With elections just around the corner amidst an environment punctuated by populist sentiment, it is no surprise to see numerous investment-related articles advising investors on how to position for particular electoral outcomes. In fact, I was asked to provide our own perspective on positioning for this year's elections, but, truth-be-told and at the risk of sounding overly provocative, I find such articles utterly worthless.
With that said, here is our take on the futile exercise of investing around political narratives. Why is it futile? First, because positioning around specific regimes is notoriously difficult (see 3D's Q2 2016 Market Commentary) since the forecaster has to accurately predict two outcomes: 1) regime outcome and 2) asset class price reaction to #1. Second, because 'how should one invest around a specific electoral outcome?' is the wrong question to ask. Rather than asking how I should be positioned for a Trump or Clinton outcome, the investor should ask, "Am I comfortable with my current risk positioning given the air of uncertainty surrounding the current political climate?" The answer to the second question follows later, but first, let's explore the futility in trying to invest around a Trump or Clinton electoral victory.
Investors Feeling Edgy This Year?
Money Magazine wrote a more thoughtful perspective piece on not letting emotions surrounding this year's election spill over into your investment decisions. For instance, they cite a paper, "Political Climate, Optimism, and Investment Decisions," published in 2012 on how investors from the party controlling Washington tends to take greater market risks while investors from the opposition party tend to "grow restless and trade securities more frequently." And, too frequently, the investment narrative surrounding electoral candidates tend not to play out as expected. Consider this excerpt:
Investment narratives form quickly in election years. Right now, for instance, market opiners are advising you to buy shares of clean-energy companies, defense contractors, and multinationals in the event of a Clinton victory. A Trump presidency, on the other hand, should be a windfall for coal miners, small-company stocks (because their sales are mostly in the U.S.), and, of course, shares of construction companies that specialize in erecting walls. It all seems so simple…But remember the assumption in 2008 was that Obama would put gunmakers out of business, turn health providers into wards of the state, and usher in a golden era for alternative energy. Tell that to Smith & Wesson, whose shares have trounced the market by 35 points a year for the past five years. Or to the health care sector, which has outpaced the broad market by more than two points a year in this administration. Or to clean-energy stocks, down 47% so far under Obama.
Let's look at another example: Aerospace & Defense stocks (S&P Aerospace & Defense Level 3 or "A&D"). This sector certainly performed well under George W. Bush (43) when defense spending as a % of GDP increased from 3.50% to 4.50-5.00% towards the end of his presidency (Exhibit 1). When adjusted for the total return of the S&P 500, A&D stocks returned 106.50% on a market-adjusted basis (Exhibit 2).
Exhibit 1 - U.S. Defense Spending as % of U.S. GDP (2000 - 2008)
Exhibit 2 - Aerospace & Defense Stocks Perform Well Under Bush '43
Now the investment narrative under President Obama, who won the Nobel Peace Prize immediately after taking office, was to avoid defense-related stocks as investors and pundits expected a new 'peace' dividend under Obama who would undo much of the 'neocon' foreign policy initiatives of his predecessor. However, the narrative didn't exactly play out as expected. Defense spending as % of GDP actually rose to higher levels (Exhibit 3), even during the 2010-2011 period when fiscal austerity measures such as spending caps were agreed upon in order to avert a shutdown, and remains around 4.50%, not too far from where it stood under Bush '43 (although it is expected to drop to 4% for FY2016). Not only did budget commitments to defense spending remain higher under Obama than Bush, A&D stocks as a group were able to outperform the market over Obama's terms just as they had under Bush (Exhibit 4). Now would any pundit have picked A&D stocks for the 'Obama' portfolio to outperform the markets? Yet, A&D stocks have produced a 23% cumulative excess return above the markets so far over Obama's two terms.
Exhibit 3 - What Peace Dividend?
Exhibit 4 - A&D Stocks Perform Well Under Obama
The example of the Aerospace & Defense industry also exposes a key flaw in deriving investment narratives around electoral outcomes: such analysis assumes a static rather than dynamic response from the industry constituents. In the face of lower absolute levels of defense spending, did the A&D industry just sit idly by and watch their shareholder base erode under anemic returns? No, the A&D industry tightened their belt by becoming smarter capital allocators, consolidating smaller players, and focusing on higher shareholder returns such as share repurchases and dividends. Not all companies can or will make this adjustment around new political realities, but even near-bankrupt industries such as coal miners were more at the mercy of exogenous forces beyond the political environment. Low natural gas prices from North American fracking helped contribute to the dismal economics of coal mining as much as the EPA's strict regulatory curbs on coal usage. The fact is that investment narratives assume a static response by the industry participants, and that is not the reality of our capitalistic economy.
Speaking of energy, oil and gas stocks actually performed well during both the Bush and Obama presidencies up until the time oil prices took a dive in both 2007-08 and 2014-2015 (Exhibits 5 and 6). Was it the policies of both administrations that drove the relative performance of energy-related stocks or was it more due to macro global forces and the reaction function of OPEC?
Exhibit 5 - Energy Exploration Stocks Do Well Under Bush Up Until the 2007-08 Oil Price Collapse
Exhibit 6 - Energy Exploration Stocks Do Well Under Obama Up Until the 2014-15 Oil Price Collapse
And as the Money Magazine article alluded to, alternative energy stocks haven't exactly thrived under Obama (Exhibit 7). Maybe the economics of providing cost-competitive alternative energy matter more to the performance of these stocks than presidential policies.
Exhibit 7 - Global Alternative Energy Goes Nowhere Under Obama
Asking the Right Question
The Money Magazine article also made this astute point: regardless of the outcome, nearly half the country will be miserable over the outcome, but life will move on as the political and economic establishments will help keep both candidates' powers in check to some degree. Investors fearing a specific outcome should heed political pundit Charles Glasser:
Truth be told, I'm just not that freaked out and worried. Clinton is a crony capitalist, not a raving Socialist. Trump is not Hitler or even Mussolini, he's more like Berlusconi.
The right question investors should be asking is: Am I comfortable with my current risk positioning given the air of uncertainty surrounding the current political climate? First, in making this assessment, check to make sure your political biases are not unduly affecting your investment decisions. Second, revisit your time horizon for making risky investments such as equity investing. If it is less than 10 years, then your investments may not be able to ride out the volatility that can come from risky investments. If the markets do sell off, it will be more likely due to forces beyond which presidential candidate prevails in November. Third, consider diversification. The U.S. market is not the only stock market to invest in - there are plenty others, particularly in regions less susceptible to populist movements. Exhibit 8 displays the rolling 5-year return between the MSCI All Country World (ex-USA) Index versus S&P 500. After having outperformed through much of the mid-2000s, ex-U.S. markets have underperformed the U.S. to the point where investors are questioning the merits of global diversification.
Exhibit 8 - Is the Cycle About to Turn? U.S. Stocks Have Trounced International Over the Last 5 Years
Will the U.S. cede its leadership to foreign markets after such a strong run? If the current U.S. political environment is giving you angst, reconsider the merits of global diversification.
Disclaimer: The above is the opinion of the author and should not be relied upon as investment advice or a forecast of the future. Neither the author nor the firm openly endorse any of the political candidates, parties, movements, etc. referenced in this article. The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. It is not a recommendation, offer or solicitation to buy or sell any securities or implement any investment strategy. It is for informational purposes only. The above statistics, data, anecdotes and opinions of others are assumed to be true and accurate; however, 3D Asset Management does not warrant the accuracy of any of these. There is also no assurance that any of the above is all inclusive or complete. Past performance is no guarantee of future results. None of the services offered by 3D Asset Management are insured by the FDIC, and the reader is reminded that all investments contain risk. The opinions offered above are as of August 8, 2016, and are subject to change as influencing factors change.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.