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Third Quarter 2016 Investment Report

Trumping the Market

How will the market react if Donald Trump wins the election?  That is the most popular question our advisors have been hearing over the past few months, especially as more states appear as “toss-ups” and their Electoral College votes going in either candidates’ direction.  Some investors think the market would tank were Trump to be elected.  Some think the opposite.  Most have no idea what will happen.  All are concerned.    Here is a partial list of items that could affect the economy and/or the stock market’s direction if Trump wins with a Republican-controlled Congress.

  1. Taxes – Trump’s desired lowering of individual and corporate income and federal estate taxes would put more money in people’s pockets.  This could result in a high degree of productivity gains, or leave the country with a multi-trillion dollar increase in the US deficit.   Either of those results would have potential economic and market repercussions.
  2. Trade – Trump does not like the inequality of certain trade agreements and unilateral import/export practices, wherein other countries use tariffs, but the US doesn’t.  This has the potential to start trade wars, which would both allow for potential slowdowns in trade, but increase sales of domestic goods to US citizens.  This would undoubtedly have a carryover effect on goods and services revenue of both domestic and foreign companies, which would undoubtedly affect corporate earnings and stock prices. 
  3. Dodd Frank – Trump has promised to do away with many of the financial industry regulations found in this 2010 legislation, due to its perceived costly, complicated and burdensome regulations that retard growth and competition.  Were this to happen, it would have far reaching consequences for both the financial industry and potentially the stock market.
  4. Foreign Policy – Trump has been very critical of the way the current Administration has handled many international relationships and situations, and vows to be a much stronger and effective proponent for the US in all dealings with foreign powers.  His promised aggressive, blunt, shoot from the hip style with world leaders may have an effect on how foreign leaders and investors view the US and its equity, bond and currency markets.

More than anything listed above, the rule of thumb with politics and financial markets has always been very basic and simple -- markets do not like change, nor surprise.  They are usually quite happy with the status quo, because “the evils that they know are superior to those they don’t.”  Consequently, having a new President with new goals from a different political party will always have the potential for a change or surprise.  Trump’s personality and leadership style add another layer of intrigue to this equation.  His brash, in-your-face method is clearly different from typical politicians who are steeped in political correctness.

The problem with playing the guessing game of applying politics to financial markets is that there are no guarantees that anything will happen the way you think it will, and the results of those guesses may be quite different than the outcomes one might expect.  For instance, the Brexit we all lived through a few months ago is a great example of how political events can be surprisingly different than initially surmised.  Most believed that Great Britain would vote to stay within the EU.  When the opposite occurred, most believed it would be a terrible drag on stock markets throughout world. 

Yet, even if you had guessed the correct outcome of the vote, and made investment bets that the markets would fall dramatically, you still probably wouldn’t have been successful. That’s because the entire downward event took two trading days to unfold, with the markets leaping back upward three trading days after the vote.  Even if you had guessed correctly, you would have been wrong about the short duration of the market move. 

The same situation confronts investors who feel compelled to change their investment outlook in reaction to the possibility of a President/political party in the White House.  It’s a multi-headed beast of a decision.  First, when do you make the decision that Trump might win?  Today?  Election Day?  The day after that, when the answer is evident?  What direction will the market move if Trump does win?  And assuming you guess correctly, how do you change your portfolio to confront your concerns?  Convert to cash?  Short the market?  Protect your portfolio with expensive put options?  Put all your money into companies selling wall-building supplies?  

And finally, what happens if the market moves against your strategy?  Will you have to pay capital gains taxes on sold positions, only to have to buy them back in a week, month or year or whenever you “feel better” about the news? And if you guessed wrong and the market advances, what is your plan to get back into the market?

There is no empirical evidence that one political party has a superior record for stock market gains.  See the chart below which tracks Presidents, their political parties and the stock market performance since 1926.

These are the times when investor discipline is of utmost importance.   Being a long term investor allows one to roll with the ebb and flow of political changes, and the potential volatility that may accompany a shift in power.  If there is a substantial market correction immediately following the election, it would obviously be a news-based, knee jerk variety, which would give an opportunity of rebalancing a portfolio back to your specified equity/income proportions.  Buying equities at a lower cost, especially during a frenzied, news-induced correction, has usually been a winning strategy for those with patience to wait out the storm.  There is never a better time to have a plan, and follow that plan.  Allow us to finish this little political and market history lesson with a word that Mr. Trump would hardily endorse.  By adhering to the DHGWA strategy, we feel very confident that your portfolio will have “HUUUGE” success over the long term!

Third Quarter 2016 Asset Class Returns

While many of us were being deluged with political talking heads, or political attack ads or political satire, third quarter asset classes had a very successful campaign, with almost all having generous positive returns.  The universe seemed to right itself a bit by reverting to some normalcy regarding those areas of your portfolio that we modestly overweight when compared to the broad market makeup.  During the quarter, Small Cap asset classes outperformed Large Cap (and the S&P 500 actually came in dead last for a change.)  In addition, Value outperformed Growth.  This occurred both in the US and internationally. 

After dramatically underperforming in 2014 and 2015, Emerging Markets are now leading all others year-to-date.  Last quarter’s report discussed the fact that Emerging Markets had already experienced a bear (greater than 20%+ correction) market, and it appears as though that bear has fled and a new bull market has taken over.  During the first nine months of 2016, Small Cap has outperformed Large.   If this holds through the end of the year, it will be the first time in three years that Small Cap stocks have beaten the S&P 500.  This may be signaling that the valuations of Small Cap have become too low for the marketplace to overlook.  Whether or not these trends will continue in the immediate future we do not know, but there is certainly room for much more outperformance when viewed by the amount of time they have lagged their comparisons.

There are still plenty of issues to cause investor concern.   US stock markets are very fairly valued leading most analysts to believe further market gains stemming solely from undervaluation are unlikely.  In addition, global economic growth is tepid at best.  China’s economy is experiencing a historic slowing of its growth rate while Europe is continuing its very slow economic path.  If you add the still questionable effects of Brexit to the equation, Europe is clearly in a very delicate economic position.  Accordingly valuations of European stock markets are much cheaper than the US.  

But not all news is negative.  In the US, employment remains strong, wages are rising and our economy, although not explosive, is still the healthiest of any major country.  Add to that a very accommodating Federal Reserve, low energy prices and solid consumer spending, and there is reason to hope for a continuation of the long term upward trend in corporate earnings. 

Of course, the short term elephant (and donkey) in the room is the upcoming election and any residual market volatility it may produce.  The Presidential election campaign has proven to be one of the most unique on record, and by the time we communicate again, the USA will know what direction its electorate has chosen.  And then another four years of fun begins!

In the meantime, remember to have a good sense of humor, savor the cooling, beautiful fall season and enjoy the upcoming holidays with those you love!

Sincerely,

Frederick F. Kramer IV, JD
Chief Investment Officer

Attachments

  1. 3Q16 Investment Report Final.pdf 10/5/2016 11:15:05 AM