Expectations for Trump Take Center Stage
For those getting used to not having down days in the market, or having the down days amount to mere rounding errors, it was good to get the reality check Tuesday that we can still drop 1% or more in a given day (it had been nearly six months). The complex side of politics and legislating dominated the news this week, and our long-held, long-proclaimed belief that the market was not appreciating the nuances and volatility that would go into implementing most of President Trump’s agenda legislatively took center stage. We’ll unpack all of that and more in this week’s Dividend Café … Off we go!
The market dropped 238 points on Tuesday, the first day in forever that the market was actually down more than 1% in a given trading day (quite literally, since October – the 9th longest streak without such ever). The market had actually opened up 50 points or so, meaning it must’ve been mid-day news that changed direction, and that mid-day news was the jitters that came after Trump met with the GOP House to make his case for passing an ObamaCare repeal and replace. Essentially, the thesis is this: If they House cannot come together for this bill with $600 billion of tax cuts, the elimination of the entitlement, and other deregulation and defunding efforts they generally love, then surely other parts of the Trumpian agenda are under attack as well.
Setting the record straight, again
When I look back at Dividend Café writings since the election and several media appearances where the same topic has come up – perhaps the theme we have harped on the most to describe our present market outlook has been the reality of political volatility. We do indeed believe that much of what the market is hoping for and wanting will come to pass, and we include in that list a repeal/replace of ObamaCare, corporate tax reform, repatriation of foreign profits, an improved individual tax code, and significant deregulation (particularly in financials and energy). We have focused more on where those things can happen all out of the executive branch (there are not many), as that is reasonably quick and easy. But most reform and change requires the legislative branch due to the brilliance of our founding fathers in our system of separation of powers (this writer identifies as a Hamiltonian and Madisonian every chance he gets, though admits that never impressed too many ladies when I was still on the dating scene). So we have and will continue to have complexity in getting things done, because the involvement of the legislative branch of government is messy. There are 435 Congressmen and women, and 100 Senators. There are 50 states. There are a plethora of voting blocs, coalitions, special interests, and unique issues. There will be horse trading. There will be amendments. There will be all sorts of up and down gyrations around what needs to happen and how it ends up happening. And yet, we remain steadfast that much of the market expectations around the new administration’s policy agenda will come to fruition.
Coloring in the dove
To add a little color to the Fed actions last week, they raised rates a quarter point again (following up on their quarter point raise in December). They still project two more this year, which still would only have the fed funds rate at 1.25% (from 0.75% now). Chairwoman Yellen did clarify that the Fed intends to continue telegraphing to the media their rate plans, but she also said that March plans were initially not believed by market because 2015 and 2016 ended up seeing a pace that was so much below what the Fed had initially intended. Her major additions to the news in the press conference were that they are acting now on what they see in the economy now, and not what they believe may come about after some potential Trumpian fiscal stimulus. She did not offer a lot of color on how European and Japanese policies and actions are informing their decisions, if at all. We see that as key as should she continue to hike rates and the Japanese/European central banks decide it is time to tighten their own monetary policies to some degree, there could be an ugly bond market rout. And should she tighten even as the others do not, there could be heavy divergence resulting in a dollar rally that offsets what they are going for.
Making Monetary Policy Easy
There is sort of a play on words here, as what we mean is “making it easy for our readers to understand” the terminology of monetary policy, and yet “easy” is itself a monetary policy term – it being the adjective used when the Fed is “accommodating” the economy, and “tight” being the term to describe the process of the Fed trying to take the foot off the gas in the economy (to slow things down a bit when they worry things are getting overheated). I read a report this week that offered what we think is a great definition of when the Fed is “easy” and when they are “tight”: when the Fed funds rate is BELOW the core inflation rate, it is “easy” and when it is well above the core inflation right, it is “tight.” Today, after three increases of .25% each in 15 months (Dec 2015, Dec 2016, March 2017), we see a Fed Funds rate that is STILL 1.3% or so BELOW the core inflation level, and therefore by any reasonable definition, still quite easy, or accommodative, or loose.
Eating the steak but not the veggies
What if an investor was only invested in the stock market when the Fed was “easing” monetary policy (periods of cutting interest rates, etc.), and went to the sideline during periods of “tightening” monetary policy? While it is true that historically returns have been stronger during easing periods relative to tightening periods, the fact of the matter is that being invested in BOTH periods has TROUNCED just being in during periods of monetary easing. Investors historically have not improved their lot by using monetary policy to time their way in and out of the market.
So if not monetary policy, then what?
For long-term investors, valuations are a better indicator for future expectations than Fed policy. Finding companies at reasonable valuations with opportunities for growing free cash flow and the ability to grow their dividend has been a phenomenal indicator of long term investment returns vs. other macro indicators like the Fed. The reason for this is simple, and yet very important: No two macro periods have ever looked exactly alike. We can talk about two periods of Fed rates being “X”, but that ignores what inflation was doing in those two periods, or corporate confidence, or fiscal policy, etc. In other words, extrapolating data and making broad conclusions is tough to do as an investment policy, because the eras and data sets being evaluated usually have clear and compelling reasons to not behave in tandem.
Oil still matters
Through all the conversation about fears over Trump’s policy agenda getting enacted, the slowness of deregulation in financials, the political drama around Comey and Russia and so forth, and of course the potential exhaustion of the bull market, we would note that it was the drop in oil prices from its high a month or so ago that began the drop in many sectors of the equity market. Now, the overall market has hung in there, and in fact as we circle below, Emerging Markets are up big through this period (for totally different reasons), but small cap, high beta stocks, the banks, and energy have seen drops which have coincided with oil prices.
Just hedge it away – it’s easy
A popular sentiment in investing is the idea that one can just “hedge away” market risk – and yet stay invested in the market. These “hedges” cost money, of course. Keeping exposure to the upside of markets without inviting the downside risk is a really dangerous fallacy, intellectually silly at best, and immoral at worst. We would just simply point out for those believing they can buy protection against BIG moves down in the market index – that “protection” is current the most expensive it has ever, ever been.
Active vs. Passive
The debate of the investing world is often the debate between passive investing (buy and hold low-cost index funds) and active investing (using fundamentals and various criteria to make investing decisions about what to own and not own). The Bahnsen Group has a very simple belief on the topic: It is almost always a moot point, because 90% of investor outcomes come down to their own behavior, not a passive vs. active approach. However, an indisputable fact in the sort of silly debate is that passive approaches tend to do best in periods of great market environments, and active approaches tend to do best in more challenging market environments. People are free to decide if the next 5-10 years are likely to be easy or are likely to be challenging (we usually don’t know things like that until we have a rearview mirror to tell us). But we do know this – tough return environments suggest an active approach, and tough return environments usually come when valuations have reached fuller levels, and inflation has bottomed out. I suspect you can tell where I am going with this …
Turning convention on its head
Look, the last thing we want to do is brag about one quarter, let alone a quarter that hasn’t even ended yet, but we do want to make a point about emerging markets. It was a universally accepted convention after the election that the dollar was going to rally, U.S. equities strengthen, and Treasury bonds were cooked – all three events supposedly combining to make for a really bad environment for investors in emerging markets. And yet here we are, with emerging markets stocks up somewhere between 11% and 14% year-to-date. The dollar has not rallied (nor declined), so perhaps it is not that the conclusion from the premises was wrong as much as one of the premises themselves, but we would make a different point. Investors entered this period with emerging markets currencies under-valued, not over-valued, and they also entered underweight emerging markets stocks. Inflation expectations are higher which has allowed EM to weather the modest Fed tightening in stride thus far. China hasn’t fallen out of bed and to the surprise of many has kept the sort-of “goldilocks” scenario alive. Essentially, the big picture for emerging markets has come together quite well, and investors who believe in a bottom-up approach to great values in areas of compressed valuations (strong risk premium) are being rewarded. We believe this will continue, though not in a straight line by any means, for many years to come.
Chart of the Week
This week’s chart of the week could basically be titled “why we exist on planet earth.” You see here a reality that is not likely to change – ever – but is a reality we work tirelessly to protect our clients from. You see here an incredible inflow of money from “retail” investors (individuals) into stocks in the years going into the financial crisis, and then you see incredible moneys out of the market just in time for an eight-year recovery. The red line, though, indicating “institutional” flows points to full participation in the great recovery bigger and stronger investors. We do not know if “retail” money after two bad bear markets last decade will ever behave normally again, but seeing so many people not participate in this bull market can only be described as tragic.
Quote of the Week
“Worry does not empty tomorrow of its sorrow. It empties today of its strength.”
— Corrie Ten Boom
By this time next week we will be closer to the end of the first quarter of 2017, and have a better read on much of the political landscape and environment the Trump administration faces for the rest of their economic agenda. We don’t have a Fed meeting any time soon, and Q1 earnings season will not launch for three more weeks, so it will be all politics (more or less) for a while longer. But hopefully for your weekends, there will be no politics, no earnings, and no stress. Enjoy your families, enjoy college basketball, and reach out to us any time.
Article originally published on Dividend Café.
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