Before we discuss the Trump rally and if it has legs, it is instructive to recap 2016 and how our views and portfolio positioning played out relative to the markets. One of the things our firm does differently than most is how we proactively manage risk in client accounts.
When we see red flags beginning to surface in the financial markets, we take steps to adopt a more defensive posture to protect capital and avoid large losses. Over the years clients have repeatedly told us that they much prefer to focus on capital preservation when things look rocky, even if that means we may leave a little upside on the table as a result.
That essentially describes exactly what played out in 2016, as markets appeared poised for a down year, but in the end were able to avoid it. Coming into 2016, we were already discussing with clients various clouds on the horizon and how we wanted to move to a more conservative stance. We published the chart below which shows the topping formation in the stock market, the inability to make higher highs at the time, and how it looked like lower prices would be forthcoming.
As 2016 unfolded, stocks stumbled heavily out of the gate. The S&P 500 Index fell -11.4% in the first five weeks of the year – the worst start of any year for that index going back to 1926! At the time, our concerns looked prescient, and it seemed like more volatility was in store for the remainder of the year. In addition to the bearish technical (price) action in the stock market, there were a few other factors that also played into our thinking:
1. An earnings recession: coming into 2016, earnings growth for S&P 500 companies had shown negative growth (contraction) for five consecutive quarters. When earnings are falling, stocks usually follow suit
2. Slowing economic growth: In the US, China, and abroad, economic growth had been slowing for several quarters in a row (GDP, PMIs, etc)
3. Lack of catalysts: With earnings growth contracting and economic growth slowing at the same time, there appeared to be few catalysts on the horizon that could shake stocks out of their malaise and foment a new uptrend in the market
Yet each time the market appeared poised for more downside in 2016, buyers stepped in and the market would bounce back. Probably the most striking example of this was in June after the surprise “Brexit” vote. Markets plunged for 2 days, and then rallied back nearly as sharply as they had fallen. This choppy action persisted most of the year. In the end, what finally propelled stocks out of this rangebound trading pattern was the surprise Trump victory and the Republican sweep of Congress.
While most stocks rallied in the aftermath of the election, the ensuing spike in bond yields (see chart above) caused a sharp selloff in any interest-rate sensitive investments. As such, defensive investments such as utility stocks, consumer staples, as well as munis, preferreds, and most bond funds declined in value in the last two months of the year. Suddenly what had been working well in portfolios for several years was suddenly being thrown out like the baby with the bath water. We expect this knee-jerk reaction to settle down in 2017 as more clarity comes to light on policy proposals.
And that brings us to 2017, with a change to our outlook and portfolio positioning. The stock market had ample time to experience a larger correction last year, but that window now looks like it has closed for the most part. As we enter the New Year – with a new President and administration – there are several catalysts on the horizon that could be very bullish for the stock market going forward.
We understand the Trump victory has been polarizing for many, and want to clarify upfront that we are not making any characterization of Trump himself, but rather the prospect for the newly proposed policies and the effect they are likely to have on markets:
1. Improving economic growth – In the US, GDP growth looks to have bottomed and should pick up as 2017 progresses. Additionally, PMI indices across Europe and in China have also started to pickup, which could help this economic rebound turn into a global phenomenon, and not just a US-centric one.
2. Corporate tax cuts – Trump has vowed to cut corporate taxes in America, where our corporate tax rate has been the highest in the developed world for years. This would be a huge boon to small business in the US, and likely spur more hiring and more growth. Additionally, it would immediately provide a big boost to corporate profits, which would support higher earnings and thus stock prices.
3. Asset repatriation – US multinational corporations that earn revenues abroad have left sizeable cash hoards in those foreign countries to avoid the double-taxation that the US government levies. A “tax holiday” that allows these large companies to repatriate assets back to the US at a much discounted tax rate would result in hundreds of billions in cash to flow back to the US. These funds would likely be put to productive uses such as investment in plants and equipment, as well as dividend payments and stock buybacks – both of which would have an upward bias on stock prices.
4. Infrastructure bill – this would be a fiscal stimulus measure aimed at providing a boost to GDP growth in the US, creating lots of new jobs, as well as renewing and repairing the aging infrastructure in our country (roads, bridges, airports, etc). If it is constructed correctly it would provide a nice boost to GDP which would be net positive for financial markets.
5. Regulatory reform – many of the regulations that have been enacted over the last eight years, while well intentioned, have been burdensome for both small business and large corporations. The prospect of rolling back some of those regulations would be seen as a pro-growth move and provide a boost to business confidence and investor sentiment. Even the recent talk of a less onerous regulatory environment spurred the NFIB small business index to its largest monthly increase since 1980.
The above factors are positive influences for financial markets at the margin. For many investors, they represent changes to the investment landscape that the investor class has been hoping for years but ones that few thought were likely to come to fruition. As such, hope springs eternal on the Street of Dreams, with many citing the analog back to when Ronald Reagan was elected with his pro-growth policies that ultimately helped spur one of the great bull markets.
That said, we remain cognizant of the fact that sometimes markets can get ahead of themselves. While the stock market has enjoyed a strong rally since the election, there is the possibility that disappointment or at least impatience sets in due to the fact that the above policies are likely to take some time before taking meaningful shape and being enacted. As such, we would not be surprised to see stocks experience a pullback in the not too distant future, as well as periodically throughout the year. That would be the normal course of events for stocks, and would not diminish our renewed constructive optimism on the market for the year(s) ahead.
As always, we encourage you to contact us to review your accounts and update us on any changes that may affect your personalized investment advice.
Jordan L. Kahn, CFA
Chief Investment Officer
Sources: Stockcharts.com; BTIG research; Raymond James; Briefing.com; IBD; Standard & Poors; Barron’s; Charles Schwab