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Investors are cautious after calls on 2016 election, Brexit proved to be wrong

Investors around the U.S. are bracing for the unexpected heading into the midterm elections, wary of being caught wrong footed as many were after the 2016 presidential election, Brexit and other crucial votes over the years.

Few are predicting that the outcome widely seen as most likely—Democrats winning the House and Republicans retaining control of the Senate—will fuel the type of violent price swings that came on the heels of President Trump’s victory.

But many agree the elections could create fresh winners and losers in the market: Manufacturers and construction firms could get a boost if a divided Congress can come to an agreement on infrastructure spending, while banks stand to lose if a Democratic sweep leads to a halt in deregulation.

Investors can take some comfort: History suggests the stock market will fare well no matter who wins on Nov. 6. The S&P 500 has risen in the year after every midterm election since 1946, according to brokerage and advisory firm Strategas. Analysts attributed this to investors redeploying funds kept on the sidelines ahead of elections, as well as the market’s tendency to climb throughout history.

Still, the potential for a shock has investors keeping a close eye on the results as they trickle in late Tuesday and early Wednesday.

“I have a feeling I’m not going to sleep that well that night,” said Ben Phillips, chief investment officer of New York-based EventShares. “Maybe a catnap here and there.”

About two weeks ago, EventShares added shares of Martin Marietta Materials Inc., Granite Construction Inc., United States Steel Corp. and other industrial firms to its U.S. Policy Alpha exchange-traded fund. The wager: Even if leadership in Congress is split, legislators may be able to come to an agreement about boosting infrastructure spending. The firm’s fund also includes banks like BB&T Corp. and Goldman Sachs Group Inc. that could benefit from a looser regulatory environment.

“Our base case is a split Congress,” Mr. Phillips said, adding that the firm will be watching for the opportunity to add or trim positions after the election.

Investors have been less confident in strategies hinging on a pure Republican sweep.

An ETF trading under the ticker “MAGA,” an acronym for Mr. Trump’s “Make America Great Again” campaign slogan, has posted net outflows for six of the past seven months after attracting millions of dollars at the start of the year, according to Lipper. The ETF, whose top holdings include cigarette makers Philip Morris International Inc. and Altria Group Inc., invests in companies whose employees and political-action committees have donated to Republican politicians.

It is down 5.7% this year, while EventShares’ fund—which bets on policy, rather than on political party—has fallen 0.9%. The S&P 500 has risen 1.8%.

Some analysts are advising investors to be wary of fleeting gains.

Regardless of who wins the elections, stocks will likely rise, supported by some removal of uncertainty over the direction of domestic politics, said Lee Ferridge, head of macro strategy for North America at State Street Global Markets in Boston.

But those gains are likely to be short lived, Mr. Ferridge said, adding he has told investors to use any rally as an opportunity to sell stocks. He said he believes markets are likely to turn rocky again before year-end amid rising U.S. bond yields, pricey technology stocks and other issues that have weighed on equities in recent weeks.

“We will have a rally because everyone thinks we will have one,” Mr. Ferridge said. Over the long term, however, “there’s an awful lot of uncertainty out there.”

One group that could take a hit following the elections given a Democratic sweep: bank stocks. Analysts at UBS Global Wealth Management believe a Democratic-led Congress will work to impede recent White House efforts to roll back financial regulation such as the Dodd-Frank Act.

“There’s a wing of the Democrats that views financials less favorably,” said Justin Waring, strategist at UBS Global Wealth Management’s chief investment office in New York. “Markets may not like the change in tone.”

Nevertheless, the firm currently has an “overweight” rating on the sector, believing that low valuations and other factors will override political considerations over the long term.

Other investors say they plan to sit back and watch what unfolds in the following weeks, rather than trying to place bets on the market right away.

When Mr. Trump won the presidential election, U.S. stock futures plunged overnight, at one point hitting the 5% limit that exchanges set to prevent further drops. But by the end of the following day, the Dow Jones Industrial Average had rallied more than 200 points.

“The midterm effect on markets will be quick,” said John Augustine, chief investment officer of Huntington Private Bank in Columbus, Ohio. “Things like the Fed and U.S.-China trade relations—those to us are the focus, and those will be developing over longer periods of time.”

Mr. Augustine added that his firm wasn’t planning to have staff stay on site on the night of the midterms.

If the Republicans end up holding on to their majority in both chambers, Mr. Augustine said he might consider taking on more shares of so-called cyclical sectors: companies whose fortunes tend to closely align with economic growth.

Experts’ poor track record of predicting key votes such as the referendum on Britain’s membership in the European Union and the 2016 U.S. election have made many wary of committing to a particular outcome ahead of time.

“You can’t position yourself for something like this,” said James Bianco, head of Chicago-based advisory firm Bianco Research. “There’s a consensus, but the results have confounded consensus again and again.”

As a rule of thumb, investors should bear in mind that “Trump’s policies are pro-business, and anything impairing that would be negative for the market,” he said.

“Are we living in interesting times? Yes,” he said.

Consumer-electronics giant’s growing services business remains closely tied to its own hardware

By no longer reporting device unit sales, Apple Inc. AAPL -6.63% actually hides some good news instead of obscuring bad news.

On the face of it, Apple’s unit sales haven’t been great for a while now. Unit sales of the iPhone and Mac computers peaked three years ago, and the iPad topped out even before that. Combined sales of iPhones, iPads and Macs totaled 279.5 million units for the fiscal year ended September—flat with the year before and down from 306.7 million combined units in fiscal 2015. Analysts estimate the Apple Watch added another 21 million units to the most recent fiscal year, according to Visible Alpha.

Unlike most consumer-electronics companies, though, Apple keeps generating revenue from its devices long after the initial point of sale through things like apps, content, advertising and Apple Care. The company has grown that contribution significantly. Apple’s service revenue per device unit reached about $124 in the most recent fiscal year—nearly double fiscal 2015, when combined device shipments hit their peak.

Services are now Apple’s fastest-growing segment, but they are tied to its devices. Apps purchased from the App Store don’t run on Android phones, for example. And even the estimated billions Apple gets from Google every year in licensing payments are predicated on the belief that Apple’s device users are valuable enough to justify buying that access.

So for all of its success with services, Apple is still a hardware company. Combined sales of iPhones, iPads, Macs, the Watch and other accessories were 86% of Apple’s total in the last fiscal year. It deserves credit for figuring out how to squeeze more revenue out of those devices. But obscuring those sales means Apple is trying to sell the sizzle without the steak.

Fewer than 65 people are likely to get the nod, as CEO David Solomon aims to keep the Wall Street firm’s upper ranks exclusive

Goldman Sachs GS 1.20% Group Inc. is handing out fewer brass rings.

The Wall Street firm is set to name its smallest class of new partners in years this week, according to people familiar with the matter. It’s the first crop of promotions under Chief Executive David Solomon, who aims to keep Goldman’s upper ranks exclusive and compensate for a recent influx of outside hires.

Fewer than 65 people are likely to get the nod, the people said. That would be the smallest class since 1998, when Goldman was still a private company, and fewer than the 84 promoted two years ago.

Being a Goldman partner once meant tying one’s personal fortunes to the firm’s. From its founding in 1869 until its 1999 initial public offering, Goldman’s partners funded its balance sheet, sharing profits and shouldering losses.

Today the title is largely symbolic—partners own less than 5% of the firm—but the every-other-year selection process remains a central part of Goldman’s identity, a way to reward and motivate employees and guard the firm’s culture.

Candidates are vetted by a group of top executives—a process known internally as “cross-ruffing,” a term borrowed from bridge—but aren’t interviewed themselves. If selected, they can expect to hear the news personally from Goldman’s CEO.

Mr. Solomon told managers to be extra selective this year, people close to the process said. Fewer people were considered and there has been less of the last-minute lobbying that has padded the final list in past years, the people said.

Mr. Solomon, who took over as CEO a month ago, aims to keep the partnership aspirational, avoid a watering-down of Goldman’s upper ranks, and concentrate power among those able to drive business. The partnership has risen from 221 at the time of the IPO to about 435 today.

Also squeezing the size of this year’s class: More than a dozen outsiders have joined the firm as lateral partners over the past year. That’s unusual for Goldman, which tends to promote from within, and has elicited grumbles from existing employees as word has spread of a smaller 2018 class.

Partners represent just over 1% of Goldman’s employees and earn minimum salaries of about $1 million, with bonuses that can be multiples more and access to firm investment funds.

They are charged with safeguarding the firm’s culture and reputation—a responsibility that gained fresh importance after former Goldman partner Timothy Leissnerpleaded guilty last week for his role in a scam that siphoned billions of dollars from 1Malaysia Development Bhd, or 1MDB, Malaysia’s sovereign-wealth fund.

About one-third of Goldman partners are investment bankers and one-quarter are traders or securities salespeople, according to a Wall Street Journal analysis. Fourteen were already partners when Goldman went public in 1999, made fabulously wealthy by the listing. Two-thirds have been promoted since 2008 and have come up in a leaner environment.

Only about 15% are women, and they are twice as represented in back-office roles such as operations and human resources than in trading or banking. Raising that number is a priority for Mr. Solomon, a father of two daughters who has set a goal of gender parity in Goldman’s junior ranks by 2021.

Mr. Solomon, a former investment banker, has set aside fewer partner seats for support functions, The Wall Street Journal reported earlier this year. After the financial crisis, Goldman promoted heavily from its legal, compliance and control departments, in part to show regulators that it was taking seriously the lessons from 2008. Seven Goldman lawyers are partners.

The postcrisis boom in U.S. corporate profits appears to have peaked for this economic cycle, a development that poses a fresh threat to a nine-year rally that has taken the Dow Jones Industrial Average up more than threefold.

With more than half of S&P 500 firms having reported results, third-quarter earnings have risen 24% from the same period a year earlier, driven by strong gains at firms from retail and Web services giant Amazon.com Inc. to manufacturers General Motors Co. and Boeing Co. BA -1.47% That compares with 25% increases in each of the past two quarters and the 20% gain that Wall Street analysts were forecasting, according to FactSet.

Surging earnings have been the major driver of the Dow industrials’ run this year to 15 records. Last year’s corporate tax cut supercharged profits, easing stretched valuations and fueling an intense rally in some of the fastest-growing, most highly valued companies.

But executives and investors are now saying they believe the earnings bonanza is at an end. Analysts are forecasting 6% profit growth in each of the first two quarters of 2019, as the impact of the tax cut dwindles. That is down from the 7% analysts had been forecasting in early October.

The earnings slowdown stands to add to concerns swirling around U.S. stocks in the wake of an October rout that rattled many investors and sent the S&P 500 to its deepest monthly decline since 2011. While analysts and portfolio managers remain largely bullish, contending that stocks only got more attractive relative to other investments in the wake of last month’s selloff, many are starting to prepare for a more-unpredictable period in both the U.S. and Europe, in which they won’t be able to bank on windfall profits.

“This is a very classic end to the business cycle to me,” said Dean Tenerelli, a T. Rowe Price portfolio manager in London. “Expectations are very high for companies, valuations are very high for companies and eventually things start to slow, along with the economy and earnings momentum.”

Mr. Tenerelli’s fund recently bought shares of some industrial companies, taking advantage of the lower valuations of what he considered to be oversold stocks that had strong earnings and stable profit margins.

While earnings growth over time tends to be the strongest driver of stock-price gains, analysts say, it is clear other factors can compensate in supporting share prices in the near term. Corporate buybacks will likely pick up in coming months, investors say, and foreign buyers who have been largely absent lately could pour more money into the U.S.

Accordingly, Wall Street expects stocks to rise, even if haltingly. Bank of America Merrill Lynch forecasts the S&P 500 will rise to 3000 by the end of the year from 2723 Friday, implying a gain of 10%. That target is 2850 at Goldman Sachs Group Inc., implying a gain of less than 5%, while Morgan Stanley forecasts an S&P 500 reading of 2750 by mid-2019, up just 1%.

But the threat to the market has been clear in this earnings season. The dollar’s rise this year has hit multinational companies that convert overseas sales back into U.S. dollars. Companies from Apple Inc. to Kellogg Co. have said in recent earnings reports that the dollar’s 4% rise this year has hit profit and sales in countries like Turkey, Brazil and India.

Even the world’s most valuable company is showing signs of slowing down. Apple Inc. said Thursday that revenue for the final three-month period of the year would come in below analysts’ estimates, with the stronger dollar pressuring results in emerging markets.

“These are markets where currencies have weakened over the recent period. In some cases, that resulted in us raising prices and those markets are not growing the way we would like to see,” Chief Executive Tim Cook said Thursday on an earnings call with analysts.

Drugmaker Pfizer Inc. last week narrowed its full-year revenue and profit targets, saying that the rolloff of certain patents and pricing challenges will crimp sales.

Scotch tape and industrial adhesives maker 3M Co. also lowered its earnings forecast for the year and reported slower sales growth in the third quarter, citing currency troubles.

Adding to concerns about the future returns for U.S. stocks: the continuing trade spat between the U.S. and China, which threatens a new source of higher prices and narrowing demand for some companies.

The outlook for European stocks is similar. Companies in the Stoxx Europe 600 are on pace to expand profits by 14% from a year earlier, the highest growth rate since the end of the year, according to I/B/E/S data from Refinitiv. But analysts project that profits peaked in the third quarter, expecting earnings across European companies to come in lower through 2019.

SEB SA, a French household-appliance maker behind brands like Tefal, was among companies that cut revenue guidance, blaming foreign exchange and rising material costs on creating a “difficult environment.” Shares have tumbled 15% this quarter.

“Investors are repricing assets across the market,” said JJ Kinahan, chief market strategist at TD Ameritrade of brokerage TD Ameritrade Inc. “This is going to continue through the end of the year.”

Irish bank denies it used accounting arrangement to boost profits artificially

The sale by Ireland’s Allied Irish Banks of €1.1bn of problem loans to a consortium led by Cerberus Capital has raised questions over whether the bank took advantage of a transitional accounting arrangement to artificially boost profits.

At the state-controlled bank’s results in July , its then chief executive Bernard Byrne revealed that AIB had made a gain of €140m — equivalent to nearly 20 per cent of its half-year pre-tax profits — when it sold the loans to a consortium led by the distressed debt fund.

The gain came after Ireland’s largest lender used transitional arrangements designed to help banks shift to a new international accounting standard, IFRS 9.

These allow banks to write down problem loans without hurting their reported profits in the year of the changeover, merely taking the impairment straight to balance sheet reserves. The hit to regulatory capital is also deferred, with any shortfall from the impairment being phased in over the following five years.

In AIB’s case, the bank booked the profit on the sale of part of its loan portfolio, but in the small print revealed that it took advantage of the IFRS 9 concession to exclude losses of €271m from the income statement, raising concerns that the loan sale to Cerberus might have in fact been a loss that was then portrayed as a profit.

In a statement to the Financial Times, the bank said it breaks down its loans into different buckets known as stages 1, 2 and 3, depending on how risky they are. AIB claimed the €271m loss allowance was applied to stage-2 loans whereas the loans sold to Cerberus were from the riskiest stage-3 bucket.

However, analysis of the bank’s figures shows that after the transitional adjustments, the provisions against stage-2 loans actually fell by €591m as a result of the switchover, as opposed to rising by €271m.

“What appears to have happened is that AIB allocated the €271m to stage 2, but then shunted a whole load of loans and provisions to stage 3. Through this it constructed the opportunity to create artificial profits,” said Cormac Butler, a financial consultant who has testified before both the Irish and British parliaments on international accounting standards.

AIB refused to confirm or deny that any of the loans sold had benefited from the additional loss allowance, saying that it would be wrong to provide any additional financial information to that it had already disclosed.

Mr Butler, a longstanding critic of European banks’ accounting practices, claims AIB’s ability to extract profits from the sale of problem loans appears to be an abuse of transitional arrangements.

“Using transitional arrangements to create profits would be an outrageous fiddle,” he said.

Mr Butler said it stretched credibility to believe the Irish bank could have made such profits on selling loans to value-conscious investors such as Cerberus.

“The bank disclosed that these loans had been heavily underwater for some time, with nearly three-quarters five years in arrears,” he said. “It is hard to see how these could have appreciated in value by nearly 25 per cent between December 31 last year, and May 17 when the portfolio was sold.”

Sue Lloyd, vice-chair of the International Accounting Standards Board, said the arrangements were intended solely to help banks adjust to the new reserving standards imposed by IFRS 9 without “artificially distorting a company’s profit in the period of the change”.

IFRS 9 requires banks to make provisions on their balance sheets for expected losses in the future, rather than losses they have already had. The old standard, IAS 39, required them only to recognise losses when loans actually turned bad.

However, there are worries that some banks may have “front-loaded” expected losses to take advantage of the favourable optics of the scheme and the generous regulatory capital treatment.

The rules mean banks only deduct 15 per cent of the impairment from their “core equity tier one” capital in the year of transition. In AIB’s case, that would mean the bank taking off only €14m of the €271m provision, while still getting to record the full benefit of the €140m “gain”, thus producing a temporary strengthening to regulatory capital of €126m. The full impairment is then unwound over the following five years.

“In theory, any artificial gains could be used to support bonuses for managers and even additional dividends,” said an accounting expert who did not wish to be named. “These are emphatically not why the transitional arrangements were invented.”

AIB, which is 71 per cent owned by the Irish government, has been lobbying hard for an end to curbs on pay and bonuses. Chairman Richard Pym warned last month that these restrictions were turning the group into a “training ground” for bankers, who then went on to work for higher paying, often foreign firms.

Mr Byrne recently announced his resignation as chief executive to join Dublin stockbrokers Davy as deputy chief executive. In September, finance director, Mark Bourke, said he would stand down “early next year” to join Novo Banco, a Portuguese bank.

Loan sales to hedge funds are a particularly sensitive political issue in Ireland. The country has about 100,000 mortgages in long-term arrears, a legacy of the financial crisis. A number of US funds, including Cerberus and Lone Star, have bought up portfolios of mortgages, where they are seen as far more likely to evict householders than conventional lenders.

Schroders has approached embattled Swiss investment group GAM over a potential acquisition of its Systematic division that houses the Cantab quantitative hedge fund.

However, GAM has rebuffed the approach, concerned that selling one of its prized assets would make an overall sale more difficult, according to two people familiar with the matter. Both London-listed Schroders and GAM declined to comment.

GAM’s share price has collapsed by more than two-thirds this year, valuing the entire company at just SFr966m ($963m). The tumble in shares accelerated in July, when GAM warned that first-half profits would be hit by SFr59m in write-offs at Cantab, which it bought in 2016 for an initial $217m cash payment.

Soon afterwards, GAM stunned the market by suspending Tim Haywood, its investment director who oversaw the SFr10.8bn absolute return bond fund range, after discovering “potential misconduct issues”. After a wave of redemption requests, GAM restricted withdrawals from those funds before announcing it would liquidate the funds and return money to investors.

GAM has said in recent months it is exploring all strategic options to maximise shareholder value, which analysts say includes an outright sale of the Zurich-listed group. Chief executive Alexander Friedman is under extreme pressure to stabilise the group.

Its Systematic division has clung on relatively well in recent months, judging from GAM’s third-quarter trading update on October 23. Although overall assets in the investment management business fell from SFr84.4bn at the end of the second quarter to SFr66.8bn in the third quarter, GAM Systematic’s assets were flat at SFr4.6bn.

Fellow Swiss group UBS has recently indicated it would consider acquisitions to bulk up its asset management division, and industry insiders said Systematic unit could fit in well with its plans. UBS declined to comment.

Tomasz Grzelak, an analyst at Zurich-based bank Baader Helvea, said given the SFr59m write-off at Cambridge-based Cantab, the value of GAM Systematic is much lower than it was two years ago. “It was growing fast with very stable fees but its performance worsened materially this year. It will probably generate zero performance fees this year,” he said.

He estimated that the business is worth roughly half what GAM paid for it. “It is a hot target,” he said. “Any buyer would be trying to pay as little as possible.”

While many quant funds have suffered a bruising 2018, investor appetite for more computer-driven, systematic strategies remains high, spurring many traditional fund managers to attempt to reshape themselves and adopt popular quant techniques and approaches.

Schroders has been beefing up its renamed Schroders Systematic Investments division, which manages £8bn. Last month it hired Philipp Kauer, a senior quantitative investment specialist with more than two decades experience, from Man Group.

Cantab was founded in 2006 by Ewan Kirk, a mathematics PhD and former head of Goldman Sachs’s European strategies group, and Erich Schlaikjer, a programmer who also worked at Goldman Sachs. Mr Schlaikjer has since retired.

GAM Systematic’s co-heads are Adam Glinsman, former Cantab chief executive, and Anthony Lawler, who is also portfolio manager for Alternative Risk Premia solutions. Much of the value in the business lies in its technology platform.