About jimhemphill

I am Chief Investment Strategist for an investment advisory firm in Radnor, Pennsylvania, just outside of Philadelphia. Our investment approach is globally-diversified, with our research focus on using relative-pricing and relative-yield information in historical context as a guide to optimal asset allocation.

After the Deluge


 

I went to bed last night at 2 a.m. I’d been sure of the outcome since about 11 p.m., and got tired of waiting for one network or another to announce it. I woke up this morning to Donald J. Trump as the President-elect. Not what I expected yesterday morning when I went to vote, though I had discussed the specific scenario by which he won several times in the days before the election.

So how do we find sound footing after being swept away in this historic flood? We don’t. Because there was no flood.

Donald Trump secured one of the most unlikely victories, in one of the most amazing upsets, in American political history. This is bigger than when “Dewey beats Truman” was wrong in 1948, because Trump won against the projections of a massive apparatus of scientific polling. He confounded the doubters and the critics. He has swept away one of the most powerful American political dynasties. (And good riddance.)

But astonishing does not equal overwhelming. Right now, Donald Trump trails Hillary Clinton by less than 200,000 votes. Yes, you read that right, he trails. Depending on which website I consult, he has a confirmed total of between 276 or 289 Electoral votes. (The most likely final count adds 30 Electoral votes to the lower of Trump’s totals.)

This is a huge upset. Trump won, Clinton lost, absolutely certain, almost entirely unexpected. But it is no kind of landslide, no kind of mandate. It is, for the fifth time in American history, an Electoral College victory combined with a loss in the popular vote.

President-elect Trump savors his victory amid the most bitter partisan divide since Abraham Lincoln took office at the beginning of the Civil War. Public anxiety is the highest since December 8, 1941, the day after Pearl Harbor. Confidence in government and our public institutions is at the lowest level ever. And over 60% of American voters believe that Trump lacks the temperament to be President.

Sounds like we have nowhere to go but up.

Eight years ago, Obama took office with high expectations that he would lead us into a bright, prosperous and post-racial future. That hope went unfulfilled, with the blame fairly shared between President Obama and Congressional Republicans.

Trump will take office with the lowest possible expectations, with Republican majorities in the House and Senate, but with Senate Democrats retaining the power of the filibuster. He’ll have the opportunity to replace a deceased, very conservative Supreme Court Justice with a new judge unlikely to be any more conservative.

Last night his victory speech hit all of the right conciliatory notes. Let us all hope that Trump governs effectively and inclusively, that he surrounds himself with capable men and women, and that America’s future is bigger than its past.

May God bless, protect, and strengthen the United States of America.

 

 

End of the Nightmare

“It’s amazing what one honest man can do. One honest man and a cause.”

General Lo Armistead

“I don’t think on that too much anymore. My only cause is victory. This war comes upon us as a nightmare. You pick your nightmare side. Then you put your head down and win.”

General James Longstreet

I’ve had the Longstreet quote above running through my head the last few weeks, unable to recall where I’d heard it. Today I was finally able to retrieve the context from my aging brain. When I located the entire passage from the 1993 movie Gettysburg, I realized the complete exchange was even more pertinent to the entire 2016 election, now coming mercifully to a close.

In the movie, a group of Southern generals are discussing the excellence of Robert E. Lee, while their commander General James Longstreet is reflecting instead on the brutal nightmare the Civil War had become in its third bloody year. The ultimate result of the Civil War was largely decided at Gettysburg, just two hours drive from where I sit in eastern Pennsylvania. In the event that Trump pulls off a surprise upset tonight, Pennsylvania will likely be a key part of his victory.

This entire election cycle has been a nightmare. Asked about their feelings on the final day of the campaign, voters most often identify anger, fear, and depression. Those negative feelings are especially strong among independents, a group with which I find myself identified for the first time. Most Americans have picked one of the two nightmare sides, and are hoping their side wins.

Our national angst at the election contest derives in part from the bitterness and divisiveness of the rhetoric on both sides, but even more from the absolute lack of confidence in the nominees of either party. These are the two most disliked candidates of my lifetime. Despite the apologies of partisans on both sides, I believe that dislike is entirely deserved, again on both sides.

During the Civil War, Americans literally killed each other, in numbers never equaled in any other conflict. Yet the fighting men of both sides were able to recognize the excellence of their opponents, their courage and commitment, despite the fact that they were fighting to the death.

We seem to have lost that ability. The bitterness of this election divides friends, families, communities. How is it possible that our ancestors at Gettysburg could treat each other with respect immediately after slaughtering each other by the tens of thousands, yet our candidates today are unwilling even to shake hands before a debate?

A central reason for the partisan divide is that we have lost the very idea of virtue in public life. This process really began in the 1990s, during the first Clinton Presidency. Conservative William Bennett wrote The Book of Virtues, desiring to instruct children in those qualities of character necessary in a democratic society. Democrat Ben Wattenberg responded with Values Matter Most, a book asserting that such liberal priorities as education or affirmative action should form the core of a more elevated national conversation.

The problem, of course, is that values are something that you are not likely to share with your opponents, especially if values are defined in narrow partisan terms. Virtues, on the other hand, are affirmative qualities of character and soul that you can recognize even across profound partisan, cultural, national or religious divides. At Gettysburg Union General Winfield Hancock, gravely injured, brought water after the battle to his dying Masonic lodge brother, Confederate General Lo Armistead. He loved his friend, even though they fought on opposite sides of the most divisive question in American history, whether men might hold other men as property.

This year, the nominees of both major parties are individuals of poor character. Both have lied about issues of material importance. Both have a history of treating ordinary people with brutal indifference. Both have ignored the law, the rules, and common decency whenever necessary to advance their own interests. Neither candidate possesses any visible humility or ability to admit error.

We once shared the belief that good character was a necessity in any candidate for high office, and we celebrated such character in the lives of great Presidents like Washington, Lincoln, Teddy Roosevelt, and Truman. The choice of these two individuals, Trump and Clinton, to compete for the world’s most important office represents a betrayal, not just of a commitment to character in our leaders, but also of the central values of each party. The Democrats chose someone who has used political influence to accumulate a vast fortune, mostly through relationships with powerful financial interests and authoritarian foreign governments. The Republicans chose a crude man with no understanding of American history, Constitutional principle, or the necessary limits of government power.

Both parties have failed us, in fundamental and obvious ways. Each party’s voters believe that a victory by the other party’s candidate poses a fundamental danger to the health of our democracy.

So my wish is that both parties, regardless of the outcome of today’s contest, will recognize the damage done, in choosing their standard bearers, by abandoning a commitment to basic decency and to the principle that the public interest must take precedence over personal gain . Out nation needs, and our history and principles demand, a better class of candidate next election cycle.

The Election and Your Money

In past years, I’ve written on this topic once the results of the Presidential election are known. This year, I’m posting prior to the election, because some of the potential short-term effects of the election results are worth considering, so as to be ready if market dislocation follows next Tuesday’s vote.

This is my eleventh presidential election, and surely the most contentious. I won’t tell you how to vote, or even touch the arguments against the two major-party candidates. Good luck to all of us when we step into that booth and confront the duties of our citizenship.

What I will comment on is the investment implications of this election. You can also watch a recording of our recent webinar, The Markets & The Election Season. How will the results affect our portfolios? Is there anything we should do in advance of the election, either to protect ourselves or to maximize our opportunities? Are there actions we should be prepared to take after the election, depending on the result?

As always, let’s start by examining the data. We have really good data going back to the presidential election of 1952 about how U.S. financial markets have reacted in the short-term, over the two months on either side of presidential votes, to different election outcomes.

Here’s a summary of some of the key points:

  • Markets usually go up slightly in the two months bracketing the presidential election.
  • They go up more if the election is close.
  • If the election is a landslide, they go down a bit.
  • If the party in the White House changes, they go down. If the White House remains with the same party, they go up.
  • If a Democrat wins, markets decline, while a Republican victory sends markets up by exactly the same margin.
  • None of these historical moves averages as much as 2% in either direction.

So the best scenario for the markets is if the Democrats retain the White House by a slim margin, and a Republican wins the presidency. Which is clearly self-contradictory, and thus no help at all.

Does either party have a longer-term advantage? Yes, there is a slight advantage for Democrats in long-term returns. But if you deduct the market crash of 1929-1932, the Republicans have a slight edge. As investors, we really have no reason to prefer either candidate based on historical market reactions to partisan outcomes.

Is there a more reliable metric we could apply?

As we often do, we fall back on valuation. Economist Robert Shiller of Yale University won the Nobel Prize in Economics for his insight, captured in the Shiller CAPE (Cyclically-Adjusted Price Earnings ratio), that when stock market valuations are high, future returns are lower, and when valuations are low, future returns are higher.

The last two times the presidency changed hands, in 2000 and 2008, we used Shiller CAPE to inform our broad perspective on the markets.

In 2000, when George W. Bush finally won, valuations were high, and we warned that risks were high and prospective returns likely to be low. We took a defensive posture. As the tech crash continued through 2003, our portfolios largely avoided the market decline.

In 2008, when Barack Obama won a compelling victory in the midst of the worst stock market decline since the Great Depression, we observed that stock prices were below average. With risks lower and opportunities higher, we pounded on the table in favor of buying stocks. At the market bottom in 2009, our stock holdings were the highest ever. We were ultimately well-paid for owning stocks, as Barack Obama’s first term was one of the most profitable for U.S. stock market investors in a generation.

Today, market prices are high. With Shiller CAPE at 26.5 times trailing earnings, we are in the top 7% of historical valuations (93.6th percentile). Our portfolios are defensive, just as they were in 2000 when Bush 43 was elected.

A little more than a week ago, a Hillary victory with limited “coattails” appeared to be priced in.[1] A sharply different result—either a Trump victory or a Hillary victory with big coattails, giving the Democrats control of the House and Senate, would have been surprising, and thus likely to lead to a short-term market decline. (For what little it is worth, historically market returns have been highest with a Democrat in the White House and Republicans in control of Congress, just as we have now.) As Trump closed the gap, the U.S. stock market declined for nine straight sessions, the longest losing sequence since 1980. We have done limited buying during this decline, mostly for clients who were over-weight cash.

There is an aspect of our portfolio strategy that may intersect in interesting ways with the election results. While U.S. valuations are very high, all foreign stock markets are cheaper as measured by CAPE, without exception. We are overweight foreign equities.

To evaluate how this positioning might perform after the election, let’s examine the reaction of markets to the British vote on whether to leave the European Union (Brexit). Immediately before the vote, the final polls predicted Brexit would fail and Britain would remain in the EU. Markets rallied sharply. But Britons actually voted for Brexit, against polling predictions. Markets fell sharply, both in the U. S. and in Great Britain. But within weeks, markets fully recovered in both the U.S. and overseas. So far, so unremarkable.

But one market fell sharply and has continued to fall in reaction to Brexit—the currency market for the British pound, which fell by 6.0% the next day and has fallen another 10.4% since, with no sign of recovery.

What is the similar scenario in the U.S.? It would be a Trump victory, against the indications of the majority of polls. If we followed the Brexit path afterwards (no guarantees of that at all), we would see a sharp decline in the S&P 500, followed by a full recovery in stock prices, but we would also see a sharp and persistent  decline in the value of the U.S. dollar.

That single, entirely speculative scenario would actually benefit our target portfolios, because we are strongly over-weight foreign equities. A falling dollar increases the price of foreign stocks. Of course, there are multiple other scenarios under which we would not benefit.

Our advice is to exercise your franchise in line with your moral, political, and philosophical convictions, and to expect markets to react to the election results in unpredictable ways. Know that our portfolios are defensive and diversified, that we have cash available to invest in the event of a large market decline, and that we remain committed to a global perspective on investing. As always, we are devoted to your lifetime financial success, and none of our personal political perspectives will ever deflect us from making decisions solely based on what we believe to be your best long-term interests.

[1] A President’s election is said to have “coattails” when it also results in large gains for down-ticket candidates for Congress, Governorships, or state-house races. Examples during my lifetime were Johnson in 1964, Reagan in 1980, and Obama in 2008.

Rolling Bubbles

I just ran across an article on the recent collapse of the “emerging art” scene, which revolves around works by young artists, many still in their 20s. An art dealer bought a work by a hot young artist for $100,000 back in 2014, and is now trying to sell it for $20,000, before it goes to zero. Here’s an excerpt from the article:

This week, estimates for three Smith pieces are as low as $7,000. One, from the series he made by spraying more than 200 canvases with paint from a fire extinguisher, is estimated at $12,000 to $18,000. A bigger spray work sold for $372,120 two years ago.

Who knew that one episode of spraying paint from a fire extinguisher could create art worth more than $74 million at the peak? If the nomination of Donald Trump was not enough proof, this seems like persuasive evidence of the apocalypse to me.

This is also a good reminder to every would-be speculator about the risks of buying any asset simply because it is going up, without regard for its intrinsic economic value. When bubbles burst, they do so without warning, and they can trap even the most sophisticated investors.

We have been defensive in our portfolio commitments for several years now. As a result, we’ve missed some of the apparently easy money, in emerging tech stocks in particular. Right now we’re observing a global tendency for some of the most over-inflated asset markets to head south. This broad decline has already affected some of Silicon Valley’s “unicorns,” the term for non-public companies valued at more than $1 billion, as well as real estate in recently red-hot markets like Vancouver, which was down as much as 17% in a single month.

When considering any investment, the two questions we always ask are:

Does this investment represent an underlying asset or business with real and enduring economic value?

Is the price I’m paying reasonable in relation to that underlying economic value?

If the answer to either question is “no,” our practice is to stay on the sidelines. This causes us to miss out on some apparently easy money, but also helps protect us from permanent and irrecoverable losses.

I’ve been in the investment business since 1978. Time and again, I’ve observed greedy individuals chasing over-priced nonsense, solely based on the fact that it has recently gone up. They always seem to believe there will be some sort of warning before the bottom falls out.

Let’s all consider ourselves warned.

A Choice, Not an Echo

Spoiler alert! This post will disclose my political affiliation, not that I believe most long term readers will find it a surprise.

I grew up as a Democrat. My first vote was in the Presidential election of 1976. I was a registered Democrat and had spent the summer working in the office of a Democratic Congressman. I actually met candidate Jimmy Carter in my office building on Capitol Hill. But that fall I cast my vote for Republican Gerald Ford, and against the candidate of my own party. I thought Jimmy Carter was a fool, and his foreign policy positions a collection of self-righteous platitudes.

Events proved me correct. Carter won the 1976 election, announced that the United States was “at long last free of our unreasoning fear of Communism” and then pronounced himself astonished at the Soviet invasion of Afghanistan. At that point in Carter’s single Presidential term, I switched parties. By 1980, I was a Republican, because it was the party of free trade, a strong military, and robust leadership in the international struggle against totalitarian Communism.

In the 1990s, I watched as the Democratic Party tied its fortunes firmly to the coattails of the Clintons, nominating for President in 1992 and then re-nominating in 1996 a man who was clearly a sexual predator, who abused his office to suppress legal scrutiny, whose campaign took money from foreign interests including the Chinese military, and who lied carelessly and deliberately about both issues of public policy and personal transgressions. Since their Arkansas days, the Clintons have been unable to differentiate their personal political, financial, and legal interests from those of the nation. Indeed, by using the Clinton Global Foundation as a personal piggy bank, they have conflated their personal finances with those of global progress itself.

In the 1990s, I gave meaningful dollars to the Republican Party. I attended both the 1996 and 2000 conventions. I’ve met the last three Republican Presidents, all but one of the last four Vice Presidents, even every failed Republican candidate for President except Mitt Romney. Heck, my oldest child’s middle name is Reagan. So an election between any Republican nominee and Hillary Clinton should be a slam dunk decision for me. Easy and obvious.

Except it’s not. In 1996, I said the Democrats had made a deal with the Devil in re-nominating Bill Clinton, definitively decoupling the Democratic Party’s fortunes from historically progressive principles–that public service is a higher calling, requiring the highest standards of integrity to command the nation’s allegiance to our shared purposes.

Now the Republicans have done the same thing.

Donald Trump, like Bill Clinton before him, and like Hillary Clinton today, has personal qualities that clearly disqualify him from holding high office. He is an habitual liar. He is a gross, childish bully. He has been entirely unprincipled, both in his past business dealings and in his recent political campaign. He is less intelligent than any other major party Presidential candidate of at least the last half century. He has less impulse control than the typical adolescent male, and he appears to be impervious to advice, instruction, or any form of self-correction. And at age 70, none of this is remotely likely to change.

I spent the first year of Trump’s campaign in denial that he could secure the nomination. And then got stuck there, as he won primary after primary and walked out of Cleveland as the standard bearer of my party. Like so many of my conservative friends, I’ve been confused and conflicted about what to do. Time and again, I’ve watched Trump give another speech, or lead another rally, hoping against hope that he’ll somehow rise to the occasion, always disappointed.

It might be tempting to overlook Trump’s character flaws if he was sound on policy. After all, Lyndon Johnson was one mean SOB. Richard Nixon was a paranoid tough guy, surrounded by similarly ruthless partisans. FDR and John Kennedy were both notorious philanderers. If being a nice guy was the criteria for occupying the White House, Jimmy Carter and George W. Bush would be among the great Presidents.

But Trump’s policy positions are a confusing and incoherent mash-up. The defining principles of Republican domestic policy since Reagan has been an informed skepticism about the effectiveness of larger government, coupled with an understanding of the Constitutional limits on executive power. There is no indication that Trump even understands that we have a Constitution, and every indication that he believes the President has the same kind of autocratic power as the owner of a non-public company.

On foreign policy, Trump is a protectionist and a quasi-isolationist. He has aligned himself with Vladimir Putin, who has stolen tens of billions from the Russian treasury, murdered hundreds of journalists within Russia, assassinated his political opponents overseas, and invaded two neighboring countries. Putin has been clear about his desire to revive the Cold War, and his belief that the United States remains Russia’s principal enemy.

Trump is not qualified to be President.

I remember when the racist David Duke secured the Republican nomination for governor of Louisiana, and the national Republican party endorsed the candidacy of corrupt Democratic Governor Edwin Edwards, launching the slogan, “Do the right thing. Vote for the crook.” Edwards won, and later went to prison.

I’ve always said that I am a Republican third, a conservative second, and an American first. So must I vote for the crook, Hillary Clinton, to keep The Donald’s hands off the nuclear codes?

After months of struggle, I have decided that rejection of Trump in no wise justifies a vote for Hillary Clinton, an individual herself disqualified on personal character criteria from the Presidency, even if I agreed with her policies (whatever they actually turn out to be), which I do not. (I will note in passing that Hillary Clinton is smart, very hard-working, and supremely disciplined, all fine qualities. Plus it would actually be nice to see a woman occupy the highest elected office. Just not this one.)

Fortunately, the range of possible choices does not stop with two lying, unprincipled, self-centered, super-rich liberals from New York.

For the first time in my adult life, I will be supporting someone other than the Republican nominee for President. I will vote for the Libertarian candidates, Gary Johnson and William Weld, for President and Vice President. As soon as I get a chance, I plan to put a Johnson-Weld sign on my lawn.

For all of my conservative friends still struggling with the Hobson’s choice of Clinton or Trump, let me offer you some hope.  Once I made my choice, my despair and confusion vanished, replaced with relief, optimism, and even excitement. I believe this is much more than a lesser-of-three-evils choice or protest vote. It is, at a minimum, a vital next step in an overdue national conversation. More on this later.

On this post, more than any other I’ve ever written, I’d welcome your comments.

Brexit or Bust

As it happened, my wife and I were in Europe when the Brexit vote took place, and had several conversations with bemused Britons, Scots and Italians about the vote and its potential consequences. I was out of the office until July 5, so I missed the sharp market decline and equally sharp recovery, though I followed both the commentary and the market activity quite carefully.

The Economist, the English-speaking world’s most reliable source of utterly conventional wisdom, called the Brexit Leave vote “a senseless, self-inflicted blow.” Nigel Farage, head of Britain’s nationalist UKIP party, called it “a victory for ordinary people, for decent people.” Wealthy London, home to the UK’s powerful finance sector, voted to Remain, as did poorer, welfare-dependent Scotland. Most of the rest of the country voted to Leave.

The contrast says much of what one needs to know about the two closely-balanced factions throughout the West. Bureaucratic elites, finance types  and wards of the state versus strained working and middle classes struggling with a moribund global economy and stagnant wages.

The immediate consequences for the markets were negative. Worldwide, equity markets fell sharply, then rallied. For the second time this year, bears cried havoc and were proved wrong…or at least, premature.Markets dislike uncertainty, but amid record low interest rates on cash, stocks remain the preferred asset class. The dollar strengthened against both the pound (significantly) and the Euro (slightly).

A key investment principle is that disorder creates opportunity. The V-shaped market action (sudden fall, quick recovery) has been a pattern in recent years, as one market break after another has failed to transition into a true bear market. As usual, we took careful advantage of the market break to buy low in accounts with excess cash.

What will Brexit mean long term? That is very hard to predict. Protectionism weakens economic growth, but the UK leaving the EU does not necessarily mean adopting higher tariffs. All that must be negotiated.

Brexit is a very different proposition from Grexit. In the case of Greece, a net recipient of Eurozone transfers required immediate financial assistance in order to avoid defaulting on its obligations and possibly suffering a chaotic exit from the common currency. Brexit, on the other hand, contemplates one of the Eurozone’s wealthiest members, a net payer into the system, exiting the common market but not the common currency. (Britain never joined the Euro, keeping the pound.) Further, the Leave vote represents a mandate without a mechanism. There are provisions within the Lisbon agreement for member states to leave, but they have never been tested. Britain’s departure is likely to be a protracted process of negotiation and compromise. There could even be another vote repudiating the Leave vote.

We appear to be witnessing the end of the post-war project of economic and political integration in the Western democracies. That project paid great dividends, both in rising wealth and  (more important) in two generations of peace in Europe. (Or at least Europe’s core. The Balkans wars of the 1990s demonstrated the inability of united Europe to deal with even minor security issues, absent American leadership.)

Free trade and free markets create wealth, as Adam Smith argued centuries ago. But not everyone wins from globalization. In recent years, the economic benefits of a more-connected world have been concentrated in the hands of the finance sector and government. They have almost entirely bypassed the working and traditional middle classes. For those voters, Brexit was a rational rejection of the status quo.

Reducing regulation and bureaucracy, making markets more free and hence more dynamic and productive, could have widespread benefits. But higher growth would come at the cost of reducing both the power and the compensation of entrenched, unaccountable elites in both Europe and the United States. We’ll see whether those members of the New Class get the message.

Hope Springs Eternal

“This is not the end, nor even the beginning of the end, but it might just be the end of the beginning.”

                                                                                                                           Winston Churchill


The runaway Trump train may have finally begun to run out of steam. More accurately, the Trump Express may have lost just enough momentum to roll to a steaming, trembling halt just short of enough votes to secure Trump a first-ballot victory in Cleveland, and the Republican nomination for President.

One can only hope. In every way that matters, Trump has shown himself to be intellectually and temperamentally unfit for high office.

Trump briefly lost momentum because of comments about women that were ill-considered and offensive even by his standards, as well as positions on foreign and defense policy revealing a comprehensive ignorance of the sources of international stability and prosperity after the Second World War. But in the last week, both in his home state of New York and elsewhere, he has achieved dominant victories.

Trump’s complaint is that the voting process is rigged, which is true, though not wholly in the ways he means. Each state party has its own rules. But the combination of all the various state-specific rules has resulted in Trump controlling a larger percentage of first-ballot delegates than he has received of the total primary vote. In this sense, the system is indeed rigged — for front-runners like Trump, and against second-tier candidates.

Polls suggest that most Republicans believe the candidate who arrives in Cleveland with the largest delegate count should receive the nomination, even if he fails of a majority. They misunderstand both the nature of the rules and the history of their own party. The Grand Old Party’s second nominating convention, in Chicago in 1860, began with no candidate near a first-ballot victory. The two front-runners were Senator William Seward of New York and Governor Salmon Chase of Ohio. Both had alienated key segments of the party. Seward carried a commanding lead on the first ballot, with Lincoln a distant second. But having failed of a first-ballot majority, the front-runner from New York saw his support began to erode as delegates sought a less-divisive and more broadly-appealing alternative. The Keystone State of Pennsylvania switched to Lincoln on the second ballot, and Honest Abe won the nomination on the third.

So the precedent exists for a bad-tempered jerk from New York to come close on the first ballot, and still be denied the nomination. And the precedent exists for my home state of Pennsylvania to have, every century or two, a consequential influence on the Republican nomination for President.

When I get home from work tonight, I’ll cast my Republican primary ballot against Trump, hoping to do my small part to save my party from intellectual and moral ruin. If you can, I urge you to do the same.