Immediately following President Trump’s surprise election victory, a cross-section of stocks that were seen as beneficiaries of many elements of his economic policies had strong rallies. Features of the agenda such as the rollback of regulations, tax rate cuts, capex write offs, infrastructure tariffs, foreign cash repatriations, etc., would likely be a big positive for these sectors: Financials, industrials, materials, energy, and consumer discretionary goods, industry groups that had all outperformed the S&P 500 between election day and the inauguration.
But before long, impatience and doubt about the plan ever being enacted began to set in. Many investors have become skeptical that the administration’s agenda will ever materialize. Just recently, for example, a major construction company was downgraded by a prominent analyst with the observation that “she has no idea whether Trump’s infrastructure plans will ever be enacted”.
Reflecting this same sentiment, the value of the major global steel ETF (SLX), which had seen large gains in the months following the election, fell almost completely back from its February peak and has subsequently recovered less than two-thirds of what it gave up. New Chinese supply regulations have now brought back some gains from the international sector, but concrete plans for possible American tariffs on steel are still thought to be in doubt.
To be sure, media coverage of the “distractions” that have plagued the administration and the inability, thus far, of congress to move forward on healthcare reform and tax cuts have been real issues. But given Republican control of both the White House and Congress, the odds of the pro-growth agenda NEVER becoming reality are pretty low. Indeed, if most elements of the Trump stimulus plan ultimately do materialize, and these affected securities perform substantially better over the next few years, then arguably the current skepticism toward the so-called Trump Trade names could turn out to have been a whopping episode of what the behavioral finance folks call Status Quo Bias (SQB).
Our mission at McAlinden Research Partners (“MRP”) is to identify change-driven, alpha-generating investment themes early in their unfolding. Very often, transformational change is greeted by investors with SQB, which is why our themes often appear contrarian.
Change-driven thematic investing captures alpha opportunities that arise from sudden shifts, discontinuities, and other disruptions to the status quo that usher in new market themes. Disruptive change can be caused by: technological innovations, business-cycle turning points, government regulations, elections, new business models and natural events. These changes can arise gradually until tipping points are reached, or suddenly when gales of Schumpeterian creative destruction rip through economies.
When the equilibrium is shifted, assumptions that are embedded in security market prices are disrupted, but not instantaneously. Status quo bias thus creates alpha opportunities when markets adjust only incrementally to sudden disruptive change.
It is not just investors that are prone to SQB, it is a human tendency to prefer not to respond quickly to make changes or even to recognize the transformative nature of changes to the existing state of affairs. Experts of all kinds are no exception to this behavior. The bias is observable over the course of recorded human experience, during which many events have caused tremendous disruptions, even though the consensus of experts did not tend to readily recognize the consequences.
Consider the fate of Galileo Galilei, the Italian astronomer who publicly stated in 1632 that “the Earth is not the center of the universe but instead moves around the Sun.” Galileo was subsequently convicted of heresy and compelled to admit under tremendous threat that his findings were wrong.
In a similar example of the human tendency toward status quo bias, in 1846 a Hungarian physician named Ignaz Semmelweis observed that when doctors washed their hands before delivering babies, the mortality rate of mother and child dropped precipitously. So, he logically ordered all operating room personnel to wash their hands before every procedure. Unfortunately, his observation conflicted with established medical thinking, so he was fired. Semmelweis’ contribution to saving many lives was not recognized by his peers until they were eventually forced, through experience, to accept the fundamental veracity of his argument, and adopt it as their own.
As these selected examples illustrate, major disruptions can be faced with great skepticism, if not outright rejection at first. In the 19th century, German philosopher Arthur Schopenhauer came up with this description: “All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident.” MRP is not unfamiliar with this SQB in relation to our thematic ideas, which are often greeted with skepticism on their way to broad acceptance over time. Sometimes the market responds quickly to disruptive changes, but often it does not, reflecting status quo bias. We believe the Trumponomics trades are a case in point.
Related MRP Themes:
Trump’s plans to reform the tax code and rebuild the nation’s infrastructure will have profound implications for several very specific industry groups in the United States. When combined with other features of the Trump plan, the broad sector of capital spending-sensitive issues could be poised for several years of outperformance. The Trump administration has recently been conducting an investigation into US steel imports under section 232 of the 1962 Trade Act. While the investigation has temporarily been put on the backburner, the report must conclude within 270 days, and its findings could be the first step toward such capital spending increases. These plans – from building the wall with Mexico (which earlier this month had $1.6 billion allocated to it in the House’s DHS funding bill), to imposing tariffs on imported goods (like steel), to the infrastructure rebuilding program, and the proposed tax cuts on individuals and corporations, plus the plan to repatriate billions of corporate dollars held overseas – suggest there will be substantial increases in demand for industrial materials and machinery.
The environment over the next several years should also be particularly good for the fundamentals of the financial services industry – in particular, banks. The Trump administration’s moves to roll back onerous regulations imposed over the past decade would be an obvious positive. In June, top regulators and GOP legislators began the process of easing such constraints as the U.S. House of Representatives passed the Financial CHOICE Act which, if enacted, would begin the process of dismantling the 2010 Dodd-Frank Act. These changes should benefit the entire financial services sector, particularly smaller and regional banks that will experience a substantial reduction in compliance costs. If the new administration is successful in accelerating the US GDP growth rate, that should be reflected as well in an acceleration in loan demand. So, fewer regulations, better spreads from a steepening yield curve, and stronger volume growth would add up to a greatly improved environment for banks and financial services in general.
MRP remains very positive on the energy sector overall. Based upon our contrarian expectations of oil shortages developing in the near-term, we don’t expect Trump policies to materially alter the supply/demand picture, with one exception: if the Trump GDP growth goals of 3-4% come anywhere close, the demand acceleration for energy in the US will be considerable. The U.S. is still the world’s top oil consumer, so revved up economic growth will mean big gains in energy consumption in the wake of slowing production: despite all the headlines about U.S. fracking flooding the market with crude, BP’s Statistical Review of World Energy showed earlier this month that 2016 saw global oil production rise by only 0.5%, the lowest percentage increase since 2009. In the short-to-intermediate term, even though U.S. production seems to have rebounded, the OPEC cutbacks will help constrain global supply. Already, US crude inventories have plunged by over 44 million barrels over the past 12 weeks! Our expectation is still that crude prices will rise to $60-$80 per barrel.