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.

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.