Forward with Confidence
Market volatility has risen dramatically this year. In this episode, we discuss:
1. Market Overview
2. Fed Policy Change (they are stuck)
3. S&P 500 Index Levels
4. The Big Four Stocks (Microsoft, Apple, Amazon and Google)
5. Potential Outcomes
6. Portfolio Positioning
Incorporating a large lump sum of money into a financial plan requires thinking through a series of impacts that happen over time.
There are financial, emotional, tax, legacy, employment and a host of other issues to be addressed.
Whether the influx is due to an inheritance, an asset sale, or an IPO, taking some time to adjust before making any decisions is a good idea.
We get into some immediate implications, and then some further down the road.
Before you address the changes a large sum of money will bring, you may want to process the events that led to the inflow.
The loss of someone you care about, the sale of a business you’ve built, the monetization of the work you’ve put into a career are all emotional events.
The cardinal rule of investing is to remove as much emotion as possible. So taking time to work through the underlying feelings before you think about the ongoing changes to your life is a healthy approach.
By far the most important part of this process is to prioritize your actions.
There are some issues that require your immediate attention:
Following the death of a loved one, for example, there is the ugly “business” of processing and settling the estate. Good planning can help make this transition a smooth one, but there are still steps you must take those first few weeks and months.
Selling a business or having a large inflow of stock options require careful tax analysis, which we discuss below.
With any inflow of wealth, you’ll need to address these immediate deadlines.
However, you shouldn’t feel that you need to develop an investing plan right away. Yes, there may be opportunity costs of not immediately getting funds invested, but it is far more prudent to develop a disciplined investment plan to avoid making costly investment mistakes with large sums of money. And the volatility you may be used to with your portfolio takes on a different meaning when you add a zero or two to the end of the values.
Also, if possible, you should avoid any large amounts of spending right away. Your needs, wants, goals, etc. may change as you get used to your new reality, and you don’t want to do anything that can’t be undone.
By prioritizing what decisions you need to make first, you can more easily process the inflow of wealth to help you avoid costly mistakes.
The money may be yours – but the government most likely has a claim on some of it.
Having a very clear accounting of how much tax is due and when, and how you are going to pay it, is the first step. The taxes due may come out of the lump sum, or it may be more advantageous to pay the taxes from other sources of funds. You’ll need a plan to understand the right choice for you.
For example:
Be sure to identify all tax strategies with a tax professional, because there may be ways to reduce your overall tax bill in the year that the event happens.
For example, if you have charitable inclinations, you might want to consider a gift in the year you received the lump sum. One example is via a Donor Advised Fund. Learn more HERE.
The ideal situation is to discuss potential tax implications prior to a large liquidity event when possible.
Adding a large sum to your overall financial picture will change how you think about risk.
You’ll need to assess your liability and protect your overall assets. This may mean an umbrella policy, structuring or titling assets differently, or in the case of an inheritance, it may mean a different insurance strategy.
Your investment goals may also change with time.
If you’ve sold a business and this is your retirement fund, your risk profile will look different than it did when you had a business creating income.
With an inheritance, an IPO, or other lump sum, you may decide to change, cut down, or stop work. This will create different time horizons for investing and different risk tolerances.
It may take time to understand what you want to do and put a plan in place.
Keeping assets as flexible as possible is the key to giving yourself choices as you move forward. You’ll want to minimize risk and avoid locking up funds until you have a clear understanding of your new goals.
Once you get used to your new situation, many people decide to make big changes.
These could include creating a legacy, actively gifting to help others, or using your funds to provide income for yourself so that you can devote your most valuable resource – your time – to causes you care about.
Or it may mean making a big purchase you’ve always wanted, travel, or just taking time to spend with family.
Most likely it is a combination of these dreams.
In the case of a business owner, you worked hard to get to where you are. You most likely made sacrifices that no one sees or knows about.
It is okay to enjoy your new wealth while still using it to positively impact others in whatever way you choose.
Thinking through your options means working carefully to create a financial plan that maximizes your assets, minimizes your taxes and provides for you and your loved ones.
The new plan may be bigger and more complicated, but the basic principles will still apply. You’ll still need to take the time to work with your team to set out what you want, and then put it into action.
We’re always here to talk it through with you.
As of March 2021, Amazon had over 12 million different non-book products for sale (if you count books, it’s more than 75 million). Having an incredibly diverse product set is a vital part of Amazon’s business strategy.
Investors are often told diversification is a critical part of their investment plan. But is it really?
Taking numbers from 2019, there are approximately 4,210 equity mutual funds. The average number of stocks in each fund is about 38 for a large cap fund, and about 50 for a mid-cap fund. A broad asset allocation based on mutual funds could potentially have an investor owning hundreds of different stocks.
What happened to your portfolio in March 2020? Did broad diversification pay off?
There’s a saying that diversification is the “only free lunch in finance”. The premise is that a diversified portfolio will contain assets that move in different directions during periods of market turmoil.
For example, growth stocks may struggle when value stocks are doing well, as we saw earlier this year. It goes from style to asset class, sector, capitalization, and geography – all potential sources of diversification. Building a diversified portfolio is supposed to reduce risk, which will potentially increase return.
In theory, all well and good.
But what happens when there is systemic risk, as we saw during the early days of the pandemic?
Diversification can’t hold back a tsunami. Granted, black swans like 2008 or the pandemic are fortunately rare. But what isn’t rare at all are market cycles. They are predictable and regular. As the market moves through different cycles, different risks and opportunities emerge.
The problem is that asset allocations built on the principle of diversification aren’t built handle changes in the market cycle. They don’t see risk or opportunities coming, and don’t effectively react to these cycle changes.
Adding non-correlated investments to your portfolio is supposed to lower risk and increase return – but you can have too many. The result is that the risk-return profile decreases – you take more risk and get less return.
It’s called “deworsification.”
Deworsification is caused by creating a portfolio in which too many assets are correlated with each other. It can be caused by investing in multiple funds that hold many stocks, as described above. It can also be the result of combining different strategies in a portfolio. Investors need to be aware of hidden sources of over-diversification, such as target-date funds held in a 401(k).
Adding an additional asset allocation in a brokerage account can result in a portfolio that is simply duplicating efforts.
The problem here is that the portfolio isn’t just vulnerable to systemic risk – it’s also missing out on potential gains. The fear of concentrating in any one position often means investors lose out on potential sources of alpha because their asset allocation doesn’t allow for building a position or letting it run.
Said another way, assets tend to not perform the same in up markets, but perform identically in bad ones.
So having too much diversification hurts returns in good times without providing much protection in bad times.
An ideal portfolio would seek sources of alpha and would be sensitive to risk – but only when risk exists in the market.
Limiting positions when the market cycle is indicating positive signals means reducing return. And risk management that reacts to changes in the market by reducing exposure to riskier assets can both protect your portfolio, but also allows for cash to be redeployed when signals turn positive again.
Creating this kind of portfolio isn’t about investing in stocks according to a static asset allocation – it’s about having rules that take the emotion out of investing.
Successful investing means you own right exposure, in the right amount, during the right point in the cycle. And when necessary, going to cash.
Investors have many options now, and investing can be deceptively easy – until markets change.
The free lunch quote above is attributed to Harry Markowitz, who developed modern portfolio theory – in 1952. There might be a better way than relying on traditional methods of portfolio management that haven’t kept pace with the realities of our investment universe.
Despite economic data showing massive improvement from the COVID recession and inflation running hot across all parts of the economy, the Fed continues to pump trillions of dollars into the financial system. Why? They know that if they stop, things will come crashing down.
It is well that the people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”
Henry Ford
The Federal Reserve board met earlier this month to discuss their interest rate and bond purchase strategy.
Following the meeting, markets fell nearly 2% on terrible news that surely signaled the Fed was going to finally pop the massive bubbles across the markets and economy.
What news was that?
Instead of raising interest rates in 2024, they were considering doing it in 2023 instead.
WHAT???
You can’t make this stuff up. Markets sold off hard because the FIRST interest rate hike might occur 2 years from now instead of 3.
Granted, markets (as they often do), reassessed the situation and realized that the Fed just brought a huge case of booze to spike the punch bowl even more, despite the party-goers being ragingly inebriated and in no shape to consume more. Markets promptly recovered those big losses.
But inflation is obviously running hot. The economy is obviously improving. There are millions of job openings. Employment data would be incredibly strong if government stimulus had not made it more profitable for people to not work than getting many lower waged jobs.
Despite things being in much better shape than it was a year ago when the Fed flooded the market with liquidity, they continue to add $80 Billion each WEEK into the financial system.
Why?
The answer is pretty simple…they are stuck.
They will tell you the reason is that inflation is “transitory”. (This is a word you are likely to hear way too much of in the coming months.)
In some ways, inflation is transitory. We recently shared a brief blog post “The First Wave of Inflation is Receding“, where we showed that lumber prices fell over 50% from recent highs.
Let’s share the chart of lumber in case you missed that report. (We published it on social media, so be sure to follow us for the latest reports.)
In just over one year, lumber prices went from under $300 per unit to over $1700.
These are crazy price movements.
As soon as everyone was predicting that inflation was here to stay, lumber prices fell 52% in a matter of weeks.
The price of lumber is exactly what we are talking about when we discuss inflation waves. Our thesis is that inflation will not just immediately come upon us and stay. Instead, it will ebb and flow into the economy in gradually increasing levels.
This thesis is based on both human behavior and history.
The impact from human behavior is pretty easy to think about. Let’s look at the recent increase in home values and lumber as our primary example:
This is how inflation works. Prices begin to rise, and it makes more sense to buy something now, because it will most likely become more expensive in the future.
Inflation can, in fact, be self-fulfilling. High prices tend to lead to even higher prices. It’s FOMO, the “fear of missing out”.
While at first inflation supports even more inflation, there comes a point where it is also self-correcting.
Prices reach a level where it simply doesn’t make any sense to buy it. Whatever “it” is.
This is what happened with lumber. Prices simply became too expensive and people stopped buying it.
We’re not winning any Nobel prizes in economics for this one.
The pace of home building slowed down, and people stopped hoarding lumber. Things just got too expensive. When demand slows, prices tend to fall. Voila. Lower prices.
This is what the Fed is banking on. They believe that inflation is “transitory” because they believe in the self-correcting mechanism of inflation itself. They believe that human behavior will naturally keep a lid on the inflation rate.
Janet Yellen, the US Treasury Secretary and former Fed Chair, said last week that she expects to see 5% inflation this year, but that it will drop to 2% by sometime later this year or in 2022.
Current Fed Chair Jerome Powell blamed inflation on supply bottlenecks in various ports across the globe. He suggests that once this bottleneck gets resolved, inflation will decrease as a result.
Here’s a great article from Reuters about it:
In the short-term, they are probably right…inflation does tend to self correct.
But higher prices also can be sticky.
Why? The expectations of sellers increase.
Let’s say you are going to sell your home. Over the past few years, homes have sold for $800k-900k pretty regularly in your neighborhood. So you list your home for $900k.
But you just saw ten of your neighbors’ homes sell for $1.2MM. Two even sold for over $1.4MM, but maybe they had done some upgrades. What would you do? Probably increase your sales price (either officially or just mentally) to $1.2MM. That is the new floor.
Homes didn’t stay at the peak sales price. But they stuck at a level higher than the previous prices. Not quite as high as the highest price point, but significantly higher nonetheless.
Outside of a crisis, either personally or economically, you’re probably not going to ask for less than what the average or most common sales price has been. Your expectations have caused a stair-step higher in price. Two steps forward, one-step back.
Thus, we have our first inflation wave.
Simply from human behavior.
These inflation waves happened before. We are no different than previous generations, other than the fact that our access to information is much more easily and quickly accessible than in the past.
We discussed the historical reasons for this theory in “The Coming Inflation Waves“, so we won’t go back over the details. We’ll only say that every inflationary cycle over the past 300 years has started in this way, so it’s a pretty easy bet that it will happen the same way again this time. Humans are, after all, still human.
That does not mean the coming inflation cycle will be easy to predict with regards to timing and magnitude.
The price of lumber should not have risen by THAT much over the past year. But it did. And we have one group to thank…the Fed.
The Fed’s easy money policy for over a decade has put massive amounts of liquidity into the markets and economy. And that makes the inflation cycles much more difficult to predict.
There are smart people on the Federal Reserve Board.
The people at the Fed know that the financial system has become dependent on the easy money policies instituted over the past 13 years.
And they know that if they start to reduce the amount of liquidity they are injecting into the markets that they will lose control of both the narrative of financial stability and the upward support of asset prices.
Let’s look at a couple charts that shows results of the Fed’s actions.
First is a chart of the Fed’s balance sheet versus the S&P 500 Index, courtesy of Lance Roberts of Real Investment Advice.
It doesn’t take a professional statistician to see that there is a correlation between how much money the Fed is printing and stock prices.
This chart is all over the investment industry, and the Fed certainly knows of this correlation as well.
Former Fed Chair Ben Bernanke said back in 2010 that stock prices were a way to deliver confidence into the economy. Read it HERE.
Ever since then, the Fed has viewed their role as the driver of stock prices.
But why would increasing liquidity support stock prices?
Simple…it increases valuations.
The next chart, courtesy of Bloomberg, shows an even higher correlation between the Fed and stocks. And it shows the REASON why stocks prices have gone up with the Fed balance sheet.
This chart shows the Fed’s balance sheet versus the P/E ratio of the S&P 500. P/E ratios are the most common way to show valuations in the stock market by taking the price per share of a company’s stock and dividing it by the earnings per share.
This chart is much more in sync than the first chart. For example, in the chart above of the Fed vs the S&P 500 Index, there was a period between 2017 and 2019 where the Fed’s balance sheet declined, but stock prices rose.
When we look at the chart of valuations, we can see that between 2017 and 2019 valuations actually declined as prices rose. Valuations reflected the reduction of the Fed balance sheet while prices kept moving higher.
The secret to the Fed’s ability to impact stock prices, it seems, is by increasing valuations.
The primary way valuations are affected is by investor sentiment.
So what this really tells us is that the Fed is driving investor behavior by flooding the market with trillions of dollars of liquidity.
Exactly like Mr. Bernanke said.
And here lies the problem.
The Fed needs to pump the markets with so much liquidity that the economy becomes so strong that stocks will remain stable even if they stop asset purchases. God forbid they actually go so far as reducing their balance sheet.
More accurately, the Fed needs to pump so much liquidity into the market that they generate so much CONFIDENCE in the economy that the Fed can taper without crashing the system.
So far it is working.
Markets have become dependent on the Fed to keep prices afloat. They expect it.
If the Fed tells the market that they will raise rates in two years, it is similar to telling a drug addict that they are going to rehab in a couple months.
What would that addict do? They would binge on everything they could get their hands on and roll into Betty Ford in a stupor.
That’s what we’re witnessing in financial markets. Risk taking is everywhere. Assets of all types have been sought after. Prices across the board have gone up. We’re in an environment where even fake digital assets with dog memes are being coveted.
This speculative attitude towards risk could contribute to a massive rally over the coming months or years. Similar to the tech mania in the late 1990’s. Unbridled speculation would lead to one final blow-off top that puts a cherry on top of the bull market. Chef’s kiss.
Unfortunately, the same support of massive risk taking today is laying the groundwork of the volatility that will follow.
The Fed knows this as well.
Thus, they are stuck.
Do they rip off the Band-Aid now and stop the party? Or do they continue to support the craziness?
It comes down to one thing: they don’t want the party to stop on their watch.
It is easy to criticize from the outside. But no one wants to be in charge when it comes crashing down.
And that’s what we’re dealing with.
No matter how well-intentioned the people at the Fed may be, they are still human too. And they don’t want to go down in history as presiding over the end of the golden era of speculation investing.
So we’re likely to continue on the current path until someone is forced into action.
And inflation is the likely culprit.
The Fed will likely change the narrative before they start to tighten. They will start to blame something other than their own policies. They will blame bottlenecks or China or Congress or us. Anything but their own policies.
And that’s when we’ll know the cycle is truly changing.
When the consequences of the Fed’s actions are eventually felt, Henry Ford’s quote in the beginning of this report will most likely prove significant. For there is likely to be a backlash against the Fed for the reckless behavior and influence.
Until then, we must be prepared for volatility, but we must be prepared for an out-of-control stock market first. And out-of-control markets can be a lot of fun.
But now is not the time for complacency. And it is not the time to be stubbornly bullish or bearish.
Now is the time to be stoic. Be completely in tune and at peace with reality. When investing, that’s a good state of mind to be in anyways.
We can’t unstick the Fed. But we can try to navigate the consequences of their actions, whether good or bad.
Invest wisely!
In 2019, the amount of money invested in passive funds in the United States surpassed that of active funds for the first time.1 Over the last decade, passive funds have increased assets under management to $11 trillion, from $2 trillion.2 Given the title of this piece, are we saying that all that money is in the wrong place?
Our issue isn’t necessarily with passive funds – we deploy some ETFs in our investment management strategies. Our issue is with the sea-change in portfolio management that the availability of low-cost index-tracking funds has brought about. It’s the prevailing idea that you can create an effective, all-weather asset management strategy by buying a bunch of different funds that represent different asset classes.
The Commodity Trend
Our foundational insight is to turn on its head the belief that asset management has become commoditized. We believe that for much of the asset management industry, investors are the commodity. Most advisors use a one-size-fits-all pie chart strategy. They do a little tweak for your age and how far you are from retirement, and their tools spit out a portfolio recommendation with a bunch of different funds in it. Their theory is that these magical beans funds are going to work together to lower risk and maximize return.
They believe this because they are using data mostly since the early 1980’s to support their recommendation. The problem, as we discussed recently in our “Inflation Waves” report, is that almost every asset class has risen since then.
So they are looking at data that does not include some major market cycles. Specifically the one that we believe we are entering into now…one of rising interest rates and rising inflation.
The words “broadly diversified” have become a mantra, used by large and small firms alike, recommending that investors should be in all asset classes at all times. And meanwhile, broad market indexes like the S&P 500 are only getting more concentrated. It’s hovering around 27% in the IT sector, as defined by GICSs. But if we include companies like Google, Amazon and Facebook, tech exposure is close to half of the index. So, what is that doing to asset allocations?
The notion that diversification is an investment strategy that can replace a disciplined, rules-based investment process is where we draw our line in the sand.
Market Cycles are King
An asset allocation based on age is going to bump up against the realities of the world. Economies and businesses have cycles. Add in the natural human behaviors of fear and greed and you have the market cycle.
And the market cycle doesn’t care how old you are.
If you are lowering your risk during a period when market cycle signals indicate risk is low already and the potential for return is high, you are leaving money on the table. And vice versa.
Diversification Doesn’t Manage Risk
We aren’t suggesting that risk management isn’t necessary…quite the contrary. We believe the management part is important. Volatile markets require a system to manage risk. Being 50 years old or five years away from retirement isn’t a system, it’s a statistic.
Unfortunately, diversification fails exactly when you need it to work. Data shows that asset correlations rise when volatility rises. This means that when markets undergo stress, most assets fall at the same time.
The reported benefits of diversification (having assets that perform differently during different periods) simply isn’t true. In fact, the opposite what happens in the real world.
Rules Are Good
So if passive investing is not the way to go, and broad diversification isn’t all that great, what can you do?
First, we must recognize that investing is inherently emotional. We spend a lot of time with our clients to ensure that their emotions will not impinge on their investment plans. The best thing a client can say to us is that they don’t worry about the money we manage for them, and we strive for that with every client.
We do the same thing with the money we invest. We are tactical investors that follow a rules-based process in each of our portfolios. Simply put, we look at the underlying trends and momentum in the markets to determine good and bad environments. And then we make adjustments to our client portfolios, daily, weekly, monthly – whenever we identify either an opportunity to exploit or a risk to avoid.
That might mean we are broadly exposed to different asset classes; it might mean we are relatively concentrated in our exposures. We just don’t believe that identifying asset classes and then keeping exposure to them through every environment is a successful strategy.
The goal of our process is to participate in up markets and mitigate risk in down markets. Said a different way, our goal is to do more of what’s working and less of what’s not.
Passive management cannot do that. It can only allow you to participate in up markets while also participating fully in every down market.
Ultimately, a passive investment strategy works in up markets. But that is only part of the market cycle. When the down market comes, your (or your advisor’s) emotions take control. That’s when mistakes happen.
The answer is simply to develop, test and implement a rules-based process.
If you can prove a process works in different environments, and stick to that process, then you can have confidence that your system will work during all parts of the market cycle.
That is active management. And that is what we believe works.
With less than a month to the election, we look at the dangers of overconfidence, analyze sector performance under tremendously different legislative environments, and discuss whether you should reduce risk prior to November 3rd.
“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.”
-Mark Twain
Overconfidence
Mark Twain’s quote above seems appropriate for the weeks leading up to a Presidential election. It is about overconfidence.
The exact origin of this quote is not completely clear. It is credited to Twain, but many scholars have a hard time tracing it directly to him. Some give credit to one of his contemporaries, Josh Billings, who was a prominent political humorist in the late 1800’s.
Originally, Mr. Billings used it as a jab towards politicians. But over time, it has been used to criticize religion, the military, politics, environmental activists and finance.
This quote was included in the opening scene of an excellent film about investing called “The Big Short”. This movie was based on a book written by Michael Lewis. The main character is a hedge fund manager who bets big against the housing market leading up to the 2008 financial crisis.
The events in the movie are almost entirely true. The main character, who in both real life and the movie is named Michael Burry, was ridiculed for taking a stance that was extremely opposite of the consensus view that housing prices would never fall. By taking this position, he lost clients, lost employees, and almost lost his entire business.
When the financial crisis hit and home values across the country plummeted, he made hundreds of millions of dollars for himself and his clients. (We strongly recommend reading any of Michael Lewis’s books, particularly those about finance. They can be found on Amazon here.)
Both “The Big Short” and Mark Twain’s quote have one major theme…the danger of overconfidence.
An entire generation of financiers were convinced that housing prices would not fall. They were so confident in their belief that the bets they made brought down legendary companies like Bear Stearns and Lehman Brothers. Other companies who made the same bets and should have gone bankrupt are companies like Merrill Lynch, UBS, Wachovia, Countrywide, Fannie Mae, AIG, Washington Mutual, Lloyds and Royal Bank of Scotland. The overconfidence was amazingly broad and well accepted.
Presidential elections represent the apex of overconfidence in modern society.
Each election cycle, we ask presidential candidates to make bold predictions about how they will steer society to a better future. These days, it’s almost a job requirement to have unhealthy amounts of overconfidence. To run for the office, you must either have a massive ego or a very special calling. Usually both.
But presidential elections don’t only bring out overconfidence in the candidates. Investors, and the investment industry as a whole, are just as guilty of this on a very widespread scale.
With less than a month before the election, our inboxes have been bombarded with reports predicting the market outcomes under Trump versus Biden administrations.
All of these reports sound eloquent and well thought out.
But there is one important question…should we listen to any of them?
Previous Legislation by Industry
Nearly every conversation we have with clients and prospects right now includes a discussion about the election. Specifically, people are wondering if they should reduce risk before the election.
When considering an action like this (or any other action for that matter), you must first have a reliable understanding of how effective that implementation may be.
So let’s look at a few examples of major policy initiatives that were both campaigned on, and also legislated into action. And then look at the resulting performance that resulted from that policy action.
Most presidents have domestic policies that are very industry-specific.
President Obama and President Trump are polar opposites in many ways. Perhaps the most contrasting policy initiatives between Obama and Trump were in three main industries: healthcare, financials and energy.
The chart below shows just how different the two men were with regards to legislation that affects these industries.
President Obama passed major legislation that dramatically increased regulations on large financial institutions, energy companies and the entire healthcare industry.
In 2016, candidate Trump ran on an agenda of repealing each of these laws, and to a large extent was successful in removing large portions of them once he became president.
Surely these dramatically different policies would have a noticeable effect on the stock prices of each of these sectors.
Quite the contrary. Under President Obama, here is how these sectors performed annually during his administration:
Here are the performance of the same sectors under Trump:
Read that again.
Despite the huge differences in policy, the performance of healthcare and financials were practically identical. And energy did much WORSE under Trump than under Obama!
Policy differences sure didn’t lead to stock performance differences in these sectors.
If we look back to 2016, most investment firms were predicting that a Trump presidency would be very supportive for Financials and Energy. They literally couldn’t have been more wrong.
Let’s pick on JPMorgan, one of the more well-respected behemoths of the financial world.
The chart below shows their predictions from 2016 of which sectors would be hurt, and which would benefit under a Clinton versus a Trump presidency.
A green (+) in the column below each candidate represents which sectors they believe would benefit from that candidate becoming president. A red (-) represents which areas they believe that candidate’s policy will have a negative impact on the performance of that sector.
There is quite a bit of data on this chart, but the fine folks at JPMorgan essentially predicted that under a Trump presidency the best performing areas of the market would be Financials, Discretionary and Energy, while the Technology sector (IT in the chart above) would under-perform the broad market.
Just like people are doing in 2020, they laid out a very logical argument on why you should follow their highly intellectual musings and rely on their vast intelligence to guide your investment decisions.
You probably know where this is going.
Despite teams of “experts” in markets, politics, taxes, legislative processes, company fundamentals, and who knows how many other areas of expertise, they were flat out wrong.
Unfortunately, this doesn’t surprise us at all.
Maybe this is just industry-specific. Surely there were meaningful differences in stock performance of various sectors, and possibly the broad market as a whole under such different administrations.
The next chart, courtesy of LPL Financial, shows a more comprehensive sector performance under both Obama and Trump. The Trump data is shown through the end of September. The chart is organized in descending order by sector performance under Obama.
To continue picking on JPMorgan, let’s first look at the column under “Trump”.
Despite massive deregulation for Financial and Energy companies, they were the two worst performing sectors under Trump. Energy stock prices were hit especially hard, down nearly 16% per year. Most large investment firms predicted that energy stocks would be the single biggest beneficiaries of a Trump presidency.
To add insult to injury, Technology, which JPMorgan predicted would be the worst performer sector under Trump, ended up being the best performer BY FAR.
To be fair to JPMorgan, they were not alone in their poor efforts of prediction. Most large firms made very similar predictions, and all were made with a very high degree of confidence. Hopefully these firms didn’t use their overconfidence when implementing client portfolios, because their clients would have suffered dramatically if they followed their own advice. Or maybe they did shift client portfolios, which partially explains why we’re seeing consumer trust in financial institutions near all-time lows.
But if they didn’t shift client portfolios in that direction, why would they go to the effort of making these predictions in the first place???
To finish up with the chart above, it is incredibly interesting to us to see just how similarly the sectors performed under each president. The top two sectors were the same, the bottom two sectors were the same, and the rest were within a few percentage points of each other.
From an overall market standpoint, stock performance is very similar as well. The S&P averaged 12% per year under Obama and 14% per year under Trump.
This is real data.
Despite completely opposite legislation, and despite huge PR campaigns to rally support while the bills were being passed, there was very little difference in performance in nearly every sector.
So what explains the similarity?
It’s the Economy Fed Stupid
One of the more popular phrases during presidential elections was coined by James Carville, one of Bill Clinton’s primary advisors during his 1992 presidential campaign. He said, “It’s the Economy Stupid.”
He meant that how the economy is doing is the single biggest factor in whether an incumbent would win re-election.
Today, the single biggest factor in determining stock prices is simple…it’s the Fed.
We’ve written about this many times this year, and will write about it many times in the future. It continues to be the single most important theme for the markets.
The next chart below shows the Fed balance sheet since 1994. It is amazing just how much money has been printed this year in response to the COVID crisis. The values on the right side of this chart are in thousands. This means that the current Fed balance sheet is $7 million-thousand, or $7 Trillion for everyone on planet earth who is not an economist.
Stock prices have soared on the back of this massive injection of liquidity. Since the Fed started printing in late 2008, markets have relentlessly and consistently moved in tandem with the Fed’s actions.
And there is scheduled to be even more in the coming months, to the tune of nearly $4 Trillion of additional money printed.
This is what makes the market performance so eerily similar between Trump and Obama. The Fed began massive money-printing just before the start of Obama’s presidency. And they have continued until this very day.
Markets are responding to this liquidity by going up, despite what legislation has been passed.
The Fed is making company valuations irrelevant. They are making economic data irrelevant. They are making tax policy irrelevant. They are making geopolitics irrelevant.
And they are most likely making the presidential outcome this year irrelevant as well, at least as it pertains to the stock market.
Someday there will be massive consequences to these actions, but that day is most likely not today.
So What Should We Do?
Will the Fed’s massive support of the stock market help Trump get re-elected?
When the markets are higher in the 3 months leading up to the election, the incumbent president has won EVERY SINGLE TIME.
Will history repeat itself? Who knows. It is 2020 after all.
At this point, it doesn’t seem like that would be a very good bet. Biden has huge, double-digit leads in the polls. But continuing the theme of the danger of overconfidence, we would suggest that based on 2016, the Biden campaign and his supporters shouldn’t get too comfortable.
The final chart below shows the probability that Donald Trump will win during the days leading up to the election in both 2016 and 2020. This chart was derived from the betting odds via RealClearPolitics, and shows the likelihood of him winning versus the number of days left until the election.
At this same point in the election cycle, Trump had a 20% LOWER probability that he would win the election in 2016 than there is now. And the pattern is eerily similar.
So anyone confident that they know who will win the election is simply guessing, or more likely just trying to sway public opinion.
Should You Reduce Risk before the Election?
Let’s get back to the original question we keep receiving from clients, which we haven’t answered yet…”Should we reduce risk before the election?”
Bottom line, no. At least not as of the time of this newsletter.
And the other primary question…”Should we listen to the pre-election predictions?”
Once again, no. Don’t listen to the ivory tower academics at the large investment firms. They are most likely going to be wrong, despite spending lots of resources on trying to sound smart. And just like everyone else, if they were right, it’s as attributable to luck as anything else.
Our investment process raised cash for clients in early September, not because we were predicting volatility around the election, but simply because the market became volatile and we followed our predetermined process. As a result, most of our client accounts moved to roughly 25-30% cash.
The S&P 500 proceeded to declined 10% in September. Frankly, we thought that our system would likely keep us with increased cash exposure into or past the election. However, last week we had multiple buy signals. And despite the election drawing closer, our system had us increase stock exposure across the board, not decrease.
Now, the market is back to flirting with all-time highs. Despite the pending election, stocks are moving higher.
One thing is for certain…STAY NIMBLE.
Just because we invested in stocks last week doesn’t mean we will stay at our current investment exposures from now to beyond the election. A lot can happen, especially in this crazy year. We have our exits already mapped out in case volatility does return, so if our system tells us to move funds back to the sidelines, we will do it.
And if we do raise additional cash before the election, it does not mean that it will stay in cash long. We have predetermined buy signals to get our clients back in.
The anticipation of market volatility around the election is normal. It will happen this election, and will likely happen in every election for the rest of our lives.
The Lesson?
The main lesson is that you should create a process that is agnostic to anticipated risk.
The expectation of risk is greatly different than the realization of risk.
Adapting your portfolio when risk happens is key. When markets actually start to realize risk is when you should adapt, not when you think risk should happen.
Way too many investment managers fall victim to the same overconfidence that politicians and financiers make, and use their “experience” and “intuition” to make adjustments based on what is nothing more than guesses.
Don’t let it happen to you.
Most of our clients have heard us say this before. We don’t know what the market will do in the future. No one does.
And that’s okay.
Don’t try to guess when volatility will happen. Chances are that you will be wrong. And if your investment advisor is trying to guess when volatility will happen, they should stop also because chances are they will be wrong too.
By following a predetermined process, we don’t have to worry about the possible effects of the election on our clients’ portfolios. Our system will adapt to whatever the future may bring.
The best part of this process is that it allows us to have comfort in the fact that we don’t have all the answers right now. We don’t have to worry about whether we should worry about the election.
The most important thing to the market right now is not the president, but the Federal Reserve chairman. If that were to change, markets could undergo dramatic increases in volatility. But that appears to be very unlikely under either Biden or Trump.
Bottom line, the trend in the market is higher, and has been since the March lows. Valuations are stretched in many areas, but it simply doesn’t matter at this point. Don’t miss out because you think that the market should be volatile around the election. A pre-set plan will help greatly reduce the worry you may experience around big events like the election.
Then you can worry about more important things…like how a country of 330 million people can produce these candidates as our two primary options.
Invest wisely!
We help clients achieve those goals through forward-thinking portfolios, principled advice, a deep understanding of financial markets, and an innovative fee structure.
Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. *The information contained herein has been obtained from sources that are believed to be reliable. However, IronBridge does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness. Disclaimer This presentation is for informational purposes only. All opinions and estimates constitute our judgment as of the date of this communication and are subject to change without notice. > Neither the information provided nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The investments and investment strategies identified herein may not be suitable for all investors. The appropriateness of a particular investment will depend upon an investor’s individual circumstances and objectives. *The information contained herein has been obtained from sources that are believed to be reliable. However, IronBridge does not independently verify the accuracy of this information and makes no representations as to its accuracy or completeness.
