Rockbridge 2020 election preview

With the general election one week away, many Americans and capital markets are awaiting the results. In this piece, we will go over expectations heading into the election and possible market reactions based off those outcomes.

Before we dive in, it’s important to remember current market prices reflect all known information and expectations. And while we don’t know the outcome of the election or how the market will react, we do know it pays to be invested over the long run which is what we are recommending for all clients. Stick with your plan, take a personally appropriate level of market risk, and enjoy the long-term appreciation we’ve observed over the last 90 years and will observe over the next 90.

In the election forecasting world, two of the best sources are FiveThirtyEight.com and online betting markets (we’ll look at PredictIt). Between the two, we feel FiveThirtyEight is more reliable but it’s worth showing both.

Both sources show Biden as the expected winner with FiveThirtyEight showing very high likelihood. The betting website has Biden at 63% which indicates its users are less certain of a Biden victory. Though there are limitations around betting market regulations which make the true likelihood of a Biden victory larger. On the FiveThirtyEight side, Trump’s 11% chance of winning reelection is quite a bit lower than the forecasting website showed in 2016. While things with odds of 11% do happen 1 in 9 times, it is reasonable to say the market has priced in a Biden victory and will be surprised if Trump is the winner.

The following tables show a few other ways of looking at expectations of the upcoming presidential election.

We don’t have data for the expected PredictIt margin in 2016, but in 2020 we again are seeing a Biden victory, with a narrower margin among online betters than the forecasting website FiveThirtyEight. Again, it’s worth noting how much more decisive FiveThirtyEight is predicting the 2020 election than the 2016 election – reiterating that markets expect a Biden victory.

The House of Representatives is relatively boring. Democrats have a sizable advantage and that is expected to stay the same. The current makeup is about 54% Democratic and it’s expected to slightly rise to 55% Democratic.

It’s interesting that the online betting market and FiveThirtyEight are more or less saying the same thing when it comes to the House of Representatives, but not the Presidency.

What will likely be the most interesting part of the election is what happens in the Senate. At the moment, Republicans hold a 53-47 advantage. It is expected that Democrats will pick up seats, but how many is not known.

Republicans are expected to gain a seat in Alabama, where Democrat Doug Jones is up for reelection. Democrats are expected to gain a seat in Colorado as former Democratic Governor John Hickenlooper has a large polling lead over incumbent Republican Cory Gardner. Democratic candidates also have narrow(er) leads over incumbent Republicans in Arizona, Maine, North Carolina, and Iowa. If the polls hold in all those, that will give Democrats 51 seats in the Senate. If Republicans hold on to one of those, but Biden wins the Presidency, Democrats will have the ability to control the Senate because the Vice President (Kamala Harris) serves as the deciding vote in the event of a tie. In a dream scenario for Democrats, they could pick up additional seats in Georgia (2), South Carolina, Montana, and even Kansas. Republicans have an outside chance at picking up seats in Michigan and Minnesota.

A narrow Democratic majority isn’t expected to be overly liberal. Democrat Joe Manchin of West Virginia has a fairly conservative voting record, as does Jon Tester of Montana. Angus King of Maine is fairly moderate and it’s reasonable to expect a new Democratic Senator from a purple state like Iowa, Arizona, or North Carolina will want to strike a moderate tone in their first term. From a markets perspective, the expectation is for a fairly moderate Senate that doesn’t pass any policies overly different from the status quo (like Government run healthcare, or a Green New Deal).

If Democrats got 53-55 seats, this would be different from expectations, but it’s not clear how the market would react. Some might be concerned that a more liberal senate would pass policies unfriendly to businesses and a strong democratic showing might encourage liberals to push for more business regulation through the executive branch. Those would be seen as bad for future corporate profits and harmful to stocks. However, others might see a more democratic senate as better on getting COVID under control and more likely to pass a large and generous infrastructure / general spending bill. That would be positive for expected corporate profits and stocks.

Remember, under current Senate Rules most legislation needs 60 votes to avoid a filibuster. The exception is one budgetary bill per year that just needs a majority and passes by the “reconciliation” process. This is how Republicans passed their tax cut three years ago. While it’s only one bill a year, it can be a large bill with broad provisions/impact. It’s possible the next Senate could change the rules but that isn’t likely.

To conclude, the current expectations are for Democrats to maintain a similar majority in the House, Biden to win the presidency, and Democrats to narrowly gain control of the Senate. If all this happens you would not expect the market to react in a meaningful way over a longer period of time. There may be high volume that causes some choppiness in the immediate aftermath of the election, but the overall direction of the market should not move much from this outcome. It could move from other news – like COVID, or issues abroad.

We are quick to concede “experts,” forecasts, and predictions are wrong all the time. We saw it in 2016 with the election, we saw it with economists and interest rates in 2019, and we saw it with the American hockey team at the winter Olympics in 1980. That said they are often right. Despite poor performance in 2016, FiveThirtyEight was spot on in 2008 and 2012. They also called the House in 2018 almost exactly and were a seat off in the senate.

If we see an election outcome different than what’s expected that could lead to volatility, but like we saw in 2016, it’s hard to predict how the market will react. On the night of the 2016 election, stock futures were down 5% at midnight after it was clear Trump would win, however they regained all their losses by the market open and finished up 1% on the day.

 

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Presidential election reflection

Here’s an interesting puzzle: Why do we cringe at the sight or sound of breaking glass, but we salivate over breaking news?

In the run-up to the U.S. presidential election, you’ve probably been hit by enough breaking news to propel you well into 2021. Predictions abound on who will prevail, and what will happen to our political, social, and economic landscape as a (supposedly) direct result.

Come what may, the results will undoubtedly be attention-grabbing and action-packed. Social media and the popular press will see to that, as they feed on – and are fed by – our fascination with things that break.

To counter all the excitement, we offer three calming insights:

  • Cause and effect are rarely as direct as we might hope or fear. Please apply this point to any temptation you may be feeling to alter your investments because “X” has just happened, or in case “Y” seems about to. Before, during, and after the election cycle, pundits will be proclaiming they can predict the financial fallout from an election characterized by such stark contrasts. At least in terms of tomorrow’s market prices, they do not know. They cannot know. There are simply far too many interacting interests to make the call.
  • It’s much easier to explain an outcome than to predict it. In this Forbes column, the author describes how scientists have detailed models for explaining why volcanoes occur. But they still cannot predict each eruption. The same can be said for financial markets. We have excellent models for explaining a market’s overall factors and forces. But our ability to predict its individual events or specific moves remains as elusive as ever.
  • Elections come and go. Your investments last a lifetime. As U.S. voters, we have the opportunity to select our next president every four years. As investors, we are best served by measuring the balance of power in our portfolio across decades rather than years. As Dimensional Fund Advisors has demonstrated in this excellent illustration, “for nearly 100 years of US presidential terms [the data] shows a consistent upward march for US equities regardless of the administration in place.”

In other words, no matter which political party is in power, your best chance for achieving your personal financial goals remains the same: Continue to give your investments ample time and space to benefit from the market forces just described. As we move together through the breaking news yet to unfold, we hope you vote according to your values, but heed this valuable advice about your lifetime investments. Stay the course!

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Market commentary: Q3 2020

Stock Markets

Stocks continued to come back from their sharp declines earlier in the year. Over the September quarter, stocks are up across the board – Domestic Large-Cap stocks and Emerging Markets are up 9%. Since December 31st, a diversified global portfolio is off 8% year-to-date excluding the Domestic Large- Cap market, which is driven by the largest tech companies. Returns from domestic stocks continue to exceed those of non-domestic stocks.

Value stocks are priced based on expected earnings from assets in place while growth stocks reflect expected earnings mainly from future investments.

Research shows that markets tend to overprice these future earnings. Yet, there has been a significant discount to value stocks in recent periods, which is especially pronounced in the year-to-date numbers.

Looking back over a long history the average difference in five-year returns between a blended index and a value index is close to zero. The historical variability is such that a discount to value stocks of more than5%, such as we experienced over the most recent five-year period, is clearly an outlier.

Results over the past quarter show the stock market continuing to shrug off the economic and political uncertainties of today. The well-worn observation that the stock market is not the economy continues to resonate as stocks are based on expectations well into the future.

Bond Markets

The Yield Curve below shows the pattern of observed returns from holding bonds to term across several maturities. Today, these Treasury yields go from essentially zero to a little above 1% across a twenty-year spectrum – little change from last quarter which explains the essentially flat bond returns regardless of maturity over the period. On the other hand, look how yields have fallen over the past twelve months in response to the Fed providing the market with liquidity. This change explains bond returns over the past year that run from 4% to 11% – the longer the time to maturity, the greater the return.

In response to ongoing economic uncertainties the Fed is keeping interest rates low and doing all it can to ensure liquidity. These activities result in a yield on 10-year inflation adjusted Treasuries of a negative 1%, which means investors are essentially paying the Treasury to hold their money. While these negative yields have been the case since February, it does not seem sustainable over a long period.

Dealing with Today’s Unconventional Markets

It is difficult to reconcile today’s investment landscape with established expectations – negative real interest rates; massive government spending with little impact on inflation; some stocks trading at PE ratios well above 30 times trailing twelve-month earnings; sharp discount to value stocks; large variances in returns among several markets. Today’s conditions reflect the external shock of the Coronavirus pandemic; we have fewer clues as how things might look on the other side.

Massive government spending without inflation is inconsistent with conventional wisdom. Inflation did not happen with the 2008 financial crisis and is not happening now. The view from the Fed is that interest rates and bond yields will remain low. The only way to do better is to take risk – either credit risk, interest rate risk, or liquidity risk, which oftentimes is difficult to access. Yet, because bond results remain uncorrelated with stocks, they are important to managing a portfolio’s risk. While fulfilling that role, we need to accept an essentially zero return for the time being.

The Fed’s actions mean bonds are not attractive causing investors to turn to the stock market for expected positive returns thereby increasing the demand for these assets. Today’s stock market is driven by the largest tech companies. While other markets have come back to some extent from the sharp fall-off in March, it is just these tech companies that explain much of the results of the S&P 500 Index.

With some stocks beginning to look pricey and anemic bond returns assured, there is a strong urge to take profits in stocks and move to the sidelines until the investment environment improves. History has shown this is not a good idea. Moving away from established allocations due to a worry of the investment environment is “market timing,” which everyone acknowledges rarely works out.

There is no reason to think this time is different. Yet, just like a hot fudge sundae, market timing is something you know you should avoid but it is hard to do. History tells us to establish commitments based on long-term risk objectives, rebalance regularly, but expect a bumpy ride. u

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Historical stock market volatility around elections

With the general election approaching, many investors are worried about heightened volatility in the stock market. We have had several people reach out with three types of concerns: concern around an election without a clear winner (or a candidate not admitting defeat), concern around an election result different than their preference, and concern around general volatility.

This election is unique, but so is every election. That’s what makes it “news” and news moves markets. While the news is always different, the way markets react to news is fairly steady over time. In this piece, we analyzed market behavior in the 30-day period around each election over the last 96 years.

Starting 15 days before the election (a Monday in late October) and ending 15 days after the election (Wednesday in November) we looked at returns of the S&P 500 and the standard deviation of daily moves during that time.

In the 23 elections listed above, the average return over the month is 0.72%, which is slightly behind the 0.83% we’ve seen on a monthly basis over the last 95 years. The volatility (standard deviation of daily returns) during these 505 trading days was also slightly elevated, at 1.44% per day compared to an average of 1.20% (23,310 trading days since 1926).

The volatility is 20% higher, which isn’t a meaningful difference for a month. The return averages 0.11% less but is still rather positive and the difference is far from being statistically significant.

That message probably won’t allay the fears of those who feel this particular election is too unique to be captured by historical data. Still, it should provide a degree of comfort that returns around elections have historically been positive and close to average market returns.

Two things are worth remembering. First, markets move on events that differ from expectations. The stock market didn’t drop in 1984 because Reagan was reelected or in 2008 because Obama was elected, both of those outcomes were expected. The market dropped for other reasons. Second, a company is worth the present value of all future profits. Perhaps the market will be volatile around this election, but for stocks to drop, and stay down, the market must decide expected future corporate profits are worth less.

At Rockbridge, we believe the best course is to stay invested through the election, we are recommending that to all clients and doing it with our own investments. However, if you can’t sleep at night you should reach out and have a conversation with your advisor.

Departing thoughts: I recently overheard someone intending to get out of the market now and buy back in at a lower price. They said they were hoping to “make” a little money from the trade. They should have said “win” a little money. Timing the market is a zero-sum game, and a game of chance, it’s not earned money and if the market doesn’t behave as desired money will be lost.

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