November 15, 2016

In the wake of Brexit in the U.K. and the election of Donald Trump in the U.S., 2016 has now secured its place in history as a historic year of change. In the weeks and months ahead, the U.S. now faces a series of political and economic adjustments that most investors thought unthinkable just a few weeks ago.

A survey released this morning highlights the impact the election has had on the investment markets. Institutional money managers indicated, on average, a level of bullishness not seen in years.

The logic behind this new level of optimism may not be sound, but the market rotation in the past five trading sessions is the most substantial we’ve seen in decades. Financials, Industrials, healthcare, and biotech are the biggest beneficiaries, while bonds, gold, silver, technology, and emerging markets are the losers thus far.

As I evaluate the markets, the biggest difference I’m seeing is the “perceived” change in the risk-reward potential. One of the reasons cash positions for institutional investors were at record highs and growing in recent months was that upside potential in both the equity and bond markets seemed limited, while the downside risk appeared significant.

Today, equity markets now seem to carry the “fear” that real upside potential exists.

From a behavioral standpoint, this is a major shift in market psychology. For the first time in well over a year, the fear of missing out on a healthy rally is present, even though most realize the downside risk has likely not changed.

*As I outline the pros and cons of our new environment, I would ask readers to please set aside politics – this is not meant to be political – it’s strictly investing.

The Optimism Trade

The optimism in the market this week revolves around the notion that a return to pro-growth policies will heal our sluggish economy.

The new plan highlights: A new trillion dollar infrastructure package that will employ tens of thousands; A decrease in the corporate tax rate to 15% that mathematically translates to a 40 percent boost in earnings growth rate; The easing of the most burdensome regulations in US history that will spur small business; The normalization of interest rates for savers; Lower personal tax rates and a simplified tax code for all; The repeal of Obama Care and Dodd-Frank; And better trade deals and tariffs to drive new job growth and strengthen American business interests.

All of which, when combined, will create an immediate surge in economic growth to a healthy 3 percent plus range that will justify today’s lofty stock valuations, allow interest rates to normalize, and permit the government to finally address the national debt.

The Reality Check

First, much of the optimism trade is being driven by the hope that the return of policies from the 80’s and 90’s will have the same type of success today.

That may be a reasonable assumption in some ways, but certainly not all. Our economic and market starting point today is much different than it was in the early 80’s. President Reagan started his first term with an ugly environment, but stock valuations and our national debt (Debt to GDP) in 1980 were near historic lows, not near historic highs as they are today.

Second, implementation is not immediate. In the coming months, most of the policies being discussed today will be met with political negotiation. Likely the easiest and most impactful in the near-term will be regulatory relief, but both tax cuts and infrastructure targets will likely see some opposition and compromise. Moreover, infrastructure projects won’t kick in until at least late 2017, and the bulk of their economic impact will take time.

Third, the biggest risk in the new economic plan is renegotiating existing trade deals. Even the hint of “serious” renegotiations could roil markets in the short-term, as Governments would rhetorically position to defend themselves from the threat. When it comes to trade, the thing for investors to keep in mind is that billions have been invested by governments and business based on existing trade deals, and history is littered with examples of trade disputes hurting economies.

The Big Picture

We’re about to see a historic economic policy shift. The economy will soon receive a multi-faceted stimulus boost based primarily on infrastructure and the private sector rather than the Federal Reserve.

Working against that stimulus will likely be higher interest rates, a stronger dollar, possible trade disputes, and a non-accommodative Fed. All of which create a substantial hurdle for the new found stimulus to overcome.

Moreover, most of the fundamental concerns that were present before the election are still intact today - record corporate debt loads, elevated stock valuations, record consumer credit debt, low productivity, a Fed switching course, and an aging bull market.

The challenge for investors is to now weigh the new stimulus against both the new and old negatives. In my opinion, the extremes on both sides of the near-term investment ledger create cross-currents unlike anything we’ve seen since 1980.

To refresh our memories, in 1980 President Reagan reversed course on economic policy while the Fed simultaneously raised interest rates. At first, the markets rallied on the pro-growth agenda, but within a year the increase in rates overwhelmed the stimulus, and we slipped into the deepest recession since the great depression.

It wasn’t until after the 1981 recession, and a market fall to prices not seen since 1966, that we experienced the greatest economic prosperity boom in history (1982 to 2000).

Given the complexity of today’s fundamentals – many of which are highly dependent on the unpredictable behavior of the Fed and politicians – I think it’s wise to accept the reality that economic and market analysis will be a difficult high risk toss-up for many months to come.

As such, my top risk management priority in our present high-stakes environment is to protect from a major loss, such as the average bear market loss of 30%. Given this objective and the present conditions, this is a textbook environment for active / tactical portfolio management.

Unfortunately, buy and hold (B&H) investing is now all the rage in the media, but the popularity of B&H by the investment herd is just another classic red flag for investors to add to the growing list of red flags. Sadly, the vast majority of B&H investors are likely taking much more risk than they realize or can ultimately tolerate. It is uncanny how this cycle repeats… Today, the mantra is, “active investing is dead.” In 2009, the mantra was “buy and hold is dead.”

So what’s an investor to do?

On the equity side of the equation, tactical investment models are presently neutral to positive. Given this, I’m advising clients to increase exposure to equity-based ETFs, dependent on their present allocation and personal risk tolerance.

As for bonds, since the election bonds have seen sharp losses, and most tactical models are negative. Given this, shorter maturities may be more attractive than intermediate and long.

Investors with new lump-sum money to invest are being encouraged to invest systematically, using a flexible dollar-cost-averaging approach.


*** For those not familiar with the firm, it’s important to note that we are not short-term market timers. In most environments we prefer to be predominantly buy and hold investors, but in high risk environments our strategy turns more tactical (active) with a greater focus on risk management. We’ve been primarily tactical since December 2015.

For more information on how we blend buy and hold with tactical strategies please read our Investment Strategy page.