From Top Down to Bottoms Up
A sea change is under way in the stock market, which I believe is about to perform quite differently over the next few years than it has in the recent past. First, stock prices are at record highs, despite three years of declining corporate profitability. Second, the Federal Reserve is committed to raising interest rates after nearly a decade of keeping them artificially low. And third, President Trump will govern in a manner that is completely unpredictable.
With so much sand shifting beneath our feet, a conventional approach to portfolio management will only produce random results. The top-down method of choosing stocks worked well under President Obama because central bankers’ policies to stave off global disinflation drove the markets. That left a trail of bread crumbs for investors to follow as the flow of money had an impact on currencies and commodities. So you could build an investment strategy around how you thought specific regions and sectors might succeed.
That’s no longer the case. Every country now needs to be viewed through the prism of the Trump administration. Instead of thinking of Asia or Europe as regional blocks, we should stop and consider how each Asian or European country will fare based on how much its interests align with those of our new leader.
The same holds true for industries, such as car manufacturing. Companies like Ford and GM may experience vastly divergent outcomes under Trump, depending on how well he believes each company complies with his policy of putting nationalism before profits. We have already seen the effect favoritism can have. On Jan. 4, Ford announced it was cancelling plans to build a new plant in Mexico after Trump threatened a stiff border tax on any vehicles made there. That day, Ford’s shares closed 8% above where they opened the day before.
Then, despite a solid earnings report that came out the next day, the stock gave all those gains back and then some over the following weeks because Ford publicly disagreed with Trump over the number of U.S. jobs that changes in fuel efficiency standards and environmental policy would affect. For investors, the juxtaposition of these two events could not be more telling: If Trump doesn’t like what your company has to say, good operating results won’t matter much.
That’s a scary thought, because historically operating results have been the backbone of stock market analysis. But what good are past results if a company’s future performance depends more on the whims of a president whose actions are difficult to anticipate? Instead of pouring through data from Standard & Poor’s to find undervalued companies, we’re now reduced to parsing a jumble of tweets to divine future White House policy.
Several years ago, I wrote that we had entered a two-tier stock market, with roughly the same number of winners and losers that would produce little net gain overall. My prediction proved correct, but now I believe we have transitioned into a trader’s market, one in which almost every stock can go from being a winner to a loser (or vice versa) with little warning.
Investors who can’t tolerate volatility have two choices. They can either exit the market entirely or adopt an investment strategy that capitalizes on the opportunities that constant chaos creates. This means choosing stocks from the bottom up, with little regard to sector allocation. Forget about starting out with a global economic thesis that logically progresses from regions to sectors to companies. Instead, look at a specific set of circumstances and identify the businesses that are most prepared to capitalize from those conditions.
In the current issue of Personal Finance I describe how I will manage the publication’s Growth Portfolio this way, and then later in the issue I introduce a company that stands to gain from how I believe Trump’s highest policy initiative will play out.