What investors need to know about the Trump stock market rally
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Stock markets have been rallying since the surprise election win by Donald TrumpDonald John TrumpBiden campaign slams Facebook after thousands of ads blocked by platform's pre-election blackout Mnuchin says he learned of Pelosi's letter to him about stimulus talks 'in the press' Harris to travel to Texas Friday after polls show tie between Trump, Biden MORE.

What explains this? Conventional market wisdom was that the financial markets were both favoring and expecting a Hillary ClintonHillary Diane Rodham ClintonHarris to travel to Texas Friday after polls show tie between Trump, Biden Harris more often the target of online misinformation than Pence: report The Hill's Campaign Report: What the latest polling says about the presidential race | Supreme Court shoots down GOP attempt to block NC mail ballot extension MORE victory. Wall Street supported Clinton, largely on the basis that she was a known quantity and Trump was the most unpredictable candidate in history.

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Expectations were that a Trump victory would result in increased volatility and falling stock prices. But that expected sell-off was limited to the futures markets on the night before the election and the wee hours of the following morning.

Since that overnight dip, stocks markets have dramatically advanced. Volatility, as measured by the VIX Index, has declined. The market response to the election has been a bit like Alice in Wonderland, where up is down and down is up.

Investors should caution in putting too much credence in the short-term market response to Trump’s win.  The victory may have unleashed some animal spirits in the market, a kind of sugar rush to Mr. Market. The allure of an unknown Trump presidency is that it becomes a blank canvas upon which prognosticators and investors can paint their imaginings before reality sets in after January.

Investing in an imagined future, however, can be a dangerous game. One only has to look to history to get an idea that markets are often wrong in the short-term regarding the consequences of elections.

The worst market performance from election day to inauguration day followed President Obama’s election in 2008, when the S&P 500 fell by about 20 percent. The best market performance from election day to inauguration followed none other than Herbert Hoover’s triumph in 1928 when the S&P 500 rose by more than 13 percent.

The returns in Obama’s first administration were among the highest of all time, while the returns in Hoover’s four years were the worst. This is not to say that the Trump years will be poor for the equity markets. One should realize that if the next four years were a marathon, we would be at about the half-mile mark. We have a long way to go until we cross the finish line.

Investor have their eyes on Trump, but it would be wise to focus on a different target, specifically the Federal Reserve. The central bank is expected to announce an increase in interest rates after its meeting next week. Two or three rate hikes will likely follow this move in 2017, which would put interest rates around 0.75 percent to 1 percent higher by the end of next year.

In Invest With the Fed, my co-authors Gerald Jensen of Creighton University and Luis Garcia-Feijoo of Florida Atlantic University and I document the importance of the direction of interest rates on equity returns. From 1966 through 2013, the S&P 500 returned 15.2 percent when interest rates were falling and only 5.9 percent when rates were rising. Simply put, when rates are rising stocks perform much worse than when rates are falling. Low interest rates are the fuel that feeds the stock market fire.

This does not mean that investors should rush to the exits and get out of the stock market. It only means that investors should lower their return expectations while rates are rising.

The bond market is certainly not the place to flee. Many investors mistakenly believe that bonds are safe and stocks are risky. But in an extremely low interest rate environment, even small changes in market yields can lead to dramatic changes in bond values.

Bond investors have suffered losses as interest rates have sharply risen since the election. The normally staid government bond market has seen large losses. Consider that the holder of a 10-year Treasury note would have seen the value of that note fall by the equivalent of three year’s interest payments in only 10 days following the election.

One other factor working against the stock market in the short term is the Presidential election cycle. On average, returns in the last two years of a president’s term are higher than returns in the first two years. The late Barron’s writer, Alan Abelson, suggested that presidents are “keen on getting the ugly stuff out of the way early in their tenure so that they can act expansively the rest of the way.”

Markets are complex and becoming more complicated all the time. That is why financial advisors need professional education to help them understand these nuances and be better equipped to serve consumers. Only a strong commitment to high-quality, ongoing education will enable advisors to help investors think in the long-term way that leads to successful results in funding more secure retirements.

Put all of the factors outlined above together, and the near term does not look strong for the stock market. Having said that, investing is a long game and the prospects for the U.S. economy in the long run are tremendous.

After the Trump victory, none other than Warren Buffett, the Oracle of Omaha, said, “Long-term, the stock market is going to be higher. The stocks we were buying and selling the day before the election were the same stocks we were buying and selling the day after the election.”

Robert R. Johnson, PhD, CFA, CAIA, is president and CEO of The American College of Financial Services. He is co-author of Strategic Value Investing, Invest with the Fed, and Investment Banking for Dummies.


The views of Contributors are their own and are not the views of The Hill.