This commentary was originally sent to Action Alerts PLUS subscribers at 05:30 on Nov. 4.
After enduring eight consecutive days of declines, the S&P 500 is limping through the end of a brutal earnings season plagued with uncertainties and risks, the greatest of which is the outcome of Tuesday's election. Before we dig into the optics and offer recommendations, let's have an honest conversation about cash.
Cash is the most overlooked position in our portfolio, despite the fact that cash represents our largest investment by a country mile -- four times the size of our largest equity position. We intermittently discuss the role our cash balance plays in serving as a strategic hedge (limited options given long-only equity portfolio) as well as our most powerful currency within our artillery to counter the myriad risks facing the market.
The decision to hold cash is not an idle one; rather it is conscious and excruciating. As investors, we are wired to screen, evaluate and identify new opportunities. We approach each day with a level of optimism in our search to identify a company that is trading at a discount to our internal fair value estimates (a fancy word for "price target"). We are constantly screening new ideas, sometimes overwhelmed by the impetus to bite when opportunity appears to strike. We constantly resist this force -- hence our decision over the past several months to ring the register and book profits on the likes of great companies like Thermo Fisher (TMO) , PayPal (PYPL) , Kraft Heinz (KHC) , Lockheed Martin (LMT) , Procter & Gamble (PG) and White Wave (WWAV) . Each of these sales resulted in a sizeable gain for our members. Shares of each have traded sharply lower since our sale with the exception of PayPal and WhiteWave (both of which are essentially flat).
Separately, our decision to avoid digging our heels in specific investments is equally critical. Watching Costco (COST) come down and resisting touching it, along with Occidental (OXY) , the latter of which we are actively considering exiting considering the entire story was slashed in one fell swoop of an announcement.
The inherent structure of the trust portfolio -- which carries many restrictions -- prevents us from operating like a hedge fund, constantly taking profits and rotating in and out of positions rapidly and consistently. Instead, we take a long-view and evaluate the market from a macro-level and work our way down to secular, industry, sector, sub-sector, and stock-specific. We make mistakes along the way, but do our best to make the best decisions we can make given the information we have on hand.
Our fourth quarter outlook, published precisely one month ago, vocalized our concern that 4Q'16 and FY2017 "consensus estimates for the majority of companies in the S&P 500 are too high and must come down", a prediction which has so far proved true across the majority of industries. Additionally, we stand behind our recommendation: "Faced with limited options, we recommend investing selectively and with discipline, practicing prudence amid greed when it comes to sizable gains on specific investments. Stocks may be the best house in a miserable neighborhood, yet the three months into year-end are long on expectations, events and enthusiasm and short on visibility."
One way we manage our investments and cash position is by first evaluating and identifying key risks facing the market. This summer, after extensive filtering, we laid out six specific risk factors in order of priority, a fluid experiment which helped us and ideally our members make sense of what drives the market.
Although the order of priority is constantly changing, the six factors -- Political Uncertainty, Commodity Volatility, Central Bank Policy, Currency Volatility, Global Economic Slowdown, and Rising Equity Valuations -- remain unchanged (although we are tempted to add upward inflation risk as a contrarian, underappreciated risk). The overt risk factor staring us all in the face centers around the results and impact of election day Tuesday. After the outcome became all but defined on the heels of the third and final debate, the resulting comfort proved transitory one week ago to the day as last Friday's bombshell, that the leading candidate running for president of the world's most important country was suddenly on trial, after the FBI decided to reopen its investigation of Hillary Clinton's e-mail.
Here's where we stand: the combination of the inability of people to fathom a Trump victory or a contested election when it seemed like a done deal 10 days ago is beyond the scope of possibilities for most investors, especially when the Fed is seemingly on rate hike auto pilot. The consequences of Tuesday's results are undoubtedly profound, and are likely to set off a chain reaction as it relates to the major decisions set to take place next year. Staying domestic, we have the Federal Reserve rate hike, fate of Janet Yellen, Supreme Court nominations, and cabinet appointments with the Treasury Secretary being the most critical for the financial markets. Before panicking or allowing the election to feed anxiety, we suggest taking a deep breath and trust that we will continue to guide you through the turbulence while keeping every new piece of information in perspective.
As an important side-note, we strongly recommend members avoid any temptation to trade around political events. Empirical evidence suggests you are more likely to make money on a coin flip than any attempt to trade around electoral uncertainty.
We are investors, not traders, which naturally shifts our focus towards outcome preparation over outcome prediction. As such, we have evaluated the impact of potential market-augmenting scenarios in order to help deconstruct several potential outcomes. In the following paragraphs we lay out the most prevalent scenarios, starting with the highest level of market shock to the lowest.
First up is a Trump victory. Many have attempted to equate this to a "Brexit"-like surprise, where polling failed to capture the highly emotional populist and nationalist component that resonates with individuals who harbor a protectionist attitude. Borrowing from Five Thirty Eight's updated election forecast (the most accurate we have found, using polls, economic metrics and historical data), the odds of a Trump presidency have more than doubled from less than 15% after the third debate in October to 34% as of Thursday night (image below).
Source: Five Thirty
Using the market's reaction to Brexit as a (soft) proxy, the "Leave" decision roiled global markets, wiping $2 trillion off the books within hours of the decision. Investors who blew out in panic were left hung to dry as the markets made up for the 7% sell-off within a week's time. Whether or not the extended rally was deserved remains unknown, but the takeaway is clear: long-term investors hummed their way through the carnage while short-term traders got burned. The instinctual tendency to revert to fleeting panic will always be present amid uncertainty and collective mania, yet bargain hunters emerge whenever they smell blood in the water, as the post-Brexit market rally proved quite poignantly. A Trump victory carries vast unknowns. The first cabinet appointments, such as Treasury, will be key. Separately, whether they acknowledge it or now, the resulting market volatility may persuade the Fed to hold off on raising interest rates in December, although Wednesday's minutes suggest otherwise. The one major benefit we can confidently pinpoint from a Trump victory would involve sweeping corporate tax reform and repatriation of offshore cash, topics that are quite market-friendly.
Second Scenario: Democratic sweep. Currently, betting odds place a roughly 10% chance that the democrats will take control of the house. If that were to occur, we would expect financials to sell off, biotechs to continue getting slammed given no protection between ferocious price control measures and the entire Democratic party. Attacking the biotechs is easy political currency, while a continued blunt force attack at financials would be uninhibited under the control of Senator Elizabeth Warren.
Third, a divided government, where Clinton wins, the Democrats take the Senate and the Republicans hold on to the House. This is the most likely outcome according to most polling data, yet this outcome carries its own list of questions. First, as with Trump, Clinton's choice of Treasury Secretary will be key as it will serve as a key indication of where she stands in terms of financial regulation and oversight (her ties to the banks are well-known yet pressure to move to the Warren extremism would be significant).
In a separate piece we will examine consequential decisions being made outside of the U.S., with a garden variety of other critical elections and/or referendums -- starting with Italy's Constitutional Referendum, France, German and Iranian Presidential Elections and China's leadership transition.
Irrespective of the outcome, we will continue to remain vigilant yet disciplined, prudent yet not afraid to pick away at opportunities when they present themselves. We will continue to stay honest, transparent and thoughtful throughout, and hope our guidance can help remove the burden of uncertainty off of your back and onto ours. It is our job to inform as well as perform the rigorous analysis and making what may appear to be complex concepts easier to understand. As a club, we promise to always tell it to you straight and do our best to alleviate any election-related anxiety and induced uncertainty.
For now, we continue to screen the portfolio on a politically-neutral basis to identify future opportunities. Amid a litany of risks, we are here for each and every one of our members. We remain committed to maintaining our historically high cash balance for the time being yet will not be afraid to pull upon the dry powder if shares of specific companies hit our stated levels.