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Trump victory offers lessons for stunned investors

Stocktake: Market response to US election result confounds bearish forecasters

What will the US presidency of Donald Trump mean for stock markets? An honest observer would note the unpredictability of recent events and admit: I don't know. A more appropriate question is: what can investors learn from the recent presidential election and the subsequent market reaction?

Quite a lot, as it happens. Here are six important lessons that should be heeded by all investors.

Nothing shifts sentiment like price

Prior to the election, strategists were almost uniformly negative regarding the likely market impact of a Trump win. The uncertainty caused by a Trump victory could trigger a global recession, warned Citigroup chief economist Willem Buiter. That was echoed by JP Morgan, which cautioned that the US equities and the dollar would be hit in the event of a Trump victory. Allianz chief economist Mohamed El-Erian called for investors to reduce their exposure to equities in the run-up to the election and to be cautious about viewing a Trump-induced equity market sell-off as a Brexit-like buying opportunity.

As the results rolled in and it became clear that Republicans were going to gain control of Congress as well as the presidency, El-Erian warned the “total party sweep will make markets even more nervous”.

However, as markets rallied following Trump’s victory, Wall Street changed its tune. Citigroup raised its recommendation on global equities to overweight from underweight. JP Morgan, whose immediate reaction to the election results was to reduce the probability of a December interest rate hike on the grounds of market “uncertainty and volatility”, said two days later that markets would continue rallying into 2017 as the election outcome was “pro-growth for equities”.

El-Erian, too, was less circumspect than usual, saying Trump’s administration “has the potential to encourage interest-rate convergence consistent with higher economic growth and greater financial stability”.

Bullish stock-market action forced many who were cautious about a Trump victory to suddenly embrace the prospect, noted Reformed Broker blogger Josh Brown. Quite simply, “nothing shifts sentiment like price”.

Don’t write off the pollsters

After getting it wrong on Brexit and Trump, the new conventional wisdom seems to be that investors should be wary of pollsters and data-driven quants. Nate Silver, heralded for predicting the results of all 50 states during the 2012 election, "is now being seen as the face of everything that's wrong with America's pollsters and data journalists, and their absolute disconnect with the populace", opined one Economic Times commentator.

The backlash is overdone. Yes, prediction markets got it badly wrong on Brexit but the polls didn’t, consistently showing there was a real chance that Britain would vote to leave the European Union. As for the US election, the polls rightly indicated Hillary Clinton would win the popular vote, but overestimated her margin of victory by about two percentage points. That’s in line with historical averages, and slightly better than during the 2012 election. Polls in swing states, points out Nate Silver, also performed “just as well as they did in 2012”.

Silver's analysis consistently showed there was a real chance Clinton could win the popular vote but lose the electoral college; on the eve of the election, Clinton was viewed as a two-to-one favourite, nowhere near the 90 per cent odds accorded to Barack Obama immediately prior to the 2012 vote. "There was widespread complacency about Clinton's chances in a way that wasn't justified by a careful analysis of the data and the uncertainties surrounding it", says Silver.

Data analytics is far from perfect, but the number-crunching approach beats going with your gut. Investors who think otherwise have taken the wrong lesson from the US election result.

Value process over outcome

Investors have long been seduced by the idea of finding the perfect forecaster who could divine the future. Nouriel Roubini’s bearish prognostications resulted in him achieving cult status during the global financial crisis. Following the 2012 presidential election, it was the turn of Nate Silver, after he successfully predicted the winner in all 50 states. Silver’s stock has dropped in 2016, whereas those who predicted a surprise Trump victory are now receiving the plaudits.

They include pollster and economics professor Arie Kapteyn, with Bloomberg reporting that he had employed "what experts called a unique and more complex weighting model" that had allowed him to envisage a Trump victory.

Similarly, political historian Allan Lichtman also predicted a Trump victory. The system used by Lichtman, who looks at 13 different factors that have traditionally influenced US voters, has been lauded for correctly predicting every election since 1984.

That's not the whole truth, however. Both men predicted Trump would win the popular vote, in Kapteyn's case by as much as three percentage points. As Howard Marks of Oaktree Capital has pointed out, such forecasters "were right about a Trump victory, but for the wrong reason". How often, adds Marks, do we see that in the investment world?

Too often. "Investors often make the critical mistake of assuming that good outcomes are the result of a good process and that bad outcomes imply a bad process," writes Credit Suisse money manager Michael Mauboussin in his book More Than You Know. They have it backwards, says Mauboussin: always focus on process, not outcome.

Be wary of narratives

“Politics of anger in play,” tweeted Mohamed El-Erian in the aftermath of the vote. “Directly related to years of low and non-inclusive growth, with associated loss of trust in the ‘establishment’.”

Such sentiments have become commonplace of late, invariably prompting speculation about the spread of political populism and its implications for global financial markets. That case can be made. At the same time, Trump lost the popular vote. He received fewer votes than Mitt Romney did in 2012. Roughly a quarter of Americans voted for Trump; another quarter voted for Clinton; almost half the population didn’t bother voting.

“A combined shortfall of just 113,000 votes in Pennsylvania, Wisconsin and Michigan made Clinton the loser,” notes Howard Marks. “If she had won just 57,000 of those votes (or 0.4 per cent of the 13.6 million total votes cast there), she would be the president-elect.”

There is truth in El-Erian’s “politics of anger” thesis, although one can make equally compelling cases for the politics of apathy, race, gender, class – whatever case you wanted to make, really.

Markets are unpredictable

Investment strategists were almost unanimous in predicting a Trump victory would be bad for stock markets. It’s easy to scoff now, but that was a perfectly rational interpretation of months of market action. Stocks rose when Trump’s odds declined following his poor performance in the first presidential debate. They gained in late October, when Trump appeared all but certain to lose the race, only to tumble after the FBI announced it was reopening its enquiry into Clinton’s use of a private email server. After the FBI announced that she had no case to answer after all, stocks again raced higher.

Accordingly, you could be forgiven for being puzzled by the fact that news of Trump’s victory catalysed the best week for US stocks since 2014. “How could the expectation of a Clinton victory make stock prices rise, and then the reality of her defeat make them rise further?”, asked Howard Marks in the aftermath of the result.

The reaction, said Marks, brought to mind an old cartoon of a newscaster saying: “Everything that was good for the market yesterday was no good for it today.” People may “search the market’s behaviour for logic”, he added, but “there really doesn’t have to be any.” The simple reality is that “sometimes the market interprets everything positively, and sometimes it interprets everything negatively”.

Avoid macro agonising

Investors have been busy asking what a Trump presidency means for financial markets, with the early reaction being one of buy US stocks, sell bonds. However, numerous questions arise. Did Trump mean what he said on the campaign trail? Which promises will he actually try to implement? How likely is it that he will be able to implement these particular policies? Will he stick to his early plans? After all, Trump has, to quote a recent Barlcays note, “taken both sides of the debate on gun control, abortion, skilled immigration, universal healthcare, to name a few”, as well as switching between the Democratic and Republican Party “at least five times in the past”.

Even if one successfully predicts the trajectory of policy, can one predict future market reaction? Almost everyone expected a Trump win to mean lower stock prices, higher gold prices and less chance of an interest rate increase in December. Instead, stocks roared higher, gold tanked and now everyone expects a rate hike in December.

Most notable, perhaps, has been the failure of analysts to anticipate the spike higher in bond yields. Within days of the election, 10-year US government bond yields had risen to 2.26 per cent. Of 65 analysts surveyed by Bloomberg, how many expected yields to be above 2 per cent by year-end? None.

Professional strategists and money managers can’t forecast macro developments. Neither can you.