I trust you but cut the cards – W.C. Fields
As investors continue to reassess the 4Q16 equity rally, the dramatic rotations and the prospects for 2017, we also reexamine our frameworks to better understand how the different factors contributed to the moves. In our view, the equity rally has been underpinned by positive economic data, a turn in earnings and a fund flow rotation back to equities. A simplistic view that market performance and current sentiment is a function of the impact of President-elect Trump’s pro-business agenda is to miss much about the current economy and how that reads through to markets in the US, and frankly, Europe too.
The Plausible Coincidence of a Trump Win and Market’s Rally
It is not the purpose of this Investor Letter to argue points successfully. The point is to express to your satisfaction, how we seek to make clients money, by “getting it right.” So understanding the year-end rally and its drivers is valuable in considering the possible outcomes going forward. If for example, it is plausible that the market’s year-end rally was more about economic factors and less about a Trump victory, it may be the case that markets will be more buoyant in the face of the new administration’s initiative’s inevitable pivots, capitulation or delays. Alternatively, that market pullback on such political “disappointment” may portend attractive entry points into a market that will continue its ascent despite who is in office.
Earnings Drove a 3Q16 Rally, then Exacerbated (but not caused) By Prospective Trump Policies
3Q16 reporting was in full gear the last two weeks of October and through November – the same time that US election developments dominated our attention. Increased election uncertainty more than offset a strong quarter for earnings. To put it into perspective, S&P 500 earnings jumped 6% qoq in 3Q16 to solidly break out of the flat-to-down trend in place since 2014. SPX revisions were also less negative through 3Q16 reporting and turned positive the last two weeks, led by financials. It would appear to us that a 3.3% S&P 500 rally in 4Q16 is justified by the 6% rise in 3Q16 earnings.
Financials Drove 4Q16 Equity Performance, Prospective Fed Tightening, a Function of a Healthy US Economy, the Greatest Factor in Financials Outperformance (Rates a Partial Consequence of Trump Election)
Of the 4.6% S&P rally from the election through the end of 2016, the financials sector was responsible for 2.2% of the move. In our view, the relative outperformance of financials reflects the broader move in rates. Industrials accounted for about 15% of the S&P rally, followed by energy at 13%. Oil prices are about 20% higher since the US election, underpinning the 9% rally in the energy sector. Those three sectors accounted for nearly 80% of the rally, with the other 8 sectors contributing just 1% to the S&P rally since the election. The sector composition of the equity rally outside the US is even more pronounced, with financials accounting for 60% of the rally in the ACWI and adding in energy and industrials would explain 93% of the global equity rally.2
With the Fed comfortable that the US economy is on firm footing, Fed tightening commencing in December had been market participant’s base case, and rising rates were surely a near term consequence. Financials are the greatest beneficiary of a rising rate environment in the US. The combination of the imminence of rate hikes in the US and costs of either Clinton’s or Trump’s stated plans helped drive the 10 year US treasury rate from 1.40% pre-election to over 2.50%.
Wenote that Financials outperformance is logically in -line with the increase in interest rates, and perhaps, simply coincidental with a Trump victory.
The Importance of Intellectual Consideration in Investment Management
This is the business we’ve chosen – Hyman Roth, Godfather II
We occasionally get asked questions about our forays down these rabbit holes. Is it necessary? Too time consuming? Does it take away from your more core research and portfolio work? Doesn’t this research and writing take a lot of time? Yes, no, no, no are the answers. Less flippant: This work is central to making money and not losing money (two different things) in these current sideways trading and correlated markets. This is the business we’ve chosen. It is daily and ongoing. All (good) investment professionals do it. What differs is that we commit our efforts to writing, to help produce a roadmap, first for us (we are the driver) and secondarily, for you (you should want to know how we are getting from here to there). Oh, and on the time and effort (aside from it being part of the job), I admit to being advantaged, in this idiot-savant sort of way, of taking all that I read, all that I then synthesize into perspective each month, and am able to sit down and write 90% of it in one 3 hour session on a Sunday (while your other managers are watching a football game).
Back to the Plausible Coincidence of a Trump Win and a Market’s Rally: in the end, this alternative explanation to the knee-jerk norm you might hear from other managers or financial media pundits is simply that we should consider it, and seek to properly weight all the factors that contribute to outperformance and underperformance. To the extent we can “get it right,” there can be clues that lead us to better investment decisions.
1 Global Asset Allocation, JP Morgan Research, January 5, 2017
2 Macro, Sentiment and Market Cycles, Barclays Global Equity Strategy, January 5, 2017
The above post has been excerpted from a letter of Tiburon Capital Management.