January 23, 2017

Doug Kass on Donald Trump and the markets

The market had a solid first day in the Trump Era with all three major indices up solidly as the 45th president of the United States was sworn into office. I have no idea where the country and market go from here, as one would expect when the biggest outsider since Andrew Jackson is now commander-in-chief. But I guarantee the ride will not be boring. 

It remains my view that volatility and risk are materially under-priced in today's markets. While animal spirits have taken over the markets, abetted by machines and algorithms that often create an artificial market setting by exaggerating market moves, I will remind all that there is a reason why they are called animal spirits and not human spirits. Animals, you see, are mostly a lot dumber than humans.

I am as bearish on stocks as I have been in months based on the following (and my portfolio reflects this):

- An Untested President Trump.
Regardless of one's political affiliation, it can be argued that, as a leader, Donald Trump is untested.His ability to understand, study and execute/implement far-reaching, complex and cohesive policy remains in question, particularly against a backdrop of deep-rooted animus between the Republican and Democratic parties.


- Will the President-Elect Really Come to the Rescue of the Middle Class and Fulfill His Campaign Promises?
Donald Trump ran on the notion that he will represent the Average Joe. After years of "Screwflation of the Middle Class," in which most Americans' disposable incomes had flat-lined with salaries unchanged while the costs of the necessities of life increased, the Republican candidate promised that he would represent them over the next four years. As noted below, in several bullet points, I remain a skeptic.


1. Will Donald Trump Be More Elitist Than Hillary Clinton?
Donald Trump's cabinet appointees are comprised principally of wealthy individuals who are not representative of our broader society.


The president-elect has argued that these appointees have been successful in private life and are good representatives to affect the change he has espoused. We shall see whether they feather the beds of their contemporaries or whether their policies "trickle down" to their constituents.

2. Campaign Promises Recanted?
The president-elect has made numerous extreme campaign promises to his supporters that he already has recanted in areas of immigration ("the wall"), a possible legal response to the Clinton Foundation and Hillary Clinton's emails, tariffs and trade and other core campaign principles.


3. Pay For Play -- Selling Access? 
Donald Trump's two sons already have gotten into "pay for play" problems, something that the president-elect and the Republican opposition were critical of regarding the Clinton's. Trump should be avoiding these conflicts at all costs, but he is not. Thus far there have been other examples of selling access; the president-elect doesn't yet seem to understand the degree of scrutiny a person in his position is in. He needs an army of lawyers around him building a Chinese wall between his business and the presidency. Will this be fact and can he separate himself from his business empire in order to do good and follow the will of the people without conflict?

- Fiscal Policy Limitations. 
The Fed's monetary largesse is no longer a factor or effective in catalyzing domestic economic growth. The baton pass from monetary stimulation to fiscal expansion is likely to be less smooth and probably will be implemented much later than the consensus expects. This applies to both the U.S. and Europe, as it is all now about politics and the ability to coordinate fiscal policy successfully. Will the president-elect get cooperation of a Republican-controlled Congress to embark upon aggressive fiscal stimulation while taking the budget deficit sky high? Is this a reasonable leap of faith by investors? There are also real issues as to timing and whether fiscal stimulation will be effective in a new administration. Fiscal policy efforts, such as the monetary expansion since 2009, may fail to trickle down to where they are needed most -- the middle class. In other words, fiscal policy may not be as effective in catalyzing growth as anticipated. As an example, the CEO of Cisco, which possesses a large overseas cash hoard, recently was asked what the company would do with a repatriation of its foreign profits. The answer he gave was that half would go to merger activity and the balance to share buybacks -- neither would add new jobs; indeed, the former probably will lead to lower net jobs.

- Lower Corporate Tax Rates Likely Will Not Produce a Hockey Stick Effect in Earnings Growth. Another example of market optimism is the excitement associated with the introduction of lower statutory corporate tax rates, which are currently at 35%. A rate of 20% to 25% seems to be the desire of the new administration. I have seen estimates that a new tax law will add as much as $15 a share to S&P 500 aggregate earnings. But, with the average S&P company only paying an effective tax rate of about 23%, how is the introduction of a lower statutory rate going to move the needle of S&P profits?

- Rising Rates May Not Be a Positive For the Markets. Another "fact" is the notion that rising interest rates are positive to our equity markets. But given the policy uncertainties (some listed above), is this belief fact-based? Interest rates are heading higher. While this helps a segment of our markets -- e.g., banks, which have an imbalance of rate-sensitive assets over rate-sensitive liabilities -- it hurts a broader swath of industry (utilities, telecoms and REITs). As I discussed in "Look Out Above! Rising Rates Pose Economic, Market Risks," a higher risk-free rate of return and cost of capital theoretically reduces the value of equities, produces competition to stocks from fixed-income instruments, likely will moderate buyback activity and, as discussed in the next bullet point, could raise the value of our currency, which will diminish the value of our exports and corporate profits.

- The U.S. Dollar Conundrum. Higher U.S. interest rates already are producing a rise in the value of the U.S. dollar, which could be unfriendly to growth as it reduces our import business. With 45% of S&P profits non-U.S. based, is a strong currency factually positive for U.S. equities?

Bottom Line

On top of the (false) optimism associated with Trump's message of Making America Great Again through lower taxes, the repatriation of overseas cash, the elimination of burdensome and expensive regulation and other policies aimed at jump-starting domestic economic growth, the dominant investor today -- quant funds such as ones that employ volatility-trending and risk-parity strategies -- have likely exaggerated the climb in stocks since the election.

Is it Reagan's "Morning in America?" -- a metaphor for renewal. We all hope so, but I doubt if this will be the case this time.

There is little basis for comparing the conditions that existed when Reagan gained the presidency to the current state of things. Economic, labor market, demographic and other conditions three decades ago were dissimilar.

Of even greater consequence is the issue as to whether the basic assumptions that have led to the surprising market advance are based in reality.

I am doubtful and I continue to believe that Donald Trump will make volatility and uncertainty great again.

I would fade the "animal spirits" -- the prowl of which has been documented by Jim "El Capitan" Cramer -- as I am fearful of elevated stock prices in a post-fact investment world. 

I would overweight gold and underweight stocks. 

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