What a difference a day makes. Readers of The Wall Street Journal woke up to an incongruous headline buried near the bottom of yesterday’s page one that read: “Stocks Surge As Investors Put Money On Stimulus”, which appeared well below the much larger “A New Political Order” primary headline, and rightfully so. U.S. voters had just elected Donald Trump, the ultimate political outsider, as the 45th President of the United States against steep odds, in the process proving the vast majority of political pundits dead wrong. My focus today, however, is not on the political implications of the election but rather on what the results mean for U.S. stocks and, more specifically, for the Barron’s 400, which is why the tiny headline at the bottom of page one of the WSJ caught my attention for reasons I explain below.
Before doing so, some context. As I watched the election returns roll in on Tuesday evening, just as much of the country did, I kept checking market headlines on various websites including WJS.com, Barrons.com, Bloomberg.com, Fortune.com and on my now-indispensable Flipboard app. It didn’t take long for U.S. stock futures to roll over when it became clear Trump would win Florida and Ohio, which turned into a full-blown panic as the market priced in a Trump victory. Dow futures tumbled 800 points and S&P 500 futures fell 5%, triggering a futures market halt. Around 7 pm one particular headline had caught my attention: “WORLD’S BIGGEST HEDGE FUND: Stock markets around the world will tank if Trump wins” from the ever-effusive and subtle Business Insider website[1]. It referred to Bridgewater Associates, the $150 billion hedge fund, predicting a 10.4% drop in U.S. equities and similar declines in Europe, Japan and China if Trump were to succeed. The story, if it can be called that, summed up nicely what I had been reading from market pundits in the run-up to the election: Hillary, good for stocks, Trump, terrible for stocks, not to mention the global economy. (Sigh). I immediately thought about the implications for the Barron’s 400 Index and the many investors that follow it and tried to objectively quantify what it meant for the index if the market did indeed roll over the next day. In short, I wasn’t buying it.
Wednesday, as it turns out, was one of the most remarkable days I have seen in my almost 20 years following the stock market. Overnight U.S. equity futures had firmed up somewhat and it seemed the market would open to a more moderate 300-350 point decline in the Dow. At 9:30 I watched my monitor closely expecting an opening rout that, in fact never materialized. Not long after the open the market rallied and by the 4 pm close the Bridgewater rout was no more. Stocks gained across the board on heavy volume with the Dow Jones U.S. Total Stock Market Index gaining 1.29% on the day. The S&P 500 was up 1.11% and the Barron’s 400 had gained 2.46%. According to Bloomberg, it had been the biggest reversal in the S&P 500 since October 2008, when the market was in the throes of the financial crisis. Furthermore, U.S. markets had only experienced three single-day turnarounds larger than what we saw Wednesday (including the overnight futures market); two of them occurred in October 2008 and the other had taken place in October of 1987. These were just the headlines, though, which, on the surface to many may have seemed unremarkable. The undercurrent, from my vantage point, however, was fascinating, as it seemed to me the market had suddenly and in dramatic fashion switched gears and entered an entirely new phase from the easy-money driven period in which it had been the last seven years. Was it possible that it was entering an entirely new phase grounded on a new economic reality if the new administration follows through with its economic platform (which didn’t receive nearly as much attention during the campaign as the building of ‘the wall’)? A search for the answer to that question brings me back to yesterday’s page one headline. Had the market really staged one of the most remarkable turnarounds in its history on the belief that the new administration would implement a roads-and-bridges stimulus plan to help revive the economy? How, I wondered, did the authors of the story know this? In trying to explain the market rally they wrote: “Investors are welcoming the prospect that expansive fiscal spending under the Trump administration could bolster economic activity, push up inflation and support higher bond yields in coming years.” Really? Was it that simple? I decided to look into the drivers of the turnaround for better answers, especially in the context of a momentous election and the first time that a single party will control the legislative and executive branches of government since 2009. My feeling was that, regardless of political affiliation, investors first and foremost vote with their wallets and it seemed they had sent a clear message on Wednesday.
For starters, Wednesday’s market rally was broad across size and styles, as can be seen in Figure 1. Based on Russell size and style benchmarks, gains happened across the board even if the advance/decline ratio in NYSE trading was only 1.3. Truly broad rallies are often accompanied by ratios above 2. So there was more to it than a simple garden-variety market rally, I thought.
Figure 1.
Source: FTSE Russell
A closer look at the chart on Figure 1, though, begins to clarify the undercurrent to which I refer. Notice the difference in performance, for a single trading day, between small and large cap benchmarks. Russell 2000 Growth outperformed Russell 200 Growth by 227 basis points, while Russell 2000 Value outperformed its mega cap counterpart (Russell Top 200 Value) by 145 basis points. The gaps between micro caps and mega cap are even more pronounced. So, on Wednesday, size was clearly a factor, which begins to explain a few things. As our regulars readers are probably aware, in the course of the last two years large has outperformed small, something we have written about this year (Barron’s 400 + Income = A Smoother Path Forward). In my view, much of this has to do with large money flows into large cap value, or large cap dividend payers as artificially low interest rates have pushed fixed income investors into bond proxies in the equity space. Look no further than the valuations across sectors and broad benchmarks in June, illustrated in Figure 2. At the time, the Consumer Staples and Utilities sectors of the S&P 1500 Composite were trading at 22.2 and 19.5 times trailing 12-month earnings respectively, while Technology, a traditionally more expensive sector, traded at 18.8 times trailing EPS. Companies with much better growth profiles, as represented by the Barron’s 400, traded at 16.7 times trailing EPS.
Figure 2.
Sources: Bloomberg, MarketGrader Research
A telling sign about the money flows to which I refer was the breathtaking selloff in treasuries on Wednesday with the yield on the 10-Year U.S. Treasury soaring 20 basis points to close at 2.07%. Usually this money would have flowed to the bond proxies I referred to before (dividend payers) but, I suspect, not this time. This time those flows were as much a bet on higher inflation (the Fed has finally been acknowledging as much) as one on the return of growth. Look no further than Figure 3, which shows the performance on Wednesday of the ten sectors of the S&P 1500 Composite. Consumer Staples fell 1.27%, Utilities fell 3.31% and Real Estate (the newly named 11th sector) fell 1.78%. Financials led the way, up 4.1%, followed by Health Care, which had been the worst performing sector in 2016, at least until now. Industrials rounded up the top three with a 2.68% return on the day.
Figure 3.
FactSet
This is where I would like to depart from what has, so far, been common wisdom, particularly about how damaging a Trump administration would be to the economy and the stock market. As many an expert has informed us, Trump’s policies would be not only recessionary but, in fact, actually ruinous. His administration would not only start a trade war but would also saddle the U.S. with debt burdens that would no doubt send interest rates sky-rocketing (somehow many of these experts seem to have missed the fact that the national debt more than doubled under the outgoing administration). My goal here isn’t to discuss the politics but rather to try to interpret what the market is telling us. What if instead of the common wisdom a Trump administration, with the support of the President-elect’s party in control of congress, does indeed achieve reforms that were heretofore impossible in a divided government? A few of my own points in support of my argument:
- In terms of monetary policy, the President-elect hasn’t been shy in criticizing the Fed’s loose monetary policy under its current leadership (nor has David Malpass, one of Trump’s economic advisors and in my view a possible candidate to lead the Fed in the future). Further expectations for interest rate normalization, and a steepening yield curve as investors sell out of long-dated bonds, is no doubt bullish for banks and financials in general. On Wednesday they led the rally.
- The new administration would undoubtedly focus on rebuilding the country’s manufacturing base in the heartland, which, in my opinion, can be partially accomplished in a number of ways. Easing of existing regulations is the most obvious one as is a green light to domestic energy producers to supply the domestic market and compete internationally. Combined with a better price discovery in credit markets (normalized interest rates), which would lead to a restoration of credit to small and medium enterprises, domestic manufacturing could undoubtedly become a beneficiary of the new administration’s policies. As noted above, Industrials were the third best performing sector on Wednesday.
- Health care could be trickier given the sector’s diversity and the stark differences between winners and losers in the current Affordable Care Act environment. But, generally speaking, better price discovery, a freer market and more consumer choice typically leads to robust business in any industry. Biotechnology and Pharmaceutical stocks were among the best performers Wednesday, helping Health Care reverse a months-long slide that was clearly overdone.
- Tax reform, an almost certain impossibility a week ago, within the political environment of the last few years, suddenly seems not only possible but actually probable. A lower corporate tax rate, combined with, perhaps, a territorial tax system and a mechanism to repatriate much of the $2 trillion that U.S. companies have stranded overseas, would no doubt be bullish for equities. Tax relief on domestic SME’s, the majority of which are pass-through entities and pay taxes at personal income rates could also have a positive effect on business creation, employment and overall economic growth.
- Lastly, not to be overlooked (despite my opening comments), Mr. Trump has made it clear that he plans to focus on rebuilding the nation’s infrastructure, which seems to be a clear point of agreement with the Democratic minority in Congress. This not only would result in the fiscal spending the authors of the WSJ piece referred to but it would also be a long-term stimulus to U.S. productivity and higher nominal GDP growth, the ultimate driver of earnings and thus higher share prices.
How does the Barron’s 400 fit into all of this? As most of our readers know, the Barron’s 400 is focused on identifying consistent creators of economic value as the best generators of long-term capital appreciation. The index selection process, done semi-annually, is based on MarketGrader’s growth-at-a-reasonable-price methodology, straddling the divide between growth and value and focusing on profitability and sound financial management. The result is a domestic portfolio that leans further to growth than to value, is usually comprised of 50-60% mid caps, even though the index is multi-cap, and does well when the economy is growing, as can be seen in Figure 4, which illustrates its performance against market benchmarks in the last 10 years; this included the most recent expansionary cycle from the 2009 bottom, which topped last year. The reader may judge as to how well B400 is positioned to take advantage of the scenario I have described above with a little help from Figure 5, which shows B400’s current sector exposure compared to the S&P 1500 Composite, from which a few points may be inferred. The index has a 20% exposure to Industrials, many of which are mid cap domestic manufacturers in industries as diverse as Building Parts, Trucks, Construction & Farm Machinery, Aerospace & Defense, Industrial Machinery and Environmental Services, to name just five of the 21 Industrial sub-industries to which it is exposed. It also has a 20% exposure to Financials, most of which is in Regional Banks (12.5%). From a market cap perspective, over 55% of the index is in mid cap stocks across 41 different industries.
It is most definitely too early to tell whether the economic scenario I have outlined here does indeed materialize under a Trump administration. However, if the market continues its current transition phase into new size and sector leadership, as it has done two days in a row, it will be difficult to argue that it is on the expectations of a new “fiscal stimulus program” alone. Then again, I am well aware that two trading days do not a trend make.
Figure 4.
Source: Bloomberg
Figure 5.
Sources: FactSet, MarketGrader Research
[1]Rachael Levy, Business Insider, November 8, 2016.
