Following the fireworks of BREXIT that marked the end of the second quarter, stocks rallied into mid-August reaching an all-time high for the S&P 500® Index. From there, stocks meandered with a slight downward bias until a rally in late September brought the major averages back to almost record highs.
BREXIT is the name given to the surprising outcome of the vote by citizens of the United Kingdom to leave the European Union. It deserves some examination because we think that something similar to BREXIT, but on a grander scale, may occur here in the U.S. come November 8th.
Our view on BREXIT was that the vote would likely go the way of the U.K. staying in the EU albeit a close one. This would represent the path of least resistance and frankly the “smart money” was betting on that outcome. At Kessler Investment Group (KIG), we agreed that the voters would likely choose to stay, but we remained prepared for the opposite. In other words, we did not want to be fully invested, in case the vote went for BREXIT. At the same time we did not want to be too heavy in cash and believed that there was already enough cash on the sidelines in advance of the vote to limit the downside for stocks. We split the difference and raised a little bit of cash in advance of the vote so that we would be well-positioned to take advantage of the volatility regardless of how the vote went. This turned out to be a reasonably good decision.
We want to emphasize to our clients that while we formed an opinion on the outcome of the vote, our primary focus was fixed on the underpinnings of the market and the economy. The KIG view was that regardless of the outcome, the market would likely move higher following the vote due to other factors. Relatively strong economic data and rising cash levels had failed to push the stock market higher, as stocks had not budged since early April. We felt that a vote to leave the EU would not be the catastrophic event described in news reports, yet stocks had not fully priced in a vote to stay. So, despite the surprising but not “catastrophic” outcome of the vote, stocks rallied nearly 4% from their levels before the vote and over 10% from the lows that were reached 36 hours after the vote.
KIG came by our decisions in part by placing little faith in polling data. We more or less agreed with the polls that suggested the U.K. would stay in the EU, but we didn’t lose sight of the limitations of polls on predicting the outcome of humans voting. Polls capture the fickle nature of voters more than how they will actually pull the lever. As we saw, people voted in favor of leaving the EU in a kind of “protest vote” because they felt (as the polls suggested) that the “Stay” vote would prevail anyway. Apparently, so many voters did this that it seemingly changed the referendum’s outcome.
Fortunately for our managed accounts, our view that volatility would increase following the vote but that stocks would move higher proved fairly accurate. The downdraft and recovery in stocks was so quick that we did not have time to deploy all the cash we had available. None the less, we were able to purchase a few companies that we felt were unduly sold following the vote. As a result, our managed accounts were almost fully invested during the strong 10% rally off the lows that followed the vote.
As for our Presidential Election on November 8th, we think something similar to BREXIT could happen. Specifically, there could be a meaningful difference between the number of people who say they support Donald Trump in polling and the number of voters willing to cast their vote for him as President. There are similarities in the sentiment surrounding the Trump campaign to that of the BREXIT campaign. That is, a sentiment driven by nationalism, cynicism and contempt. We offer no commentary on whether this sentiment is well-founded or misinformed. Instead, we are working hard to discern if the market has priced in one outcome over the other and whether the economy will be materially affected by one outcome or the other. This is our charge and what we dedicate our time and effort to understanding.
Interestingly, we see a similar set-up ahead of the presidential vote as that of BREXIT. The polls are fairly close but the likelihood that the “path of least resistance” wins seems to be swaying the markets. In other words, the polls that suggest Clinton will win and maintain a similar approach as the last 8 years is calming to the market. This is what we believe has led to a fairly stagnate market since mid-August despite the retched tone of the campaign.
We expect volatility, on a much grander scale than what we saw following BREXIT, will define the market for a while after the election. However, within that period and beyond lies a tremendous opportunity for investors. Economic data is lining up in a way that we believe will drive a long-term rally in stocks. Those with a steady hand can use the volatility to find tremendous opportunities to make significant gains in stocks.
As we look forward to the election, our conviction lies not in the accuracy of the polling data but in the checklist of positive economic indicators that exist here at the end of the current 17-year investment cycle that began at the end of 1999. Our conviction lies with our belief that we are about to transition to the next 17-year cycle which, if the trend that began before the Civil War continues, it will be reminiscent of the period 1982-1999. During this period the S&P 500® Index rose 11-fold.
As we frequently point out in these missives, the real value in looking at past market cycles is not to focus on what is different between them but what is similar. What is different is much easier to see and therefore of less value. It takes a bit of a trained eye to correlate the similarities in investor sentiment, political tone and fiscal and monetary policy. So, here are a few of the similarities we see between the end of the 1965-1982 period and our current one which began in 1999. Keep in mind that what followed the 1965-1982 period is what we believe could be in store for us now.
- Negative sentiment among investors and voters is near record levels now as it was at the end of the 1970’s. The Iran hostage crisis reminded us how tied to the Middle East the U.S. had become. The echoes of Watergate were still ringing in our ears and the Republicans had nominated a candidate who was quite an actor but not a career politician.
- The need for cooperation between the Federal Reserve and the White House was at a critical stage. Back then the Fed wanted to raise interest rates but economic growth was already stagnating. It took a bold (and expensive) fiscal plan from the White House to offset the negative effects of the Fed raising interest rates to drive down inflation.
- The stock market came into 1965 hitting an all-time high but never built on it. While stocks are near an all-time high now, there has not been a significant gain over the level hit in 1999. In fact, the period between 1965-1982 saw three 30%+ declines in stocks during this period with one of them, in 1974, hitting 50%. Each decline was followed by a robust rally that simply brought the averages back to the record level that had been hit in 1965. This is similar to the pattern which has played out since 1999.
- Cash levels, or more accurately non-stock investments, was at a record level at the end of the 1970’s as it is today.
While these bullet points and many others line up with our historical view of the markets, we also see the necessary fundamental ingredients in place for a prolonged rally. If you were to query academics in finance about the economic pre-conditions necessary to support a sustained market rally, we believe they would list most of the conditions already in place today. Here are a few:
- Low energy prices to keep profits high and consumers spending.
- Low interest rates to encourage home buying and investment by large corporations.
- Low unemployment.
- Wage inflation that is not so hot that it eats into corporate profits but strong enough to bring about pay raises.
- High levels of cash reserves that will seek out better yields than sitting in checking or demand deposit accounts.
- Technological advances that spur new products and services.
All of these factors are essential for a rally to take place but the real “kindling” is negative investor sentiment. If investors are optimistic then it is likely they will be fully invested. If they are fully invested, then there are fewer dollars (and buyers) to push prices higher.
Heading into the current market cycle, The American Association of Individual Investors bullish sentiment indicator sat at 60%. The Association’s most recent survey indicated bullish sentiment was a paltry 25%. With current investor sentiment this low and all of these ingredients mentioned above in place, we expect cash reserves to fuel rising prices in stocks for a long time to come.
As for the long-term effect of the election on the 17-year cycle, we believe either candidate will deliver the fiscal stimulus necessary to propel stocks higher. It will take different forms depending on the victor.
In the case of a Donald Trump presidency, we believe fiscal stimulus will come in the form of infrastructure spending. This is a business man as comfortable spending other people’s money as his own. So, we expect him to utilize the U.S. Treasury in this low-interest rate environment to its fullest potential. This spending will grow the deficit initially but as long as it accelerates economic growth then there is a real possibility that tax revenues will accelerate too.
Interestingly, we believe such a fiscal plan would work because the obvious merits would lead the Democratic Party to embrace it, regardless of their distaste for a President Trump. Donald Trump has been successful in his professional life as a deal maker. This skill will serve all of us well if he is able to negotiate deals between the two parties.
In the case of a Hillary Clinton presidency, we believe fiscal stimulus will come in the form of tax reform. Ms. Clinton had a first-row seat to the way Bill Clinton handled fiscal stimulus. We believe she is as cunning a politician as her husband and just as populist. The House and Senate are likely to remain under Republican control if Hillary wins. (We believe the opposite is true if Trump wins.) So, it is likely that many of these Republicans will thank a President Hillary Clinton by helping her push through tax reform. Tax reform is very much a text book approach to fiscal stimulus that the Republican Party could embrace regardless of their distaste for a President Clinton.
Whether the fiscal stimulus comes in the form of infrastructure spending or tax reform, we believe it is coming and at a critical time. The Federal Reserve is desperate to normalize interest rates and move back to a less radical monetary policy. Such a shift in monetary policy would almost certainly push the economy into recession unless it is married up with a pro-growth fiscal policy. With a strong opinion that either candidate will work hard early in their presidency to set a pro-growth tone, our optimism feels reasonable. It feels even more reasonable given the overwhelmingly negative tone surrounding this election. While we believe that there are risks with either candidate, we do not believe the United States of America will collapse any more than we believed the United Kingdom would fall into the North Sea following BREXIT.
Before our optimism turns Pollyanna, let us emphasize that volatility is likely to rise and soon. If Trump wins the election, we would expect stocks to drop almost across the board. To many, this would be easy to interpret as the beginning of a long-term decline or even a crash. We would interpret it differently. Significant volatility would more likely be the result of a huge unwinding of investments that were made expecting Hillary Clinton to win. It would not necessarily mean that systemic risk had entered the markets and a crash was eminent. Once the trades are unwound and investors can see more clearly the direction of White House policy, new investments would be made with this new policy in place.
The volatility following a Clinton victory would also be misread if one thought a crash was imminent. Many investors are content to leave their positions in place thinking that a Clinton victory would mean four more years of Obama policies. It seems unlikely to us that a President Clinton would stay the course on Obama economic policies. As an independent-thinking politician she would likely want to establish her own policies. This would likely lead to investors repositioning their investments in response to a shift in policy. This repositioning would lead to volatility and a decline in stock prices but only temporarily.
Regardless of the outcome of the election, we are gearing up for an increase in volatility during what is typically the best-performing part of the year for stocks. We have raised cash and sold out of some stocks in favor of others stocks in different sectors. We have done this to reduce risk and increase flexibility to take advantage of opportunities that come out of such volatility.
If stocks do not follow our script and go straight up following the election, then we will likely underperform the major indexes due to our reduced exposure to stocks. However, if volatility does follow the election, we believe we will be well-positioned to take advantage of such a decline and prepare client portfolios for the coming rally.
Kessler Investment Group, LLC