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A Market Pragmatist's Reaction to the Election

 November 13, 2012 01:10 PM


(By R. Scott Raynovich) The U.S. Election presidential election is over. Capping off one of the more partisan election seasons in memory, that means surly neighbors around the country now can exchange retorts of "I told you sos" and "go away." The simmering, partisan feuds in my own extended family have already upped the ante for potential holiday-season disaster.

Media pundits have jumped all over last week's selling, explaining it as some kind of Obama protest vote or a mini nervous breakdown about the "fiscal cliff." That's silly. First off, the sell-off was triggered by bad German economic numbers, not the U.S. election (the market actually intially rallied on an Obama victory, then sold off in the early morning hours after German industrial production numbers were released).

[Related -Initial Jobless Claims Rose Unexpectedly]

Secondly, if you view the election empirically, an Obama victory would be bullish, as the data is unambiguous that "the market" favors Democratic presidents. Democrat presidents have precided over better returns than Republican candidates -- by a margin 38% to 8% in inflation-adjusted returns, according to historical research (see "The U.S. Presidency and the Stock Market: A political relationshiyps study of the market performance," written by Ray Valadez and Marshall Nickles.").

So, that data clearly dispels some myth still held by media pundits that somehow a Republican victory would boost the market. Blaming Obama for a randomized set of market losses in four days of the year has few statitistical legs to stand on.

[Related -All Quiet on the Record High Front]

If you are a bear looking for data to support your thesis, the presidential cycle theory paints an uglier picture. Markets tend to perform poorly in the first two years of a new presidential term and better in the last two years. We just capped two year of excellent returns -- in the better half of the election cycle. The presidential election cycle theory was popularized by Stock Trader's Almanac author Jeffrey Hirsch.

The idea is this: During the 3rd and 4th year of a Presidential term, the market is likely to perform better as the incumbent introduces policies designed to stimulate the economy just in time for the election season. Note that this theory tends to work regardless of who is in power.

But focusing on these somewhat short-term data points also ignores the larger forces at work with the economy: The global deleveraging cycle. This is something that won't be solved overnight by the politicians in Washington D.C. or Brussels, but at least the early indications are that it's going okay -- at least in the United States it's not nearly the disaster that some paint it to be.

The sad loss of this past election season was that these issues were not adequately explained to the general public. The debate was framed over classical economics in the context of just another cyclical downturn: Should the respnonse be Keynesian or supply side? This is no ordinary cyclical ecomomy: It's a 50-year global credit deleveraging cycle.

Historically these have taken decades to resolve. If you're wondering why the boom years of the 1980s and 1990s felt so good compared to today's World is Flat days, the answer lies in the credit deleveraging cycle. We're now paying the price of decades of credit build-up -- and then collapse.

Look at the chart below, and you can see what credit de-leveraging -- the removal of private credit from the system -- means for the American consumer. The era of borrowing and spending is over. People are now saving and cutting back -- and have been for years. 

(img:/assets/12/1112/0918)

I suppose saying this during a nationally televised Presidential election is wonkish and would not be fully understood by the Mom & Pop. "Sorry, folks, but we are deleveraging the largest shadow banking credit bubble in history -- you're going to have to wait five more years."

People don't want to wait. They want stuff now. That's our problem in a nutshell. 

The good news? According to Ray Dalio, one of the world's best hedge-fund managers, he thinks the United States is doing a decent job of deleveraging while Europe is doing miserably. This is Dalio's "Beautiful Deleverging," a combination of monetary stimulus and active reduction in bank balance sheets. You can read an interesting interview with Dalio on the topic here in Barron's. If that's not enough, he's written an entire paper detailing the "Economic Machine," and explaining how the current downturn is no ordinary cyclical downturn, but part of a a once-in-a-generation 50-year credit deleveraging.

Looking at deleveraging in the political context, private debt has been slowly reduced, but much of it has been transferred to sovereign balance sheets in order to "save" the financial system. This is what brings us our heated political debates. That can be seen in the next chart, where the public debt inflates to "fill in the hole" to meet the evaporation of private debt.

(img:/assets/12/1112/0925)

We are at an interesting juncture there, as those lines above are close to meeting. There is no doubt that the explosion of sovereign balance sheets poses great risks, but the questions isn't if we need to reduce the sovereign budgets and balance sheets, it's when. Moderates such as Dalio and Jeremy Grantham argue that you need to approach the sovereign de-leveraging slowly -- while the private credit de-leveraging takes place. If you don't cushion the collapse in private sector debt with some sort of public offset -- either monetary or fiscal -- the economy would have completely collapsed. So far, the healing of the markets over the last four years has proven them right. But we're not out of the woods yet.

Yes, now that we've deleveraged banks we need to start thinking about deleveraging the government, but it's a delicate balance that can easy be thrown off track. Yes, they'll need to fix the budgets, but be careful -- global deleveraging cycles do not respond well to sharp right turns -- just check with Herbert Hoover. A slow, bit-by-bit approach without any radical right or left turns makes the most sense.

In Dalio's model, you cut budgets slowly and if you raise taxes -- you raise them slowly. Meaning, you don't do what Europe did: Full-bore austerity. Meanwhile, the Fed, fully aware of the problem, is undertaking the largest monetary relation in history, attempting to push up assets with its ever-powerful printing press. This process will continue, until there is sufficient inflationary pressures in the in the system to force banks to lend again. This is why owning some gold as protection is not a bad idea. It's good insurance. It's also a reason why gold has been in one of the strongest bull markets in history.

As for the stock markets? Our markets have accurately reflected the credit-cycle deleveraging. Price/earnings ratios have been compressing for a decade. This has produced 12 years of mediocre returns to compensate for the great bull run of the 1980s and 1990s.

Is it possible we can explain this action with plain-old reversion to the mean? Yes, it is. Credit acceleration fueled economic growth and consumption for many decades. Deleveraging produces retrenchment for a typical 15 years or more. It's that simple. Democrat or Republican Presidents be damned, you can't fight the 50-year credit deleveraging. You have to embrace it.

Be patient, because we are nearing the end of one of the worst market periods in history. Develeraging will take another five years. In the meantime, as Apple Inc. has shown us, you can still find winners if you pay attention to stocks that are priced cheaply relative to their growth rate.

The recent selloff seems a bit overdone to me. With the Fed still putting its foot to the floor, you should still buy cheap stocks in this dip. Yes, by the end of this deleveraging cycle P/Es will be more compressed than ever in history. But with a disciplined approach to value stock selection, that means you are being afforded to buy stocks more cheaply than ever before, regardless of who is president.

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