Year 3 – Can Trump Magic tame The Bear?
Posted by: Brian Dennehy
Donald Trump was elected on 8th November 2016, and his third year* has just begun. After two cracking years for markets, what can we expect from Trump 3?
Trump’s first two years have been very profitable for the US stock market, up 15.9% and 9.63% respectively.
Why did that happen? Was it Trump’s “magic”? (a word he used to describe himself on Wednesday with all due modesty). Or something else?
And, even more importantly, what does this hint at for the next 12 months?
You have to go back a step and ask “what drives markets?”, whether up or down. One note I read today is similar to many I have read day after day for far too many years. The writer tells us that the markets should continue to make “good progress” because “the world economy should expand at more than 3%”. The prospects for the US stock market are “particularly positive” due to “strong earnings growth in the technology sector”. This is what our web designer calls W.O.B.*
This is the positive mantra of many analysts and fund managers - cheerleaders all.
The problem is that the link between economic growth and stock market strength is (counterintuitively) weak. This can be quite complex. Academics regularly cross swords on this subject. But two features do appear consistent:
Investors are typically better off investing in the more sluggish economies (based on research by LBS of 19 major countries, 1900-2011)
Investors typically over pay for growth (because by the time economic growth actually appears, stock markets have already allowed for it in share prices)
Another light was shone on this recently by new research from Robert Shiller, who made who made famous the CAPE
measure of stock market value. On this occasion he was exploring the 13 bear markets since 1871, and the conditions preceding each of them.
Beware High Earnings Growth
Shiller observed that real earnings grew by 1.8% p.a., on average, since 1881. But before all the 13 bear markets they averaged a very high 13.3%. They are currently running at 13.2% - expecting more real earnings growth is therefore a negative indicator.
How about low volatility. Is low volatility good news? (Volatility in this case being the standard deviation of monthly returns in the prior 12 months).
Before answering that just bear in mind this quotation from Hyman Minsky:
“Stability Breeds Instability”
The long-term average volatility is 3.5%. The peak month before the 13 bears was lower than this, at 3.1%, and before the 1929 crash was 2.8%. Today volatility is at an extraordinarily low 1.2%.
In short, on these measures alone the US stock market (the global bellwether) looks like it is in much the same place as it was before prior bear markets (which Shiller defines as a 20% fall within 12 months).
So What Does Drive Markets?
Confidence. And, in aggregate, it drives economies too.
People must be confident about the future to buy investments. As consumers they must be confident to spend their earnings. Company owners and manager’s must be confident to hire employees or spend large sums on new equipment.
Most of our lives are spent with confidence in the vanguard – it ebbs and flows of course, but at some level confidence oils our existence from day to day.
For many economists and analysts, the role of confidence is either ignored or only begrudgingly acknowledged because it defies definition or measurement by an equation – it lacks precision. Confidence has too many inputs – it is a behavioural matter, the bête noire of many economists and theories of how markets behave.
Yet there are ways in which confidence can be measured, and the level of the stock market is one such measure. In particular Robert Schiller’s CAPE
tells us right now that market participants in aggregate are very over-confident – certainly equivalent to 1929 and 1999. But I digress…
How does this inform us about Donald Trump’s third year?
Donald Trump knew what levers to pull in the first two years of his presidency. The dictionary tells us that other words for confidence are trust, belief, faith, and conviction. Trump gets this.
Those who felt their Faith was threatened now feel they have an ally. Those who feared the next economic cycle trust Trump to put cash in their pockets. Those who feel they have been ignored by the political elite for decades now have someone who believes in them, creates jobs and appears to care.
Trump appears to pull all of these strings with some dexterity (not an adjective you would naturally associate with him).
When his supporters are confronted with his, how can I say, idiosyncrasies they do tend to acknowledge them. But they feel that yes, he might be a S.O.B., but he is our S.O.B.
Trust, belief, faith – and conviction. The votes follow with conviction.
This confidence is infectious, and its impact is also reflected in the stock market, which is why he has so vocally claimed credit for the stock market boom – on this at least he is probably right.
Will that Trump “magic” keep markets headed up?
In year 3 we don’t need to predict what might change – predicting change is always difficult. In contrast identifying what will stay the same is relatively easy. Trump will deliver more of the same. He will keep pulling the same strings.
But stock and bond markets have recently begun to show cracks. The problem for Trump is that he came on board when valuations were already extremely stretched, when the economic recovery was already long in the tooth, with debt levels sky high, and where the Federal Reserve was already committed to raising interest rates.
These are formidable barriers.
A large part, perhaps the largest part, of his support base do not care about the stock market. But two problems remain for the President.
He cannot afford for even a small part of his voting base to lose confidence. If the Trump-ite wealthy, whose pockets have been lined by tax cuts and booming profits, are hit by markets falling sharply (let’s say more than 20% for the sake of argument) he is in trouble.
Confidence is contagious, and lack of confidence is even more contagious. Faltering sentiment triggered by stock market falls will feed through to those who have little or no direct exposure to the stock market. Less confident business owners and managers will reduce spending and lay off employees,
He can blame a raft of others if the market cracks widen, but The Magic Man will need to pull a very large rabbit out of the hat to counteract the factors which would ordinarily pull the market much lower. You can bet he will give it a go – the how will be interesting.
Year 3 – Not For The Faint Hearted
Year 3 seems certain to be much more volatile than what we have experienced in the first two years. That’s the optimistic view. But it could be a bad year. A very bad year.
Just keep your guard up. From the ashes (whenever that might be) you will be presented opportunities that might only arise a handful or so of times in your investing life.
Right Now? – Plan For That Downturn
Do ignore the complacent noise from too many economists and the wider investment industry – at best it is irrelevant, at worst it will distract you at a time when your attention is vital.
If you are a DIY investor, and reasonably fully invested today, you must be prepared to be fleet of foot. Do have a stop-loss strategy to avoid the possibility of much larger drawdowns than 20%,
* His inauguration was in 20 January 2017. But his impact began as soon as he was elected
** “Warm Old Bxxxxxxs” = meaningless.