The overwhelming narrative over the last few weeks has been concern over the impending election, and what effect it might have on the financial markets. As much as we can speculate who will be elected, what will happen to the majority in congress, and how nominations, legislation and policy initiatives may rattle markets, the reality is volatile political environments do not necessarily translate into a volatile stock market. As these next few weeks progress, it is important to keep one thing in mind: volatility comes in clusters, but never lasts in perpetuity.
Here are a few key items to watch and understand for the near future:
1.) Don’t lose sight of the big picture. After Trump was elected in November of 2016, stock market futures were down nearly 5% in overnight trading. The following day, the Dow Jones finished positive up nearly 1.5%. The market’s initial reaction to Trump’s victory completely reversed course inside of fifteen hours. Similarly, at that time, almost everyone agreed Trump’s first year as president would be a bumpy one for stocks – logic tells us changes in Washington lead to changes in policy that bring uncertainty, and uncertainty leads to higher market volatility. Instead, 2017 was one of the calmest markets in history, posting nine of the ten lowest readings ever recorded by the CBOE Volatility Index. You see, the world often works differently than we expect. One political party or President does not solely control the massive complex system that is the U.S. economy or global financial markets, so whether Biden or Trump resides in the White House next January is unlikely to have a major influence on long-term stock returns. Whether Apple’s next iPhone is a success or failure is more indicative of where the market trends than any elected official or policy coming out of Washington. Business cycles and American enterprise drive bull markets and bear markets, not politics. Every single President has seen the market go up and go down during their term. But over time, the path of least resistance for stocks has been higher. View the attached chart of historical S&P election returns, breaking down the year before, year of,1st year after and 2nd year after each Presidential election.
2.) Recent historic government intervention helped stabilize financial markets and the economy. We must realize that cushion needs to be paid for at some point. In addition to the stimulus, PPP program and increases to unemployment benefits, the Federal Reserve is buying every bond in sight, increasing money supply (another effort by the Fed to stabilize markets). We are off the charts in terms of historic money growth, and that is not good long term for the value of the dollar and inflation. Eventually, the bill for this influx of money will come due. The Fed will have to stop buying bonds and the only solution left is to raise taxes. It is likely that it will not matter who is in the White House, it will not be an issue of a Democrat vs. Republican Congress and who will/will not raise taxes - taxes will have to go up over the next 4 to 8 to 12 years to pay for it. Plain and simple. But remember, raising taxes does not necessarily kill the stock market or bond market. Being fiscally responsible is not completely bad for the economy, nor will it likely be the sole reason for a recession.
Not to mention, this will not happen overnight. There is not a single politician out there that wants to see the current fragile labor market crushed by tax reform.
The prospect for a return to lockdowns due to COVID appear to be on the rise causing some panic and speculation, but we likely will see localized and more precise shutdowns as opposed to national, which decreases the risk of a widespread recession and bear market. Here are the reasons why:
A. Healthcare systems are not overwhelmed: Positive cases are rising in many countries, but the percentage of those tested that are positive, along with hospitalizations and deaths from COVID-19, remain relatively low.
B. Precision pays off: Mid-summer second waves of virus cases in the U.S. and China faded when narrow, and localized restrictions were put in place, achieving success while limiting overall economic impact.
A. Huge cost: The economic and human toll of national lockdowns is now known to be severe; the first half of 2020 experienced the worst global recession since the Great Depression. The high economic and social costs make it more likely governments will respond to outbreaks with targeted restrictions rather than new lockdowns.
The only certainty is continued uncertainty, but this pessimism ironically may be a good thing for investors. Another common question these past few months has been how in the world the market corrected back to all-time highs so quickly following the March lows. The simplest explanation is the stock market doesn’t always move in tandem with the broader economy; but, when profits become scarce, the market becomes very Darwinistic – it’s survival of the fittest. Investors bid up the valuations of fewer and fewer stocks they feel can maintain their growth. We had a select group of companies in a severe economic environment that maintained their growth rates, and investors supported their enormous valuations. Thus the “reason” behind the “Fab Five” (Apple, Microsoft, Amazon, Facebook and Google) valuations. Combine that with the stability of government intervention and it can rationally validate where we are today. But that doesn’t mean it cannot change quickly we can all agree there is heightened fragility in our economy and most investors hold a cynical view of the stock market. The real question is can profit cycles turn and the economy improve enough that a broader universe of companies begin to grow and the market rotates toward those companies. We believe the market will provide enough opportunity to earn returns assuming a long holding period. In the past, bad news has been a friend to investors. That was the case in the 1940s, 1980s and in 2009. And it may be the case today.
Sources and Citations: Jeffrey Kleintop, Charles Schwab; Andy Friedman, The Washington Update; Richard Bernstein, RB Advisors; Daniel G. Noonan, Savant Capital; Morningstar Direct