Dear Friends and Colleagues,
We thought it might be a good time for a check in to address some of the questions we have entertained from our last update in July. Markets have moved higher over the last few weeks while headlines continue to suggest that we have a long way to go in the climb to recovery.
While many of the items we highlighted in our 2Q “Bull & Bear” cases are still valid, given the run up in the markets and the approaching election, we wanted to update you on our thinking.
Updating some major themes…
The Election: We are now a month closer to the November 3rd election. While many investors are intensely focused on the outcome, less than three months away, markets tend to look 6-9 months into the future and often discount tomorrow’s events in today’s prices. So far, the markets have continued their rise but with narrow leadership. At play is uncertainty about the election process itself in the current environment. Delayed vote counts, post office issues, and challenged results are concerning for many- and then we have the impact of the outcome of the elections to digest.
The main question we have received surrounds a Biden win and a Democrat sweep of Congress. While corporate tax increases imposed under a Democratic led government are expected, they are likely to be offset in part by significant spending packages aimed at helping the country recuperate from the pandemic. Such a pro-growth strategy could bode well for stocks and potentially assuage corporate profit concerns. Proposed infrastructure projects could possibly help offset what is estimated to be a 5-10% reduction in S&P 500 Index earnings under Biden’s stated plan to raise corporate taxes to 28% from 21%. Capital gains tax increases being discussed are possible but not guaranteed. Tougher anti-trust policy could be a headwind for earnings if implemented. To be clear, higher taxes would not be good for consumers or businesses. However, the future of tax rates is unclear and if the Congress were to remain divided post-election, the ability to implement big change may be limited. While politics can have a big impact on equities, history suggests that broader developments in the economy often matter more. At this point, it is too early to handicap any outcome and make meaningful portfolio changes.
Stimulus: We know that fighting the Fed has not often been a winning investment strategy. Recently, Fed Chairman Powell remarked that “we are not even thinking about thinking about raising interest rates” anytime soon. The Fed still has the back of the markets and his comments made that clear. Supportive policies will likely be in place until the economy gains firmer footing…at least that is the Fed’s pledge. Eventually, debts will have to be paid back but for now it seems we can service this debt at low rates.
Federal stimulus measures cannot last forever. Stimulus is the medicine to help the patient (the economy). We’ll want to see the patient standing on its own two feet in coming quarters. The price for borrowing today will be felt down the road but for now it seems that more Federal stimulus is warranted and on the way.
The Virus: The virus is unpredictable. As one commentator put it recently: “Viruses are going to virus.” We cannot stop the virus. The pandemic is a very serious matter and fears of a second wave, and the harm another wave can do to our health and our economy, cannot be taken lightly. However, we are learning and adapting as we wait for a vaccine. We are getting better at treating it. Peak states are seeing a leveling off. At some point, the worst will be over. Recent market action reflects this optimism. The impact to the economy that the virus has had, and will have, is likely to be felt for years to come. The economy has historically been resilient and we are optimistic that we will get through this part of history as well.
Valuations: When investors are paying upwards of twenty times earnings (a P/E of 20x+) for equities, one should typically be cautious. These valuation levels are historically considered quite expensive. Investors might pay these prices when earnings are expected to rise to a certain degree or when rates are low as they are today. While we are still early in this recovery, we note that 2Q earnings surprised to the upside with an earnings beat percentage that was the highest since 2011.
Interest Rates and Inflation: Currently the yield on the on the bell-weather 10-year US Treasury note is in the .70% range. This low rate, along with stimulative polices, does cause concern for inflation down the line. For the next 18 to 24 months, we feel the Fed will do its utmost to maintain very low rates. However, we are vigilant in watching for signs of inflationary pressures building up in the economy and in commodity prices. In Q3, we initiated a position in gold as a hedge and are looking at other inflation hedges (equity is one!) as well. As US interest rates remain low, the US Dollar has tracked lower as well. While we did expect some decline, we feel it will be limited.
Investor Sentiment and Money on the Sidelines: Recently, the American Association of Individual Investor (AAII) survey told us that only 22% of investors are bullish (38% is the historical average) and 48.5% of investors are currently bearish (30.5% is the historical average). These sentiment numbers typically occur at market bottoms rather than market tops, so these readings do provide some comfort. Given the level of bearish sentiment, cash levels held in money markets are still quite high. High cash levels often reflect more potential fuel for financial assets as investors get more comfortable and deploy those funds. Conversely, if investors remain cautious, these funds will remain in short term instruments.
The Economy: July economic readings overall showed steady improvement as we slowly continued to open the economy. The second quarter GDP report showed a large drop-in economic activity as expected. However, we are seeing positive reports in construction spending, manufacturing PMIs and durable goods orders. It does feel like the economy is exhibiting some green shoots. TSA checkpoint data tells us that visits bottomed at 80k/day in March. They have since risen to 800k/day. Housing starts are up as are auto sales. That said, many are coming up off low bottoms so we are cautious.
As always, we are here for you to discuss your portfolio and how you are positioned to reach your financial goals. We know that these trying times have prompted many to re-evaluate their goals and objectives. We are here to help.
The PRW Wealth Management Team