The Worst Part About My Job
Without question, the most annoying and frustrating part of my job as a money manager is following the dysfunction in the U.S. government. I cringe when reading a newspaper or watching a television segment involving politics because I feel as if the incentives of most who service public offices are positioned solely to benefit themselves and not their constituents.
To make matters worse, we are a year away from another presidential election, and this one is setting up to be a real nail-biter. There seems to be more uncertainty around this upcoming election than perhaps any other in recent history.
The byproduct of such uncertainty has led many investors to question the ramifications of a new presidential administration on their portfolios. What will happen if the Republicans take back the White House? Will a Democrat win be good or bad for stocks?
These and several other questions have made it to my desk in recent weeks, so let’s spend some time discussing the impact of elections on financial markets (specifically equities).
Before I go any further, it’s important that I go through my “political disclaimer” so that investors know where I stand:
I despise both parties equally but for very different reasons. Furthermore, I am not a registered voter of either party, and my only motivation for following politics is to better serve my investors.
Investors pay money managers for only one reason and that is to make them money. Politics stir up incredibly powerful emotions, which are extremely dangerous to the investment process, and simply must be excluded from any investment decision. Hence, when discussing political issues, personal opinions must be checked at the door in order to shield the investment process from unnecessary risk.
For example, whether I am a Democrat or a Republican bears no value whatsoever when it comes to assessing a company’s ability to increase sales or raise their dividend over time. Personal opinions only complicate the process because they are irrelevant to the fundamentals.
NOTE: The danger of incorporating political views is evident over the last seven years. Had an investor avoided stocks because their belief that a Democratic president is bad for the economy, he/she would have missed out on phenomenal returns.
That being said, history has shown the propensity for elevated volatility going into a major election year. Financial markets despise uncertainty, and elections often create a layer of ambiguity until the victor is announced.
However, history has also shown that this volatility typically dissipates rather quickly after election day, and equities usually perform well going into the following year.
A common misconception is that a Republican win is good for stocks, and a Democrat is bad. There is no data to support this notion, and we don’t have to go any further back than the last two presidential elections in 2008 and 2012. An Obama win caused the market to fall days after each election, but markets quickly recovered both times.
The U.S. is an $18 trillion economy with a force so great, that not even the President can do much to reverse its course. Besides, our system of government is set up in a way that prevents the President from wielding enough power to do so through various checks and balances and separation of power.
Long-term investors know this fact, and when the market sells off due to fear, they swoop in to buy from those who sell into the panic. Hence, the market rarely stays down for too long when the future direction of the economy is positive.
NOTE: The only force powerful enough to truly drive the U.S. economy into a recession quickly is the Fed. They control interest rates, which is the life and blood of our economy. However, the Fed has no interest in any policy that would cause our economy to slow down at the moment.
Where Government Can Impact
Although a new president rarely changes the direction of our economy as a whole, an administration certainly has the power to destroy and/or grow smaller portions of our economy.
For example, in the summer of 2012, we made the decision to sell all coal stocks and buy solar energy stocks, only if President Obama were to win a second term in November of that year.
Our thesis was built on the belief that if Obama were to win re-election, he would lead a gruesome attack against the coal industry. The Democratic Party dislikes coal because the pollution created from power plants fueled by coal is an environmental concern.
As we moved closer to Election Day, we became more certain that Obama would win, but we still remained disciplined and waited for all the votes to get counted. We finally made our move the day after the election, and the chart below shows the results of our strategy over the following two years:
The chart above shows that the investment strategy worked very well. The red line indicates that the coal sector fell over 30% and First Solar (ticker: FSLR) was up over 130%.
Imagine if Obama had lost and the Democrats never waged their war against coal. It’s pretty safe to say that this chart could look dramatically different, which shows just how much impact a government election carries on sectors in an economy.
Implications for Investors
Two questions are probably on the minds of investors right about now:
1. If history shows the potential for volatility going into an election year, why not just go to cash and wait out the storm until after the election?
2. What is our plan next year to keep the portfolios safe from any changes that ensue from the election?
In regards to the first question, going to cash is not a viable option because (1) the volatility is nowhere close to guaranteed, and (2) the fundamentals don’t change. Since a new president rarely possesses the power to reverse the direction of our economy, there is little reason to assume that our long-term investment thesis will be altered by the outcome of the election.
Furthermore, this type of volatility is completely unpredictable, and trying to time markets in such a manner is akin to gambling. Even if history did repeat itself, determining the precise moment to go to cash is impossible, and a premature move could harm investors by missing out on any potential gains between now and then.
The answer to the second question is predicated upon one of the cardinal rules of our investment process, and that is to never, under any circumstances, bet on the future when it involves the government. Take the coal and solar energy example above.
We could have done much better had we implemented the solar strategy months before the election, but the risk was too great simply because there was no way to fundamentally assess whether Obama would win his second term with absolute certainty.
Instead, we devised an investment plan that was expected to perform well if Obama won, and we also had a plan in the event that he lost. Therefore, we remained disciplined, politically agnostic, and shielded portfolios from the risks associated with an unexpected outcome.
This identical strategy will most likely be used in the coming months. As we get closer to November 2016, we will know the final two (or three) contenders, which will allow us to devise a plan for either of the two (or three) outcomes. But just as before, those plans will not be executed until near certainty of the victor is secured.
The bottom line is that you should never underestimate the government’s ability to create or destroy businesses, nor should you assume that Uncle Sam is either logical or fair when they enact new laws. However, the ability to reverse the direction of an $18 trillion economy takes much more than just the President’s political platform.
Lastly, sound investment strategies require investors to check their politics at the door and remember that the goal of investing is to make money. Don’t make this already difficult task more complicated by mixing powerful emotional forces into the equation.
This commentary is not intended as investment advice or an investment recommendation. It is solely the opinion of our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Past performance is no indication of future performance. Liquid securities, such as those held within DIAS portfolios, can fall in value. Global Financial Private Capital is an SEC Registered Investment Adviser.