Warning. Investment “narratives” may be harmful to your financial health.
An investment narrative is a market forecast based on a hypothetical chain of events. If X, then Y, and of course Z. Narratives are an important part of the investment process. We need deductive logic to form strategies. But as every experienced investor knows, forcing an opinion on the market can easily go wrong.
Narratives gone wild
In recent client meetings, I’ve noticed a wide range of opinion regarding potential market outcomes in the new political environment. The dispersion and polarity of beliefs is perhaps the widest in my three decades of money management.
On one hand, President Trump intends to lower tax rates. On the other, he might start a trade war. On one hand, he is pro-business. On the other, his deal-maker meddling goes against free-market principles.
A savvy investor friend is constructing a “Trump” portfolio, favoring businesses with power structures that align with the new political reality. A list of business executives who endorsed Trump is readily available on Wikipedia. This is important information. But let’s not forget empirical testing. If a stock – or sector – that should thrive in the Trump era exhibits relative weakness, that’s very bad. And vice versa, of course.
Case study: Emerging Markets
A Trump administration is presumably bad for EM, especially China and Mexico. But after a 60% underperformance over the past six years, EM is historically cheap versus the U.S. market. The sector is due for a long-term reversal.
Prior to the November election, EM exhibited promising leadership. But hopes were dashed by the election results, evidenced by a sudden collapse in relative strength. The bearish view was corroborated by market action.
But what if EM were to regain its pre-election leadership? This would be highly constructive in our view. A market that overcomes a bearish narrative is inherently bullish according to the principle of “underlying trend.” When under-recognized forces overpower a popular view, those new forces are particularly strong.
Will EM buck the conventional wisdom? It hasn’t yet, but is something worth watching in 2017.
Test that narrative
Everyone knows that the investment landscape has changed. But there are many cross-currents, and interpretation is up for grabs. Fundamental facts remain important. But sometimes the market just doesn’t cooperate with our best designs.
To navigate the current environment, we need both deductive and inductive reasoning. Political views must be corroborated by market evidence. With today’s abundance of conflicting narratives, the message of the market is more important than ever.
Illustration: Narrative gone bad – by Ben Garrison