Trumped Up Markets: The Market Reaction To The Election

Date: November 27, 2016 3:16 am
Author: Evan Axelrod

America is now a couple of weeks past the election and many people are just starting to believe that the stunning upset election of Donald J. Trump happened. Regardless of one’s political standing, some have dubbed the outcome of the 2016 presidential election the most shocking electoral result of their lifetime. Polls that were accurate during the last two election cycles were proven wrong by a “black swan” result. This phrase, made famous by author and statistician Nassim Nicholas Taleb in his writings and book The Black Swan, means an event with a totally unforeseen outcome. However, as pundits look back in hindsight, many view it as predictable. By now, several election followers and experts all have a justification for the Trump victory. The markets, as well, have presented their own version of an acceptance of this revolutionary outcome. The victory of a political outsider has shockingly led markets to reach record highs. However, it did not always appear that would be the result. In fact, for a while, it seemed like chaos had struck the markets.

As election coverage on various media outlets announced each state’s outcome during election night and the unthinkable began to become reality, headlines flashed across screens announcing the major decline of futures markets. The price for Dow Jones Industrial Average (the Dow) futures notably declined 800 points at one point during the night. This was the expected reaction of global markets that were pricing in a Hillary victory. A Trump win was totally unexpected and markets don’t handle the unexpected well. Predictable outcomes that match Wall Street’s expectations are the ideal. However, in reality, predictability is scarce.

Humans have a tendency to be overconfident in their predictions. Whether in sports, politics, or investing, the overconfidence effect takes over, leading to the belief that future expectations are foregone conclusions. A similar phenomenon happened with Brexit, the English vote to secede from the European Union, an outcome most investors didn’t see coming. Market volatility, or the variation of prices, increased tremendously due to the unforeseen circumstances regarding the vote. History is full of examples where markets reacted to the extreme after a significant event. Whether these reactions are rational or irrational depends on each occurrence. But for a long-term investor, when the market moves south, fast opportunities for bargains only increase. In the face of unexpected outcomes, the constancy of human nature will prevail. Since markets are made up of millions of human participants, the irrationality of human biases will be evident again and again.

At 9:30 AM EST on November 9th, the day after the election, U.S. markets opened. Surprisingly, there was no hundred-point decline in the Dow, or 5 percent declines in the NASDAQ or S&P 500. While there was disbelief in the results of the night before, markets seemed to increase as the day went on. Why was there a sudden shift from doom to triumph? Initially, the markets judged a Trump victory by his character, but shifted in the morning to a positive judgement based on his policies. With a Republican majority in both the House and Senate, coupled with a Republican in the White House, investors seemed to ignore the uncertainty of whether Trump’s campaign policies would come to fruition. Instead, Trump’s agenda was seen at face-value as pro-business, intended to stimulate domestic growth, bring jobs back to America, and commit to infrastructure investments. His agenda was additionally seen as being intended to decrease the U.S. economy’s reliance on global trade deals. Ray Dalio, founder of Bridgewater Associates, a hedge fund managing about $150 billion, believes this presidency might bring about a reversal of our economic standing. For example, in the 1970s, stagnation, or economic standstill, transitioned into a decade of high growth and productivity in the 1980s.

It remains to be seen whether Trump will indeed implement many of his economic policies proposed during his campaign. The markets are extrapolating two agendas as the drivers for stocks: lower regulation and lower corporate taxes. If companies don’t have to pay as much taxes to Uncle Sam nor have to deal with as much government regulation, their profits will only improve. Many domestic companies are being looked at as more attractive investments in order to avoid the risks of trade deals being scrapped, which would affect multinational companies.

Sectors, such as healthcare and financials, have already seen their stock prices rise. Banks, such as Bank of America (Ticker: BAC) and Goldman Sachs (Ticker: GS), have seen their stock prices rise at least 15% in the last 2 weeks. Much of this plays off the aforementioned policies of lower regulation, as banks have had to deal with overwhelming regulatory policies following the financial crisis. Additionally, banks stand to benefit from a rise in interest rates, which is more likely under Trump. Without getting too complicated, interest rates represent the cost of borrowing. If interest rates rise, it costs more for a small business owner to borrow from a bank to finance his or her business. The bank, therefore, receives a higher return on each loan it lends out at the higher interest rate. With Trump’s future pro-growth spending policies, many people believe the Federal Reserve will allow an increase in interest rates to accompany a higher growth environment. If rates increase, banks will be more likely to loan, thereby producing higher loan revenue for the banks. This paints a rosy picture, as this thesis implies Trump’s policies will spur GDP (Global Domestic Product) growth and spending, leading to higher corporate profits. If the profits don’t follow, however, higher interest rates will lead to inflation and markets will probably decline.

As was stated before, predictability is scarce. Just as before the election, when many people were certain Hillary would win, it seems now that many people, including markets, are certain Trump will be the catalyst allowing the U.S. economy to significantly grow again. Though the chances are high for tax and regulation reforms with a Republican controlled congress, whether this will translate into meaningful GDP growth is the big question. Rationality should always be taken into consideration when investing. Much of the recent market moves are based off of expectation and not reality. Howard Marks, founder and chairman of Oaktree Capital Management, noted this idea in a recent memo. He wrote, “I felt during the campaign, that as opposed to Hillary Clinton, the range of possible actions and outcomes in a Trump administration were far too broad to be predicted. I’m still convinced that’s the only thing we know for certain.”

A terrific analogy for the psychology of markets comes from another Howard Marks memo. It may help to understand why markets move to the extremes every so often at such a quick pace: “The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum ‘on average,’ it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc. But whenever the pendulum is near either extreme, it is inevitable that it will move back toward the midpoint sooner or later. In fact, it is the movement toward the extreme itself that supplies the energy for the swing back.”

Let’s hope for a prosperous future with smart investing through the various extreme market pendulum movements which we will inevitably encounter during our lifetime.

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This post was written by Evan Axelrod

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