Should Investors Trust The Trump Rally?
Maybe you love the new U.S. president, Donald J. Trump. Maybe you hate him. But regardless, you ought to be wondering what to make of the stock market rally that has taken place since his surprise election last November. Time to hang on or bail out?
Stocks rose about 6% in the first few weeks after the election. The rally stalled in mid-December but picked up again this week, nudging the Dow Jones Industrial Average past 20,000 and the S&P 500 to almost 2,300. On average the 500 large companies in the latter index are trading at around 17.5 times their estimated earnings, according to data from Birinyi Associates. This certainly is not low by historical standards.
Will a much heartier long-term rally take hold? Quite a few of our clients have called us—some dismayed, some jubilant—about what the election means for stocks. Here’s what we’re telling them: Forget President Trump’s Twitter account. Instead, focus on his tax and regulatory plans. Essentially, sit tight. Or even buy in.
As part of research for a new book, Investment Atlas II, published in November, I looked at political history since 1848 and puzzled over how presidential elections since then have influenced stocks, bonds and housing going forward. I noticed some interesting patterns. For one, this was not the first time that the U.S. electorate shocked us in a presidential vote. Remember Democrat Harry S. Truman’s 1948 victory over Thomas E. Dewey (you know, the one with the famous photo of a grinning Truman holding up the erroneous “Dewey Beats Truman” headline)? How about Republican George W. Bush’s eventual win over Democrat Al Gore in 2000 by a paper-thin margin festooned with Florida “hanging chads?”
But what struck me had nothing to do with electoral surprises. Rather, what was significant was the election of presidents who promise big changes in the tax code and regulatory schemes. It turns out those promises had enormous influence on stock prices in the months and years after a new president was elected. Very simply, after voters elect presidents who have promised to roll back taxes and regulations, stock markets have tended to have powerful multi-year rallies.
The prime example is the rally that followed Ronald Reagan’s election on November 4, 1980. Stocks quickly bounced up 9% after his election, but just as quickly slumped. The real rally began in August 1982, several months after Congress enacted Reagan’s first big economic stimulus package. That package included heavy cuts to regulations and taxes. By the end of Reagan’s term in 1989, the S&P 500 had risen 170%, or 16% a year on average—one of the greatest investment booms in U.S. history.
Granted, today’s overall economic picture is not just like the one in 1980, particularly when it comes to that era’s extraordinarily high interest rates and inflation. Yet, as Mark Twain may or may not have said, history doesn’t repeat itself, it rhymes. Trump has pledged he’ll get Congress to pass a Reaganesque plan to boost the economy. His plans should also give stocks a huge lift. The details aren’t out yet, of course, but here is what Trump has promised:
A historic cut to business taxes
Most interestingly, Trump has promised to slash the top corporate tax rate to 15% from the current 36%. To appreciate the enormity of that cut, you have to consider the history of the top corporate tax rate. In 1909, it was 1%. A decade later, it was 10%. During the depression, it lept to 19%. After World War II, it jumped to 40% and 50%. The hikes were bipartisan, certainly. Even Reagan struggled to reduce the rate, to roughly its current level.
Trump’s plan to slash the top rate in half is unprecedented, and investor skepticism that he can pull it all off is certainly warranted. Equally, it may be partly offset by eliminating loopholes favored by large companies. We’ll see. But the reason why any significant slash could be a boon for stocks is straightforward: It quickly could boost per-share earnings of profitable companies. That would make U.S. stocks look more attractive versus bonds and other global investments. Insofar as lower taxes leave more retained earnings available to companies that want to use it for investments or share buybacks, that’s also a boon for stocks.
A major rollback of regulations
After the Great Recession, recall, Congress passed lots of regulations—some of them quite punishing to banking in particular. Now Trump has called for a rollback. Trump says he’ll cut two old regulations for every new one Congress enacts. He has also promised to ease strictures on oil, gas and coal energy companies. Regardless of whether you agree with these, they are likely to make it less risky for banks to loan money. That should spur economic growth. We’re already seeing a slight shift in stock market leadership from consumer staples, utilities and REITs to financial services, manufacturing and energy.
Cuts to taxes on investors
In addition to proposing to reduce individual tax rates on ordinary income from 40% to 25%, Trump is promising (-ish) to cut taxes that affect investments, like those on capital gains and dividends. Trump has also called for phasing out the Obamacare investment tax supporting Medicare and reducing taxes on short-term capital gains—the kind that impact active stock & ETF traders.
A boost to the U.S dollar
Surprised? True, when Trump calls China a “currency manipulator” and threatens to impose tariffs up to 45% on imports from China, it sounds like he’d like the dollar to weaken versus the Yuan. But actually, most of his plans are likely to lift the dollar against it and most of the world’s other currencies. It seems inevitable if the U.S. economy booms. Witness what occurred to the dollar when the economy picked up in 1985 and the dollar had its historic rally. Suddenly, foreigners were rushing to purchase U.S. stocks, bonds and real estate. The simple fact here is that U.S. markets still look better and more stable than those of other countries.
Stabilizing interest rates
Trump doesn’t control these. But Janet Yellen, chairwoman of the Federal Reserve, will not likely make the mistakes her predecessors made in the late 1930’s. Back then the Fed mishandled exiting its Depression Era “0% interest rate” policy, which triggered the “Roosevelt Recession” of 1937-1938. Yellen isn’t under anything like the pressure of the 1930s or even the early 1980s. Inflation pressures are relatively low, and economic growth looks sustainable. She can commence the process of raising the federal funds rate to something that looks normalized at a pace that is so glacial that it won’t unsettle an accelerating economy.
A Congress eager to please
Reagan benefitted from a Congress that, despite being controlled by Democrats, was eager to turn the economy away from the stagnation of the 1970s. Now, with members of Trump’s own party in control of Congress, he should have an even easier time enacting his pro-business agenda—at least until the mid-term elections next year.
Dry powder for a bull run
Since 2008, many investors fearful of sharp interest-rate increases have kept large amounts of cash in money market accounts and CDs. According to the Federal Reserve, U.S. investors have some $10.8 trillion sitting in cash, CDs and money-market accounts. As the economy expands over the next few years, much of this money could be invested into U.S. stocks (reduced to some degree, perhaps, by the oldest baby boomers finally forced to take required minimum distributions from their IRA and 401k accounts). There could also be an investment shift from low yielding municipal and treasury bonds into U.S. equities.
For years, I’ve told my politically conservative clients that regardless of what they thought of Barack Obama, he was good for bonds. The post-Great Recession period brought us historic declines to near 0% interest rates in support of a recovering economy. During his administration, income investments (bonds, preferred stocks, REITs, etc.) offered investors a better risk-adjusted total market return than did stocks. Investors who invested in corporate bonds even though they didn’t need investment income did quite well.
Lately, I’ve been telling my politically liberal clients that regardless of their dismay over the former real estate developer and reality TV star who now occupies the White House, they ought to consider lightening up on bonds and getting into stocks. I think equities will outperform income investments. Will they achieve annual returns not seen since the Reagan and Clinton years? (Egged on by a Republican congress, Bill Clinton learned to embrace cuts to taxes and regulations, and the S&P 500 Index had historic average annual returns of 19% during his two terms.)
Time will tell. But I’m optimistic we’ll see the Dow Jones Industrial Average near 30,000 by sometime in 2020. And that shouldn’t depend on your feelings toward president Donald J. Trump.
Kenneth G. Winans is a veteran investment manager based in Novato, California
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