administration would release those pent-up “animal spirits”, with better growth, sales and earnings the result. It was a game changer, and quite unpredicted. That’s the positive spin.

There are negatives to Trump’s economic plans. Bigger budget deficits (and more debt) are a possibility. And Trump’s rhetoric on trade protectionism and anti-globalization is worrisome. I suspect his bark is worse than his bite, but who knows? Congress will likely moderate any extreme measures. No one wants a trade war.

Better growth and higher inflation give the Federal Reserve reasons to tighten policy and push up short-term interest rates a little faster than previously thought. They will no doubt hike rates at their meeting on December 14. This and worries that a larger budget deficit means more issuance of government bonds sent long term rates higher over the month. The 10-year Treasury hit an all-time low of 1.35% in the summer and now yields 2.38%. Money is finally flowing out of bond funds and into equity funds.

Donald, sounds like Ronald

This all has some thinking of the Reagan years. The Gipper cut taxes and the economy boomed in the 80’s; so did the stock market. Remember though, at that time the economy was just beginning to recovery after a double dip recession. There was plenty of pent-up demand. Stocks were very cheap – they had attractive “valuations” – and interest rates and inflation were headed down, not up like today.

Oh, and by the way, there was lots of “Japan bashing” in the 80’s over the “dumping” of Japanese steel and autos in the US. In fact President Reagan imposed “voluntary” import restrictions on steel and auto imports. Today, as well, China and Mexico are in the President-elects cross hairs.

So there is something to the Reagan analogy. It is suggestive of stronger growth but is only mildly positive for stocks given their elevated valuations. For example, by one valuation metric US stock market capitalization was at a record low of 40% of GDP when Reagan took office versus a higher and pricier 160% today.

One basic principal of investing is that it is not enough to get the macro picture right you must also figure how much forward looking information is “in the market”. Often at meetings when someone waxes on about how good the macro picture is my response is “yah, yah, yah, it’s in the market”. The particular asset or class already reflects all that good information. It is priced for perfection, and will go down hard on any bad news.

Many years ago someone summed this concept up by commenting on IBM saying “It’s a great company but will be a lousy stock”. All of the good things about IBM were already priced into the stock.  It was “overvalued” and probably wouldn’t provide a high return going forward.

Not to belabor the point but here is what the WSJ said a few weeks ago when oil was $45: “While failure to reach a deal (an OPEC deal to cut production to prop up prices) would be bearish for oil prices, a Morgan Stanley analyst said the downside risk is limited since a “fair amount of skepticism” about the deal has been priced in to the market.” Of course, OPEC did reach a deal and oil prices jumped almost 10% to $51.

Getting the macro story and valuation right at the same time is very tricky. While tactically tilting portfolios can add value, smaller bets are best.  Humility is an under-appreciated trait of good money managers.

I know I sound like a broken record, but the key to successful investing is relatively straightforward. Get the initial asset allocation right, based on your needs and ability to shoulder risk. Spend some time on this. Diversification is the only free lunch in finance, so get diversified. And finally, choose mostly low cost index funds. They will provide consistent results and beat most active managers. APCM does this and more of course.

I hope everyone had a wonderful Thanksgiving. For the first time in quite a while we had all of our kids and grandchildren at our house.  And we still had enough leftovers to feast on turkey sandwiches for several days!

Jeff Pantages, CFA®
Senior Vice President, Investments

 

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