Does The Political Turmoil In The U.S. Matter?

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.

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At the beginning of every month, I brief members on how MoneyGeek's Regular portfolios have performed and comment on the state of the financial markets. In this update, Ill also discuss the impact that the U.S. political situation could have on the stock market.

May Performance of Regular Portfolios

The performance of MoneyGeek's Regular portfolios for the month of May 2017 were as follows:

I've chosen to list below the performance of some of our competitors. For the sake of brevity, I've decided to show only those portfolios that have a similar risk profile to MoneyGeek's Regular Slightly Aggressive portfolio.

In contrast to our competitors, MoneyGeeks Regular portfolios employ stocks/ETFs that follow the value investing strategy (QVAL, IVAL and BRK-B), and also allocate a larger percentage of the portfolios toward Canadian oil and gas stocks (XEG.TO) and gold (CGL-C.TO). If you would like to take a look at our portfolios, I invite you to sign up for our free regular membership.

The Regular portfolios underperformed their competitors in May. QVAL and XEG.TO were to blame, as they went down by 4.1% and 5.6% respectively. The underperformance of QVAL indicates that investors are increasingly favouring growth stocks over value stocks. XEG.TO went down because oil prices failed to rise, even though OPEC extended its output cuts to early next year.

The stock market had a relatively quiet month except for one day. On May 17, allegations that Trump colluded with Russia during the election intensified, stoking fear among investors that Republicans would have difficulty pushing their pro-business agenda. The stock market fell by 1.8% that day as a result.

But though the stream of negative news kept pouring out in the ensuing days, the U.S. stock market more than recovered its losses to end the month up 1.4% in May. Given the stock market recovery, I think it makes sense to ask whether the political situation in the U.S. actually influences the stock market in any significant or meaningful way. To answer this question, its worthwhile to examine the narrative that investors have put forward to explain the stock markets rise since the election.

You may recall that when Trump first got elected, the U.S. stock market plunged by nearly 5% as many investors worried about the possibility of trade wars, as well as general political uncertainty. However, the markets quickly recovered and have never had a down month since.

Some people tried to explain the markets upswing by suggesting that investors are focused on the positives that Trump can bring. On the campaign trail, Trump promised to cut regulation, reduce taxes and spend more on infrastructure. If Trump were to succeed in achieving some or all of these goals, the U.S. would see inflation rise as a side effect, and thats also good for stocks.

Theres a problem with this explanation, however. If the stock market is in fact rising because of optimism about Trumps policies, then it stands to reason that the market should fall when Trump doesnt seem able to push his agenda through congress. Indeed, in late March when it became clear that Trump wouldnt get the votes necessary to approve his own health care bill, the stock market dipped as investors realized he would also have difficulty getting his budget approved later on.

In the weeks following the collapse of the health care bill, nothing happened that should have given investors more optimism regarding Trumps agenda. Despite this, however, the stock market more than recovered its losses through mid-May. Then, as I mentioned previously, the stock market dipped again on May 17 as the Russia scandal grew, but ended up reaching all time highs towards the end of the month.

Judging by the actions of the stock market, it doesnt appear to me that Trumps agenda has any influence on the direction of the market. Instead, it seems likelier that the growing economy and the resulting high investor confidence has propelled more cash to pour into the stock market, causing the market to go up.

However, many investors dont like this psychological explanation. Perhaps influenced by the idea that the markets are always efficient, they always try to find some rational explanation as to why the markets went up. Thus without any real evidence, I think these investors created the narrative that the markets are optimistic about Trumps policies. The financial media then popularized this narrative, because they too like rational sounding explanations.

But although the narrative has failed to predict the direction of the markets so far, I think it would be a mistake to dismiss its influence altogether. Thats because rightly or wrongly, investors have come to expect the markets to move in accordance with Trumps prospects. For instance, Bridgewater Associates, the largest hedge fund in the world, has predicted that the stock market will drop by 11% if Trump were to be impeached.

Such predictions have a tendency to become self-fulfilling prophecies. If every investor thinks the stock market will crash, then they will each try to sell before that crash comes. Such selling can in turn trigger the crash.

Currently, it feels as though theres nothing that can keep the stock market from rising. However, its important to realize that such feelings are an illusion, partially built around the narrative that Trumps policies will boost stock prices further. But if that narrative takes a big enough blow, theres a real chance that investor psychology will take the blow as well. For this reason, I believe the U.S. political situation is worth paying attention to.

This blog post was originally published on the MoneyGeek.ca blog by Jin Choi. The website no longer exists, but Jin has graciously allowed us to re-publish his research for the benefit of future investors forever.