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“Go out on a limb,” advised the former peanut farmer and Oval Office occupant Jimmy Carter. “That’s where the fruit is.”
With one of the strongest bull markets in U.S. history still going strong in its ninth year — and with valuations having attained heights achieved only twice in the last century — investors appear to have taken those words to heart.
From a fundamental standpoint, the equity market’s metaphorical limb seems sturdy enough to justify additional risk taking. Though U.S. growth remains subpar, economic activity is accelerating in Europe and Asia. Meanwhile, the American economy has not generated the wage inflation that would cause the Federal Reserve to aggressively raise interest rates.
The inflation metric is crucial: Since the mid-20th century, economic expansions have died from tight money, not old age.
Experience also counsels investors to ignore so-called tail risks, or highly unlikely events that would have hugely outsized consequences. Despite reasons to suspect otherwise, it remains the consensus view that two such possibilities — a constitutional crisis in the United States and a military confrontation on the Korean peninsula — are still safely confined to the tail risk category.
Maybe so. But if the consensus is wrong, being out on a limb isn’t a good place to be.
There have been five major political crises in the U.S. since 1970. Three caused significant downside volatility; two others — the Iran Contra scandal in the 1980s and President Bill Clinton’s impeachment in the 1990s — did not, because growth was strong and there was never a serious chance that President Ronald Reagan (in Iran Contra) or Clinton would be removed from office.
It’s clear that President Donald Trump wants to fire special counsel Robert Mueller to prevent him from following the money in probing possible collusion between his campaign and the Russian government.
That story line inevitably draws comparisons to the Saturday Night Massacre of October 1973, when President Richard Nixon ordered the firing of special prosecutor Archibald Cox to prevent having to release tapes showing his complicity in the Watergate cover-up. Stock prices promptly fell by 10% over the next month and by 15% over the next two months.
The following summer, the Supreme Court ruled that Nixon had to surrender the “smoking gun” tape subpoenaed by Cox’s successor, Leon Jaworski. The S&P 500 fell by 7% over the next month — a period that included Nixon’s resignation — and by 26% over two months.
The virtual tie between Al Gore and George W. Bush in the 2000 presidential election also caused a constitutional crisis and an equity market correction. Between election day and the Supreme Court ruling that effectively handed Bush the presidency, stocks fell by 5%, and then kept tumbling, eventually putting in a temporary bottom 14% lower.
Importantly, however, additional factors were involved in the three sell-offs. In 1973 and ’74, gas prices were soaring and the economy was in recession; in 2000, investors were getting the first whiffs of an approaching economic downturn.
Under current circumstances, a constitutional crisis arising from Trump’s firing of Mueller would probably not cause panic selling, but would trigger a buyer’s strike.
‘Fire and fury’
More worrisome is how an “America First” policy could lead to calamity in Asia.
There are no good options for stopping North Korea’s nuclear program, which soon could threaten any U.S. city. Kim Jong-un, the country’s despotic leader, views nukes as his only chance for survival; using them, therefore, would cause the result he’s trying to avoid.
But if the U.S. launched a preemptive strike, hundreds of thousands could die within hours in South Korea and millions more would perish in nearby Tokyo, assuming North Korea sent nuclear weapons against Japan.
Historically, regional wars have not caused global recessions, but there has never been a regional war fought with nuclear weapons or that involved major economic blocks. A military confrontation in Korea would be a human and economic catastrophe.
So for investors, solid economic fundamentals accompanied by perilous geopolitics suggest two different locations along the risk spectrum. What to do?
A Swedish army training manual suggests one possibility. “When the map and the territory don’t agree,” it advised, “always believe the territory.”
For investors in an overextended stock market, that’s out on a limb.
Tom Saler is an author and freelance financial journalist in Madison. He can be reached at tomsaler.com.