The Trump Market

We’ve been talking a lot between the two of us over the last week about what a Donald Trump win means for us, the economy, and the financial markets.

Let’s state the obvious—we didn’t see this win coming. Not too many did, and we wouldn’t have forecast this short-term reaction we’re seeing from the stock and precious metal markets in the event of a Trump win. Citizens of the U.S., and even the rest of the world, are still absorbing what the win means, but the markets have reacted with confidence in the directions they’ve moved so far. Ever since the election on late Tuesday night (around midnight eastern time), the financial markets have behaved in a much different way than what was widely expected. We know it’s been confusing.

The Trump rally has now been in full effect for about 10 days. Between the lows of the S&P 500 futures on election Tuesday night, and the close of yesterday’s market, the S&P 500 has seen a 7.8% rebound in prices in just one week. That’s a fast gain.

On top of that, the price of gold has fallen from its election Tuesday night high of $1,321/ounce, to as low as $1,204/ounce—almost a 9% drop from high to low. That’s a fast drop. It’s since rebounded a bit.

The general consensus before the election was that stocks would be down on news of a Trump win; some analysts and major publications were predicting as much as a 15% drop in stocks in the first few weeks if Trump were to somehow be elected. They also predicted that volatility (VIX) would be up.

It was also a foregone conclusion that gold and precious metals would soar if Trump won the election.

The reasons for these various market moves were simple:

First of all, nobody really knows what Trump is going to do—he’s a bit of a wild-card, especially when it comes to politics. Since the stock market does not like uncertainty—a guy with Trump’s comments and actions would usually indicate weakness in equities.

Second, the potential for a trade war with China and Mexico. He’s stated his desire to add tariffs and make it undesirable for U.S. corporations to create factories outside of the United States borders. This could cause an immediate drop in profits for our major, multinational corporations, and/or cause price hikes from these companies who produce overseas at lower costs than they could in the United States. This would be a major short-term headwind for these companies. It could also inhibit our free trade and cause rifts between our trading partners. Once again, the effects and ramifications of actions such as these are still unknown. Some results could be favorable, while others might not be.

Third, his proposed budgets and economic policies are certain to (at least in the short-term) continue to run a budget deficit and add a tremendous amount of debt to the economy. With tax cuts and increased spending, government debt (currently at almost $20 trillion) will likely explode higher, and some experts fear a recession will be the result.

In all, a Trump win would indicate an uncertain future, shock, and fear. This seems like it would be the recipe for a higher gold price, a higher VIX, and a lower stock market.

Obviously, these concerns have been brushed aside—and the market has instead chosen to focus on the positive aspects of a pro-business President who is not afraid to take on debt and ruffle some feathers.

Considering the analysts and experts were dead wrong about the market’s reaction to the uncertain President-elect Trump, they are now surprisingly confident about the future.

“Buy X industry.”

“Sell Y stock.”

“This is what Trump means for the economy.”

“Inflation is coming.”

“Interest rates are headed higher.”

These headlines are the polar opposite of just one to two weeks ago. Many investors and analysts suddenly seem confident of what’s to come; that’s what happens with large price moves, even if it’s in the opposite direction of what they predicted. They encourage bold headlines and loud predictions.

But let’s remember that just about everyone was also confident of what turned out to be their completely wrong forecasts just last week. Instead of getting overwhelmed or lost in what’s going on in this new “post-election market”, let’s slow it down and keep a few key things in mind as we make our way through this crazy financial environment.

First, nobody really knows what Trump is going to do. There is still a tremendous amount of uncertainty that comes with his Presidency.

Even if the markets, right now, are behaving as if they know what Trump is bringing to the table, he is still largely an unknown. The markets are choosing to focus on the positives, but as of today, nobody really knows what events/policies are going to take place, and what will unfold over the next four years of his Presidency. And certainly, no one knows what the market’s reaction to those future unknown events will be.

So there’s still much uncertainty, but investors right now want to believe they know what is going to happen, and they’ve been investing their money based on these convictions over the last week.

In just over one week so far, investors have shown (according to the movement of money) their belief that a Trump economy will be good for corporate and GDP growth, and that the massive spending, fiscal stimulus and debt he is talking about taking on, will create positive effects—not negative ones. He’s a businessman, and Trump certainly intends to be a pro-business President, loosening up regulations and understanding how business works. Many investors believe this will help drive the stock market higher.

They seem to also be betting on his potential tax reform boosting the economy. During his campaign, he proposed lowering the tax rate for both corporations and individuals. Investors are hopeful this will create business growth, jobs, and an increase in disposable income for consumers—which should help grow the economy. However, others believe his tax reform could be a negative for the government, as it creates less tax revenue in the short-term, but the stock market is brushing aside these concerns, for now.

Many investors also believe that the repatriation of corporate profits from overseas under Trump’s new tax laws will spur the economy. He has proposed allowing corporations like Apple, Nike, Caterpillar, Visa and others, to bring their overseas money back into the country at a low tax rate, so that it could be put to work for shareholders. These are companies which have massive cash hordes of billions of dollars parked overseas not being optimally employed.

We’ve talked extensively about this in regard to Apple—who currently has over $200 billion in cash, much of it overseas. Right now, these companies would have to pay a 35% tax rate to bring that money into the country—so they choose not to do it. The result is that they can’t use that cash to grow the company or return it to shareholders. In Apple’s case, they have chosen to take on low-interest rate debt to pay their shareholders, instead of paying the hefty tax rate they would need to otherwise pay on their own, overseas cash. Trump is proposing a one-time low tax to get these companies’ cash brought to the U.S., as well as a decrease in the corporate tax rate, which could encourage businesses to bring their cash back into the country on an ongoing basis. This is obviously a positive for these companies.

Those are the potential positives, which many investors are choosing to focus on for now, but remember there were many reasons as to why so many thought the negatives would outweigh any positive effects of a President-elect Trump.

So far, many investors are largely ignoring some of the potential negatives, or worrisome issues that plagued Trump during the campaign. They’re reacting as if things like his protectionist measures (such as tariffs on overseas goods) will not take hold, that his economic policy will create net-positives for business, and that the soaring debt his Presidency will likely continue running up is not going to be a major issue. There is also the ongoing wild-card of Trump’s personality, his shoot-from-the-hip leadership style, his views on global affairs, and his temperament that the stock market at least is brushing aside for now.

We aren’t disagreeing with some of these reactions. In our opinion, Trump will be a net-positive for business—by lowering the corporate tax rate, loosening up regulations and improving (or repealing) Obamacare (a major drain for small business). However, it’s amazing what an opposite reaction the market has had toward these issues from pre-election to post-election. They have focused mostly on the good, as opposed to the bad. Plus, many of the ramifications of his potential policies and actions are still unknown. In normal times, some of these issues would create fear and uncertainty—but that’s not the case today.

Here’s where the major movements of the market have been coming from…

One of the biggest components of the Trump election win that has been moving markets is infrastructure. Trump campaigned on improving America’s infrastructure, things like roads, bridges, and highways, and he reiterated that thought to spend $1 trillion on infrastructure in his victory speech immediately following the election. Investors believe this equates to:

  • More debt issued by the government in order to fund the spending. It has to, debt is the only way this country can fund new initiatives. This flow of new government bonds (debt) should raise the interest rates associated with them, and push bond prices lower (these work inversely—when rates go up, bonds go down). These expectations raised interest rates to a large degree over the past week and half—with the 10 year U.S. Treasury yield moving from 1.8% up to 2.3%. This crushed bond prices and raised the U.S. Dollar, relative to other currencies (the dollar tends to rise directly with interest rates).
  • Large increases in government spending. Along with raising the debt, the infrastructure spend will boost GDP automatically, since government spending is a component of the GDP calculation, and accounts for about 20% of our country’s output. All else equal (which it’s not, since government spending can have negative consequences as well), this is a catalyst for stock market growth.
  • This spending will also add more jobs to the economy, which is an additional boost to GDP and corporate profits, since more people will have working wages. Obviously, if these things played out well, this would greatly help our businesses in the stock market. Some are comparing this initiative to a modern “New Deal”, which was the government program FDR used after the Great Depression to put Americans to work on improving infrastructure and other government programs. Time will tell what the “Trump New Deal” turns out to be.
  • As a result of all of this, recent money has gone to the basic material sector, defense contractors, construction companies, and any company seen as benefitting from a build-out of infrastructure across the country.

Promises of less regulation on banks and finance is another theme that has moved markets in the last week.

iyf financials

This chart of the iShares US Financials ETF shows the recent surge in financial stocks.

 

Trump has proposed dismantling the Dodd-Frank bill, and lifting various regulations from banks and corporations across the country. The Dodd-Frank bill is a controversial bill that added all sorts of regulations to banks, lending, financial products, and other areas of finance. Getting rid of it, or at least amending it, is seen as a major positive for the financial sector, and the industry has soared (IYF) over the week due to this, as well as the recent rise and future expectation of more hikes in interest rates. Banks would very much welcome a rise in the interest rates, since profits have been kept down over the past eight years in a near-zero interest rate environment. Just look at the almost-collapse of Deutsche Bank earlier this year as evidence of what zero and negative interest rate policy can do to banks. Banks need higher interest rates to stay in business, and a Trump win makes that more likely.

Biotech stocks have also rallied (IBB), on the belief that Trump will go easier on the drug companies than Hillary Clinton would have.

IBB biotechnology

This chart of the iShares Biotechnology ETF shows the recent surge in drug stocks from the Trump win

Healthcare will continue to be a major theme in his presidency, as he has promised to repeal and replace, or at least amend, Obamacare. This will have large ramifications across the healthcare sector for years moving forward.

Volatility on the stock market has been crushed, as shown by the VIX chart.

vix

This chart of the volatility index (VIX) shows the collapse in volatility, or fear, since the election

The VIX, also called the “fear index” measures the price of options on the S&P 500. It indicates how fearful or complacent the market is at any point in time. A low VIX shows that market participants are not paying very much for stock options, which means there is not much fear in the market and they are complacent. A high VIX (above 25 or so), indicates that stock options are expensive, and there is a good amount of fear in the market. Most analysts expected the VIX to soar after a Trump win—when uncertainty arises, fear usually follows. However, this wasn’t the case. Instead, VIX plunged on the Trump win; this is how we know the market is complacent with Trump, for now.

Note that a low or high VIX does not tell you anything about market valuation—it’s based simply on option prices. Keep in mind that markets tend to fall when investors are most complacent, in other words, when they least suspect it. We use the VIX as an indicator for when to sell put/call options—when the VIX is high and fear is in the air, we sell expensive options to lock in big returns.

These Are All Speculations

The key point to remember is that market moves over the last week are all speculations based on what a Trump Presidency might look like—but nobody knows. He hasn’t taken office yet, and most of his expected policy changes won’t have full impact for a long time, if at all. We don’t even know what some of his potential policy changes will be. Remember that there is still very much unknown. Even though investors are deploying their money so quickly as to imply these things are a certainty, we can’t overreact and make quick decisions without sufficient evidence. Otherwise, it’s pure speculation—not smart investing.

Questions still come to mind such as:

  • How much of Trump’s campaign rhetoric will come to fruition?
  • Will a President Trump be different from “Campaign Trump”?
  • How much of what he actually tries to implement (things like repealing/amending Obamacare, threats to free trade, energy policy, and tax reform) will be supported by congress or take effect? And how long will it be until this happens?

Policies such as deregulation, lower taxes, and repatriation of corporate profits can certainly spur the economy and business investment, at least in the short-term, especially when coupled with increased spending by the government in order to create jobs.

But the problem is, none of this magically solves any of our underlying economic problems—in the country or the world. It doesn’t change the fact that the stock market is nearing record high valuation levels, and that the bond market has been in bubble territory for years. The things Trump is talking about will only add to increased deficit spending that we’ve become accustomed to during the Obama years—the same kind of deficit spending and record increases in government debt that got us into the situation we’re in now.

It’s fairly safe to say that the range of possible actions and outcomes in a Trump administration are broad—too broad to be predicted with a whole lot of certainty. His policies and leadership style could either be great and exactly what the country needs—or it could speed up the path toward recession that we’re on right now. Many investors choose to believe the former, for the time being. We can see that in the plunging VIX and the rising stock market. Time will tell what plays out, which leads us to the second key thing to keep in mind amid the post-election market.

Second, we cannot get overwhelmed by what’s going on in the financial markets, and we don’t want to make emotional decisions.

It’s easy to fall into that trap, or panic in a fast-moving market like we’re in right now.

  • Panic about missing gains
  • Panic about losing value in open positions

What we’re seeing right now are emotional reactions on one side of the investment pendulum. In the stock market, investors are on the upside of the pendulum, while in the bond and precious metals markets, they are on the downside of the pendulum. Most investors tend to react emotionally during times such as these, rather than objectively. They panic, they get excited, they get too optimistic or too pessimistic, they get skeptical, or they become arrogant.

What we don’t want to do is get caught up in that emotional aspect of this post-election market—and jump on the extreme ends of the pendulum. We need to maintain a long-term perspective and stick to what we know and can control. We can’t lose sight of that. Because trying to predict the short-term, or what will happen over the next month, is just a losing battle.

We aren’t rushing in or out of a certain industry looking to make a quick buck, playing the market’s game right now of predicting the next move of the Trump rally. If you want to do that with some of your money, that’s fine—but that’s now what we’re doing here. We’re maintaining focus on our precious metals portfolio, and on finding high-quality companies at fair prices. We’ll continue researching and uncovering these types of companies each week.

In our opinion, this is the only way to approach it in order to position ourselves for long-term success. Rather than jumping on one end of the pendulum, we’ll stick to what we know, and leave the emotional decisions to others.

So with the long-term picture in mind, we need to consider if anything has materially changed with a Trump presidency looming. Does the election change the picture on future stock market returns or in the gold and precious metals market? So ask yourself…

Where will stocks be priced in one to three years?

We can begin our answer to this question quite simply by looking at various market valuation metrics.

The Shiller P/E ratio, one of the most widely used valuation metrics for the broad market—shows a grim picture.

Shiller P/E

Source: Multpl.com

The Shiller P/E ratio is the price earnings ratio based on the average inflation-adjusted earnings from the past 10 years. It’s also known as the cyclically adjusted PE ratio. In other words, it smooths out the earnings from cycles and inflation to give an accurate representation of what the market is paying for the average earnings of the S&P 500 companies. This is a much more relevant and accurate measure than the simple P/E ratio, which only looks at the past twelve months of earnings.

The lower the ratio, the better; because a low ratio indicates the market is not valuing S&P 500 stocks at very high levels. The average Shiller P/E ratio sits at about 16.7. The current ratio is 27. The only three times it has been at the current level or higher was in the run-up before the Great Depression, the run-up of the internet boom in 2000, and right before the market collapse of 2008. That’s not a very good group to be in. What this tells is the only way we can make very good returns from buying the S&P 500 index at these levels is if the market starts putting even more insane valuations on stocks than it already is, similar to the 1990’s internet boom.

That’s just one ratio, so we need to look at other metrics. One of Warren Buffet’s favorite market valuation tools is the ratio of the Wilshire 5000 index market cap, divided by the gross national product (GNP). The Wilshire 5000 is a market-capitalization-weighted index of the market value of all stocks actively traded in the United States. When this ratio is low, stocks tend to be a good buy; when the ratio is high, stocks tend to be expensive. Here’s where the ratio is currently:

Wilshire 5000 over GNP

Source: GuruFocus.com

1.2, or 120%. In other words, the entire stock market is valued at 120% of the total annual output produced by United States residents. This is a high percentage—and unsustainable. The only other times the market has been valued this expensively (as a percentage of GNP), was in 2015 and in 1999—right before the market tanked. The stock market was not even this expensive during the subprime mortgage collapse that almost brought the entire U.S. economy down in 2008. Again, this doesn’t paint a very good picture for future broad market returns.

What about the debt scenario of the U.S Government and of corporations that make up the stock market? Interest rates have been low for quite some time, and both government and corporate debt has soared in the past eight years as a result. Debt can be good up to a point, but if it gets to be too high, as a percentage of gross domestic product (GDP), that’s when governments, businesses and stock market returns can suffer. So where are the debt levels at right now?

Well here’s the amount of debt U.S corporations hold on their books, as a percentage of GDP:

Corporate debt to GDP

Source: Inflation.us

As you can see from the chart, corporate debt is currently at a level it has never seen before—about 45% of GDP—the entire annual output of the United States. It’s only been close to this level two other times, in 2001 and in 2009, well after the stock market had peaked (the S&P 500 is the orange in the above chart). 44% of GDP seems to be about the tipping point where debt starts to default and companies go bankrupt (this is indicated by the fall of the blue line below the average of 40%). The current 45% level serves as a warning sign to an upcoming market drop and credit default cycle in corporate debt. History tends to repeat itself, and as interest rates rise, the record amount of corporate debt (currently about $8 trillion) will become a major burden and extremely hard to service or pay back. This is not a good sign for heavily indebted corporations, or the stock market as a whole.

And if you’re thinking the corporate debt scenario is bad, just take a look at what our government is doing. Here’s where the U.S Government debt is currently at, in relation to the GDP for the country:

Government debt to GDP

This chart means that outstanding government debt currently makes up 105% of the entire output of our country. It’s been on the rise for many years, particularly since 2008, and it now sits at nearly $20 trillion. This figure does not even count the unfunded liabilities of the country, such as Social Security and Medicare, which USDebtClock.org currently has at $104 trillion. Keep in mind, those numbers are TRILLION, with a T! The only other time government debt has made up this high of a percentage of GDP was from about 1942-1948, much of that attributed to World War 2. At that time, the debt-to-GDP ratio topped out at about 120%.

This type of debt cannot be sustained for very long, and at the rate we are running it up, it will soon hit record levels, compared with the GDP. In total, all of the U.S. Government’s public debt plus unfunded liabilities comes out to $1,037,975 per taxpaying citizen. That’s quite the number.

Donald Trump’s administration will almost certainly run this debt even higher, at least in the first couple years of his Presidency. With a likely increase of interest rates, servicing our upcoming debt (paying interest) will cost a much higher percentage of our annual budget than ever before. This debt is a frightening number, and one which we need to start to get a handle on as a country.

In summary, each of these charts does not make the broad stock market look too attractive at current levels. Each one of them show either an overheated market nearing historical highs, or a debt-load that is unsustainable. A President Trump cannot overcome the debt issues and market valuations he’s inheriting. No President can.

As we’ve talked about before, even though the current state of the stock market does not make us want to get overly aggressive on our equity purchases, it doesn’t mean we should trim exposure altogether. If there’s one thing we know, it’s that we can’t time the top or bottom of a market. The market could still hit extremes and head higher from here, so we don’t want to be completely out if valuations continue to get stretched.

Even though we think buying the S&P index at current levels will virtually guarantee poor long-term returns, it doesn’t mean we can’t find individual companies to acquire to make us great returns. The game plan remains the same—find great companies at fair prices. And don’t worry about what the general market is doing or where it’s valued. We’ll continue to sell puts to establish positions in these companies, and sell covered calls against our holdings amid high volatility. This game plan will continue bringing returns into the equity portion of our portfolio, and shielding us from taking too great of risks, even as stocks sit near record highs.

The next question to ask yourself is, where do you think gold/silver prices will be in one to three years?

In the short-term, these metals have been beaten down. This is due to rising interest rates on government bonds (which have increased greatly since the election), and the likely rate hike on the fed funds bank lending rate coming in December. They have also dropped due to the rise in the U.S. Dollar, which has surged recently. Anytime the U.S. dollar rises, gold and silver tend to drop. What has been largely ignored lately is the almost sure-bet of high inflation on the horizon. High inflation would be a catalyst for a price increase in these metals.

So we have a few different factors pulling at precious metals prices, but what’s winning out right now is interest rate increases and the strong dollar, causing gold/silver prices to drop. That’s the short-term, but we need to think long-term.

Considering the long-term…

Interest rates are almost certainly headed up—that move has already started. We’ve talked about this for a long time now with our subscribers. This would be a negative factor for the price of gold. But we don’t believe that this is a new trend of interest rates rising to very high levels. We are at laughably low-interest rates now, and the debt that we’re in virtually guarantees that we will stay at relatively low-interest rates for some time. So most likely, a low-interest rate economy is not going anywhere anytime soon. This should keep gold/silver prices elevated, but not necessarily surging.

What we believe will make these prices surge in the coming years is a low-interest rate environment on top of soaring debt and rapid inflation. Debt + high inflation + low-interest rates is a great formula for much higher gold and silver prices. As we showed earlier, government debt will only continue to rise, and corporate debt is hitting unsustainable levels. This means we will start to see heavily indebted companies default on their debt, and the high government debt is a strong indicator of high inflation on its way. This will cause fear and renewed demand for gold and precious metals.

These are the major reasons as to why we remain long-term bullish. The short-term picture for these metal prices is certainly up in the air, and it’s hard to take right now as we have established positions in the associated stocks. But if you keep your eye on the long-term perspective, we think it’s hard to find a strong bear case. However, since the gold/silver portfolio is our financial chaos hedge, we urge keeping the allocation at no more than 10%-20% of your holdings.

In summary, don’t let short-term movements of this post-election market affect your overall game plan, and try to refrain from acting emotionally. We still don’t know what a Trump Presidency will bring, but we do know that the President can only affect so much. Nothing has changed about our outlook on gold/silver, and our game plan for returns in the stock market.

Good investing.

Kevin Tudor
11/18/2016

 

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Kevin Tudor is the VP of Investment Training for Margin of Safety Investing, LLC. After a significant amount of time in the financial services industry, Kevin moved on to investment research and analysis to bring his expertise to the individual investor. He now resides in Scottsdale, Arizona where he conducts online newsletters, webinars, and various investment trainings to show others the key strategies to successful investing.

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