Stock Prices, Politics and the Business Cycle

 In Strategy Updates

It ain’t what you don’t know that gets you into trouble.
It’s what you know for sure that just ain’t so.

–  Mark Twain

In recent months political turmoil has continued to escalate – just when we thought it couldn’t get worse!  The recent drama surrounding ex-FBI Director James Comey makes previous episodes of the Trump presidency pale in comparison.  Despite the whirlwind of media attention and political analysis, there is still much to be discovered – or not – in regard to this possible scandal.  One thing we can be sure of is that further controversy in the political realm is likely to be the norm for the foreseeable future.  The important question for investors is what effect will further political damage have on stock prices and the risk of owning financial assets?  It depends on the business cycle.

As we have mentioned in previous strategy updates, the corporate profits recession of 2015-16 and the corresponding 20% decline in global stocks marked the end of the bull market that provided handsome rewards for investors from 2009 through 2014.  Since the summer of 2016 (just 9 months ago) we have witnessed the beginning of a corporate profits recovery and the beginning of a new business cycle and economic expansion.  The stellar performance of stock prices since the recovery began is due to this more constructive economic and profit growth environment – not the Trump administration.  Over the past few quarters corporate profits, particularly in economically sensitive sectors (many of which you own), have been equally stellar, serving as further evidence that we have entered into a new economic expansion.  Remember, economic expansions typically last years, not months.  This is not simply a domestic phenomenon as corporate profits and stock prices overseas are also in recovery mode.

Though politics plays a role in the business cycle, the extent of the volatility it can cause very much depends on which phase of the cycle we are in. During the later stages of an economic cycle and profit growth, politics can weigh heavily on an elevated and vulnerable stock market.  However, at the beginning of these cycles, political turmoil usually does not de-rail economic recoveries.  One need only to take a good look at 1974’s economic and stock market recovery, which was not phased in any way by one of the most politically disturbing events of modern day – the scandal and resignation of Richard Nixon.  In fact, that year marked the beginning of a powerful multi-year stock market rally.

Today’s stock market is not overvalued based on a number of valuation tools including price/earnings ratios.  In fact, the continued increase in earnings may cause P/E ratios to contract over the next year, which is often the case at the beginning of the business cycle.  Though events of the day can cause stocks to gyrate, investors would be better served by focusing more on corporate profits, economic growth and the Federal Reserve than unconfirmed political drama.  In terms of volatility it is also important to remember that a 400 point drop in the Dow Jones Industrial Average is less than 2%!  We have come a very long way over the last few decades since such a decline represented a significant percentage change.

Though we continue to be optimistic at this point of the economic cycle, we also are aware that we are dealing with the unknown. Therefore, to protect your portfolio from events that we cannot predict, we continue to employ our Active Risk Management process, which includes your allocation to stocks, active sector management and the use of carefully placed stop loss orders.

We hope you find this update helpful. If you have experienced any change in your financial circumstance, or would like to discuss your portfolio, please let us know at your earliest convenience.

Thanks again from all of us for your continued vote of confidence. As always, if you have any friends or colleagues who you feel may benefit from our services, we would be happy to introduce ourselves to them with a no-obligation introductory meeting.

Your Team at Main Street Research