Take a step back, Part 2 -- MMM v5-46

Watching the stock market Wednesday through Friday last week, my brain couldn't help but keep singing this song.

I'm all for the stock market rocketing to all-time highs. Higher stock prices means higher account values for our clients. For most of the year we've been presenting what the DATA says about the impact one president, one Congress, or one party has had on the economy LONG-TERM. For those of you who didn't take the time to tune in, the short version is this:

It is very difficult for one president, one Congress, or one party to change the trajectory of our economy.

Here is the full presentation:

One of the biggest fears on Wall Street was the election wouldn't be decided for days, weeks, or months. With the overwhelming victory by Donald Trump and the Republican sweep of Congress that is no longer the case and all those pent-up worries went away. There is seemingly no risk in the market now. I've been bombarded by webinar invitations to hear what the 'experts' believe the next 2-4 years will look like now that we "know" what we have. I wouldn't waste your time on those because anybody who believes we have major, only positive changes ahead is naïve and has a very short-term memory.

Remember, we had 3 pre-COVID years of Donald Trump – the first 2 with a Republican controlled Congress. We only saw TWO quarters where the 12-month growth rate was above the 3% long-term average – the same as the post-COVID Biden years. Pre-COVID Trump and post-COVID Biden saw identical average GDP growth rates of 2.8%.

Donald Trump made at least 25 important campaign promises. I'll say the same thing I said in 2016:

The issues Donald Trump is promising to address are CRITICAL for the LONG-TERM growth of our economy. However, the SOLUTIONS will cause shorter-term slowdowns in economic growth and are highly INFLATIONARY.

Please keep that in mind before you start to believe "Everything is Awesome" for the stock market.

Let's take a brief look at some of his most popular promises:

1. Tariffs
   1. Yes we need to address our trade deficit – it is draining our growth
   2. Tariffs are a tax on AMERICANS, not foreign companies. Either the American importer takes a hit to their profit margins, or they raise prices and the American consumer pays the tariff.
   3. Tariff revenues WILL NOT be enough to cover all the other promises President Trump has made (everything from ending income taxes, saving social security, and sparking economic growth so huge to take care of health care, high rent, and everything else Americans are upset about.)
   4. It takes TIME and INVESTMENT to re-shore production
   5. We've had 6 years of Trump's first-term tariffs (since Biden didn't repeal a single one of them) and our trade deficit has gotten slightly worse (and inflation is right back to the 20-year average.) The chart below shows the contribution to GDP. The first tariffs under President Trump went into effect at the beginning of 2018. The grey line is our exports (lower than they were in 2018). The orange line is imports (same as 2018). The pink line is the NET imports (worse than 2018).

2. Ending most regulations
   1. While there are certain over-reaching regulations which do hurt consumers (such as the DOL rollover rules on IRA to IRA transfers), I hate to say it, but left unchecked, businesses will do what is in THEIR BEST INTEREST. The reason we have to have regulations is there are bad actors out there who will take advantage of consumers if it means higher profits.
   2. Businesses will not simply lower prices because regulations are reduced. They will lower prices if the economy is slowing and they want to try and boost their sales.
   3. Regulations are not the reason prices are high. The top reasons prices went up so much are:
      1. Wages – most states raised their minimum wage over the past 6 years by significant margins. In addition, fewer workers meant businesses having to raise wages to attract workers.
      2. Rent – there are plenty of reasons rent skyrocketed, one of them is all of the private equity ownership of buildings, farmland, and single family homes. This would argue for MORE regulation to bring down rent. The purchase of large swaths of farmland to build data centers to support AI, which also uses a ton of energy (making prices higher) does not help and I've seen no mention of pushing private equity firms out of their large real estate purchases.
      3. Healthcare – President Trump promised in 2016 he'd get rid of Obamacare. That obviously didn't happen. Neither party dares to address the real reason healthcare is so expensive – unchecked price increases from the providers (which would argue for MORE regulation).
3. Immigration / Mass Deportations
   1. Let's face it, Americans do not want to do many of the jobs people from other countries willingly want to do because those other countries have a much lower standard of living.
   2. Mass deportations will mean higher wages to find a price Americans will demand to do those jobs.
   3. If employers cannot find Americans to do those jobs at those prices, productivity will drop (and thus economic growth).
   4. We need MORE LEGAL IMMIGRATION – we do not have enough Americans to do the jobs we need to run the country. I've seen no mention of this from Republicans.
4. Drill, baby drill
   1. There will be no immediate gain in production or drops in prices on day 1 (or even year 1)
   2. It is EXPENSIVE to start more drilling (which will need financed–more on that below)
   3. The FREE MARKET determines how much oil is produced. Production dropped in 2020, not because regulations changed but because the free market said it didn't need as much oil. We are currently producing more oil per day in the US than we did under Trump in 2019.

5. Lower taxes
   1. As we learned after the Tax Cuts and Jobs Act (TCJA) of 2017, simply lowering taxes does not stimulate so much growth they "pay for themselves".
   2. The way the TCJA was written (with most provisions expiring at the end of next year) and the data we have on the significant impact it had on our budget deficit to the negative, simply saying we're going to "extend and expand" the TCJA is easier said than done. There are plenty of moderate Republicans who actually care about the deficit who will have to be on board with the changes.
   3. Ending taxes on Social Security benefits will move the insolvency date of Medicare up by SIX YEARS and Social Security by TWO to FOUR years, meaning if we have a recession, those programs could be insolvent before or just after the NEXT ELECTION.
   4. By the way, giving Social Security recipients a tax cut is WASTEFUL spending because the only way to grow the economy is to INCREASE WORKERS and/or INCREASE PRODUCTIVITY. Americans seem to forget the only way Social Security benefits are taxable is if the recipient receives enough ADDITONAL Income other than Social Security. I've not seen a tax return where the taxpayer had only Social Security income where they paid anything in taxes.
   5. If not done correctly (such as during a very mature economic expansion inherited from the prior administration), the impact on growth is very short-term.

Please take a step back

Again, most of the things President Trump promised and campaigned on NEED TO BE ADDRESSED LONG-TERM, but all of the implementations are painful SHORT-TERM.

2017 or 2018?

During President Trump's first term, I often broke down "Good Trump vs Bad Trump". I was talking about him as a person, but rather the policies which were good for the market and those which were bad. I often criticized President Trump because he would back down on his NEEDED policies if the stock market dropped by 3-5%. That seemed to be his most important gauge of his success (based on his Tweets). With him not running for re-election it will be interesting to see if he has the stomach to follow-through on the NEEDED policies which will cause SHORT-TERM pain for LONG-TERM gain.

Here is the chart I posted throughout 2018. Keep in mind, 2017 was great for the market – 2018 was terrible and included both a 10% and nearly 20% drop in stock prices. The market finally bottomed when most of the threats were backed-off of from President Trump and the market breathed a sigh of relief.

What about interest rates?

The bigger issue for the market will be what happens with interest rates. The Fed lowered rates another 1/4% last week as they continue to see tightness in the labor market. The bond market however is deeply concerned about inflation. Long-term rates have been moving higher since the Fed's first rate cut. Remember, the Fed controls short-term rates, the FREE MARKET controls long-term rates. This uptrend in rates should be a concern for those who believe "Everything is Awesome"

Another thing to consider, is most of President Trump's promises mentioned above have to be financed. We are already paying nearly $700 BILLION in interest expenses. With no changes, that is expected to be at $1 TRILLION in 2025. Most budget experts expect an INCREASE in the deficit under President Trump.

We could literally wipe out all "wasteful spending" (in the 'other' category) along with "welfare", transportation, & education and still be running a budget deficit. President Trump has promised to INCREASE defense spending and will make the deficits in Social Security and Medicare even bigger by both removing the tax on social security benefits and promising to NOT increase the retirement age.

The other thing the market should be worried about is what could be Trump vs Powell 2.0. During the press conference, Chair Powell was asked if he would resign if President Trump asked him and he flat out said "no". The Fed Chair cannot be removed without cause and it is hard to believe somebody with Chair Powell's reputation would do anything to bring into question his independence. The Fed Chair also spent a great deal of time discussing the importance of the Fed being independent. Finally, Chair Powell again mentioned the danger of unchecked spending and our increasing deficits.

This could get interesting.

1-Year Returns are SPECTACULAR

Regardless of your outlook and even ignoring everything above, it is important to take a step back and understand where the market has come from over the past 12 months. The chart below shows the 12-month rolling returns of the S&P 500 (currently at 38%).

There have been just 8 periods where the 12-month returns have been better:

• September 2021
• March 2021
• February 2010
• August 1999
• April 1998
• August 1997
• July 1983
• June 1971

Every case was followed by at least a 15% drop in stock prices. The 2022 bear market followed the last time we saw this type of 1-year gain. The tech bubble obviously burst after the August 1999 rally. Remember, we are buying at near record HIGH valuations. If you are feeling euphoric, take a step back and read our buy high, sell higher series from a few weeks ago here.

Even looking at SEM's models, we would caution getting overly excited on our longer-term models. Through last Friday, there are several of our models net of all fees which have a BETTER return over the last 12-months than the S&P 500's 38% jump. In order they are:

1. Patriot Portfolio
2. AmeriGuard-Growth
3. AmeriGuard-Max
4. Cornerstone-Max

Several others are just below the S&P, but above the total stock market index 12-month return of 34%:

5. Cornerstone-Growth
6. Dynamic Aggressive Growth (despite being just 70% invested the last 12 months)
7. AmeriGuard-Moderate

It's crazy looking at these 1-year numbers. Cornerstone and AmeriGuard-Balanced are up over 25% each in 12-months. Cornerstone-Income is up 15%.

The long-term average return for stocks is 10% and bonds is 5%. Therefore, a balanced portfolio should on average only be up 7.5% each year. We aren't saying to reduce exposure or risk simply because things are overvalued, overly optimistic, or way above average. Only your FINANCIAL PLAN should dictate that. SEM's models are designed to ride the wave up for as long as possible and when the trend changes will look to reduce exposure as mandated by each model.

What we are saying, is take a step back, do not let the gains last week make you believe 'everything is awesome'. Enjoy them, but check your expectations.

Our "low risk" portfolios (Tactical Bond, Cornerstone Bond, Income Allocator, Mastermind, Tax Advantaged Bond, and Dynamic Income) are even up 8-10% over the last 12 months. While not as 'fun' as the 30%+ returns of our riskier models, they are providing the important ballast needed in most of our financial plans. Right now the market seemingly is pricing in NO RISK ANYWHERE, including in the bond market. Our lower risk models are waiting patiently and earning comfortable returns without adding too much risk.

The best way to see the amount of risk the bond market is pricing in is the spread between corporate bonds and Treasury bonds. Right now the risk premium in investment grade cooperate bonds is at an ALL-TIME low. The risk premium in junk (high yield) bonds is a little over 1/4% from the all-time low set just before the financial market imploded in 2008.

When spreads are this low, the short-term opportunities for gains are low, but the chances of large losses are high if anything goes wrong.

Take a step back. Enjoy the gains, but be patient. Lower risk entry points will emerge.

SEM Model Positioning

-Tactical High Yield had a partial buy signal on 5/6/24, reversing some of the sells on 4/16 & 17/2024 - the other portion of the signal remains on a sell as high yields continue to oscillate.

-Dynamic Models are 'neutral' as of 6/7/24, reversing the half 'bearish' signal from 5/3/2024. 7/8/24 - interest rate model flipped from partially bearish to partially bullish (lower long-term rates).

-Strategic Trend Models went on a buy 11/27/2023;  7/8/24 – small and mid-cap positions eliminated with latest Core Rotation System update – money shifted to Large Cap Value (Dividend Growth) & International Funds

SEM deploys 3 distinct approaches – Tactical, Dynamic, and Strategic. These systems have been described as 'daily, monthly, quarterly' given how often they may make adjustments. Here is where they each stand.

Tactical (daily): On 5/6/24 about half of the signals in our high yield models switched to a buy. The other half remains in money market funds. The money market funds we are currently invested in are yielding between 4.3-4.8% annually.

Dynamic (monthly): The economic model was 'neutral' since February. In early May the model moved slightly negative, but reversed back to 'neutral' in June. This means 'benchmark' positions – 20% dividend stocks in Dynamic Income and 20% small cap stocks in Dynamic Aggressive Growth. The interest rate model is slightly 'bullish'.

Strategic (quarterly)*: BOTH Trend Systems reversed back to a buy on 11/27/2023

The core rotation is adjusted quarterly. On August 17 it rotated out of mid-cap growth and into small cap value. It also sold some large cap value to buy some large cap blend and growth. The large cap purchases were in actively managed funds with more diversification than the S&P 500 (banking on the market broadening out beyond the top 5-10 stocks.) On January 8 it rotated completely out of small cap value and mid-cap growth to purchase another broad (more diversified) large cap blend fund along with a Dividend Growth fund.

The * in quarterly is for the trend models. These models are watched daily but they trade infrequently based on readings of where each believe we are in the cycle. The trend systems can be susceptible to "whipsaws" as we saw with the recent sell and buy signals at the end of October and November. The goal of the systems is to miss major downturns in the market. Risks are high when the market has been stampeding higher as it has for most of 2023. This means sometimes selling too soon. As we saw with the recent trade, the systems can quickly reverse if they are wrong.

Overall, this is how our various models stack up based on the last allocation change:

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