Tuesday, April 14, 2015

"Whenever you find yourself on the side of the majority, it is time to pause and reflect." --Mark Twain

IT'S TIME TO START PRICING IN THE NEXT U.S. PRESIDENTIAL ELECTION (April 14, 2015): Every four years, a week or two before each U.S. Presidential election, there will be a flood of articles in the media about how you can allegedly take advantage of the upcoming election to adjust your portfolios. However, by the time that the election process has become so advanced, nearly all of the price adjustments will have already been made. Following the election itself, there is usually a brief and sometimes dramatic readjustment in response to the expectation that the new President will implement policies which are favorable to some sectors and unfavorable to others. However, the real money is made by anticipating far in advance what is most likely to occur no matter who wins, and how most investors are likely to behave as the election more closely approaches.

On Sunday, Hillary Clinton announced that she was running for the Democratic nomination, and on the following day, Marco Rubio announced his Republican candidacy. While it is possible that a different Democrat will prevail, it is highly unlikely. There will be many challengers to Marco Rubio, and his chances are certainly much less than those for Clinton because of much more intense competition, but I'm going to go out on a limb and assume that the Florida senator will prevail on the Republican side due to a combination of youth, charisma, debating ability, his Cuban background, and various intangibles. If it's going to be Rubio vs. Clinton in November 2016, then how will this affect the financial markets for the next 1-1/2 years?

Perhaps the most important point is that U.S. government deficits will likely get larger instead of smaller, regardless of the results of the 2016 elections. If Hillary Clinton becomes President, then there will likely be a surge of new proposed government programs with very few brakes put on current entitlements. Increased taxes might be proposed, but these will be challenging to actually achieve unless both the Senate and the House of Representatives unexpectedly switch simultaneously to Democratic majorities. With a Republican-dominated Congress and a Democratic President, it won't be significantly different from the current gridlock situation. Almost no new legislation will be passed. Meanwhile, because it has been so long since we've experienced a bear market, a severe one will likely occur regardless of who is President. Without the Fed being able to cut rates further, the only stimulative response to counteract a recession would be increased government spending, so both parties will be eager to prove that they're "doing something about" the economic slowdown. Translation: expect higher deficits perhaps exceeding one trillion dollars annually as we had experienced several years ago. This will contribute to a lower U.S. dollar and elevated interest rates. These reactions won't wait until after the election; we'll likely see a slump in the greenback along with rising Treasury and other bond yields in 2015-2016 in anticipation of the election rather than in response to it. It is possible that the U.S. dollar has already peaked, and that U.S. Treasuries and many U.S. corporate bonds have already done likewise.

What if Rubio prevails? In that case, you can be certain that, especially with a cooperative Republican Congress, there will be numerous tax cuts and lower marginal rates which will lead to rising deficits. There will be some cutbacks to entitlements, such as raising the retirement age for Social Security from 67 to 69 just as Ronald Reagan compromised with Congress to increase it from 65 to 67. The Medicare cutoff point could also be increased by two or more years. These will reduce government expenditures, but if you have studied Rubio's speeches you will see that his Tea Party credentials are misleading. He will likely be happy to run large deficits as long as government spending fits Republican priorities rather than Democratic ones. His theme will be one of compassionate conservatism, especially since he will keep an eye on being re-elected in 2020. With a combination of less tax revenue and limited reductions in government spending, deficits will end up increasing almost as much as they would have done with a Democratic President. If we are in a recession and it becomes severe, then Republicans won't want to be seen as being indifferent to middle class suffering. Thus, the overall impact on the U.S. dollar and interest rates will be surprisingly similar with either a Democratic or a Republican victory.

The primary difference will be in corporate regulation. If Hillary Clinton wins, then there will likely be much more regulation than if Rubio is the next President. Climate change is a popular platform in many Democratic circles, but is mostly disregarded by Republicans. Commodity-producing industries, especially mining, are likely to be treated much more favorably if Republicans prevail in the next election. In contrast, health-care stocks, which have been all the rage in recent years, are likely to fear potential changes to Obamacare and likely perform poorly if the possibility of a Republican victory improves at any time prior to the election--even if it is many months before the event itself.

Because of a falling dollar and rising interest rates, sectors which usually benefit from a strong greenback and falling rates will tend to be hard hit no matter who is elected President. This would include high-dividend shares including utilities, REITs, telecommunications stocks, and tobacco shares. Companies which do a lot of exporting will be helped by the falling U.S. dollar, while major importers will do less well than expected. Securities which benefit from rising nominal interest rates will be among the few winners and will thus receive a lot of money from asset reallocations, thereby making them especially likely to outperform since they will stand out starkly from almost everything else which is losing value. If inflation is increasing faster than interest rates then real yields will become increasingly negative, which will be especially supportive for commodities and the shares of their producers.

If the Republicans control the Presidency and both houses of Congress, then this will pave the way to a potential flood of new legislation. While this could favor some industries, the initial response by many investors will be fear of the unknown after several years of effective gridlock. If U.S. assets are already in a bear market by November 2016, which is highly likely, then such a bear market is likely to accelerate dramatically after the election. There might be an initial euphoric response to either candidate's victory, but perhaps around the time of the Presidential inauguration on January 20, 2017 or shortly thereafter, any bear market could enter an especially intense worsening. Following President Obama's election to his first term on November 4, 2008, there was a sharp drop for U.S. equity indices which continued for nearly a half year. It is likely that we will have similar behavior following the next election. The anticipation of any election contest creates a sort of anticipatory excitement and tends to delay the final stage of any bear market. Therefore, I think it would be a good idea to sell most U.S. assets now, when the mood is still optimistic about the future, rather than as the reality of a new administration becomes increasingly imminent and investors begin to focus on specific policy and thorny issues which will be challenging to politically resolve no matter who is in charge.

One interesting wildcard will be what happens with U.S. real estate during the next several years. Policies such as zero down payments (or 3% down where the 3% can be borrowed, as Fannie Mae and Freddie Mac implemented in early February 2015), interest-only mortgages, and similar policies which were assailed and temporarily restricted following the last U.S. housing slump are now back in full force, having received limited opposition from either political party. The problem with allowing almost anyone to buy a house is that it temporarily increases demand relative to supply, thereby increasing prices just long enough to encourage new buyers prior to the next recession when valuations will plummet more sharply from having become artificially inflated. Credit standards are moderately higher than they had been a decade ago, but there are more investment funds which have bought real estate in recent years--thus offsetting the reduced demand from the least creditworthy individual buyers. The problem with investment buying is that higher interest rates will cause the net yields from real estate to appear increasingly unattractive, which could encourage some of these funds to become net sellers rather than net buyers. Higher mortgage rates will likely also discourage some buyers from participating because their monthly payments will be unaffordable at current price levels. Regardless of who is elected as the next U.S. President, the dangerously relaxed lending standards of Fannie Mae and Freddie Mac are likely setting the stage for a repeat of the U.S. real-estate debacle of 2006-2011. We will probably once again experience declines averaging 34% which had been the nationwide average loss during the previous bear market. As in 2006-2011, some parts of the United States in 2015-2020 will suffer losses of 60%, although the regions which experience such outsized losses won't likely be the same ones as last time. San Francisco and other especially overvalued cities in the United States are probably most vulnerable to losing half or more of their value. Because this topic is so complicated, I will discuss it in more detail in my next posting.

Tax tip: If you own shares or funds which are trading near six-year bottoms and you are a U.S. resident, you can take advantage of their currently depressed prices if these assets are in your 401(k), 403(b), SEP-IRA, Keogh, traditional IRA, or other non-Roth retirement account. You can convert these shares from your account to a Roth IRA and pay taxes based upon their present low valuations. As these eventually rebound, all future gains will be completely tax free. In the event that these shares don't recover but end up retreating further in price, you can choose to undo your conversion, which is known as a recharacterization. You can then wait at least 30 days, or until the following calendar year--whichever is later--and then convert them again. There is no limit to how many times you can repeat this process and there are no income or other restrictions in making such conversions and recharacterizations, as long as each recharacterization is done on or before October 15 of the year following the date when the conversion had been done. It's like being able to go back in time and "unbuy" something which doesn't go up in price. It's heads you win, and tails you also win. Unfortunately, I do not know of an equivalent strategy which is permitted in any other country.

Disclosure: In August-September 2013, and at various points during 2014 through March 2015, I had been buying the shares of emerging-market country funds whenever they had appeared to be most undervalued. Since June 2013, I have added periodically to funds of mining shares--and more recently energy shares--especially following their most extended pullbacks. I have also been accumulating HDGE which is an actively managed fund that sells short various U.S. equities, because I believe that U.S. assets of almost all kinds have become dangerously overvalued. From my largest to my smallest position, I currently own GDXJ, KOL, XME, HDGE, GDX, SIL, COPX, REMX, EWZ, RSX, IDX, GXG, ECH, GLDX, URA, FCG, VGPMX, BGEIX, VNM, ZJG (Toronto), NGE, PLTM, EPU, TUR, SILJ, SOIL, EPHE, and THD. In the late spring of 2014, I sold all of my SCIF which had briefly become my fourth-largest holding, because euphoria over the Indian election was irrationally overdone and this fund had more than doubled. I have reduced my total cash position since June 2013 to less than 4% of my total liquid net worth in order to increase my holdings in the above assets. I sold all of my SLX by acting whenever steel insiders were doing likewise. I also sold all of my FCG but I repurchased it following its recent collapse. I expect the S&P 500 to eventually lose about two thirds of its recent peak value--with most of that decline occurring in 2016-2017. The Russell 2000 Index (IWM) has only modestly surpassed its high from the first week of March 2014, while the Russell Microcap Index (IWC) barely surpassed its zenith from March 6, 2014. The S&P 500 Index set a new all-time high on numerous occasions during the same period. This marks a classic negative divergence which previously occurred in years including 1928-1929, 1972-1973, and 2007. Those who have "forgotten" or never learned the lessons of previous bear markets are doomed to repeat their mistakes.