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It's Time to Election-Proof Your Portfolio

Diversification requires investment in assets whose returns are truly noncorrelated.

As Democrats assemble virtually for their 2020 convention with Joe Biden ahead in most polls, investors in stocks would be wise not to believe in the markets if they believe he will win. For a Biden presidency, particularly if coupled with a sweep of the House and Senate by Democrats, would punish the stock market with sweeping tax increases on many individuals and the very corporations that make up the market’s valuation. And a clean sweep with the removal of the Senate filibuster would put into play such expensive tax-and-spend programs as the Green New Deal and new entitlements such as guaranteed income.

Opinions about Donald Trump vary widely, but it cannot be disputed that he is the kind of low tax, low regulation president that investors respond well to—even during a pandemic.

According to the Tax Foundation, an independent, nonprofit policy group, the Biden tax plan would result in lower after-tax income on multiple income strata, increase the tax on long-term capital gains and dividends, hike corporate taxes 33%, reduce the overall wage rate almost 1% and lower GDP over the long term, leading to more than a half-million fewer full-time equivalent jobs.

By one estimate, from Goldman Sachs, a Democratic sweep of Congress and a Biden presidency would cut the earnings of the S&P 500 by 12%. If enacted, the damage to the stock market of the Biden plan is virtually unavoidable, as lower corporate profits would drastically eat into the earnings rebound that so many investors are hoping for in 2021.

The best investors are risk managers at heart, and they would be prudent to begin protecting their portfolios in anticipation of a very possible Biden victory. That type of market hedge is more urgent than ever because the stock market in many respects is a teetering house of cards even absent a Biden presidency, and the pandemic has only exacerbated its fundamental problems.

The markets have become increasingly dependent on investor sentiment dictated by Washington, D.C., and increases in federal spending have reached unimaginable and unsustainable levels—effectively fueling massive debt and artificially juicing economic activity, pre- and post-COVID. Naturally, investors have gotten comfortable with what amounts to manufactured backstops that have come to life through artificially low interest rates, stimulus packages and quantitative easing. But today’s tail winds eventually become tomorrow’s head winds.

The Federal Reserve has kept the economy and the markets on life support but have run out of ammunition, as they have cut rates to now near zero. This recession cannot be cured through a congressionally authorized bailout or central bankers because the money simply is not there. With more than $20 trillion in federal debt on the books and no plan for repayment, the next bear market may be the most prolonged and painful one in a generation.

A natural question for investors today is how do I protect my portfolio during a devastating downturn? The long-held belief that market risk can be offset by simply diversifying across stocks and bonds is not the answer. In fact, that philosophy, known as modern portfolio theory, has never helped investors effectively limit the devastation unleashed by the bust, the recession of 2000-02 nor in the global financial crisis of 2008. Industry professionals may tell investors these are hundred-year storms, but history shows that these painful market declines happen far more often than once a century. The typical 60/40 stock-to-bond portfolio experienced a maximum drawdown of 32.54% during the financial crisis, demonstrating the insufficiency of relying on diversification. The Fed’s recent rate cuts will only further drive down the yields on fixed income investment products, and the recession makes corporate bonds riskier.

The inevitable market fallout from COVID-19 will likely forever change how investors structure their portfolios. To provide risk management and portfolio protection, diversification requires investment in assets whose returns are truly noncorrelated. Unfortunately, many investors continue to pursue "false" diversification, slicing up the market into smaller and smaller pieces that have similar correlation patterns. In a bull market, investors are able to ride the wave of positive returns in these correlated asset classes. But as soon as a bear market hits, these investors will be unable to protect their assets.

As yet, the market has not priced in what will be the straw that breaks the market’s back—the Biden tax plan. Investors will be rewarded for election-proofing their portfolios because should Biden be sitting in the White House at this time next year, investors will have voted with a sell order.

Randy Swan is the founder and chief investment officer of Swan Global Investments, based in Durango, Colorado.

TAGS: Fixed Income
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