Q3 2016 Commentary

Q3 2016 Commentary

ARQ Wealth Advisors 3Q 2016 Commentary: The Election                                                                                   q3-2016-election                 

by Richard Siegel, CFP®  

Let’s cut to the chase and address the elephant in the room….and the donkey. Next month’s Presidential election is sure to go down as one for the history books. A discussion on politics is a slippery slope, but one that needs to be addressed as there is so much concern and uncertainty over what the result will mean for the future of the stock market, the economy and the country in general. We may have two of the most polarizing and controversial candidates ever running for the office, Hillary Clinton the establishment candidate and career politician versus Donald Trump the business man and true wildcard. Regardless of the victor, governmental policy really needs to change for the better in order to keep our economy on a solid growth trajectory. Policy changes should include entitlement programs, individual and corporate tax structures, and other major spending issues like health care, education, and defense.

It is important to understand that no matter who wins the election, he or she cannot run the country by him or herself. Our system of government is built on checks and balances. So much so, that in many cases it creates gridlock and little gets accomplished. So if you are dead set against some of the policies that either candidate wants to implement, rest assured that they probably won’t get fully implemented anyway.

The following chart’s data compiled by Goldman Sachs illustrates that since the mid 1970’s the equity market really has not cared which party wins the Presidency. On average the stock market has returned 10% one year after a Presidential election regardless of the winner.

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Now let’s look at the longer term annual performance under all of our Presidents in the post war era through October, 2015. Overall, the best performance has been when there was divided governmental control. Additionally, top performance came after the economy was rebounding from a major economic contraction i.e. Nixon’s resignation/oil embargo-recession and the end of the Great Recession/Credit-Housing Crisis.

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The bottom line is that as advisors we cannot manage our clients’ portfolios based on speculation and what-ifs. We must keep our eyes on the prize: solid long term returns with low to moderate risk and volatility. While government policy can affect the markets, fundamentals have historically shown to be much more of a significant driver of performance; Market valuations, corporate earnings and asset allocation have proven to have a much larger effect on an investor’s portfolio than election outcomes.

Warren Buffet recently said “It’s an election year, and candidates can’t stop speaking about our country’s problems (which of course, only they can solve). As a result of this negative drumbeat, many Americans now believe that their children will not live as well as they themselves do. That view is dead wrong: The babies being born in America today are the luckiest crop in history.”

Equity Overview:

Global markets came into the quarter like a lamb and went out like a lion – okay, maybe a lion cub. Even with the increased volatility at the end of the period, stocks again turned in positive results for the quarter, grinding higher in the face of a year-end Fed rate increase, election season, and mixed economic data. Janet Yellen and crew decided to put off an increase during the September meeting, but have been telegraphing a December increase; They most likely decided to hold off until after the election. Our position on this is that an increase is long overdue and would be a vote of confidence for the economy. Do not think for a second that short term rates at 0.50% make monetary policy anything other than accommodative. Cheap money is a tailwind for growth, as individuals and corporations can borrow money for investment and purchases, which in turn drives corporate earnings higher. A Fed induced economic slowdown should not be a factor until inflation grows closer to 3% and rates are markedly higher.

The following six month chart of the VIX (fear index) shows a big spike in volatility in June caused by the Brexit vote and then a few months of very low volatility as the stock market gradually moved higher. At the end of Q3, volatility reared its head again as the market began to digest the eventuality of higher interest rates and the uncertainty of the upcoming election. We expect these issues to remain a theme during Q4, so expect continued volatility.

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From an asset allocation standpoint, our tactical adjustment during Q1 of adding more exposure to overseas equities, emerging markets in particular has begun to pay dividends. We maintain that while U.S. stocks remain fully valued and only somewhat attractive, foreign equities as a group are more appealing on a valuation basis. Our strategies are currently allocated at 70% U.S. and 30% foreign equity exposure.

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The following Intermediate term chart illustrates the tremendous outperformance of U.S. stocks versus equities from the rest of the globe. Not only has the U.S. economy outperformed most foreign economies, but strength in the dollar over the past few years has bolstered performance. Over longer cycles, returns of domestic, developed foreign markets, and emerging foreign markets tend to be mean reverting and take turns outperforming.

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Although U.S. stocks are fully valued to slightly expensive relative to historical averages, we remain moderately optimistic as the equity markets do look attractive relative to bond yields and cash. It would take higher bond yields and disappointing 2017 earnings growth for us to reduce stock exposure in client portfolios.

Fixed Income Overview:

The returns of U.S. bonds during Q3 were bland compared to their quick start in the first half of the year. It is fair to say that high quality debt delivered flattish returns for the period. It is also fair to say that unless rates continue to edge lower from here, strong returns in the bond market will be difficult to come by. Rates going lower from here suggest that our economy is going in the wrong direction and/or that investors both domestic and foreign have strong demand for our debt, driving rates lower and prices higher.

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Here are the same chart components as above, but over a 20 year period. Over the last two decades, the U.S. Aggregate Bond Index has returned 5.6%, the Barclays Municipal Bond Index has returned 5.32%, while ultra safe short term U.S. Treasury Bonds have returned 2.13% on an annual basis. Based on where rates are today, we would expect the returns of these three indexes over the next few years to be approximately half of these 20 year averages. That said, we have positioned client portfolios in fixed income investments that have higher return potential with only marginally higher credit risk.

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As we head into year-end, try to not let the stress of the election season get to you. I know, easier said than done, but realize that headlines can create very high levels of negativity, which counter-intuitively can actually be positive for markets. Believe it or not, investor sentiment has historically been a contrarian indicator, meaning that when investors are nervous, scared and bearish, the stock market tends to do better than then when investors are positive and bullish.