Trump won and you missed the rally. Now what? Part 1

There is nothing so disastrous as a rational investment policy in an irrational world – John Keynes

Trump’s victory surprised even the most well-informed financial analysts and bloggers. A quick scan of the headlines leading up to the elections showed endless articles which pontificated what a Hillary presidency would mean for markets. And those few articles which did venture a guess at what a possible Trump aftermath would look like seem even more ridiculous now in hindsight:

• Barclays – 6% fall in the S&P 500 before a partial recovery by year-end
• Citi – 5% drop in S&P 500
• RBC Capital Markets – 10% to 12% fall in the S&P 500
• Wolfers,an economics professor at Dartmouth College – 12% off the S&P 500

Contrast that with the 8% (as of Dec 7 close) rally in the S&P 500 that just took place.

Many investors thought logically about Trump’s policies and concluded that increasing government spending while cutting taxes would not easily pass in Congress. These investors also missed:

• 20%+ increase in financials
• 80%+ increase in steel stocks

Even worse, some traders tried to short the Trump rally and are currently on financial life support as the animal spirits in this bull market have awakened and strengthened.

Ok enough about the past; let’s turn the page and look forward for a moment. For this, we’ll consult the man who DID predict a Trump victory (over a year ago) and who also predicted a rebound in long end treasury rates.

Bond king Jeffrey Gundlach, CEO of Doubleline Capital, has a pretty simple message and thinks that 10yr bond yields could hit 6% in 5 years – due mostly to higher inflation. Ray Dalio, founder of Bridgewater agrees with the view of higher inflation and muted growth prospects in stocks. Generally I don’t love name dropping to add credibility, but after following these guys for the better part of the last 10 years, it has become apparent that they often see farther and with more clarity than one could even perched atop the shoulders of all the Wall Streeters combined (I was one).

So what are their main points?

• US Inflation rate will increase due to:
  1. Decreasing globalization, free trade
  2. Aggressively stimulative fiscal policies
  3. Increased US growth
• Many investors are invested incorrectly in longer duration bonds due to:
  1. Reach for yield
  2. Reinvestment of coupons into longer duration bonds (higher prices and lower yields)
• Domestic stock market will have a tough time for the next few years because of:
  1. Higher inflation will force Fed to raise rates faster than expectations
  2. Stagflation possibility depending on specific policies

This means that investors should be underweight bonds (especially long duration) and not expect high growth in the S&P for the next few years.

With a 1-3% inflation rate, P/E averages around 19 but in a 3-5% inflation regime, P/E drops to around 16, per data spanning the last century.

We are in for some volatility in financial markets, likely starting in the later part of Q1 2017, but it seems inflation should trend nicely higher.

The world has gotten so entrenched in the idea of low inflation and low interest rates forever – it will take a long time for market participants to shift their thinking and positioning.

The foundation has now shifted and with it, your investment strategy must also quickly adapt.

So what performs well when inflationary forces strengthen? The following:

• Small caps with higher debt expense
• Fertilizer and timber producers
• Commodities linked to industrial production
• Gold, Palladium, Silver and the companies that dig them
• TIPS – but these are very complicated and are far from a sure bet

On the other hand, utilities, consumer discretionary, financial stocks and fixed income instruments with long duration tend to underperform.

Of course, choosing which, how and when to invest in these, requires a more detailed analysis in part 2 (to come).