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Written by: Nick Williams | AAM
If you were following the playbook from Donald Trump’s last victory in 2016, the markets’ post-election response has played out largely according to plan. The prospects for a pro-growth, pro-business platform that President-elect Trump centered his campaign around has once again unleashed the animal spirits pushing stock market indices to all-time highs. To be sure, the gains in 2024 were already well above average, with the S&P 500 gaining more than 20% ahead of the election. But a Trump win, along with a Republican sweep in Congress, clearly gave investors the spark they needed to further ignite the risk-on sentiment.
Highly regulated sectors have been standouts in recent weeks on the prospects for another era of deregulation. Finance and energy have been noteworthy beneficiaries with promises to ease the regulatory burden on banks, reinvigorate M&A (mergers and acquisitions), and clear the path for American energy companies to “drill baby drill!!!”
Just a month since the election, 10 of the 11 S&P GIC Sectors are higher, with the exception of healthcare (down 0.8%).
Here’s a quick look at the first 30 days post-election returns comparing 2016 and 2024.
Source: Strategas Research. Returns as of 12/4/24 | Past performance is not indicative of future results.
Given the similarities of this post-election bounce to that of 2016, many bulls are elated at the prospects for a repeat of Trump’s first year in office.
When looking ahead to the coming year, we are optimistic about the prospects for an equity market buoyed by a pro-growth, pro-business agenda. With the animal spirits reawakened, momentum strong, and earnings expected to grow double digits in 2025, a reinvigorated and extended bull run could certainly be in the cards.
However, we do believe a healthy dose of caution is warranted given some of the comparisons being drawn to Trump’s previous term.
2017 was a historic year. The S&P returned 21.6% — well above average — but the almost linear fashion in which it occurred was even more impressive.
In 2017 the S&P 500:
- Returned 21.6%, more than twice the historical average.
- Did not incur a single negative month on a total return basis.
- Did not incur a single peak-to-trough decline of 3% during the entire year.
- The VIX averaged 11.1 and never breached 20 the entire year.
A 21.6% return is certainly something to celebrate, but not unprecedented by any means. (We are currently up 27.86% in 2024 through November) However, an entire year without a pull-back of 3%, alongside a VIX that averaged 11.1 (with a peak in the mid-teens) is an entirely different feat. For a market observer with any level of experience, this level of calm is almost hard to fathom.
No Fear in the Fear Gauge
Heading into November, the VIX Index closed at 23.16 on 10/31/24, which is historically elevated above its long-term average. Often referred to as Wall Street’s Fear Gauge, an elevated VIX made sense with the market forced to grapple with a confluence of potential market moving events in a tight window. The election may have taken center stage, but it also coincided with 3rd quarter earnings season and a highly anticipated Fed meeting that followed just days later. As markets digested the headlines, the fear gauge let the air out and within weeks plunged some 40%+ to settle in the low teens.
A drop of this magnitude suggests that markets have become quite complacent, unbothered by the possibility of any meaningful downside risks. Bullish sentiment mixed with a shot of FOMO (fear of missing out) at the tail end of what is potentially the best election year in history. Derivative positioning also seems rather lopsided with a put call ratio currently less than 0.65.
This “extreme optimism” does not suggest that a major risk to the rally is imminent, but it does suggest that positioning is heavily tilted toward the upside, in our view.
Valuations & Mean Reversion
It’s also worth noting that it doesn’t necessarily take a catastrophic black swan event for equity markets to falter. A major escalation in global trade, an overleveraged carry trade, or a challenge to the U.S. dollar as the world’s reserve currency are real risks, however unlikely. This brand of catastrophic tail risk is omnipresent, but we believe so unlikely (and sometimes short lived) that they warrant little concern for the average investor.
More often, it’s simply the obvious that gets in the way. Sometimes all it takes is gravity.
Valuations today are significantly elevated when compared to 2016-2017. At the start of 2017 when Trump took office, the forward P/E (price-to-earnings) ratio for the S&P was below average, starting the year around 17 times. Today, the S&P 500 trades at over 22 times forward earnings — a significant premium to its long-term average, and nearly 30% higher than when Trump first took office in his first term.
Past performance is not indicative of future results.
Granted, we’re in a good environment and we have the old playbook to study. The Fed has made tremendous progress on inflation, unemployment is low, interest rates are coming down, and earnings are expected to grow at a healthy double-digit clip next year. But will that be enough to satisfy a market that’s seemingly priced for a perpetual “beat and raise” earnings cycle? The market can grow into these valuations with strong earnings growth, but it's a pretty high bar and it might take some time. It is entirely plausible that we continue to see solid earnings growth amidst a strong economy, but also see a multiple that gravitates back toward historical norms. A simple mean reversion could be enough to constitute a bear market downturn, even with no major catalyst.
We highlight these risks not to sound bearish (we are not), but as a reminder that risk assets are appropriately named — they are inherently risky. Even good assets can sometimes have bad returns, particularly when prices are high. The investor that is overleveraged to a hopeful outcome tends to make poor decisions when the unexpected occurs. If the best time to buy the dip is during a bull market, you should probably be prepared for one.
We believe the best potential outcome for investors is achieved through thoughtful and deliberate portfolio construction centered around the expectation that volatility is a natural byproduct of risk assets. Those expecting a repeat of the linear rise in 2017 void of any correction are likely to be disappointed. Elevated valuations and extreme bullish positioning suggest any meaningful correction is prone to catch many participants off guard. If an innocent stretch of mean reversion is enough to cause panic, you might consider positioning a bit more defensively.
We expect a safe flight, but a bit of turbulence is not uncommon. Anyone boarding a plane should be prepared for the possibility of a bumpy ride, even en route to a safe landing.