Investing Rule #1: Follow The Money

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The objective of this post is to discuss broad financial investing perspectives in light of the massive change associated with the election of Donald Trump. It is not to make a statement on whether this political change is good or bad. That depends on your personal beliefs. Additionally, this post is not intended to provide specific investment recommendations, and you should not rely on this high level perspective to make personal financial decisions.

Regardless of your view on the outcome of Tuesday’s election, the immediate surprise and sweeping change that will be ushered in with the Trump Administration in January 2017, has triggered a massive shift in global capital (money) flows. Historically, tracking large capital flows has been a good indicator of the creation and collapse of financial bubbles (boom and bust).  The goal is to buy at the start of the bubble, and sell before it pops.

For example, if you would have noticed the extraordinary flow of capital into the mortgage banking industry in 2003-2005, due to large investors’ voracious appetite for mortgage backed bonds, you could have easily predicted the massive housing bubble that developed in 2005-06. Moreover, the peak of the bubble could have been determined by watching large flows of capital fleeing from the mortgage sector in 2007, after the inevitable home foreclosure wave began. So many people had purchased homes far beyond their capabilities with “easy” money, and that had to end badly. At that point, the bonds secured by packaging those individual mortgages started to default, and investors ran for the hills…

So how does that housing boom-bust apply to our current situation?

After the financial crisis of 2008, the Bush and Obama administration, along with the Federal Reserve Bank, were forced to go “all-in” with fiscal and monetary policies that stabilized the economy. It worked to stabilize the turmoil and flight of capital. However, because the stimulus was focused on the financial sector in order to rescue the banks by shoring up their financial reserves, it did not jumpstart the economy into strong growth and significant job creation. The stimulus stabilized, but was not powerful enough, so the Federal Reserve Bank decided to remain in this low interest rate mode for eight more years in hopes that it would trigger more consumer consumption (from low rates) and corporate investment.

Therefore, for the last eight years we have experienced a continued suppression of interest rates down to historically low levels, currently 0.50% on the FED Funds Rate. Cheap money to borrow sounds good, right?

The problem is that over time individuals, corporations and governments get accustomed to the low rates, and it no longer stimulates incremental borrowing. Essentially, the party went on too long into the night and nobody is interested in drinking the free wine anymore…

The Obama Administration, responding to the excessive practices of the financial institutions that lead to the massive housing bust that caused harm to so many families and companies, decided to pursue more regulations and constraints on the financial community, manifested in the Dodd-Frank bill. This legislation constrained financial institutions by reducing the activities they could engage in, and implementing a more stringent regulatory regime that resulted in less lending and lower profits.

The election of Donald Trump and a Republican majority in the House of Representatives and Senate, who made it clear during the campaign that they were absolutely opposed to the easy money policies and regulatory constraints of the last eight years, has triggered a massive change in the market environment. John Maynard Keynes, in his 1936 publication “The General Theory of Employment, Interest and Money”, wrote about “animal spirits” , a term used to describe the human emotion that drives consumer confidence.

So what has transpired in the four days since the election shocked the world?

There has been a massive fleeing of capital from U.S. treasury and other “safe” bonds, that had very low interest rates. To understand why investors are selling these bonds, please go back and read my post titled “Should You Lend Money To Uncle Sam?” The summary is that these bonds are no longer attractive in a rising rate environment. After all, why would an investor want to hold a bond paying the current interest rate of 2.25%, when new bonds may pay 5.00%? Naturally, investors will prefer to sell the old bonds, and buy some of the better yielding newer bonds. Hence, the current sell-off of bonds based on rising rates.

From Bloomberg, Friday, November 11, 2016 07:42 AM
“More than $1 trillion was wiped off the value of bonds around the world this week as U.S. President-elect Donald Trump’s policies are seen boosting spending and quickening inflation. The capitalization of a global bond-market index slid by $450 billion Thursday, a fourth day of declines that pushed the week’s total above $1 trillion for only the second time in two decades, Bank of America Merrill Lynch data show.”

Where do we think the money from those sales are flowing? Select stocks, but most excessively into the banks.

From the same Bloomberg article quoted above, “Global stocks gained $1.3 trillion in the same period.” The Dow rose 5.36% over the past week, its biggest gain since early December 2011.

Why did the money flow into bank stocks?

The republicans will immediately initiate action to dismantle the most stringent regulations embedded in the Dodd-Frank Legislation, which will once again free the banks to engage in more aggressive lending and investing activity. Banking stocks JPMorgan Chase , Citigroup , and Wells Fargo ended the week sharply higher, while the Financials Select Sector SPDR ETF increased nearly 11%.

Other stock sectors experiencing parabolic gains included:

  • An index of pharmaceutical companies increased 11 percent, the most in data going back to 1999. The companies are expected to face less scrutiny and limitations from a republican administration and congress. Democrats would likely have reined in rampant price gouging from pharmaceutical companies, and investigated excessive drug pricing.
  • Stocks of private prison companies Geo Group Inc. and Corrections Corp. of America soared the morning after the election. Corrections was up 43% to $20.42 per share the following morning. GEO Group, another prison provider, was up 25% to $26.69 at the same time. Why? The Obama Department of Justice announced in August that the federal government would stop using private facilities. Hillary Clinton supported those measures as well. These announcements sent the companies’ stocks spiraling at the time.

An example of a stock sector that has seen capital outflows, is the hospital sector.

Why?

As mentioned above, repealing Obamacare is a major policy position for Trump, and his plan to dismantle the Affordable Care Act raises a questions for hospital operators regarding how they’ll get reimbursed for providing healthcare to low income Americans. Healthcare stocks of hospitals operators HCA, Community Health and Tenet were all down more than 10% the day after the election.

Some sectors, like the housing market, may be tough to judge.

It is logical that rising interest rates should hurt housing as borrowing rates will climb and make mortgages more expensive to buyers. However, it could be argued that the animal spirits that are released may cause personal portfolios to rise, and institutional investors to feel the “wealth effect”. That may lead to “trickle down economics”; as investors become enriched, they are more likely to embark on new business ventures and create jobs.  If that plays out, new jobs will increase home buying, regardless of the more expensive mortgage financing rates. We shall see…

Bottom line: The key for investors, in the midst of this sweeping change, is to determine where the money will flow based on expectations of what the new administration and republican congress will do once in power.

As I mentioned at the beginning, follow the money flow.

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