The Trump presidency: A glass half-full

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”

My inner trader uses the trading component of the Trend Model to look for changes in direction of the main Trend Model signal. A bullish Trend Model signal that gets less bullish is a trading “sell” signal. Conversely, a bearish Trend Model signal that gets less bearish is a trading “buy” signal. The history of actual out-of-sample (not backtested) signals of the trading model are shown by the arrows in the chart below. Past trading of the trading model has shown turnover rates of about 200% per month.

 

The latest signals of each model are as follows:

• Ultimate market timing model: Buy equities
• Trend Model signal: Risk-on
• Trading model: Bullish

Update schedule: I generally update model readings on my site on weekends and tweet any changes during the week at @humblestudent. Subscribers will also receive email notices of any changes in my trading portfolio.

A glass half-full, with caveats

Last week, I urged readers to be agnostic about the electoral outcome and to stay focus on the investment climate instead (see Don’t be fooled, Election 2016 isn’t the Brexit referendum):

It would be too easy to get into an impotent rage should your favored candidate lose, or if policy doesn’t go in your desired direction. That kind of thinking clouds judgment and leads to subpar investment results.

Stock prices are a function of earnings, the growth outlook, interest rates, and risk premium. There is much we don’t know about policy details under a Trump administration, but the market’s judgment of the election oscillated from unbridled panic on to euphoria in less than 24 hours. The fast money crowd jumped into the risk-on momentum trade last week. Based on historical studies, the rally has the legs to go much further. Here is a study from Nautilus Capital, which indicates that the returns after election day is indicative of momentum for the next 3-6 months (n=30):

 

Ned Davis Research also pointed out that the combination of a Republican president and Republican Congress have enjoyed the second best returns (caution, n=3):

 

The stock market embraced the reflation investment thesis that I have been writing about for several months, except this time it`s reflation on steroids (also see Super Tuesday special: How President Trump could spark a market blow-off). As there are many blanks that still to get filled in about the new administration, it’s important to be aware of the bull case and bear case for stocks.

Trump, the old fashioned Keynesian

If I told you that the new administration was going to usher in a new era consisting of the following market friendly measures, what would you do? (Remember that traders don’t care much about social policy).

• Personal and corporate tax cuts
• Corporate tax incentives for the repatriation of offshore cash, which will opens the door to buybacks, special dividends, or capital investments
• Decreased federal government regulation and oversight
• Massive infrastructure spending
• A repeal of Dodd-Frank, which allows investment banks to take on more risk and create the climate for a bubble – and the first leg of investment bubbles are bullish for stocks

These policies represent a shot of Keynesian stimulus, pure and simple. Despite the rhetoric about the Laffer curve and how tax cuts would pay for themselves (they didn’t), much of the boom of the Reagan years was fueled by the same kind of Keynesian rocket fuel. BCA Research pointed out that Republican administrations have tended to tilt towards expansionary fiscal policies. Bottom line: expect tax cuts, more spending, and higher deficits under President Trump.

 

The market reacted to the election with a massive risk-on response. Investors poured $24b into equity ETFs last week. The cyclically sensitive industrial metal prices soared and staged an upside breakout through resistance, though the breakout occurred before the election.

 

The rally in industrial metals was achieved with high conviction, as measured by trading volume. As an example, the copper ETF (JJC) broke out to new recovery highs on massive volume.

 

Industrial stocks, which represent the capital goods industries, also staged an upside relative breakout. We also saw similar risk-on behavior from the relative performance of high beta and small cap stocks.

 

Bond yields rose and inflationary expectations soared. Even as interest rates rose, the yield curve steepened, which indicates that the bond market expects higher economic growth.

 

Insiders also participated in the risk-on stampede. Barron’s reported that insiders have shrugged off their pre-election nervousness and started buying again.

 

The single surprise came from earnings estimate revisions. The latest update from Factset shows that forward 12-month EPS dipped last week after many weeks of upward progress. On the plus side, the Q3 EPS and sales beat rates were quite healthy by historical standards. As well, Q4 earnings guidance is coming at better than average. In addition, Brian Gilmartin observed that the Thomson-Reuters YoY growth in forward EPS improved from 3.59% to 3.69%. I will be watching the forward EPS metric carefully next week to see if this was a data blip.

 

Growth expectations are (mostly) surging. Risk on!

Reading the fine print: Geopolitical tail-risk

Before anyone gets too excited, investors need to read the fine print of Trump policies. There are two kinds of events that are fatal to bull markets, namely recessions, and war and rebellion that result in the permanent loss of capital. Both kinds of risks are rising.

The tail-risk of an adverse geopolitical event is higher than it would have been under previous post-war administrations stretching from Truman to Obama. The post-war consensus was been shaped by American leadership and participation in global institutions such as the United Nations, the International Monetary Fund, and the World Bank. By contrast, candidate Donald Trump has made it clear that he prefers an isolationist America. Should President Trump withdraw from the political and financial support of these organizations, what happens to global stability in the next crisis?

Imagine that a country like Turkey suffers a financial crisis in the not too distant future. If a weakened IMF is unable to come to its rescue, what are the geopolitical ramifications of a financial collapse be on this NATO member and Middle East country that borders Syria, Iraq, and Iran?

Financial or political chaos in Turkey is just one of the milder and more benign scenarios of an American withdrawal from global institutions. The likes of ISIS, Russia, and China are likely to test the new president in some fashion. How would Trump react if “little green men”, or out of uniform Russian special forces, were to suddenly appear in Latvia, Lithuania, or Estonia? What if Beijing decides to probe Washington’s resolve in the South China Sea? Already, the Philippines has signaled that it is moving closer to China’s orbit and away from America. How would President Trump answer such provocations?

Candidate Trump won the Republican nomination and the presidency with the use of an alpha male persona who blusters, and threatens until he gets his way. The alpha male archetype appealed to his electoral base because “he tells things as they are”, which also signaled that he will stand up to the Chinese, Mexicans, and so on. In the event of a confrontation with a nuclear armed foe, how does he respond?

Will he be the presidential Trump with a measured response, as he did by vowing to be president to all Americans in his victory speech on election night? Or will he be the alpha male Trump? Consider these two tweets of his reaction to the recent street protests. The first was written in typical alpha male fashion.

 

The second came from presidential Trump, probably after consultation with staff.

 

Which Donald Trump shows up if America goes toe-to-toe with the Russkies, the Chinese, or the North Koreans? Lower taxes, less regulation, and infrastructure investments may sound great for equity returns, but not if Hawaii gets fried by a mushroom cloud. While I am not forecasting a nuclear confrontation, but geopolitical tail-risk is far more elevated under Trump than previous administrations.

Will a protectionist America spark a global recession?

The second risk comes from the economic drag created by Trump’s protectionist leanings. This week’s cover of Barron’s fretted specifically about this possibility.

 

Candidate Trump had vowed to slap a 45% tariff on Chinese imports. Bloomberg reported that China is America’s biggest trading partner. The current era of globalization has created global supply chains that cannot be unwound easily. The imposition of significant tariffs on a country like China would wreak havoc with corporate profitability and global trade.

 

Bloomberg’s Chief Asia Economist Tom Orlik modeled the effects of a 45% tariff on Chinese goods and found that Chinese exports to the US would collapse by 60-70%.

 

Notwithstanding the even more negative second order effects of a trade war, Orlik observed that it would force Beijing to choose between lower growth or more credit-fueled bubble-blowing stimulus.

 

The 45% tariff is an extreme scenario as it probably represents the opening bid as part of a negotiation. The Peterson Institute has a handy guide on the different presidential powers available to Trump if he wishes to impose tariffs or quotas, which are quite extensive. Even if Trump were to raise duties on Chinese goods by a lower amount, such as 15%, it would cause a substantial slowdown in the Chinese economy. Such a development would sorely test the stability of their already fragile financial system (see How much runway does China have left?).

Imagine the following scenario. The Chinese economy slows from falling American trade. Asian growth tanks. as most Asian economies like South Korea, Taiwan, Singapore, and Hong Kong are tied to China. The imports of capital goods from Europe, and Germany in particular, would fall. The eurozone, whose growth outlook is already weak, then plunges into recession. As European banks have not remedied their balance sheets since the Great Financial Crisis, it sets up the conditions fo another Lehman Crisis (see How bad could a Chinese banking crisis get?). The result could be another global recession. Stock prices would crater 50% again as they did in 2008.

Still a blank slate

Don’t get me wrong, I am still bullish on equities. Being a bull, however, doesn’t mean that you shouldn’t be aware of the risks to your forecast. Right now, the Trump administration is a blank slate. The appointment of the cabinet should provide some clues to the direction of policy.

Here are some of the key appointments that I am watching. How much foreign affairs knowledge and experience will the Secretary of State have? What about the national security advisor? How protectionist will the Secretary of Commerce, or the Treasury Secretary be?

The omens look iffy. Politico reports that the two leading candidates to be Secretary of State are Newt Gingrich and Bob Corker. While Corker served as the chair of the Senate Foreign Relations Committee, Gingrich has little foreign affairs experience.

The outlook on the trade front are not good. Trump affirmed his protectionist leanings in a recent WSJ interview and stated that “he would preserve American jobs by potentially imposing tariffs on products of U.S. companies that relocate overseas, thereby reducing the incentive to move plants abroad”.

Politico also reported that the two leading candidates for the Commerce post are Dan DiMicco and Wilbur Ross. DiMicco was the former CEO of Nucor Steel, an industry that was devastated by Chinese imports. Ross is known for restructuring failed companies in industries such as steel, coal, telecommunications, foreign investment and textiles. Many of these industries were highly exposed to foreign competition. Neither is likely to be a friend of China on the subject of tariffs.

As the stock market has embraced the “glass half-full” case with great enthusiasm, I am willing to give the bulls the benefit of the doubt for now. Nothing will happen until Donald Trump moves into the White House. While geopolitical risk could blow up at any time after the Inauguration, the consequences of any protectionist policy is unlikely to show up until late 2017 at the earliest.

The week ahead: Can momentum continue?

Looking to the week ahead, the biggest question for traders is whether the positive price momentum can continue. I wrote about the Zweig Breadth Thrust setup last week (see The market has spoken!). The market has until next Friday to complete the ZBT buy signal in the 10-day time frame. If it does, it would mark another rare and can’t miss momentum buy signal. The market paused in its advance on Thursday and Friday, but did not decline significantly, which is a constructive sign. The fact that the Dow has already made an all-time high is testament to the power of this latest buying stampede.

 

Next week is also November option expiry. Rob Hanna of Quantifiable Edges shows the statistics for November OpEx below, whose profitability is roughly average compared to all of the other months.

 

Mark Hulbert reported that as of November 11, which is after the election, NASDAQ timer sentiment were nearing a crowded short. Such a reading is contrarian bullish.

 

Rydex trader sentiment is also surprisingly bearish in light of the surge in stock prices.

 

On the other hand, I highlighted the elevated level of fear in the term structure of the VIX Index last week. In particular, the fear factor was especially evident in the 9 day VIX (VXST) to 1-month VIX Index. In the wake of the election sparked rally, the term structure has normalized and fear has receded.

 

On the other hand, a historical study by Dana Lyons shows that rapid falls in the VXST to VXV ratio have tended to resolve themselves in a bearish manner.

 

My head hurts. I am confused. I have no idea of what will happen next week as the market’s mood has proven to be incredibly fickle. My inner investor remains bullish on equities, but the risks are rising and he is getting skittish. My inner trader is nervously long. He is crossing his fingers and hopes for the best, while preparing for the worst.

Disclosure: Long SPXL, TNA