Investment Workshop 17: The Math Behind the Trump Rally

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Wanderer

The Wanderer retired from his engineering job at a major Silicon Valley semiconductor company at the age of 33. He now travels the world, seeking out knowledge from other wealthy people, so that he can teach people how to become Financially Independent themselves.
Wanderer
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Hello again and welcome back to the Millennial Revolution Investment Workshop! New readers, please click here to start from the beginning.

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Happy March everyone! 2 months into the new year and we have all managed to survive the Trump presidency. So far, anyway. Time will tell.

So, how’s our portfolio doing? Well, glad you asked!

Portfolio Currency Book Value Market Value YTD Performance
Canadian Portfolio CAD $3000 $3078.12 2.6%
US Portfolio USD $3000 $3078.33 2.6%

Now, I must admit, I am just as much in shock as you are that we are actually UP so early in the year. In fact, if this performance were to continue we’re looking at a 15% annualized gain! And after enduring the majority of 2016’s election coverage warning of a stock market collapse because “Trump = Uncertainty,” the exact OPPOSITE has happened. So what is going on? Why have markets rallied the way they have? And is this all a delusional bubble about to burst?

The answer to all this lies in something called the P/E ratio.

The P/E ratio of a company is defined as the Price Per Share / Earnings Per Share. This measures how much an investor is willing to pay for a company’s profits, but I find it more helpful to think about it’s inverse (that is, Earnings Per Share / Price Per Share) as an Earnings Yield. If an investor were paying $100 per share for $5 of annual earnings, that means that investor is willing to buy that company at a P/E of 20, or more meaningfully, is expecting a 5% return on their investment. The idea being that if the company makes a 5% return on its market value, it will distribute that profit our to its investors as a dividend, or reinvest that money back into itself, which should increase its stock price since the company is now more valuable.

Now, we don’t invest in individual stocks, but fortunately, the P/E ratio applies to Indexes as well. Taken as an aggregate, you can add up all the earnings for all companies, divide by the market-cap weighted price of all companies, and come up with a P/E ratio for, say, the S&P 500.

The P/E ratio for the S&P 500 has historically varied from 15 to 25. The reason for this is that at a P/E ratio of 15, investors will think “Wait a minute. I can buy an investment that should return 7%? I want that!” And at the other end of the spectrum, at a P/E in the mid-to-high 20’s, an investor will think “Wait, I’m only getting 3-4%? I can get that in the bond market, and those are guaranteed!” So that’s when stocks cool off.

The P/E ratio is also useful for figuring out WHY a market is rallying. When most people hear news like “The markets have hit a new all-time high,” they think “Well that means a crash is coming!”

Nope.

Markets are supposed to march higher over time. That means that people are getting up, going to work, and creating value for their companies. Those companies are, in turn getting richer, and that’s what makes the stock market go up over time.

However, not all rallies are created equal.

When a stock market upturn is caused by increased profitability, then the movement makes intuitive sense. If companies are making more money, then of course they should be worth more. When this happens, the P/E ratio doesn’t change since the Price Per Share and Earnings Per Share increased at the same rate, cancelling each other out. This is referred to as an “organic” increase or an increase “supported by fundamentals.”

The other type is when P/E ratio does change. If a company was making $6 per share, and was trading at $100 per share, that is a P/E ratio of 16.7. But if the next day that company is still making $6 per share, but its price goes up to $120, nothing has changed about the company except traders willingness to pay more for it. Here, you would be able to recognize that by an increase in the P/E ratio, in this case from 16.7 to 20. In this case, the change is just a change in market sentiment, and has nothing to do with how the company’s actually doing.

So what does this have to do with Trump?

Well, the market’s been rallying like crazy since he got elected. So what changed? The market’s earnings or market sentiment? Well, according to the Wall Street Journal…

Eep.

The S&P 500 is currently trading at a P/E ratio of 24.8, which is pretty damned close to nosebleed territories. And stock market bears constantly use this figure to argue that a crash is coming.

But look at the footnotes. The 24.8 P/E ratio on the left is based on trailing historical earnings. But the much more reasonable 18.22 P/E ratio on the right is based on forward-looking projected earnings.

And that’s where the Trump Rally is coming from.

Wall Street is taking Trump’s campaign promises (the financial ones anyway) and using them to project the effects on earnings going forward. Namely, the big corporate tax cut and the tax holiday on repatriating overseas money. Both promises, if actually implemented, would have an immediate effect on corporate profitability, since less taxes means more profits. Which in turn, means that Earnings Per Share would go up. Which would make stock prices go up.

This is why Indexes have rallied since the election, and also why Wall Street is hanging on Trump’s every word. If he actually follows through with his promises on those two policies, then the stock market rally will be justified and stay at current levels, possibly marching higher. But if he backtracks, then we can expect a sudden and rapid decline.

Which will it be? Will he actually do the things he promises? Personally, I think he will, because with control of both the House and Senate, he has literally no opposition to prevent him from keeping his campaign promises. But what do you think? Tell us in the comments!

And on that note, we will now commence our regular scheduled buys.

Canadian Portfolio

First we start with our portfolio’s current allocation after adding in our cash.

Asset Ticker Unit Price Units Market Value Allocation Target Allocation
Canadian Bonds VAB $25.35 48 $1,216.80 34.01% 40%
Canadian Index VCN $31.53 19 $599.07 16.74% 20%
US Index VUN $44.70 14 $625.80 17.49% 20%
EAFE Index XEF $27.83 18 $500.94 14.00% 16%
Emerging Markets XEC $24.20 5 $121.00 3.38% 4%
Cash $1.00 514.2 $514.20 14.37% 0%

We then use this to generate our Rebalance table…

Asset Ticker Target Allocation Unit Price Current Market Value Target Market Value Current Units Target Units Difference
Canadian Bonds VAB 40% $25.35 $1,216.80 $1,431.12 48 56.5 8.5
Canadian Index VCN 20% $31.53 $599.07 $715.56 19 22.7 3.7
US Index VUN 20% $44.70 $625.80 $715.56 14 16.0 2.0
EAFE Index XEF 16% $27.83 $500.94 $572.45 18 20.6 2.6
Emerging Markets XEC 4% $24.20 $121.00 $143.11 5 5.9 0.9
Cash 0% $1.00 $514.20 $0.00 514.2 0.0 -514.2

And from here we figure out our actual orders, as always being careful to not go into Margin.

Asset Ticker Unit Price Action Fractional Units Units Proceeds
Canadian Bonds VAB $25.35 BUY 8.5 8 $202.80
Canadian Index VCN $31.53 BUY 3.7 4 $126.12
US Index VUN $44.70 BUY 2.0 2 $89.40
EAFE Index XEF $27.83 BUY 2.6 2 $55.66
Emerging Markets XEC $24.20 BUY 0.9 1 $24.20
Total $498.18

American Portfolio

And for our American Portfolio, we once again start at our current allocation post-contribution.

Asset Ticker Unit Price Units Market Value Allocation Target Allocation
Bonds BND $80.72 15 $1,210.80 33.84% 40%
US Index VTI $123.08 8 $984.64 27.52% 30%
International Index VEU $46.98 18 $845.64 23.63% 30%
Cash $1.00 536.93 $536.93 15.01% 0%

From there we generate our Rebalance table…

Asset Ticker Target Allocation Unit Price Current Market Value Target Market Value Current Units Target Units Difference
Bonds BND 40% $80.72 $1,210.80 $1,431.20 15 17.7 2.7
US Index VTI 30% $123.08 $984.64 $1,073.40 8 8.7 0.7
International Index VEU 30% $46.98 $845.64 $1,073.40 18 22.8 4.8
Cash 0% $1.00 $536.93 $0.00 536.93 0.0 -536.9

And finally we decide on our orders being careful not to go into margin.

Asset Ticker Unit Price Action Fractional Units Units Proceeds
Bonds BND $80.72 BUY 2.7 2 $161.44
US Index VTI $123.08 BUY 0.7 1 $123.08
International Index VEU $46.98 BUY 4.8 5 $234.90
Total $519.42

And we’re done! Thanks everyone! We will back next week!

WORKSHOP TOOLS:


How much does it cost to participate in this investment workshop? NOTHING. Because that's how we roll. All we ask is that you sign-up using the following affiliate links to keep it free forever:


For Canadians:
Questrade

For Americans:
1) TD Ameritrade
(Important: Note that you have to specifically enroll in the commission-free ETF program once you open up your account. It’s free to enroll but if you don’t they will charge you a commission when you make your purchase.)
2) Personal Capital


Disclaimer: The views expressed is provided as a general source of information only and should not be considered to be personal investment advice or solicitation to buy or sell securities. Investors considering any investment should consult with their investment advisor to ensure that it is suitable for the investor’s circumstances and risk tolerance before making any investment decisions. The information contained in this blog was obtained from sources believe to be reliable, however, we cannot represent that it is accurate or complete.

33 thoughts on “Investment Workshop 17: The Math Behind the Trump Rally”

  1. Please excuse my ignorance on this irrelevant question. I’m a bit confused after reading all of your workshop articles. How are we supposed to avoid paying taxes on capital gains and dividends when we are currently working? Do we harvest capital gains every year? Are the VTI stock qualified dividends so we get taxed less? Would it be best to put money in a 401k tax free and convert to a Roth IRA after we quit instead? Thank you for your help! Again, sorry for the irrelevant question to this article.

    1. How are we supposed to avoid paying taxes on capital gains and dividends when we are currently working?
      – While you’re working, you’re in the accumulation phase so you very rarely sell (except for rebalancing). And if you sell within your tax-sheltered accounts, you’re not paying taxes. When you retire, you withdraw and get it out tax-free. Check our other articles as part of the workshop where we wrote about this.(http://www.millennial-revolution.com/invest/workshop-invest/making-investments-tax-free/)

      Do we harvest capital gains every year?
      – No.

      Are the VTI stock qualified dividends so we get taxed less?
      – Yes.

      Would it be best to put money in a 401k tax free and convert to a Roth IRA after we quit instead?
      – Yes. See article on Roth IRA conversion ladder:
      http://www.millennial-revolution.com/invest/let-government-fund-retirement/

      1. Thank you for your reply! Just to make things clear, you are recommending people that are currently working to put their extra money in the pre-taxed 401k instead of opening a TD Ameritrade account and purchasing stocks there? I appreciate your time!

        1. Fill up your 401k first with low-cost Index ETFs like the ones we talk about on this site. But you should also be filling up your IRA/Roth IRAs as well, as much as possible. Those you can manage on TD Ameritrade. Or use whatever brokerage you want, I don’t care. The only reason I chose TD Ameritrade is that you can trade the ETFs we use for free.

    1. I’m in tech, and I think those P/Es are retarded.

      During the dot-com bubble, tech companies like these are saying stuff like “ignore profitability! It’s all about eyeballs maaaaan!” and that’s how you get idiotic valuations like this. For the longest time Amazon wasn’t even profitable and showed a P/E of “No.” This despite being the biggest retailer in the world. That’s why I never touch the NASDAQ. Those guys are craaaaazy.

  2. Curious to see whether making the US a (relative) tax haven will have a huuuuge (Trumpian) effect on international capital. Expect to hear a lot of whining from the EU.

  3. Loving the technical breakdowns!

    That corporate tax cut is going to change the “E” side of that equation quite a bit, if it comes around. I’m not counting those chickens just yet, of course. But even as a liberal, I wouldn’t mind the companies we invest in paying less tax. 🙂

  4. When you think the P/E ratio during the dotcom bubble for the Nasdaq reached 156 and for the S&P during the global financial crisis reached over 65, this isn’t so bad.

    Sure, stocks are valued on the lofty side of normal and are probably due a correction in the coming years (perhaps not 2017), but even if it materializes it would only be more of dip than a crash.

  5. “Which will it be? Will he actually do the things he promises? Personally, I think he will, because with control of both the House and Senate, he has literally no opposition”

    So are you going 100% equity now instead of 60% equity and 40% bond?

    1. HELL no!

      Asset allocation should be based on your investment timeline and risk tolerance. Never based on your forecast on the markets. That’s just market timing.

  6. Since you are running this workshop (and your website in general) mostly for the US and Canadian audience, do you have any advice for the Canadians in regard to currency hedging?

    Please correct me if I am wrong, but the US market ETF (VUN) is still traded in CAD, so if the market (and therefore the ETF) goes up by 5%, but the CAD looses 7% compared to the USD, than a Canadian investor is down 2% when lokoing at purchasing power, right?

    Do you invest some of your portfolio directly in USD-denominated assets so that you hedge against the currency fluctuation? The whole point of a diversified portfolio is to protect from too much shock: when one asset class goes up, another goes down, and they re-balance. However, if all our assets are in CAD, there is no diversification to re-balance the volatility in the CAD value compared to the USD.

    I would welcome some insight in this regard.

    Thanks!

    1. Most my portfolio is in VUN, which is an unhedged holding of US stocks, as opposed to VUS which is the same but hedged to the CAD.

      You’re looking at it the wrong way. If you already hold VUN and the USD increases 7% against the CAD, your CAD holdings have now increased 7% from the exchange rate gain. Think about it like this:

      If you originally bought VUN at $10 CAD and then the USD increases by 10% against the CAD, it would now take $11 CAD to buy that same stock of VUN. Any holdings you currently have are now valued at $11 CAD, thus a 10% increase in the value of your holdings. As such, a weakening of the CAD against the USD actually increases the value of your VUN holdings. Obviously any future purchases of VUN will cost you more in CAD though.

      Conversely, when the CAD strengthens, you would now get less CAD for your USD held VUN stocks, which would reduce the value of your VUN holdings.

      To summarise, holding VUN isn’t just betting on a strong US stock market, you are also essentially holding USD in your portfolio. If stocks go up AND the USD goes up, holding VUN is a winning combination. However, if stocks go down AND the USD goes down, you’re in for a killing. VUS hedges against this currency risk.

      This is why VUN has been an amazing holding since Trump got elected. It’s increased something like 15% since the election because stocks have surged but so too has the USD. VUS has also done well but not quite as well as VUN due to the exchange rate gain.

      I see the USD continuing to strengthen against the CAD over the next year due to impending interest rate rises in the US, which Canada won’t follow. However, at 0.74CAD to the USD there isn’t too much further it can go and eventually you might consider switching your holdings to VUS to avoid the downside of a strengthening CAD.

      You might want to read this: http://canadiancouchpotato.com/2014/03/06/why-currency-hedging-doesnt-work-in-canada/

      It argues there is no point in hedging your Canadian ETF’s holding US stocks as hedging actually increases risk. The general theory is that when the US stock market falls, the USD typically soars as it’s a “safe haven”. This is what happened in 2008. As such, you would actually want to hold USD assets during a crash, not hedge against them.

      Anyway, lots to consider, hopefully that clears it up somewhat. If you’re still unsure, go 50/50 VUN/VUS.

  7. Incorrect. VUN is CAD denominated, but it’s fully exposed (heh heh. Fully exposed.) to the USD. VUS is the Canadian dollar hedged version.

    The international ETFs (XEC, XEF) are also non-CAD-hedged. We want the forex exposure because to hedge it to CAD is to make a bet on CAD over-performance and we remain neutral on the CAD. We are bullish globally but neutral domestically.

    1. great timing for this answer, it was something that I have been wondering lately (exposure to other currencies) and I agree with you to being neutral domestically, at least as far as a long term CAD to USD I see the 75 cent milestone where our bank wants us to sit for exports purposes. (might be high and low swings in between, but I don’t care)

      I’m a big follower of the great bearded one and just had a question on your difference in the fixed income portion of your sample portfolio:
      you both agree on 40% fixed income, so big checkmark there, but Garth says half of it should be invested in preferred shares, which most Canadian index investor’s recommend CPD. is your difference here purely for the sake of simplicity/fees? I’m not sure if this is one of the “free” purchase ETFs at Questrade and I’m too lazy to look it up.

      1. Preferreds are great if you need the increased yield. I, for example, have a higher allocation of preferreds because I’m retired and need the income.

        However, the higher yield comes with increased volatility, so there’s a tradeoff there. For newer investors that are in the accumulation phase and still working, yield becomes less important, but at the same time newer investors are usually more nervous, so they need the lower volatility to dampen the mad market swings.

        I agree with Garth’s advice for investors who are more comfortable with market swings and early retirees actually in retirement. For newer investors who are accumulating assets like the ones participating in this workshop, I’d recommend keeping it simple.

    2. Thanks for answering, but being a NewB, I might need an example to fully grasp the differences.

      Would you mind running through this one?:

      If we invest 1,000$CAD in VUN and VUS for a full year, and assuming the underlying index performed at exactly 0% (no movement in one year), but the CAD lost 10% compared to the USD, what would be the value of each of those funds?

      I am not sure I fully understand how currency hedging works, and maybe I’m not even fully grasping what the term means. 🙂

      Is it that VUN (the non-hedged ETF), though trading in CAD actually holds US assets, so that if the USD gains 10% compared to the CAD the underlying value of the assets is increased by 10% (when calculated in CAD), which will lead to the relative increase in the price of VUN shares in CAD?

      I am sure there are good places to find some of this education, but I find that the two of you, and others on this website, are doing a better job than average explaining topics.

      Thanks!

  8. I have to say in the last two days, I’ve been binge reading your posts and you guys are fantastic! To be sharing your knowledge and how you became FI in such a methodical way, for FREE nonetheless, is unheard of!
    I’ve already opened up an IRA TD Ameritrade account and Personal Capital account to follow your steps but I do have a question. Maximum contributions to an IRA account is $5500 a year. In your workshop series, I know you opened an individual account so you can continually invest $1000/month, $12k a year. This doesn’t provide a tax shelter but it does let you invest a big chunk a year. Since an IRA has a cap, what would you recommend doing if I wanted to invest a good amount every year?
    Please keep doing the great work, you guys are awesome! Also, my best thoughts with you in your health status. Please keep us updated. Thank you!

    1. Hi Nancy,

      Thanks for the kind words, and welcome to our weird little blog!
      To answer your question, you’d want to open up an IRA AND an individual account. Contribute and buy up assets in your IRA first (since its tax free) and then continue with any spillover in your individual account. We wrote up which assets should go in which account so they’re tax-efficient in a Workshop article here: http://www.millennial-revolution.com/invest/workshop-invest/making-investments-tax-free/. Go check that out.

      Oh and in case you missed the update, that health scare turned out to be fine. We wrote about that here: http://www.millennial-revolution.com/freedom/learned-thinking-going-die/

  9. Thank you so much for your quick response and I’m so glad to hear your health status is fine! I’m sure you guys get a ton of email but which would elicit a quicker response, through a comment on a post or through email? Thanks again for all that you guys do. I’ve been sharing your blog already to so many of my friends and we’re all loving it! Stay awesome!

    1. Comments are good for short, simple questions and e-mail is better for long, detailed questions (like reader cases).

      Thanks for reading and sharing!

  10. Hi, as a former NT employee I’ve finally received my pension from the long drawn out process. I decided to go with the lump sum option, over an annuity, and the money has just landed in a newly created LIRA. Your rebalancing strategy is based on doing the rebalancing as you add funds, but what is the recommendation if that’s not possible as is the case with a LIRA? Once I’ve set up the ETF’s is there a rebalancing frequency or other trigger you’d suggest?

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