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Market Commentary: Third Quarter 2019

Market Commentary: Third Quarter 2019

September 30, 2019
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Executive Summary

Despite the drama and a four-week losing streak in August that whipsawed the market up and down with every tweet and rumor, stocks ended the quarter flat or inching toward record highs. Lower interest rates pushed bond prices up. Both U.S. equities and bonds benefited from the dovish shift in tone from global monetary policymakers, namely lower interest rates and greater liquidity growth.

Market jittering third quarter headlines left investors wondering, “what next”.

  • Impeachment Proceedings
  • Attacks on Saudi Arabia & Oil Price
  • Trillion Dollar Deficit
  • Trade War
  • Lower Interest Rates (European Central Banks & The Federal Reserve)
  • Boris Johnson & Brexit
  • The Federal Reserve & Repos
  • Inverted Yield Curve
  • Italy’s Government Dissolves

Both the U.S. and Global economies are slowing down. We expect this deceleration to continue into the first half of 2020 before moving into the next business cycle shift – an accelerating rise.1 Next year’s election outcome could change this forecast somewhat. Most importantly, the market and the business cycle are not one in the same. Politics should not drive your investment decisions. Let’s see if we can decipher relevance from the noise.

First, let me remind you that “outperformance” is not a financial goal. The tragedy of headline drama over daily market movement is the propensity to become fearful or greedy and change course with one’s investment strategy at the wrong time.

Accumulating enough money to retire comfortably and confidently is a financial goal. What does it matter if an investor achieves a significant margin of “outperformance” yet runs out of money during one’s golden years? Beating an index is not a financial goal. Sound wealth management encompasses managing the financial outcomes for accumulating enough assets to meet one’s goals such as education funding, retirement, and even legacy. Returns do matter, but outcomes matter more.

Does Impeachment Matter to the Market?

Some analysts say the market should be able to weather the impeachment inquiry. They believe even if the Senate takes it up, there’s little chance the President would be convicted by the GOP controlled body.2 The stock market could have a better fourth quarter after a range bound third quarter, even with turbulence that could come from an impeachment proceeding and ongoing trade tensions with China.

Others surmise that a Trump impeachment risks a market sell-off, especially if a more socialist leaning candidate is elected seeking to rollback many of the “business friendly” regulatory changes that have occurred under the current Administration.

A Tale of Two Impeachments

Looking at the financial history of the impeachment process, two presidents have had impeachment proceedings filed against them in recent history: Richard Nixon and Bill Clinton.

Nixon’s impeachment process started in 1973 and he resigned in 1974 to avoid an almost certain conviction for obstruction of justice. Clinton was impeached in 1998 and was acquitted in of obstruction charges in 1999.

The S&P500 lost more than 26% between October 1973 and August 1975 during Nixon’s impeachment, but gained 28% from October 1998 to February 1999 when Clinton was impeached. One may think these two data points show a consistent trend in how the stock market reacts to impeachment, but history shows us otherwise.3

President Nixon

On October 19,1973, right when Nixon’s impeachment process began, the twelve OPEC members agreed to stop exporting oil to the United States. Over the next six months, oil prices quadrupled. Prices remained at higher levels even after the embargo ended in March 1974.4

In 1971, President Nixon took the U.S. off the Gold Standard which sent the price of gold skyrocketing and the value of the dollar plummeting. This action hurt the OPEC countries whose contracts were priced in U.S. Dollars. This meant the value of their revenues fell along with the decline of the dollar. This ultimately led to the embargo. (4) Nixon’s wage-price controls and the Federal Reserve’s stop-go monetary policy contributed to the 1973-1975 recession and accompanying stagflation. Wage-price controls forced companies to keep wages high, which meant businesses laid off workers to reduce costs. The Federal Reserve raised and lowered interest rates so many times that businesses were unable to plan for the future.4

Gas prices spiked which meant consumers had less money to spend on other goods and services. This lowered demand. It also weakened consumer confidence. People were forced to change habits, making it feel like a crisis that the Government tried unsuccessfully to resolve. This lack of confidence made people spend less.

When considering this context, one could argue that the impeachment proceedings had no relevant impact on the market. Conditions were already ripe for a difficult recessionary period that was reflected in the concomitant market decline.

President Clinton

Clinton had the benefit of being President during the “roaring 90’s”, a time in which the stock market’s upward trend seemed unstoppable. From 1996 to 1999 the DJIA nearly doubled,5 during the same time in which Clinton was impeached.

During the mid-to-late 90’s it seemed as though everyone was becoming a stock trader. With the internet becoming popular and easy access to buying and selling stocks for the average individual, people flooded the market seeking the next company that was going to double or triple in the next few months. Holding cash was frowned upon.

IPO buyers throwing money at dubious dotcoms, telecoms with only a business plan, rather than a business, received an enthusiastic welcome. A more sober finance assessment would have concluded that many of the era’s telecom issuers were at too early a stage to justify a migration from venture capital to public equity.6 The fever of the 1990’s bull market could have been a function of an excess of financial sector capital chasing investment opportunities.

Nevertheless, markets climbed during Clinton’s impeachment. The cumulative return of the S&P500 from 1995 to 1999 was roughly 125%.7

While markets rambled down and up on daily impeachment news, the proceedings had little or no material effect on the market. Other factors more fundamental to market movement were the true contributors.

President Trump

Will impeachment “this time” affect the markets? What’s different?

For one, this time around it appears Democrats in the House have momentum to initiate impeachment proceedings. Second, a formerly robust economic backdrop has given way to jitters about global growth and fears that the U.S. economy is nearing the end of its lengthy expansion. Less confident investors could be more jittery in the face of political headlines than was previously the case.

Also, impeachment proceedings could take center stage in the run-up to the 2020 presidential election, potentially damaging Trump’s re-election bid. Fears of a less business-friendly Democratic administration — amplified by the recent strength of Sen. Elizabeth Warren, who has moved ahead of Biden in some polls — could also be part of the mix.

All this being said, remember Nixon and Clinton. The markets were well defined by conditions outside the scope of impeachment. Politicians and their partisan followers like to think they have more control over the markets or the economy than they actually do. There could come short-term swings in price depending on the daily narratives as this ordeal plays itself out. Conditions for a global economic slowdown is already in place. Monetary policies continue to be accommodative. Unemployment remains at historic lows and incomes are increasing. These factors are more relevant to market movement than political dramas like the impeachment process.

Repo Risk

Late quarter concerns arose around repos. Repos are “Repurchase Agreements”, which are forms of short-term borrowing for dealers in Government securities. Dealers sell Government securities to investors, usually on an overnight basis, and buy them back the following day. Repos are generally considered safe investments because the security in question functions as collateral, which is why most agreements involve U.S. Treasury bonds.8

For the average consumer, these are known as Money-Market instruments, which are short- term, collateral-backed, interest-bearing loans. While many view Money Markets as cash, they are cash equivalents. There is risk, though small, that Money Markets may become illiquid or unable to return their full value, i.e. “breaking the buck”. Breaking the buck occurs when the net asset value, (NAV), of a money fund falls below $1.9

When Government central banks repurchase securities from private banks, they do so at a discounted rate, known as the repo rate. Like prime rates, repo rates are set by central banks.

The repo system allows Governments to control the money supply within economies by increasing or decreasing the money supply available to the general economy. A decrease in repo rates encourages banks to sell securities back to the government in return for cash. This increases the money supply. Conversely, by increasing repo rates, central banks can effectively decrease the money supply by discouraging banks from reselling their securities.8

What’s the Big Deal?

One September day, the financial system ran out of cash.10 You may consider this a modern version of a “bank run”. Repo rates spiked. Repo rates can rise for several reasons, but they do so particularly when there is a shortage of cash in the system, making borrowers willing to pay more to get their hands on it.

Banks are significantly better positioned to handle financial crisis since 2008 since new regulations require them to keep higher reserves. Banks have stronger capital. The trade-off is illiquidity of those reserves when cash is needed. Whether the one-off day of spiked repo rates was a convergence of distinctive factors, such as the quarterly Federal tax payments being processed, or signals more troubling systemic risks, the Federal Reserve is investigating if additional policy should be implemented around repos.11

We do not see this as an immediate risk to the system, but our investment committee will continue to monitor as more information and Fed actions become known.

Value Shift

Growth stocks like technology dominated equity performance the last few years. Record performance levels prompted many investors to shift into assets that lagged in recent years. Value stocks, often defined as companies whose shares trade at low multiples of their book value, or net worth, outperformed their growth-focused counterparts.12

Momentum based strategies edged up 1.40% in September underperforming the S&P 500 which gained 4.20%.12 We noticed this change and our portfolios gave back some of the spread they had gained YTD. Several of our growth securities became technically negative based upon our proprietary screening so our investment committee shifted partly back to value in the portfolios. In other words, growth stocks are losing momentum which has now shifted to value equities.

Our strategy is not growth or value driven but seeks asset classes and securities that are trending up on a relative basis.

Contradictory data has investors grappling with two divergent paths for the U.S. economy. A recovery from a soft patch in growth would, in theory, boost sectors such as financials and energy, whose shares have underperformed broader markets over the years. But an economy weakened by protracted trade conflicts and slowing growth abroad would likely push the Federal Reserve to further ease monetary policy, providing a tailwind for Treasuries and growth stocks.12

Are we in an early stage signaling more protracted reversals to value? Will central banks continue to loosen monetary policy further given rates are at historic lows? Has the high concentration of “bets” in a comparatively small universe of technology stocks put portfolios at risk if value buyers gain momentum?

Trying to predict these moves is a loser’s game and underscores the importance of diversification. No one knows in advance which asset class will perform the best or worst. Trends do occur and having a rules-based approach to catch the upside and limit the down swing is a strategy that may reward investors beyond a statically allocated portfolio. This is not a perfect system, but our experience has proven this strategy to work more often than not.

Next Quarter

What can we expect next quarter? Expect volatility. Swift moving impeachment proceedings, daily presidential tweets and counter attacks may capture headlines and be a distraction for the markets. Upcoming earnings reports, unresolved trade tensions, another showdown in Congress for the yet-to-be agreed upon budget, and global economic slowdown will impact the fourth quarter market performance.

Expect earnings to be less robust than those previously reported with “priced in” corporate tax cut benefits. Expect much of the same roller-coaster swings as investor uncertainty and emotions move market values up and down.

Conclusion

We have been here before. Once again, economic media pundits are stirring up the pot by saying, “look out, the market is too high, it cannot go higher, seek safety”. Historical perspective is our best defense against destructive overreaction to relatively short-term phenomena, positive or negative.

On the upside, history shows there are no new eras – or rather that all new eras end badly, as yesterday’s miracle (from automobiles and airplanes to computers and smartphones) becomes tomorrow’s commodity. On the downside, history shows us that all panics burn themselves out when the prices of stocks fall far enough, with the result that all bear markets have proven to be temporary interruptions of the secular uptrend.13

The dominant determinant of long-term, real-life financial outcomes is not investment performance. It is investor behavior. As your financial advisors, our highest and noblest function is helping you avoid behavioral financial mistakes in periods of widespread euphoria and panic. Guiding us will be your personalized financial plan. Achieving your desired financial outcomes is what matters.


References

(1) ITR Economics, Brian Beaulieu, Insight From Our CEO: Looking Ahead to 2020 and Beyond, 09.20.2019 - https://blog.itreconomics.com/blog/insights-from-our-ceo-looking-ahead-to-2020-and-beyond

(2) “Wall Street Market Strategists See Solid Fourth Quarter Despite Impeachment Inquiry, Trade War”, Market Insider, CNBC, Patti Domm, 10.01.2019 - https://www.cnbc.com/2019/10/01/stock-strategists-see-gains-despite-impeachmentinquiry-trade- war.html

(3) Wealth Daily, “The Trump Impeachment Process and the Stock Market”, Samuel Taube, 09.29.2019 - https://www.wealthdaily.com/articles/the-trump-impeachment-process-and-the-stock-market/93665 First Trust: Monday Morning Outlook, “The Longest Expansion” July 1, 2019; Brian Westbury, Robert Stein, CFA®, Strider Elass . https://www.ftportfolios.com/Commentary/EconomicResearch/2019/7/1/the-longest-expansion

(4) The Balance – US Economy, “OPEC Oil Embargo, Its Causes, and the Effects of the Crisis”, Kimberly Amadeo, 03.30.2019 - https://www.thebalance.com/opec-oil-embargo-causes-and-effects-of-the-crisis-3305806

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