Wednesday, October 24, 2012

Why The Market (And Other Financial Assets) Should Be Shorted If Romney Wins.

Since 2008, medium term Investors in public shares have emphasized large cap, dividend paying stocks and have benefitted from a search for yield by fixed income investors unable to capture sufficient income with a bond strategy. Gains in the Equity markets alone are enough to have made one take a break from the market but there are other reasons as well.

The S and P 500 is trading at historic highs of 19 times current earnings and 17 times leading twelve month earnings. 

A Romney Administration would have a highly negative impact on Equity and debt prices for the following reasons.

The Equity markets and investors seem uniformly complacent--certainly I was; and valuations seem high. The market has run, short interest is small; dividend stocks seems to have been picked over by an increasing large crowd of income scavengers; and the likelihood of a Romney win suggests that he means what he says and will impose highly contractionary monetary and fiscal policies. This would hurt all financial assets before any benefit (which could be small) is gained. And a newly conservative Federal Reserve, if Bernake is fired, could also make the ECB even more risk adverse and result in more social unrest.  

A Romney administration could (indeed is likely) to aggressively address the debt and deficit issues with major moves which would likely result in worsening government balances and higher price growth:
  • encourage contractionary monetary policy as well as fiscal with reverse QE policies which would withdraw liquidity from the system while driving rates higher. 
  • With higher rates, debt markets will be under pressure especially at the far end of the yield curve; while equity multiples are likely to contract and the market along with other financial assets are likely to fall.
  • of almost equal importance, the cost of existing debt is likely to ballon from historic low rates putting further upward pressure on deficits. Contractionary fiscal policy will almost certainly not be able to keep pace.
  • Oddly housing purchases are likely to accelerate in the short term as home buyers seek to lock in attractive interest rates. This could be moderated by an elimination of favorable tax policies like mortgage interest deductibility. Over time, house prices are likely to fall again as mortgage money becomes more expensive.
  • Without support from accommodating monetary policy in the US, the ECB is likely to be even more cautious than it has been in support of the troubled southern European  economies. As noted in a Times article yesterday, fiscal austerity conditions are leading to higher rather than lower government balances as a % of GDP in a number of southern Euro Economies. With increased preference for liquidity by the ECB in 2013 and 2014, social unrest could intensify in societies which have made draconian fiscal bargains with the IMF and ECB.  
Well, you might argue that Romney won't change much once he enters the Oval Office, because he can't as the Senate will remain democratic, but he will be under pressure from the party core to make sharp turns in fiscal policy on his first day. 

Besides one can eliminate political risk by investing in safe stocks with high dividend yields. However, yields on dividend paying stocks have contracted sharply and there is no way dividend increases can match the appreciation of the dividend payer share prices without increasing payout ratios beyond secular trend levels. 
Equity mutual funds may already reflect the probability of a Romney win as they have seen net redemptions over the last eighteen months while the stock market continued to rise. I don’t think this is an aberration in any sense but rather beginning of a wave of dissaving--equity withdrawals by baby boomers entering their retirement years. The redemptions we are seeing could reflect a shift into fixed income assets as a way to protect capital, a move fraught with danger if inflation were to accelerate or interest rates were to increase sharply. As indeed they are very likely to do if Romney/Ryan form the next administration. 

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