A week after Donald Trump was elected the 45th president of the United States, we published an in-depth report detailing our expectations for investing in the Trump Era.
The full 25-page report covers three topics – the economic background that lead to the Trump victory, likely short- and long-term investing implications on various sectors and industries, and a review of the President Trump’s likely effectiveness as a political leader.
Of these three, we believe the most important in terms of potential market risk is the third. The point we made in the report, and which has been made many times since in the media, is that an ineffective chief executive creates an environment of uncertainty that hampers wealth creation and increases market volatility.
We believe that, by this definition, the Trump presidency is as anti-business as any administration back to that of Jimmy Carter.
Why then has the market soared since his election? Recent academic work out of the University of Chicago can help explain that, and we can explain how an intelligent investor should be preparing for what we think will be a rocky few years in US equity markets.
What Makes a Good President?
A president’s main economic role is to shape the policy framework in which companies make investment plans. In our view, a good president must do five things to create an environment conducive to long-term economic growth:
- Clearly articulate a vision for the country
- Craft a strategy for implementing proposals consistent with that vision
- Create consensus within his own party regarding his vision and strategies
- Create consensus among politicians from opposing parties that supporting his vision will create more good for them than it will create damage
- Engineer support for his policies within the populace at large, at least to the extent not to lose seats in the mid-term elections
Our report laid out the evidence we thought existed for President Trump being particularly strong or weak in each of these areas, and the first fifty days of the Trump administration has proven our assessment correct on most points.
With the unveiling of the AHCA (a/k/a “TrumpCare”) at top of mind, we can assess President Trump’s performance versus our criteria. According to the Congressional Budget Office, TrumpCare proposals differ considerably from the vision which Trump proposed during the presidential campaign (point #2). It is not only hated among Democratic lawmakers, but also among the Tea Party wing of Trump’s own Republican party (points #3-4). What’s more, there are signs that the realization among many lower income voters that TrumpCare represents a major step back for their ability to receive access to healthcare (point #5). Recent Republican “town hall” meetings are testament to the angst even in solidly Republican districts.
What effect has this had on healthcare stocks? The SPDR Pharmaceuticals ETF has floundered as the S&P has risen, partially because of the uncertainty regarding the future of ACA (a/k/a “ObamaCare”) and partially because of President Trump’s habit of periodically picking favorite sectors and industries (e.g., drug makers) in his late-night tweets.
No – a 0.36% return over four months is not terrible. However, it illustrates our point – it is difficult to invest with confidence if the rules of the game are constantly changing.
We believe that this tendency will only become exacerbated as Trump’s term wears on – he has only been in office a little shy of two months, after all – and may be accentuated by the appearance of a (natural, foreign policy, or other) crisis.
Why is the Market Up?
Despite our forecast for increased volatility, the market has just kept rising since the election. Some people are saying that the market is giving a big vote of approval for President Trump’s policies, despite my and various other observers’ doom and gloom predictions.
Interestingly, I just read an academic paper by two University of Chicago professors whose findings explain the Trump Bump* in purely economic terms.
The professors had set out to explain the “Presidential Paradox” – the persistent outperformance of stock markets under Democratic presidents versus Republican ones – using a simple economic model related to tax and wealth redistribution policies.
Their model predicts an initial rise in stock prices under administrations that promise lower tax rates, as President Trump and other Republican presidents have done. The presidential paradox comes about because investors bid stocks higher in the early part of a low-tax administration; unfortunately, low-tax administrations tend to get voted into office toward the end of a long boom period when valuations are already stretched and the expected returns for stocks is low.
Investors rush in at precisely the wrong time, the markets fall, and Republican presidents end up with a bad “track record” of market returns.
What Should Investors Do?
Assuming my argument about Trump being an anti-business president is true, what is the best investment strategy?
The first thing I will say is that trying to call a market top or trough is a fool’s game.
Market participants get too excited both when times are good and when times are bad. The key to investing well is understanding the factors that drive value creation and being able to assess a firm’s range of possible values based on best- and worst-case estimates of those factors.
The next thing I will point out is that it does seem that the economy is finally growing a bit stronger – we began seeing signs of this sometime in the summer of last year. The job market appears to be tightening and some of the slack that had been in the system due to household delveraging (i.e., paying back the debt they owe to more comfortable levels). This is genuinely a good sign and bodes well for our economy. The uncertainty added by Trump’s anti-business presidency is one of the biggest negatives we see on the horizon.
In our own research, we have been doing the same thing that we always do. Looking carefully at the valuation drivers of particular companies and taking positions when there is a significant difference between the stock’s price and our estimated valuation ranges.
That said, we have been finding more and more opportunities for bearish investments, but we think this has less to do, we think, with the macro environment or politics per se, and more to do with individual companies’ valuations versus reasonable future growth expectations.
Reducing or eliminating leverage on bullish positions is a good first step, and we think that it is sensible to increase levels of cash or “potential cash” (i.e., hedges or bearish investments) while periodically reassessing our company valuations.
* Lubos Pástor, Pietro Veronesi, Political Cycles and Stock Returns, Working Paper, January 2017
This article originally appeared on Forbes.com