What the Election Means for Investors

Instant Reaction The financial markets responded to the news of the U.S. presidential election. The Mexican peso soared, then plunged; European currencies and gold bullion rose; and Japan's Nikkei Index plummeted. (Then again, the Nikkei plummets pretty much every month.)

Should investors take action?

Hindsight urges yes. Under the Reagan presidency, fierce anti-inflation policies tamed inflation that had been sabotaging asset prices for the previous 15 years. Treasury bonds enjoyed their best performance in forever, and stocks kicked off a historic bull market. The contrast with the Ford/Carter years was dramatic. Wall Street was reinvigorated, tens of millions of Americans became first-time investors, and a little company called Morningstar was founded, to track these things called “mutual funds.”

That seems an obvious case where the presidential election's results affected the financial markets in a meaningful, predictable fashion. Ronald Reagan was the businessperson’s president, elected to whip inflation that had bedeviled his predecessors, and he delivered on that promise. When he did, stocks and bonds rallied--as of course they would when inflation is beaten. For investors who connected the dots, there was money to be made.

Not So Fast It's a story that almost convinces me. But it doesn't really work.

To start, it’s a sample size of one. There’s no comparable narrative for other recent presidencies. The stock market boomed under Bill Clinton, started and ended badly under George W. Bush, and doubled during Barack Obama’s tenure. If anybody foresaw those events at the time, they certainly did not tell me. If anything, the conventional wisdom among the business press was the direct opposite of what occurred--that the markets would struggle under the Democrats Clinton and Obama, but prosper under the second Bush.

Also, the 35,000-foot view that comes from 35-year hindsight misses a wee problem, which is that investors in U.S. securities got clocked during the first year of Reagan’s administration. When I write “clocked,” I mean “abused in a fashion to which we are not now accustomed, aside from the disaster that was 2008’s stock market.” In 1981, inflation was 10%, bonds returned 6% nominally, and stocks were at negative 5%. Thus, in real, after-inflation terms, bonds lost 4%, stocks dropped 15%, and a balanced fund was out 10%. Those who hopped aboard the day of President Reagan’s inauguration might well have hopped off when the rally began.

A further problem with connecting the Reagan administration with the financial markets’ results is that interest rates were set by the Federal Reserve, and the Federal Reserve chairman, Paul Volcker, had been appointed by the previous president. This is not to detract from President Reagan’s achievement, as he gave Paul Volcker the necessary political support, in the face of Congressional criticism, but rather to point out that inflation’s demise might also have occurred with a different result in the 1980 presidential election. We cannot say that would have been so--but we also cannot say that it would have been not.

Finally, the American economy does not exist in isolation. While the United States is easily the largest and most influential member of the world’s economy, it nonetheless is influenced by global trends. It is uncommon for the U.S. to zig if the rest of the developed world is zagging. Such was the case in the 1980s. American inflation declined during the decade from 12.5% in 1980 to 4.7% in 1989. For those same years, Great Britain fell from 15.1% to 5.4%, France from 13.7% to 3.6%, Japan from 7.2% to 2.6%, and Germany from 5.5% to 3.0%. Foreseeing inflation’s global collapse required many more data points than the result of the 1980 U.S. presidential election.

All of which is to say that for the long-term investor, attempting to predict how a president-elect’s policies will affect the financial markets is a perilous task. Indeed, most attempts appear to be politically motivated rather than economically so, with the victor’s supporters expecting an upcoming boom, and those who voted for the loser recommending bunkering down with guns, gold bars, and a bomb shelter.

Trickier Yet The undertaking is particularly difficult for the administration of President-elect Donald Trump.

From the perspective of financial-asset prices, Trump’s proposals have been decidedly mixed. Scuttling trade agreements and instituting tariffs would appear to cause harm. So, too, would prohibiting U.S. companies from moving their operations overseas. On the other hand, both Wall Street and Main Street businesses would applaud the regulatory relief that looks to be coming their way. (Whether reducing regulations helps asset prices in the long term is an argument for another day, but it almost certainly would for the short run.) Both personal and business tax rates are likely to decline; that would help, too.

If that all sounds vague, it should. As with many previous candidates, the president-elect ran a campaign that was long on aspiration and short on details. In addition, many of his proposals conflict with his own party’s traditional beliefs. Analyzing the investment implications of a Trump presidency involves much more than examining a platform, deciding which parts will be acceptable to the opposing party, and then determining the outcome. There is little platform to examine, and the additional complication that in addition to the Democrats, the Republican Party may also impede the president-elect’s plans.

As I write this, the U.S. stock market has opened down, rallied to break even, and has now risen. Thus, in the few short hours since Trump was elected, stocks have had the full meal of being down, flat, and up. That sounds about right. Most of us think we understand the president-elect, for good or for ill. We believe that we have judged his temperament, and that we have a sense of how effective he will be as president. All fine and good--such is the nature of elections. We would be well advised, however, about attempting to translate this viewpoint into investment actions.

Election Data, and Investment Lessons Last night offered the rare opportunity of seeing one poll aggregator clearly best another. Usually, it's impossible to tell who fared better, because the predictions are probabilistic, so just about any result can be explained by waving one's arms and saying, "That was in the forecast." (The same caveat, of course, also applies to investment plans that are generated by Monte Carlo simulations.) But in the case of two of the major aggregators, the websites FiveThirtyEight and Princeton Election Consortium, there was an outright winner: FiveThirtyEight.

The victory wasn’t in the predictions themselves. Yes, FiveThirtyEight’s final estimate that Trump had a 29% chance of success looks far sounder than PEC’s estimate of 1%. However, as stated above, PEC could claim that this was the one election in 100 when that particular outcome occurred. Instead, the victory occurred within the models that created the predictions. One big reason that FiveThirtyEight gave Trump a much larger chance was that its models assumed strong correlation between state results. If one state belied the polls, then FiveThirtyEight believed that other states would probably behave similarly. In contrast, PEC assumed a high degree of independence.

Two possible investment lessons:

1) Many investment and financial-planning models assume that market returns are independent, within a given year among several assets, and among a sequence of years, for a single asset. Doing so makes for simpler models. While parsimony is often a good thing, eschewing correlations could cause significant mistakes, as with PEC’s 2016 forecast. (Note: Ease of construction is not why PEC chose its approach.)

2) FiveThirtyEight's site is run by a generalist, while PEC is headed by a Ph.D. mathematician. The latter has been quite sure of himself, criticizing FiveThirtyEight's estimate as being "underconfident," in contrast with PEC's strong, unmitigated viewpoint. (Such certainty extended to a promise to "eat a bug" if Trump exceeded 240 electoral votes. I hope for his sake it is not this critter.)

At the risk of pushing a point too far, I have found from my experience that highly quantitative investors overrate the benefits that their mathematical abilities can bring, and underrate the virtues of experience and judgment. Investments are an art as well as a science, and an endeavor that is best approached with a large dollop of humility.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.