Every day investors accept unknown and potentially far-reaching economic and geopolitical risks. Watergate, OPEC’s embargo, the Gulf War, 9/11, Russia’s credit default, and the U.S. Debt downgrade are some historic examples that come to mind. More recent threats include acts of terrorism, an unforeseen foreign policy or major trade dispute, and a widespread cyber breach or disruption to the nation’s power grid.
It is today’s Presidential election, however, that has dominated investors’ focus for months now. The level of attention and angst heading into this election is unlike any experienced in generations. As much as anything, the political discourse (or lack of substantive discourse) has weighed on investor confidence. The American Association of Individual Investors’ Index, which measures investor sentiment, has now been bearish (normally a bullish read for future returns) for fifty-three consecutive weeks.
Obviously, the policy stakes of the election are high. Our nation’s debt is approaching $20 trillion, our entitlement commitments are unsustainable, and many Americans disagree on the role of the U.S. abroad. Moreover, an increasing number of Americans feel disaffected and are struggling to find their footing in a rapidly changing economy. Yet as much as anything, this election has evoked strong opinions regarding the suitability of both Presidential candidates, and a concern that the election of either foretells a state of irreversible political erosion. Admittedly, arguments along these lines can be persuasive. In a democracy, however, there will be fumbles along the way. We’ve had them before. Today’s 24-hour news cycle repeatedly reminds us we could have them today.
This year’s election and the primary process leading up to it are evidence that our process can be messy. Nevertheless, it is the best in the world. And we remain hopeful that a smooth transition of power from one President to the next will yet again prevail. After all, Clinton and Trump are ephemeral. Whereas, a peaceful transition of power and the chance for the electorate to reboot in two and four years, are what have and will continue to distinguish our great nation.
You Can’t Buy Insurance After the Fact.
If you think insurance can be expensive, try buying it after the fact. In other words, the time to reduce risk in your portfolio is not in the midst of the storm but before it. We generally think about risk in the context of valuations (i.e. an investment’s risk versus reward) and not the headline du jour — election or otherwise. This summer’s short-lived decline and rebound post the “Brexit” vote reminded investors of the risk of trying to time the stock market.
As you know, we regularly make adjustments to individual portfolios to respond to an ever changing investment landscape and an individual’s objectives and investment horizon. As for the election, no one knows for certain what the market’s response will be Wednesday or in the months that follow. We would advise some level of skepticism for anyone convinced they do. Nevertheless, below we share some of our views for what could unfold under the most-watched scenarios come November 9th, which you may agree cannot arrive too soon!
A Clinton Win / Split Congress
The equity markets, which in the short-run are not much more than a measure of sentiment, have been trading as though they prefer a Clinton win and the Republicans keeping at least the House or Senate. Most political pundits are predicting this “Gridlock,” and thus to some extent it is likely already priced in. Under this scenario, a President Clinton would have to work with Speaker Ryan and company to pass legislation.
While Senators Warren and Sanders will continue to press a business unfriendly agenda, we think Clinton realizes some level of cooperation was a lost opportunity on President Obama’s part. After all, before Sanders’ ascension, she often referenced her husband’s bi-partisan success in the early years. We also think she and most politicians recognize the Trump/Sanders party-line revolt was largely in response to the establishment’s inability to compromise/execute.
As for the doable compromise options, there is talk of a compromise around corporate tax reform, or at least the repatriation of $2.5 trillion of overseas cash, in exchange for targeted infrastructure spending. We think this could be a positive catalyst for the equity markets.
While more of a long shot, broader corporate tax-reform could represent a significant catalyst for stocks. Domestically focused companies generally pay 35–40% tax rates versus a 25–28% often cited in a reform scenario. The market would adjust rapidly to the increased cash flow available to shareholders. Put another way, this change would be similar to a company showing 7% - 12% percentage point improvement in operating margins. After all, the DCF valuation model starts with NOPAT (net operating profits after taxes).
A Clinton Win / Sweep of Congress
A Clinton win and sweep of Congress, which few if any pundits have forecasted, would be viewed negatively by the markets. Among all the various election scenarios, we think a Democratic sweep presents the biggest market threat given the removal of “Gridlock,” and the perceived economic risks from more regulation and higher taxes.
On the flip side, with Clinton winning and the Democrats taking Congress, the market could assume a continuation of the Federal Reserve’s low interest rate policies. This political makeup would support the relative value trade of recent years, which has forced many income-focused investors into equities.
A Trump Win
The odds for a President Trump are one in three according to many pundits and those wagering on the outcome. Most market strategists forecast a negative market reaction in the event of a Trump victory simply given how little is actually known about his policy platform and the team that would advise him. Many also fear a President Trump could ignite a trade war. The potential surprise is if Trump wins it very likely could mean Republicans have ridden his coattails to House and Senate majorities. While the agendas of Speaker Ryan and a President Trump may not align on every front, expectations for lower taxes (individual and corporate) and business friendly regulatory reform could spark a market rally.
Don’t Forget the Ballot Initiatives
There are a number of ballot initiatives investors are watching, including a proposition in California regarding drug price controls and a Colorado universal healthcare coverage initiative. Also, in Oregon a ballot measure seeks to remove the cap on corporate gross sales tax and establish a 2.5% tax on gross sales for corporations with at least $25 million in Oregon sales. Passage of any of these initiatives could weigh on investor sentiment, not just in healthcare but the market in general given the anti-corporate/business overtones of each.
Hardly a Pattern
Saying this Presidential election cycle has been full of surprises may be the understatement of the year. Likewise, the market has been full of surprises in the year following a Presidential election. According to Bloomberg, in 22 Presidential elections since 1928 the S&P 500 declined 15 times by an average of 1.8% only to turn positive within the next year in 9 of those 15 instances. The table below lays out more recent reactions between the election day and inauguration. Whatever the pattern, if at all, one would be hard pressed to accurately predict near-term market returns based on an election. Instead, we’ll stay focused on the prospects for corporate earnings growth, which in our view remains the most important determinant of stock performance.
Now Go Vote!
As always, thank you for your continued confidence. We look forward to answering any questions you may have. In the meantime, we encourage you to go vote. We don’t have to remind you that generations of Americans have paid the ultimate price for us to exercise this right.