What's Next For Post-Election Markets?

| About: SPDR Dow (DIA)

Summary

Election optimists could be disappointed.

Party power changes generally not good for stocks.

There is a lot of talk about the four-year presidential cycle during every election.

The financial media is full of prognostications about what the Trump presidency will mean for markets. Bonds swooned and stocks soared after the election with both markets pricing in the near certainty of fiscal stimulus and the return of inflation. Will this really happen? Nobody knows. The markets may have made big bets on the direction of the new administration, but they depend on which Donald Trump shows up for work on January 21, 2017.

There will be a steep learning curve and plenty of conflicts even though all three branches of the government are in one party's hands for the first time since the first two years of the Obama presidency. Remember, President Obama not only controlled the House and the Senate, but briefly held a filibuster-proof, 60-seat supermajority in the Senate.

Sharp divisions in the Democratic Party resulted in a watered-down version of health care that was nothing like the single-payer system the new president campaigned on. Un-affectionately known as "Obamacare", this flawed program spawned the rise of the Tea Party as well as a hard turn to the right by the Republican Party. It may also have helped defeat Hillary Clinton. Double-digit increases in the Affordable Care Act just prior to the presidential election did not help her cause.

Election Optimists Could Be Disappointed

Like Barack Obama, president-elect Donald Trump has made a number of campaign promises that he will have a hard time squaring with some members of his own party - especially deficit hawks. Trump promised not to cut Social Security or Medicare. He has also promised to increase military spending, make huge investments in infrastructure and cut taxes across the board. This would be a hard sell even with a filibuster-proof Senate majority - something the president-elect is eight seats short of.

On the campaign trail, Mr. Trump also talked about his plan to bring back manufacturing jobs to Middle America by imposing taxes and tariffs on foreign-made goods. The problem is, the stock market hates tariffs and doesn't respond well to anything which threatens global trade and profits. Trade wars tend to cause recessions, not inflation. Many blame the infamously protectionist Smoot Hawley Tariff Act of 1930 for worsening the Great Depression, which began with the 1929 stock market crash. A trade war now could push the globe into the very recession it has been avoiding - especially given the precarious financial positions of Europe and China.

New administrations tend to overreach. Barack Obama expended so much political capital on his signature health care program that he had little left to address other issues. Post-election statistics reveal that one of the main forces behind Trump's victory was economic. Middle America wants their jobs back, but not just any jobs; they yearn for a return of the factory employment that enabled breadwinners to raise a family, send their children to school, and have reasonable expectations that their children would have a better life than their parents. Achieving this will require singular focus and resolve by the Trump Administration, especially as they confront the rise of artificial intelligence and automation which is eliminating factory jobs the world over.

Will Trump be able to deliver? It is too early to tell. However, failure to do so fairly quickly could make governing a lot more troublesome down the road, even with control of all three branches. But the markets may not wait that long…

Party Power Changes Generally Not Good For Stocks

The last two major stock market crashes occurred during shifts of Presidential power. The 2001 Dot.com Crash followed the end of Bill Clinton's two-term reign. The Housing Crash began in August of 2008 - George W. Bush's final year as Commander in Chief. Both Clinton and Bush were two-term presidents who were replaced by candidates from the opposing party.

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Data source: FutureSource

We published an earlier version of this chart in April, when it looked like Donald Trump would win the Republican nomination. Is this mere coincidence or something more? There is really no way to know. One explanation could be market cycles that happen to line up with the presidential election cycle. The longest bull market in history occurred on Bill Clinton's watch and lasted 113 months. The second longest bull market in history will be 92 months old on December 1, 2016. A Shiller price to earnings ratio of over 27 means stocks are historically expensive. Combine a long-in-the-tooth bull market with a high PE ratio and you get the ingredients for a major correction, no matter what happens politically.

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Source: multpl.com

Seven-Year Cycle Postponed?

There is a lot of talk about the four-year presidential cycle during every election. Stocks tend to perform the best in the third year of a presidential term and the worst in the first, post-election year. According to the "Stock Traders Almanac," the average gain in a first presidential term is 2.5%, with down years outnumbering up years. What may be more concerning is the seven-year "bust" cycle. It has roughly defined the time-frames between market crashes and corrections in the modern era.

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The chart above superimposes the past six presidencies over the S&P 500. Note the time difference between major downturns. The US dollar shock of 1968/69 was followed roughly 7 years later by the Oil Crisis of 1974/1975. The bond shock of 1980/1981 occurred roughly 7 years later and was followed by the 1987 crash, approximately 7 years after that. The tech bust of 2001 and the housing bust of 2008 are also 7 years apart.

Interest Rates Are Going Higher - Perhaps Much Higher

Are we overdue for another "bust?" Look what has happened to the bond market lately in anticipation of the first real fiscal stimulus since the $800 billion injected into the economy after the 2008 housing crash. Bonds have been in a bubble for quite some time. Like stocks, the bull market in bonds was largely driven by two factors: 1) direct purchases by the Fed, and 2) artificially low short-term interest rates imposed to compensate for the lack of fiscal stimulus.

Both of these are going away. Not only will the Fed continue to raise interest rates, but the US will be flooding the market with new bonds as the need for cash grows due to increasing fiscal stimulus. Interest could rise further and faster than anyone anticipates, decimating not only the bond market, but sending stocks tumbling as cash finds its way back into CDs and other safe, short-term instruments. The 7-year bust may be delayed, but it remains a threat.

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Expect the Unexpected

So what's next for the markets? History tells us to get ready for even more volatility. Stocks are expensive and overdue for a serious correction, but could explore new highs first. Interest rates have probably bottomed and bonds could be just beginning a punishing new bear market. If victories by both the Chicago Cubs and Donald Trump in 2016 have taught us anything, it is to expect the unexpected.

Finally, the mostly-ignored commodity markets could surprise everyone. A stronger dollar may be weighing on sentiment now, but copper is sending another signal. Copper is often referred to as "Dr. Copper" because it is deemed to have a PH.D in economics. Copper tends to lead recoveries, often signaling the end of bear markets in commodities. Could the commodity sector be the surprise, post-election performer?

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The bottom line is, anything can happen. The latest sell-off in the bond market has already vaporized over $1 trillion of investment capital. And bonds will probably not be the last post-election shocker. Adding Managed Futures to your portfolio can provide critical diversification during these uncertain times.

Diversification in Action

We introduced the table below in September 2016. It shows the performance of three managed futures programs we are following versus the S&P 500. The first specializes in trading stock market volatility and global stock indexes. The second trades agricultural commodities, and the third focuses on energy. We will update this periodically so our customers have a real-world, dynamic picture of diversification in action.

The 22-month time period of this example is far too short to take to the bank, but it is enough to show how each program performed over different market conditions - including bull, bear, and sideways markets. (Note: We have not supplied the name of these programs, because we do not want anyone making a decision to enter them based solely on performance.)

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Investors should consider adding managed futures to their investment portfolios only after carefully reviewing the Disclosure Documents of each CTA they are interested in. A Disclosure Document is to managed futures what a prospectus is to stocks. It includes the background, trading style and experience of traders running the program. It also lists risk factors and other information, including the minimum account size each program will accept along with audited track records for the trader or traders running the program or programs.

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.