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Quarterly Review and Outlook

September 2020:

By Loyd Johnson, Chief Investment Officer
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A Look Back

The above song was written by Malcolm and Angus Young of the legendary rock band AC/DC. It was released in 1990 on the Razors Edge album. Although probably not the first song people think of, it was one of the band’s biggest hits, peaking at #23 on the Billboard Hot 100 list.

As I listened to the song recently, it registered with me that the simple line is true so often, and perhaps more so now than ever. More to come there, but September was pause time for the markets as most stock benchmarks were negative. The Large Cap S&P 500 reversed a long-standing trend and trailed Small Cap companies, as well as International Developed and Emerging Markets. Even with the pause, the index was up nearly 9% for the third quarter, and, amazingly positive by 5.57% in 2020. We have come a long way since the March 23 lows. Other asset classes like Real Estate and Commodities were down for the month as well.

The chart below looks at how the Federal Reserve Balance sheet has grown since 2008, when it was under $1 trillion. The immediate response to the Great Recession of 2008-2009 was to more than double that number. As the economy continued to struggle, the Fed eventually realized it needed to do more, and started to buy more and more distressed securities as it tried to bring order back into the Fixed Income world. 

It has been said that one of the lessons the leaders learned was that bigger and faster was better. Prior to the global pandemic brought on by Covid-19, the Fed balance sheet had started to dwindle as they methodically sold assets off their books. In early March of this year that all changed when the Federal Reserve announced that they would buy just about anything that they felt would stabilize markets. And they did. The list of potential targets expanded, as the Fed purchased Fixed Income ETF’s to get the most bang for their buck. There can be no question that the swift and massive move by the Fed, and indeed the entire U.S. government has quelled many fears and has been a big part of the economic and market turnaround. It has led many to believe that there is an unspoken Fed "put", or insurance that will continue the printing presses whenever needed to pull the economy and markets out of any real/perceived mess. So far, so good.

The S&P 500 roared back in the quarter and made another all-time high in early September to seemingly defy logic. How can stocks be making highs with the economy suffering such historical losses? After a second quarter that saw GDP decline by over 31%, the estimate for the third quarter number is that the economy will grow by 19%, nearly double the estimates from only a couple months ago. Again, we believe that the speed and the size of the government response has been the key.

In addition to the Fed response, the U.S. government has doled out over $3 trillion for additional stimulus packages to aid individuals and businesses. Right now, parties are discussing an additional $1-2 trillion stimulus legislation before the November elections. Money has talked…and investors have listened.

A Look Ahead

It is difficult, if not impossible, to look ahead without discussing the upcoming elections in the United States, and examining potential ramifications for our economy and markets. The chart below shows how bell-weather stock indexes have fared throughout history based on which political party was in power. The red bars show the average annual return by year. Interestingly, the returns gradually improve, on average, year by year. Perhaps that indicates that administrations find their footing as time passes and are able to get more done. Most importantly, the blue bars show the average annual returns for all of the various scenarios of potential government. (One party controlling all three branches and all of the split combinations possible). What immediately jumps off the screen is that markets have done well in all combinations throughout time. The average annual return has been 9.1%. The best historical returns have come from a Democratic president and a split Congress with a 10.9% annual return.

This is not to suggest that it doesn’t matter who wins. It more strongly suggests that our political process, as flawed as it may seem at times, has led to consistent, positive returns over longer periods of times in every kind of potential party leadership. The checks and balances that our forefathers put into place have invariably worked throughout history.

Oftentimes, mid-term elections can act as an additional check of approval/disproval from the electorate to further keep things in line. As we have written often, our markets are incredibly resilient. We have had no tougher test than what we have all endured over the last 7-8 months. A global pandemic that led to global economic shutdowns is something none of us have ever seen. The impact on everyday life has been profound, and yet we persevere. Just like past elections, this one is the most important…now. We have our thoughts on how election outcomes might affect the markets in the immediate aftermath, but the reality is that it is not something that is easily traded for the longer-term. Both parties tend to make many promises pre-election, and the resulting movement is typically something more in the middle as Congress battles out workable compromises.

Although still positive, the chart above shows that the lower returns occur when one party has control of all three branches. At least some political division has been good. We believe that however the presidential election unfolds, it is most likely that we will end up in that situation: with a President in one party and a split Congress. Whatever your political leanings may be, that has been the best for markets from a historical perspective.

Although the elections have taken center stage most recently, we believe that underlying market fundamentals and corporate earnings will ultimately be the longer-term driver of market returns that they have always been. Money typically rewards and flows to investments that have good prospects of higher returns. With that in mind, there are some interesting items to keep an eye on.

The above chart is a bit troubling. It examines total corporate liabilities as a % of GDP. The trend line reflects data going back to 1945. Other than the spike during the bubble, liabilities have remained closely aligned with that trend line. Until recently. As investors chase yield in a low rate environment, corporations have ramped up the issuance of lower-rated debt. The source of cheaper financing makes sense for some companies, but the chart clearly shows the historical levels of liabilities that are on corporate books.

Through the trials of Covid-19, we have seen many companies struggle, and many household names permanently close their doors. The fear is that this development continues and corporations loaded with excessive liabilities cave…and investors holding their debt get a surprise they were not counting on as the cycle feeds on itself. In the fixed income world there are basically two ways to enhance return: go longer in maturity or go lower in credit. Both can work and both have their own risks, and we have seen how quickly a credit crisis can play out and cause market disruptions.

The above chart is one of my favorites for its simplicity. It is often referred to as the Buffet Indicator as it has been his "best single measure" to evaluate markets. The formula is simple: total market capitalization/GDP. It is labeled "strongly overvalued" right now. That sounds ominous, but it is not meant to be a short-term trading indicator, but rather implies that longer-term outsized stock returns may be more difficult to come by. Finally, we do believe that the influx of money to stabilize markets and provide relief has been both timely and needed. How we navigate the added burden on our collective balance sheet will be the key.

Some of the more recent economic numbers look promising. Nonfarm payroll employment rose by 661,000 in September, and the July and August numbers were revised upward. We have now gained back around half of the jobs from our peak in February. Retail Sales jumped 1.9% in September versus a consensus .7% expectation. Consumers were buying cars and clothing and starting to dine out more often. That was welcome news to businesses across the country, and we will need that type of activity to continue to support these elevated market levels. We remain fairly neutral in our client asset allocations, but have a keen eye for opportunities that may arise from increased market volatility. We believe that some of the laggard asset classes have a chance to do better as we come out the other side.

Advances are being made on the medical front to deal with this virus, and that is certainly a good thing. As we all do our best to navigate these new times, we take solace knowing that the best minds around the world are working diligently to bring this thing under control. There may be some reckoning down the road for the unprecedented fiscal governmental response to this pandemic. We know that is never as easy as just printing more money and throwing it at a particular problem. However, at least for now, as the boys from that legendary rock band opined….Moneytalks.

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