The anticipation of an emotionally charged election and uncertainty surrounding the future of COVID-19 (and living through a pandemic) has translated into apprehension for many investors. While these events are important and have the potential to impact longer-term decisions that we make, we believe that they are short-term in nature and will ultimately come to a conclusion. These events should not disrupt a long-term strategy, which for most of us, is based on an investment time horizon that is post-election and post-COVID-19. Furthermore, we believe that there are many factors to consider, which will allow for the prospects of longer-term market stability.
As your adviser, one of the most important responsibilities we have is to help you remain confident in the design and execution of your plan, relieving some of the stress and worry you may have. As it relates to your financial security, we do this by establishing a unique set of rules for you and stress testing your plan to make sure it will be successful under a variety of different circumstances. While we plan for the long-term, what happens in the near-term is part of the journey and therefore should be taken into consideration. We do expect heightened volatility surrounding the November election and COVID-19 developments, yet we believe it’s nearly impossible to predict the results and it’s more prudent to plan accordingly for any outcome.
The equity markets have experienced incredible volatility this year. In this communication we will review the most important factors that have driven the market recovery, following the sell-off earlier this year, and provide our perspective on what we believe are current market expectations.
2020 Year to Date Highlights
The S&P 500 index experienced its fastest fall ever from record highs to Bear market territory in March, following the outbreak of COVID-19. The index then completed a record recovery to new highs on the heels of unprecedented stimulus packages. The S&P 500 has recovered nearly 50% from its March low and is now up roughly 4.7% for the year1.
Fixed Income assets continue to provide stability and portfolio protection, despite the low interest rate environment. Depending on the amount of duration in your fixed income portfolio, bonds have also provided appreciation year to date.
Federal Reserve Chairman Powell spoke at an annual Jackson Hole symposium in August outlining a revision to the central bank’s policy framework. The first change in policy is that the Fed will let inflation moderately overshoot the 2% target for “some time”. This approach will allow the economy to run hotter for longer before any tightening is necessary. The second change is that the Fed will respond when there is a shortfall to maximum employment, but they will not necessarily tighten as the unemployment rate falls. These changes fueled much debate in advance of the Fed’s September meeting which was the last time they would meet ahead of the November election. At the September meeting, the Fed formalized the shift in policy and signaled they would keep rates near zero at least through 2023.
What Has Driven the Market Recovery
Federal Reserve & Government Stimulus
Stimulus has been swift and aggressive. The ‘open checkbook’ approach from the Fed has provided unprecedented support to the equity and fixed income markets.
The Fed funds targeted interest rate remains near 0%, which in addition to making lending attractive for consumers, it has had the effect of driving investors into stocks versus fixed income assets.
Trillions of dollars have been spent on small business loans, stimulus checks, unemployment benefits and asset purchases.
Economic Recovery Expectations
With States vying to reopen their economies and unemployment stabilizing, the market is discounting that the worst is behind us. Improving data on new home sales, auto sales and retail sales, for example, helped support the idea that consumer spending is recovering.
Market Domination of a Few Stocks and Momentum Investing
Investments in ‘new economy’ stocks helped jump start and drive the tremendous rally in the S&P 500 index. The 5 biggest names now make up more than 20% of the S&P 500 index, which includes Apple, Microsoft, Amazon, Facebook & Alphabet. Historically, the weight of the top 5 holdings in the index has been below 15%.
Investors have been chasing the market and market timing decisions have negatively impacted many investors this year. When the market sold off in March, the declines were exacerbated by investors who were looking to sell everything over fears of continued market losses. In a similar fashion, as the market has recovered from the lows, the market has seen an inflow of equity investors looking to ride the momentum of the recovery.
We often hear people debate over what set of expectations are currently ‘priced’ into the market. In other words, what could happen to change market sentiment positively or negatively versus what is already anticipated. While it is impossible to know how this all plays out, let us take a look at the most important near-term issues facing the market. What do we have clarity on (i.e. considered priced into market) and what has more uncertainty?
It is generally accepted, as indicted by recent comments from Fed Chairman Powell, that the Fed will remain accommodative for the foreseeable future. This means that we should expect continued stimulus in the form of asset purchases and easy credit, which is positive for asset values and maintaining the wealth effect and investor confidence. The expectation is that the Fed is willing to keep this going for at a minimum of 2 to 3 years, even if faced with rising inflation. Accommodative monetary policy should be a positive for the markets.
Overall, it is expected that fiscal policy will also remain accommodative in the near-term, however, the degree to which remains unclear in context of the election. While the market is expecting an additional stimulus package to be approved, there is a good chance that this is delayed until after the election. Thus, the degree and impact of the additional stimulus remains uncertain. Regarding taxes, in general, if a Biden tax plan is approved the market is expecting increased taxes, including corporate, individual, capital gains and the removal of the step up in cost basis on inherited assets at death. Again, accommodative policy should be a positive for the markets.
The current expectation is for a modest economic recovery over the next few years. Any disruption to this forecast would most likely be a source of market volatility. Recent commentary from the Fed focused on improvements in: Household spending, home sales and business spending. While large issues remain, the data has been trending positive.
Within this modest recovery, the Fed is targeting unemployment improving gradually from currently 8.4% this year to 7.6% next year, 5.5% in 2022 and 4% in 2023 (the unemployment rate had been hovering around 4% or below since 2018, until the economy was shut down and it peaked at 14.7% in April). The Fed expects more material improvements for the remainder of 2020 and into 2021, then more modest economic recovery going forward. Disruption to the pace of growth in the near term could dampen this outlook.
The great unknown to this economic recovery is the ultimate impact of COVID-19. Will a vaccine be approved, will it be effective and will people take it? The market may be expecting significant advancements from a vaccine and treatments over the next 12-18 months. Any material resurgence of COVID-19, causing unanticipated economic shutdowns, would result in above average market volatility.
There is a high degree of uncertainty surrounding what the market expects and what investors anticipate in multiple election scenarios. There are mainly four scenarios, with a victory resulting in sweeping control for either party being the extremes.
We think the simple fact that this is an emotionally charged election, will lead to above average near-term market volatility. However, we believe that election related volatility will be short-term in nature. We believe the longer-term impact on the market will ultimately have less to do with who wins the election and more to do with the economy getting back to pre-pandemic levels.
Of note, the market has historically performed well during election years, with the S&P 500 positive in 19 of the past 23 election years, or 83% of the time since 1900. This is greater than normal, where the index has been positive in 75% of the years since 1937.
Higher than normal stock valuations have resulted in reduced near term market growth expectations. Technology company valuations, for example, are near all-time highs and concentrations of a few large stocks have developed within the S&P 500 and investor portfolios relative to normal exposure. In general, excluding the largest stock movers this year, S&P 500 index valuations are more reasonable. We should expect to see sector rotation within the S&P 500 (i.e. out of technology names into other market sectors) and anticipate increased volatility surrounding the movement. We have already started to see this in September.
As you review the near-term catalysts for the market, it is easy to come to the conclusion that a tremendous amount of uncertainty exists today (at least more so than normal). However, some of this uncertainty will simply go away with the passing of time and the truth of the matter is we know a lot more today than we did earlier this year when COVID-19 first presented itself. How the market reacts to the election, for example, should not disrupt your long-term strategy. Short-term dislocations in the market are accounted for in your overall plan design and should not cause you to deviate from your investment policy.
It is important to emphasize that maintaining a long-term perspective does not insinuate that we should remain passive in our approach. Conversely, we must remain active in the conversations that we are having with all of you, specifically, reviewing your target allocations, distribution strategies and risk/return objectives. Additionally, we remain active in our portfolio oversight, taking advantage of market volatility in terms of tax loss harvesting and portfolio rebalancing, where applicable. This has added significant value over the first three quarters of this year and we remain prepared for any opportunities that present themselves.
Please continue to lean on us for advice or to simply engage in conversation about your plan. If nothing else, we want to continue to provide you with the comfort that we are here for you.
Chart A: 2020 Total Return of Major Asset Class Indexes
Source: Bloomberg; 2020 Total Return, International, Emerging market, S&P 500, Barclays Agg & Barclays Muni indexes
1 - Source: Bloomberg: S&P 500 Index; Emerging Markets Stock Index = MSCI Emerging Markets Net Total Return Index; International Markets Stock Index = MSCI EAFE Total Return Index. Bloomberg Barclays Aggregate Bond Index
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