Greg Stewart's Surf Advisory - A Study of Expectation vs. Reality

Rarely do things play out as planned.  When we started 2016, people weren’t expecting Brexit, people weren’t expecting Trump, and to some degree, many people weren’t expecting the Fed to raise interest rates.

What was expected - a denial of Brexit, President Hillary Clinton, and a continuation of stalled interest rates - was priced into the market. Everyone had already positioned themselves to take advantage of these prospects.  When things didn’t go as expected, market shocks occurred.

What are the current return expectations for the market?  HIGH - as much as 20% for the year, according to some analysts. Typically, analysts are over-optimistic, and they often come down (or get knocked down) from those lofty points. No one ever gets it completely right. Expectations like these can be hard for companies to match.  Even if company earnings are up 10-15%, if they don’t hit the target, share prices, and markets react negatively.

Why?  Expectations. Investors will have positioned themselves to take advantage of those 20% expected returns. Should companies miss, they are essentially underperforming and the price that investors were willing to pay based on previous expectations will drop, based on reality.

 
 

Presidential Changes: Reality, Fundamentals, and more Expectations

The market expected Hillary Clinton to win the election. It was repeated around the industry, and in the media, that if Donald Trump won, the market would drop 10%. When he did win, equity futures sold off immediately, based on that 10% drop expectation. However, the next morning, when the markets opened, investors started thinking about the realities of this unexpected president.

Perhaps he will lower taxes, or spend on infrastructure. Perhaps he will reduce regulation. All of these possibilities might be very good for many industries, and of course, good for stock prices. Seemingly, the potential positives outweighed the negatives, and the market rose.

On the flip-slide, a few weeks ago now-President Donald Trump gave a speech calling out big pharma. Immediately, a number of related stocks went down heavily - NASDAQ biotech was absolutely hammered. Similar things have happened in response to his tweets about certain companies.

It’s fascinating, because we know that there isn’t a live person who walks over to their trading desk and hits “SELL” on a given set of stocks simply because of one small sentence in a speech or 140 characters on social media. That just doesn’t happen.

What does likely happen is that an algorithm gets programmed to take action if Donald Trump mentions a specific set of words in a negative way. At the end of the day, knee-jerk responses - even if those knees are being jerked by computers - have probably occurred. Reactions like these are rarely profitable in the long term, as they only take into account extremely short-term views and behaviors.

Over the long term, some of the new administration’s proposed changes, such as tax cuts, repatriation holidays, and so forth, could be very helpful to the market.  History suggests that a portion of those potential gains might go towards dividends and buy-backs, which would be good for stocks and the investors who own them.

Other changes, such as stimulus and infrastructure spending, will probably take a little longer to work their way into the economy. First, the spending must be approved, then the projects must be approved, and more steps will follow before funding is released. Consequently, it’s unlikely we’ll see the full effect of any such proposed changes in 2017.

Typically, the year after an election tends to be positive on average - and that’s a good thing. It would seem that the optimism with which we started the year could actually continue a while longer. As we move into the second half of the year, a lot of the stimulus spending that had already hit the streets during the 2016 election year will start to go away, which might hurt. However, this year, expectations stemming from new infrastructure proposals may help offset this.

Fundamentals, Discipline, and the Long View

Our current research indicates that GDP is growing, likely beating last year’s growth, without a single dollar having been spent on infrastructure, and without one single regulation having been cut or revised. There’s already a lot of action being taken without any input from the new administration. Expectations regarding decisions to be made by the new administration are likely already baked into current valuations, and now (as is always the case) it comes back to fundamentals.

Valuation remains a key consideration - and valuations still appear to be high. In the short term valuations may very well continue to rise, but over the long term there is a lot of evidence to suggest below average returns are on the horizon.

One of the key drivers to watch will be supply and demand. There must be an increased supply of funds flowing into the market in order to drive prices upward. Changes indicated by the new administration could free up funds and create the supply required to move this market higher.

2016 started with doomsday predictions and was punctuated by three significant pullbacks. However, investors with a strong constitution and a long-term plan saw these pullbacks as a fire sale opportunity and bought, and subsequently enjoyed the upward swing of the “Trump Bump”.

Has this wave already broken?  We’ll have to get back to you on that. Meanwhile, of this we are certain: periods of significant stress and worry are the reason a disciplined approach is important. Having a process to review competing information, and the ability to view the variables from multiple perspectives, with the expectation of being on the right side of the big moves, will remain a key to winning in 2017, and beyond.

- Greg Stewart, CIO