Judging Economic Policy

Despite the market volatility of the past week, our classification of expected market return/risk profiles shifted only modestly for most asset classes. In stocks, we observed a great deal of internal dispersion, which continues to suggest a subtle shift toward risk-aversion among investors. The global equity markets remain well below their mid-2015 peak, and the U.S. markets remain in what we would continue to describe as the extended top formation at the third most extreme valuations in history (and the single most extreme valuations from the standpoint of the median stock). In terms of leadership, we observed a new high in the Dow Jones Industrial Average last week, along with speculation in banks and pharmaceuticals that are expected to benefit from deregulation, and transportation stocks seen as potential beneficiaries of transport-related infrastructure spending. Conversely, Treasury securities plunged on expectations of larger deficits resulting from both higher spending and lower taxes.

We continue to expect 10-12 year nominal total returns for the S&P 500 averaging about 1.5% annually, with a likely market retreat of 40-55% over the completion of this cycle. Nothing in the recent election results materially changes those expectations. Indeed, my sense is that equities should build in a substantially higher, not lower, risk premium at present - if only because the stated objectives and policies of the new administration are intentionally disruptive to the status quo. It’s not clear that the fiscally-conservative side of the Republican party will embrace a large expansion of deficit spending, nor that the more moderate elements in the party will embrace aggressive deregulation, so my sense is that much of last week’s activity was driven more by a combination of hope and fear than by evidence.

Still, we don’t need to make assumptions about the success or failure of various policies. It’s just that we find no historical evidence that the mapping from reliable valuation measures to subsequent long-term and full-cycle market outcomes has any correlation with the political party in office, or even with changes in fiscal policy over those horizons. That’s also not at all to say that economic policy changes don’t have economic outcomes, but the impact on the stock market is more nuanced. As I’ve demonstrated before, since higher economic growth tends to be associated with higher interest rates and lower terminal valuations on say, a 10-year horizon, the two effects systematically wash out over time (see Rarefied Air: Valuations and Subsequent Market Returns).

Overall, our longer-term and full-cycle expectations remain dismal, but our very near-term views are better characterized as neutral than hard-negative, due to some fairly modest changes in various components of market action. An expansion in bullish sentiment or an increase in the dispersion of market internals would restore a hard-negative expected market return/risk profile. As usual, our outlook will shift as the evidence does, and we remain flexible toward either a more negative or a more constructive view.

The 10-year Treasury bond yield jumped to 2.15% last week, which even at these levels is higher than the expected return we estimate for the S&P 500 over the same horizon. Meanwhile, Treasury bill yields increased to just under 0.5%, which is the highest level since October 2008. While we still identify a fairly neutral expected return/risk profile for bonds, the increase in yields improved that very modestly. Likewise, the weakness in precious metals shares modestly improved our expected return/risk profile for that sector, but our outlook remains fairly conservative relative to our much stronger conviction early this year.

Put simply, aside from possibly increasing the appropriate risk-premium across financial assets, last week’s election results don’t materially change our full-cycle our long-term expectations for the stock market. I recognize that it’s a great temptation to speculate about policy changes and their effects on various sectors, but we prefer evidence to opinions.