Friday, November 11, 2016

The Trump Effect on Markets: A Financial (not a Political) Analysis!

I have political views, but I try to keep them out of my classes and my blog posts. I teach and write about corporate finance/valuation, not political science, and I don't think it is fair to subject my students or readers of this blog to my views on politics. I would be committing malpractice, though, if I avoid talking about Tuesday's election, since it does have consequences for investing. That said, I know that nerves are exposed and emotions are raw and I want (perhaps unsuccessfully) to stay away from the hot-button issues and focus, as best as I can, on the investment implications of a Trump Presidency. As I started writing, I realized that I was repeating almost word for word what I had written in June, after UK voters voted for Brexit. Consequently, I decided to go back and copy the Brexit post, change "Brexit" to "Trump Election", to see how close they were.  The changes are in red and the replaced words are crossed out. You can be the judge on the parallels!

There are few events that catch markets by complete surprise but the decision by British US voters to leave the EU elect Donald Trump as President comes close. As markets struggle to adjust to the aftermath, analysts and experts are looking backward, likening the event to past crises election surprises and modeling their responses accordingly. There are some who see the seeds of a market meltdown, and believe that it is time to cash out of the market. There are others who argue that not only will markets bounce back but that it is a buying opportunity. Not finding much clarity in these arguments and suspicious of bias on both sides, I decided to open up my crisis survival kit, last in use in August 2015, in the midst of another market meltdown.

The Pricing Effect
I am sure that you have been bombarded with news stories about how the market has reacted to the Brexit vote Trump Election and I won't bore you with the gory details. Suffice to say that, for the most part, it has not followed the crisis rule book: Government bond rates in developed market currencies (the US, Germany, Japan and even the UK) the United States have dropped risen, gold prices have risen stayed flat, the price of risk has increased decreased and equity markets have declined risen. The picture below captures the fallout of the vote across markets:
As the election results came out on Tuesday night, the immediate market reaction was dire, with Dow futures dropping almost 800 points, triggering circuit breakers. By Wednesday morning, though, the panic seemed to have subsided and the market effect in the two days since the election have been not just benign, but positive. I know that it is early and that much can happen in the next few weeks to spook markets again, but as things stand now, here is what we see. Rates on US treasuries have risen sharply, with interpretations varying depending upon your election priors, with those negatively inclined to Trump viewing the rise as a sign that foreign buyers are pulling out the market, leery of his comments about  and those positively inclined arguing that the rise reflects expectations of higher growth in the future. The dollar has held its own against other currencies and the fear indices (gold and the VIX) have fallen since Tuesday, with the VIX dropping dramatically. US stocks have risen in the two days since the election, with small cap stocks in Russel 2000 rising more than the large cap stocks. If you are puzzled by the NASDAQ's inability to join the rally, you can see why when you look at the returns across the S&P sectors:

Last 5 daysLast 3 monthsYTD (2016)
Consumer Discretionary2.46%-2.57%1.05%
Consumer Staples-0.88%-4.97%2.95%
Energy3.80%3.50%16.79%
Financial Services6.48%7.46%6.38%
Financials6.71%6.70%7.77%
Health Care6.20%-5.36%-1.74%
Industrials5.59%2.23%12.58%
Materials4.39%-0.94%11.15%
Real Estate0.40%-12.21%-3.83%
Technology1.37%0.45%10.55%
Utilities-1.17%-6.59%9.43%
S&P 5003.11%-0.85%5.84%
The stock market rise in the last few days has been uneven with consumer staples, utility, technology and real estate stocks (ironically) lagging and financial firms, health care and industrials doing well. Though it is dangerous to try to create full-blown stories based on stock market behavior over a few days, it seems likely that the rally in financials and pharmaceuticals can be traced as much to expectations about what Trump has said he will do (repeal Obamacare, for instance) as to relief that some of the regulations/restrictions that Clinton had proposed (on pharmaceutical pricing and more constraints on banks) would not longer be on the table. The decline in utilities can be attributed to rising interest rates but the swoon in tech stocks bears watching, since it could be an indication that tech companies, who strongly backed Clinton, may face headwinds in a Trump administration. 

The Value Effect
As markets make their moves, the advice that is being offered is contradictory. At one end of the spectrum, some are suggesting that Brexit Trump election could trigger a financial crisis similar to 2008, pulling markets down and the global economy into a recession, and that investors should therefore reduce or eliminate their equity exposures and batten down the hatches. At the other end are those who feel that this is much ado about nothing, that Brexit will not happen or that the UK will renegotiate new terms to live with the EU and that investors should view the market drops as buying opportunities the Trump effect can be more positive than negative, with changes in taxes and regulations offsetting any negative consequences from his trade policies. Given how badly expert advice served us during the run-up to Brexit the Trump election, I am loath to trust either side and decided to go back to basics to understand how the value of stocks could be affected by the event and perhaps pass judgment on whether the pricing effect is under or overstated. The value of stocks collectively can be written as a function of three key inputs: the cash flows from existing investment, the expected growth in earnings and cash flows and the required return on stocks (composed of a risk free rate and a price for risk).  The following figure looks at the possible ways in which Brexit the Trump presidency can affect value:


I know the perils of assuming that campaign promises and rhetoric will become policy, but broadly speaking, you can outline the possible consequence for companies of Trump's proposed policy changes. The biggest and potentially most negative effect would come from his trade policies, where protectionist policies can and will draw protectionist responses from other countries, putting global trade and growth at risk. Trump has been ambivalent about both the Federal Reserve's interest rate policies and financial markets, arguing that the Fed has played politics with interest rates and that financial markets are in bubble territory. It will be interesting to see whether the FOMC, when it meets in December, takes into account the election results, in making its widely telegraphed decision to raise rates (at least the ones that it controls). Trump has proposed major changes to both corporate and individual tax rates, and if Congress goes along even part way, you can expect to see a lower corporate tax rate accompanied by inducements to bring the $2.5 trillion in trapped cash that US companies have in other markets.

There is also likely to be sector-specific fall out from other Trump policies, at least in contrast to what these sectors would have faced under a President Clinton. President Trump has prioritized repealing Obamacare and that will have direct consequences for companies in the health care sector, with some benefiting (pharmaceutical companies?) and some perhaps being hurt (insurance companies and hospital stocks?). President Trump's proposal to invest heavily in the nation's infrastructure will benefit the construction, engineering and raw material firms that will construct that infrastructure but he may run into both budgetary constraints (with his tax proposals) and political headwinds (from conservatives in Congress). Finally, President Trump has promise to reduce regulation on business and put in more business-friendly regulators on the regulatory bodies and that will be viewed as good news by banks and fossil-fuel firms that were facing the most onerous of these regulations. The Trump proposals to preserve the entitlement programs, lower taxes and increase infrastructure spending are potentially at war with each other and budget constraints, but that does not mean that significant parts of each one will not become law.

In evaluating these possibilities, I am cognizant of the checks and balances that characterize the US system. Unlike parliamentary systems, where a new government can quickly  rewrite laws and replace old policies, the framers of the US constitution put in a system where power is shared by the executive, the legislature and the courts, making change difficult. Even with Republicans controlling the executive and legislative branches, I am sure that Trump supporters will be frustrated by how slowly things move through the mill and how difficult it is to convert proposals to policies and Trump detractors will learn to love the same filibusters, congressional slowdowns and legal roadblocks that they have inveighed against over the last eight years. 

The Bigger Lessons
It is easy to get caught up in the crisis of the moment but there are general lessons that I draw from Brexit the Trump election that I hope to use in molding my investment strategies.
  1. Markets are not just counting machines: One of the oft-touted statements about markets is that they are counting machines, prone to mistakes but not to bias. If nothing else, the way markets behaved in the lead-up to Brexit the election is evidence that markets collectively can suffer from many of the biases that individual investors are exposed to. For most of the last few months, the British Pound Mexican Peso operated as a quasi bet on Brexit the US presidential election, rising as optimism that Remain Clinton would prevail rose and falling as the Leave Trump campaign looked like it was succeeding. There was a more direct bet that you would make on Brexit Trump in a gamblers' market, where odds were constantly updated and probabilities could be computed from these odds. Since Brexit the US election was also one of the most highly polled in history, you would expect the gambling to be closely tied to the polling numbers, right? The graph below illustrates the divide. 

    While the odds in the Betfair did move with the polls, the odds of the Leave camp Trump winning never exceeded 40% in the betting market, even as the Leave camp acquired a small lead in the weeks leading up to the vote the polls got closer in mid-September and in the last week before the election. In fact, the betting odds were so sticky that they did not shift to the Leave side until almost a third of the votes had been counted Trump until late on Tuesday night. So, why were markets so consistently wrong on this vote? One reason, as this story notes,  is that the big bets in these markets were being made by London-based bigger investors tilting the odds in favor of Remain Clinton. It is possible that these investors so wanted the Remain vote Clinton to win that they were guilty of confirmation bias (looking for pieces of data or opinion that backed their view). In short, Brexit Trump reminds us that markets are weighted, biased counting machines, where big investors with biases can cause prices to deviate from fair value for extended periods.
  2. No one listens to the experts (and deservedly so): I have never only once before seen an event where the experts were all so collectively wrong in their predictions and so completely ignored by the public. Economists, foreign policy experts and central banks opinion leaders all inveighed against exiting the EU Trump, arguing that is electing him would be catastrophic, and their warnings fell on deaf years, as voters tuned them out. As someone who cringes when called a valuation expert, and finds some of these experts to be insufferably pompous,  I can see why experts have lost their cache. First, in almost every field , expertise has become narrower and more specialized than ever before, leading to prognosticators who are incapable of seeing the big picture. Second, while experts have always had a mixed track record on forecasting, their mistakes now are not only more visible but also more public than ever before. Third, the mistakes experts make have become bigger and more common as the world has become more complex, partly because the interconnections between variables means there are far more uncontrollable elements than in the past. Drawing a parallel to the investment world, even as experts get more forums to be public, their prognostications, predictions and recommendations are getting far less respect than they used to, and deservedly so. Finally, it is time that we that are open about the fact that we are all biased and being smart or an expert does not immunize from bias.
  3. Narrative beats numbers: One of the themes for this blog for the last few years has been the importance of stories in a world where numbers have become more plentiful. In the Brexit debate US presidential election, it seemed to me that the Leave side Trump had the more compelling narrative (of a return to an an old Britain America that enough voters found appealing to help him win) and while the Remain side Clinton argued that this narrative was not plausible in today's world, its counter consisted mostly of numbers (the costs that Britain would face from Brexit) inveighing against Trump's character and temperament. Looking ahead to similar referendums elections in other EU countries,  I have a feeling that the same dynamic is going to play out, since few established politicians in any EU country seem to want to make a full-throated defense of being Europeans first the status quo
  4. Democracy can disappoint (you): The parallels between political and corporate governance are plentiful and Brexit this election has brought to the surface the age-old debate about the merits of direct democracy. While many, mostly on the winning side, celebrate the wisdom of crowds, there are an equal number on the losing side who bemoan the madness and prejudices of crowds.  As someone who has argued strongly for corporate democracy and against entrenching the status quo, it would be inconsistent of me to find fault with the British American public for voting for Brexit Trump.  In a democracy, you will get outcomes you do not like and throwing a tantrum or threatening to move are not democratic responses.  You may not like the outcome, but as an American political consultant said after his candidate lost an election, "the people have spoken... the bastards".
The End Game
I am sure that reading this post, with its crossed-out words and red insertions, has been tiresome, but I also think that the parallels between what happened around Brexit and the US presidential election are too strong for this to be coincidence. Just as technology and social media are upending traditional models in businesses, these two elections are signaling a change in the political game and it is not just politicians, pollsters and political consultants who should be taking notice.

YouTube Video

13 comments:

Anonymous said...

I agree with you about that both of this events( Brexit and Trump Presidency) shows long term political trends instead of isolated events. And this trends are happening for quite some time . Several others bloggers ,whom I follow , had already identified this trend long ago with clear accusations on media to purposefully hiding this trends. On the other note reading this post with cross out words and red part was rather fun. One will almost think that Trump's presidency could have been predicted from brexit.

Ansgar John said...

Nothing to add. As Charlie Munger would say.

Phil Sage said...

You do realise this post is absolute proof as to why even reasoned intelligent commentary could be replaced by automation.

Abdul Gaffar said...

Great post as usual, Sir. With all due respect, I believe that you have voted for Clinton. Since, in the end of the video you looked disappointed in the way democracy might work at some times and when you said that this is the world we live in.

Great post. Respect.

Aswath Damodaran said...

Abdul,
The guesses are running at about 50:50, with half picking Clinton and half picking Trump. That is exactly what I was hoping would happen. As I said at the start, my political views are not what you are on this blog to get. I will leave that to others (and there are so many of them).

Dajo9 said...

Professor Damodaran, thanks for the great commentary. My own view is that recent market movements are transitory and based on preconceived notions about what a Trump Presidency would look like. They are about as valuable as the preconceived notions about what the election would be like. The real impacts of a GOP hegemony in the Federal Government won't be seen for years. In my view the signs point to negative interest rates in America from both fiscal policy and monetary policy impacts.

On fiscal policy, once you understand that low interest rates are a symptom of income inequality the current situation makes a lot of sense. If you look at a 100 year chart of income inequality and Treasury rates the negative correlation is unmistakeable (both hitting extremes in the 1930s, 1970s, and now).

The GOP's proposed policies of huge income tax cuts on the wealthy combined with cuts to benefits (like Obamacare) will push more money into the hands of investors and out of the hands of consumers. With inadequate demand, equity growth will be a challenge (equities will already be around record levels) and so more money will flow to the bond market driving rates down. One potential moderation of this would be a large infrastructure / jobs bill, however I don't think the GOP Congress will pass this without equal cuts elsewhere.

On monetary policy, there will be a push to drive up interest rates by many. There is a broad view (I've heard as almost concensus at places like Bloomberg Radio) that if the Fed would just raise rates it would benefit portfolios and spur the economy. This is an incredibly myopic and uneducated view of how the economy works but I think it will be the view held by those taking power in Washington DC. It will be interesting to see if Fed Chair Janet Yellen is allowed to keep her post. Ultimately, the more Washington tries to push up interest rates at the lower end, the more they will come down at the higher end.

Based on these factors, I predict negative interest rates in America before the end of Trump's first term. I have already made some minor adjustments to my portfolio.

John-David Seelig said...

The sell off was a pre-quake. The true risk comes with cabinet selection and international relations.
The Trump platform is cost now for growth later, perhaps the markets have superceded the risk for promise of growth. Time will tell, thank you for the break down by sector!

Anonymous said...

The quick reaction of markets highlights what the Prof has frequently talked about: mood and momentum vs. underlying fundamentals. Many stocks may have seen their prices go down with concern over HRC election; and now many stocks have probably risen to levels well in excess of their intrinsic value with the election of Trump, save for lower tax rates which will exert upward impact on valuations. An example of this may be names related to infrastructure that now sport P/E ratios that in no way can be related to what these companies can generate in revs, CF, etc given their fundamentals. Infrastructure is likely to benefit, but expectations will fall short of what companies can produce. There have not been many new cement factories built, so the reality of capacity constraints exist, and getting enough workers to do construction will also be a challenge as evidenced by statements from homebuilding companies.
As to politics and elections, most of us think we are right in how we view the world, or investments and cannot understand how anyone can possibly have a different view and when given the opportunity to express it will.

Dealmaker, Investment Banker said...

Is this a "black swan" event or is the bear finally catching up with the bull ?

My opinion:

1. A recession is coming. Bear up ! (lol)
2. The Silicon Valley bubble burst soon. (wayyy wayyy overdue)

Dave Close said...

I wonder how Trump will effect the valuation of some of the firms you have already looked at.

I assume he will be bad for Solar City/Tesla, Apple and the Social Media companies.

Irishmist said...

Tech index flat - probably due to Ant-trust threat trump tweeted about Amazon and Tech; possibility that he wants Amazon or its customers to pay more taxes, and he could be against large M&A deals in the sector.
But - it is Trump - and sometimes I doubt he knows what he's talking about as reads little and just watches Fox etc...

Irishmist said...

Also - check out the huuuuge surge in small cap US stocks - IJR etf - versus S&P since Nov 9. Can that be explained by assuming domestic companies will benefit a lot more from lower corp taxes, since international ones effectively pay low cash taxes already?
I see cutting Corp taxes as tough to do - a flat tax of 15% would HURT a lot of tech cos and some pharmas - their effective rates may already be much lower - Google and Apple; but benefit domestic companies.
15% would benefit small domestic companies - maybe a reason for small cap surge.
It may lead to a lot of contract workers incorporating as sole proprietors - lower rate than personal rate - contract workers can abuse it - happens in Ireland

Kanu said...

thanks for note Professor

people world seem to be saying: whatever the "establishment" wants - rejected.

Jokowi, Modi, Trudeau, [Brexit], Dueterte, Trump!