Investor Sentiment: Your Politics Can Affect Your Portfolio

charles_headshotEnough has already been written about the presidential election of 2016. While historians are likely to debate its significance for decades to come, most of the rest of us are just happy it’s over.

But the stock market’s reaction to the election… well, that’s still worth discussing because it has a direct impact on our portfolios. We have money at stake, so it’s important to know what’s going on here and if it’s sustainable.

It’s funny, I was partially right about the election and yet completely wrong about the market impact.

I’d been telling readers for weeks to prepare for the possibility of a Trump win because I believed there was at least a coin-flip chance it would happen. And I figured that, following a Trump win, the market would melt down for a few days until investors realized that not much had really changed, at which point the old trend would reassert itself. It would be a repeat of the Brexit crash and rally.

That obviously didn’t happen. When the market opened the following day, stocks shot higher… and haven’t looked back since.

The question is, “Why?”

There’s not always a simple answer. A big part was simply that, in the contrarian nature of the market, when “everyone” expects something to happen, it’s generally the exact opposite that actually does happen because the popular expectations are already baked into prices.

But an insightful paper from 2012 suggests there might be a little more going on than that.

In “Political Climate, Optimism, and Investment Decisions,” professors Yosef Bonaparte, Alok Kumar, and Jeremy Page test how investors react to election outcomes. In their own words:

We show that people’s optimism towards financial markets and the macro-economy is dynamically influenced by their political affiliation and the existing political climate. Individuals become more optimistic and perceive the markets to be less risky and more undervalued when their own party is in power.

These shifts in perceptions of risk and reward affect investors’ portfolio decisions. Specifically, when the political climate is aligned with their political identity, investors increase allocations to risky assets and exhibit a stronger preference for high-market beta, small-cap, and value stocks. Due to these portfolio reallocations, investors improve their raw portfolio performance when their own party is in power.

The authors also found that home country bias is a lot stronger when “your party” is in power. In other words, you tend to invest more at home when the political party you support is in power, and you tend to invest more overseas when “the other guys” are running the show.

On the surface, this would seem to fit with the events of the past decade. Middle-aged white men tend to have the most investable assets. They’re also far more likely to vote Republican than Democrat. It’s been reported for years that the bull market that started in 2009 is the “most hated bull market in history,” with very low market participation.

Furthermore, a handful of growth names, such as the “FANGs” (Facebook, Amazon, Netflix, and Google) have had an outsized impact on overall market returnrns. Value stocks have lagged for years.

Might having a Democrat in the White House have had an effect on the risk tolerance of Republican investors? And might those same investors start warming up to the stock market a little more with Republicans back in charge?

Perhaps. I hesitate to draw solid conclusions based off of one individual study, but intuitively, it does make sense that politics affect a person’s mood, which in turnrn affects their investment decisions.

The question is, what do we actually do with this information?

Stocks are unlikely to perform well over the next decade, and that would have been equally true no matter who won the 2016 election. Stock prices are extraordinarily expensive using virtually any credible valuation metric, and the single biggest tailwind of the past three decades — falling bond yields — has now become a headwind.

Still, I think there are a few trends we can follow here. I do believe that, whatever direction the market goes, value is likely to outperform growth. So to the extent you need to have equity exposure, it makes sense to focus on value. That’s been the approach I’ve taken in Dent 401K Advisor.

I would also question the conventional wisdom that bond yields will continue rising and that we’re looking at a bona fide bull market in bonds. The thinking is that all of Trump’s campaign promises add up to a lot of spending, and his proposed tax cuts mean a lot less in tax revenue. All else equal, larger budget deficits mean higher bond yields… or so the thinking goes.

I can immediately poke two major holes in this.

First, the largest peace-time deficits in U.S. history were during the 2008-2009 meltdown and the recession that followed… yet bond yields dropped to unprecedented lows. Second, Japan has run some of the largest budget deficits in the world for multiple decades now… and Japanese yields never stopped falling. Today, substantially the entire Japanese yield curve is sitting at zero percent.

So, while yields may go a little higher in the short-term, I wouldn’t count on that trend lasting very long. As Harry has been writing for months, bond yields going even slightly higher than they are today will probably end up being the buying opportunity of a lifetime.