Everyone, and I mean everyone, at recent gatherings wants to talk about the election and what he said or what she said. Shortly after bemoaning our lack of inspiring choices, you are likely to hear breathlessly about how the market will tank or soar based on him winning or her winning. Meanwhile, the market has yawned its way through the prior three months remaining essentially unchanged. I am laser focused on watching the Federal Reserve and wondering will they or won’t they continue raising interest rates in December. And, equally importantly, what Chair Yellen says about 2017. The stakes are getting higher as stock valuations are stretched, interest rates are silly, and even gold has a speculative edge to it. After a brief history lesson on the market and presidential elections I’ll wade into the markets.
Before we discuss some election/market details, I open with a disclaimer. This will be the 30th presidential election since 1900, which is when decent data on the Dow started. The statisticians among you will probably say it is too few cases to make confident predictions. For the record, I agree; there are too few cases and too many “one-offs” to invest on political prognosticating. But let’s try anyway.
Generally, the election year is an average return year (like 2016 so far) with an early-in-the-year correction (check for 2016 again). The correction might be predictive. Remember the ugly start to this year? When the correction is closer to 10% than 20% (2016 was 10.1%) the incumbent party tends to win (one for her). OK, but when the market is down from the end of the second convention (Democrats on July 28) until Election Day usually the incumbent party loses. So far, the Dow is down 1.4% since July 28- easily reversed but still negative (one for him). So, just enjoy the election for the theater that it has become but keep your eyes and ears on Ms. Yellen to follow the money.
US stocks are historically expensive (see chart on price to sales) but I remain cautiously long for new highs. Valuation is a critically important longer term determinant of returns but extremely poor in the short term. Up until the last few weeks of sideways action, the market breadth and trading activity was in gear with the new highs. This can change, of course, but not quickly enough to say August 23 was the final all-time high of this bull market. Moreover, valuation is country/region specific. I find many emerging markets and Canadian equities to be cheap. These markets have underperformed the US market for years and are not at new highs. They also represent different sectors – i.e. materials and energy – than the sectoral drivers for the US.
The key here is the Federal Reserve. Every day you can check to see if a Fed Governor has hinted at raising rates. On those days stocks usually go down, and, depending on which governor, can go down hard. Right now, the probability, as implied by the market, of a rate rise for December 2016 is 64%. So a tightening for December is likely priced in. Tightenings through 2017 are a different story. I watch the 2017 jaw boning closely, but for now I think the market risk/reward is still OK.
Fixed income is a different story. Usually, we observe that interest rates move in the same direction as stocks. This has made bonds a great compliment to stocks because as interest rates decline, the value of bonds increase. This relationship is starting to break down. We can also blame the Fed for this. Typically, the 20 year government bond will trade at or near the nominal (real plus inflation) GDP rate. For 2017, the market forecast is for a 4.3% nominal GDP. But the 20-year bond is at 2.1%. If it touched 4.3%, the capital loss on that bond would exceed 30%-- ouch! That’s why bonds have been losing as the Fed has threatened rate rises. The Fed has made this asset class, like stocks, expensive with its money-printing and near zero interest rate policies.
The final group of assets are the alternatives, which I have discussed in prior articles, and the precious metals/commodities. Gold is also a captive to the Fed. If the Fed raises rates well before inflation gets started, gold will get hit. But, if they wait too long, gold will again be king. This is why you should hold some gold. But you may want to hedge some of that by diversifying into a mix of other precious metals, like platinum and palladium, which are historically undervalued to gold, but also have some industrial uses. My final word will be on commodities. Commodities look to have ended their horrific 5 year bear market. Oil is the most important global commodity and the bottom looks in, just as it does for natural gas. I don’t expect a quick return to a bull market and prior highs but rather a period of back and fill. So, you might consider adding some commodity positions on weakness.
So between the election, the Fed, and, perhaps, market highs here in the fourth quarter, we might get some excitement yet.
