The Trump Rally: Buy on rumor, Sell on news?

trump-stocks526

Never in a million years did I think that Trump would not only win the election but that the stock market would rally afterwards. It proves once again how difficult it is to time the stock market.

Trump’s promise of a big stimulus package, tax cuts and less regulation has boosted the dollar and triggered a selloff in the bond market. The “Trump trade” has become the reflation trade with investors buying cyclical stocks and selling bonds. Financials have benefited as well as industrials.

The markets have rallied assuming that Donald Trump is pro-growth. However, he was also the same guy who talked about tariffs and tearing up trade deals, things that are anti-growth. The stock market is currently ignoring the negative side of Trump’s campaign promises.

Now, I’m not convinced it’s a one-way street. Under the surface, the trend has certainly changed. Whatever you thought about stocks before the election, you have to like them a little more and whatever you thought about bonds, you have to like them a little less.

Could this be the start of the “Great Rotation’” out of bonds into stocks?

Almost $2 trillion has been wiped off the value of global bonds since Trump was elected as the next U.S. president, sparking a reassessment of growth and inflation views.

JP Morgan notes that over the past week, a record inflow into U.S. equity exchange traded funds (ETFs) was accompanied by a record outflow from bond ETFs.

Within equity markets,  a sharp rotation out of so-called “bond proxies”, dividend-paying sectors such as utilities, telecoms and healthcare which were favored by investors for their yield and a move into more cyclical sectors such as banks, industrials and some commodities-related sectors is already underway.

Before you jump on the bandwagon, there’s a flood of economic data in the week ahead

  1. update to third-quarter GDP on Tuesday
  2. OPEC meets on Wednesday and it will decide whether to curb output
  3. Thursday is ISM manufacturing data and November auto sales
  4. jobs report on Friday expected to show 175,000 nonfarm payrolls

Now, the bond market has already priced in expectations that the Fed is on track to raise interest rates Dec. 14 by a quarter point. Next week’s economic data will be evaluated to determine future rate hikes for 2017. If inflation expectations are overhauled than so are perceptions about the rate outlook. Money markets are starting to price in one or more Federal Reserve rate hikes for next year.

Good economic numbers could cause a further selloff in the bond market next week which would be positive for U.S. stock markets. Plus many active fund managers have underperformed their benchmarks, there could be some performance chasing until year end.

Unfortunately, President Elect Trump is unpredictable and somewhat scary. If he shuts the borders because the anti-trade Trump comes out, we’ll have a recession and the market will go down. If that side stays quiet and he manages to convince congress to cuts taxes, it could be up a lot.

My gut tells me that we could be in over bought territory and that we could see some market consolidation. My fear is that Janet Yellen could spark a stock market selloff like she did in December 2015 when she indicated the possibility of 4 rate hikes for 2016 which didn’t materialize.

Are you buying into the Trump rally or are you a seller?

 

 

 

Trump economics could be hazardous to bonds and dividend stocks

Trump’s stunning victory for the White House may mark the long-awaited end to the more than 30-year-old Bull Run in bonds, as bets on faster U.S. growth and inflation led investors to favor stocks over bonds.

There has been a sentiment shift in the bond market. The stampede from bonds propelled longer-dated U.S. yields to their highest levels since January with the 30-year yield posting its biggest weekly increase since January 2009. The 10-year German Bund yield rose to its highest level in eight months, while the 10-year British gilt yield climbed to its highest level prior to Britain’s decision to leave the European Union on June 23, known as Brexit.

“I’m the king of debt. I’m great with debt. Nobody knows debt better than me,” Trump told Norah O’Donnell in an interview that aired on “CBS” “I’ve made a fortune by using debt, and if things don’t work out I renegotiate the debt. I mean, that’s a smart thing, not a stupid thing.”

Global bond markets worldwide have already lost more than 1 trillion dollars.  Speculation is that Trump’s tax cuts and stimulus spending could increase the national debt by trillions of dollars. The chart below is the iShares 7-10 Year Treasury Bond (IEF)

bonds-10-7

 

TIPS appeal

While investors dumped most types of bonds after Trump’s victory, they piled into Treasury Inflation-Protected Securities as a hedge against a pick-up in inflation. Investors poured $1 billion into TIPS in the week ended Nov. 9, the second-biggest inflows since records began in October 2002, data from Thomson Reuters’ Lipper service showed on Thursday.

Higher bond yields could have a negative effect on dividend stocks

Bonds have historically enjoyed a lower risk premium than dividend stocks. Higher bond yields could attract investors away from owning dividend stocks. Consumer staples and utility stocks have already fallen based on the Fed raising interest rates in December. Some experts believe that the Federal Reserve will be forced to increase rates even more in 2017.

The good news is that this could be just a knee jerk reaction to the shocking election results. In a subtle effort to lessen fears, President Obama suggested Monday that the office of the president has a way of opening one’s eyes to the realities of governing and decision making.

“Regardless of what experience or assumptions he brought to the office, this office has a way of waking you up,” Obama said.

“My advice, as I said to the President-elect, was that campaigning is different from governing,” Obama said Monday. I think he recognizes that I think he’s sincere in wanting to be a successful president. I think he’s going to try as best he can to make sure that he delivers not only for people who voted for him but the people at large.”

It remains unclear how Trump’s promises translate into policy and the degree to which they would affect the economy. So far, the rally in U.S. stock markets suggest whatever Trump may do with the help of a Republican-controlled Congress would give a lift to the U.S. economy, which is growing at about 2 percent this year.

cautionHigher interest rates could cause a U.S. recession!

Looking for yield; Beware of return of capital

percentage

This low interest rate environment has encourage the investment industry to invent investment products that have yields that seem too good to be true. A warning bell should go off when you see a yield of more than 7 per cent. Some investors are so blinded by yield that they ignore everything else, even their own better judgement.

As a retiree, I understand the need for steady monthly income but it pays to be skeptical. It is important to read the fine print on how the income is being generated. I recently did some research on iShares Canadian Financial Monthly Income ETF. (Trades on the Toronto stock exchange ticker FIE)

According to FIE’s website, the ETF’s investment objective is to “maximize total return and to provide a stable stream of monthly cash distributions.” The ETF’s list of holdings includes Canadian banks, insurers, asset managers and real estate investment trusts, plus exposure to preferred shares and corporate bonds through two other iShares ETFs. The fund’s “distribution yield,” as of Nov.  7 was 7.17 per cent.

Right away, a yellow flag should go up. Canadian banks and insurance companies generally yield between 3 per cent and 4 per cent, and the REITs and preferred shares in the fund yield, on average, about 5 per cent to 6 per cent. How is the fund able to distribute more than 7 per cent?

You won’t find the answer on the ETF’s main web page. You have to click through to a PDF of the prospectus where, on page 46, you’ll find the following:

“If FIE’s net income and net realized capital gains in a year are insufficient to fund the regular distributions [of 4 cents a month or 48 cents annually], the balance of the regular distributions will constitute a return of capital to unitholders.”

Return of capital, or ROC, is the portion of a distribution that doesn’t consist of dividends, interest or capital gains triggered by the sale of securities. In FIE’s case, ROC represents a huge part of the fund’s distribution – about 35 per cent in 2015, 52 per cent in 2014 and 66 per cent in 2013. Again, you have to dig for this information, which can be found under the “distributions” tab using the “calendar year” and “table” views.

Now we know how FIE is generating that juicy yield of more than 7 per cent: it’s giving back a portion of unitholders’ capital in the fund. This is cash that would otherwise remain invested in the fund’s securities to grow and generate more income.  

How do you suppose all of those hefty ROC distributions have affected FIE’s unit price over the years? Well, on the fund’s inception date of April 16, 2010, FIE closed at $7.10. Six and half  years later – the units closed at $6.74. So, an investor who held the units since the beginning would have collected the monthly distribution but taken a loss on the unit price.

The lesson here is that ROC is not a free lunch. In exchange for getting a higher yield now, investors sacrifice some or all the unit price appreciation over the long run. The problem is that many investors don’t take the time to understand where their distributions are coming from. If you own a fund whose yield seems too good to be true, chances are you are paying for that yield out of your own capital without even realizing it.

Skill-testing question: If a Canadian investor were to sell the units today would it be a capital gain or loss? Answer: he or she would still likely have to report a capital gain. That’s because ROC distributions are not taxed immediately but are subtracted from the adjusted cost base of an investment for the purposes of calculating capital gains or losses.

Keep in mind that return of capital isn’t necessarily a bad thing. There are cases, for example, in real estate that return of capital comes from tax savings from depreciation of some new properties.

 

Could President Trump cause another Great Recession?

Republican presidential nominee Donald Trump shakes hands with Democratic presidential nominee Hillary Clinton following the second presidential debate at Washington University in St. Louis, Sunday, Oct. 9, 2016. (AP Photo/Patrick Semansky)

Being Canadian, I am not trying to influence any of my American readers on who they should vote for next Tuesday. However, my investment portfolio is heavily invested in the U.S. stock markets, I shudder at the thought of what could happen under President Trump. Naturally enough, investors and analysts hate uncertainty. Hillary Clinton largely represents the status quo. Mr. Trump is more like Forrest Gump’s box of chocolates “You never know what you’re going to get.”

What exactly happens the day after? To markets? To the economy?

The conventional wisdom is that a Trump victory would lead to a swift, knee-jerk sell-off. Many investors will choose to sell stocks and ask questions later. The Mexican peso would most likely fall on fears of a trade fight along with ETFs that contain Mexican stocks. Some insurance companies could tumble on the uncertainty of what would happen if Obamacare was repealed.

A worst case scenario is Mr. Trump’s anti-trade policies would send shock waves around the world. Add a stock market crash and it would plunge the world into recession. Europe’s economy is very fragile and it wouldn’t take much to tip Europe back into a full blown recession. This would lead to a serous banking crisis that could spiral into emerging markets.

The biggest test for the stock markets might be pegged to the future leadership of the Federal Reserve. There is much more uncertainty regarding who Trump might nominate, though he has made it clear he would not re-nominate Chair Yellen.

Now, a handful of economists have suggested that despite all of the promises made by both candidates, odds are high that whoever the next president is, they will preside over a recession. They argue that we are in the second-longest bull market of all time and the eighth year of this economic expansion. It is hard to believe that we will go through the next four years without a hiccup. If merger activity is a gauge of the market’s cycle, the recent spate of deals suggests we’re closer to the ninth inning than the first.

In reality, it’s impossible to predict how the markets would settle after an initial sell off. It will take time for investors to truly make sense and “math out” how his policies would affect the economy. Now, Trump’s bark will be a lot worse than its bite in terms of actual implementation of his anti-globalization position. Hopefully, a split in the congress and the senate will stop Trump from carrying out any outrageous election promises.

Am I worry about the U.S. election? Not really because I am an option trader. I have sold covered calls to protect most of my U.S. stocks. I have sold only a few cash secured puts on stocks that I am comfortable holding long – term. Plus, I have some extra cash just in case of a market sell-off. I am very comfortable switching from selling cash secured puts to buying puts if there is a bear market.

Where am I going to be next week? On vacation from the markets in Orlando, playing golf with my golf cronies. Hoping that they don’t ask for any financial advice and looking for another hole in one.

hole-in-one