Recalibration

Much has been written about the market's surprising reaction to last week's even more surprising election results. Let's look at some of the interesting aspects of what happened in the markets and address some of the reasons why.

First, analysts got it wrong when it came to how markets would react following a Trump victory. The prevailing wisdom was that such an outcome would send stock prices into a tailspin. Not a crash, but definitely a bout of downside volatility as investors worked through the uncertainty of a Trump Administration. While this did happen overseas and in the futures markets during election night, by Wednesday morning the market opened flat and then began a surge that lasted most of the week. U.S. stocks ended the week up from 4-10%, depending on the index.

But this upside was uneven and certain sectors declined. Part of this could be attributed to the unwinding of hedges placed in the days and weeks leading up to the election. Markets had anticipated a Clinton victory but, just in case Trump won and the market went haywire, lots of investors hedged themselves going into Election Day, primarily by "shorting" areas of the market. As it became obvious the market was moving up instead of down, the "shorts" had to buy stock to close out their hedges. Whatever the reasons, ultimately there ended up being a massive recalibration after weeks of pricing in what ended up being faulty assumptions.

What had been the top performing sectors this year, such as Consumer Staples, Tech, and Utilities, quickly fared the worst. Other sectors, such as Healthcare, Energy, Materials, and Financials, had been declining into the election but swung back strongly. This was due to assumptions about potential Trump Administration proposals to "get rid of Obamacare", approve the Keystone Pipeline, massive infrastructure spending, and "repealing" the Dodd Frank financial overhaul legislation.

Price action in certain stocks, such as Corrections Corporation of America, a prison management company, was an example of this. The Obama Administration had decided this summer to phase out the use of "private prisons" following scandals, and the company's stock had plummeted on the news. But come Wednesday, investors assumed a Trump Administration could reverse this decision. The company's stock rose by more than 48% on the day. There were many of these one-off stock surges.

Bonds, on the other hand, fared poorly. Depending on the type, bonds were down for the week from less than 1% to as much as 7%. Ironically, this was due to many of the same Trump Administration policy assumptions that sent stocks soaring, namely infrastructure spending and tax cuts. Both are thought to add to economic growth but also to increase inflation, which hurts bond prices. The 10-year Treasury yield, a key benchmark that impacts the prices of mortgages, for example, shot up from about 1.8% to 2.2%. That might not sound like a lot, but it's a big move in the bond world.

While stock and bond markets are constantly trying to accurately price forward-looking assumptions, it's unnerving when the assumptions change so quickly. As you can imagine, a lot of analysis goes into assumptions that drive many consequential decisions.

In a conference call following the election, Morningstar, the respected research company, suggested it was too early to make wholesale changes to assumptions, but ran through a list of individual companies they were updating. An example was Western Union. The company makes a lot of money from processing remittances from the U.S. to Mexico. Analysts have to evaluate, for example, the likelihood that Trump Administration policies could restrict remittances, limiting the company's ability to generate profits. This adds risk to their outlook and, at least in theory, should cause the company's stock price to fall by an amount corresponding to the risk.

This kind of analysis will be taking place all over the world in coming weeks. Ultimately, there needs to be a "risk premium" attached to the uncertainty around potential Trump Administration policies. So far at least, the market views the risk as being mitigated by the possibility of lower taxes and higher government spending, which can be positive for stocks.

Another interesting aspect of the market response last week was how individual investors suddenly became more bullish. Read below for an excerpt from a recent Bespoke Investment Group paper:

Did Donald Trump just do what record highs in the S&P 500 couldn't?  For several months now, consumer and investment sentiment has been anchored by the uncertainty regarding the election and especially over the possibility of what a Trump Presidency would mean for the markets and, more importantly, the economy.  One of the best examples of this is the weekly sentiment poll from the American Association of Individual Investors (AAII).

Even though the S&P 500 has essentially been at or near all-time highs for much of 2016, bullish sentiment on the part of individual investors has been stuck below 40% for a record 54 straight weeks and 88 of the last 89 weeks.

This week, AAII's bullish sentiment reading still came in below 40%, but it has come closer to that level than any other point in the last year.  According to this week's survey, bullish sentiment  surged from 23.64% up to 38.89%, representing the largest one-week increase since July 2010. That's six years!

To be fair, AAII's weekly poll is conducted from Thursday through Wednesday, so the bulk of this week's responses were more than likely tabulated prior to the election, and even prior to the Comey letter saying that nothing had changed in the FBI's decision not to recommend indicting Clinton. That being said, in a year where the so-called establishment has been proven to be so disconnected with the views and opinions of the overall population, it is only fitting that a survey of bullish sentiment among individual investors surged the most in six years at the same time as the biggest US political upset in at least a generation, if not history.  It will be really interesting to see where this reading stands next week.

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