| 3RD Qtr.
| 12 Mo.
|10-yr Treas. yield||0.677%||0.653%||+0.024%||1.675%||-0.998%||-1.24%|
|Fed funds rate||0 – 0.25%||0 – 0.25%||n/a||1.750-2.0%||-1.50%||-1.50%|
(stock indices are before dividends; yield and rate changes are absolute changes)
The stock markets continued their recovery and their apparent disconnect from the economy, with both the S&P 500 and the NASDAQ hitting record high closing levels in early September before large tech stocks finally had a pullback. That decline was attributed to a loss of momentum rather than the collapse of a “bubble” and the one-year performance of the NASDAQ is remarkable. Treasury yields were pretty much flat for the quarter although an August dip brought yields down to 0.515%, quite close to the low of 0.499% since 1786 (!), according to Deutsche Bank. Federal Reserve activity increased the US money supply 24% year-to-date, compared to a long-term annual increase of around 3% and 6% to 8% for the last 10 years.
The Dow Jones Industrial Average dumped Exxon Mobil (its longest current component), Raytheon (merger) and Pfizer in favor of Amgen, Honeywell and Salesforce. The Dow has a complicated price-weighted formula, so the largest component is now United Healthcare, followed by Home Depot and Amgen. Apple’s stock split, after reaching a market value of over $2 trillion, reduced the Dow’s exposure to information technology.
The other big number was the change in GDP for the second quarter. The final decline was -31.7% on an annualized basis, (just under -10% for the quarter alone) after falling a revised -5% in the first quarter. This was the biggest decline in the post-World War II era, surpassing the -10% in the first quarter of 1958. Consumer spending was down over 34% and domestic investment was down 49%. Federal government spending was up due to stimulus payments while state and local governments tightened their belts as tax revenues fell. Federal government debt exceeded 100% of GDP, the highest level post-war, and looks to keep going. That debt level had fallen below 40% before the Great Recession, rose dramatically for several years and barely slowed during the recovery.
The Fed announced that they expect near-zero rates through the end of 2023 and warned that the lack of further stimulus could jeopardize the recovery. In a policy change, the Fed will now place more emphasis on employment and will not pre-emptively increase rates to head off inflation, looking to “even out” periods of inflation at 2% over time rather than trying to keep inflation always below the 2% target. Of course, inflation remains nearly nonexistent. Still, the Fed forecast a shallower decline in real GDP and a lower unemployment rate for the end of the year from their summer projections.
The economy added 1.4 million jobs in August after 1.7 million in July and 4.8 million in June, but permanent job losses increased 0.5 million to 3.4 million. With unemployment falling to 8.4% from July’s 10.2%, the economy is still 11.5 million jobs below the pre-COVID level in February. Both services and manufacturing activity showed solid growth and durable goods, including a proxy for business investment, were positive. The July trade deficit was the highest in 12 years as imports increased faster than exports.
Consumer confidence showed a big jump in September, reversing two months of decline. Home sales strengthened again on the return of “nesting”, low mortgage rates and low supply, as inventory fell 18% from a year prior; there is now only a 3-month supply of existing homes for sale. August saw the biggest sales increase in 14 years, 10.5% above the prior year level, and various measures showed prices increasing from 4% to 11% from the year prior. First-time buyers made up 33% while investors were 14% in August.
It may be impossible to not be absorbed by the upcoming presidential election (short of locking yourself in a dark room) and hopefully we will keep our democracy and our sanity. But this review is for the economy and the markets, not politics, so let’s look at the market data surrounding presidential elections.
Forbes tested the conventional wisdom that liberal Democrats are bad for the economy, while fiscally conservative Republicans are good, by looking at data from the end of World War II to today. The results from 1952 to 2020 show that annualized real (adjusted for inflation) stock market returns were 10.6% under Democrats and only 4.8% for Republicans. Jeremy Siegel, a professor at the Wharton School, says that this result is well-known but does not imply cause and effect because market returns have more to do with business cycles than with presidents.
Forbes also noted that Clinton had the best cumulative market return, at 210%, while George W. Bush had the worst at -40%. (Two market collapses in eight years will do that.) Trump was second best, at 131%, and Obama was next at 104%.
Vanguard took a different approach, looking at returns in election years versus nonelection years. Since 1860, the average return for the 40 presidential election years was 8.9% and the average return for the 120 nonelection years was 8.1%. And this result is consistent across the long period, not skewed by some weird 19th century data. Perhaps more relevant to today, Vanguard also analyzed volatility for the 100 days before and 100 days after a presidential election. Since 1964, the annualized volatility for these periods surrounding a presidential election has been 13.8%, but annualized volatility for the entire 56-year period was 15.7%. Conclusion: returns are higher in election years, and volatility is less before and after the election.
LPL Financial looked at data back to 1950 regarding the makeup of Congress. The S&P 500 returned an average of 17.2% for years when Congress was split between the two parties, 13.4% when Republicans were in full control and only 10.7% when Democrats were in full control. Investors favor a split Congress because the checks and balances ensure one party does not have too much sway and this tension limits the uncertainty of legislative risk.
There are plenty of legitimate reasons to be concerned about the election, but there are so many factors that drive the economy and markets that we will stick with our advice from prior elections – the president often receives more credit than is warranted for a strong market and more blame than is warranted by a weak market.
It should be clear by now that we are advocates of a balanced portfolio. The classic 60/40 portfolio (60% stocks, 40% bonds) has been around since before the Depression and has earned its all-weather reputation. But 60/40 has been under some scrutiny and criticism under current conditions. Is it time to scrap the proven standard?
Since 1980, a 60/40 portfolio of the S&P 500 and 10-year Treasury bonds has returned an average of 10.4% per year. These returns were boosted by very high returns for bonds (7.4% per year) because bond yields steadily declined, and prices increased, as interest rates went from the highs of 1980 to historically low levels recently. In other words, it was a 40-year bull market for bonds that is not going to repeat since we are now starting with such low rates. And with stock prices also at record levels, how can stock returns be as strong as they have been in the past?
Doomsayers predict another “lost decade” as companies struggle to recover from the coronavirus and the stimulus from the Federal Reserve eventually winds down. (We survived a lost decade for US stocks from 2001 to 2011, digesting two major declines.) Paul McCulley, a former economist at PIMCO and now a faculty member at Georgetown Law School, goes further, saying that the dominance of monetary policy that began with the fight against inflation in 1980 succeeded at suppressing inflation and boosting financial assets. The attention-grabbing headline is “if 60/40 keeps working, democracy has failed” because the 40-year run is due to victory by those who control capital over those who provide labor, and this trend cannot continue forever.
If ever a discussion called for context, this is it, and it is important to understand the perspective of the commentators. For institutional investors, David Kelly, chief strategist at JP Morgan Funds, says “long-term asset allocators will need to find a replacement strategy if they are to meet their target returns”. Other naysayers tout “alternative investments” as the tool to maintain high returns, but as we have repeatedly warned, these alternatives can be expensive and carry many other risks.
Note that nobody is saying that 60/40, or any balanced portfolio, won’t perform its basic function of balancing the risk and return in a long-term portfolio. While bonds may not perform as strongly going forward, they will never have the volatility and potential for decline of stocks. The complaint is basically that the returns won’t be what they have been in recent decades. We all know that past performance is no indication of future returns and that pursuing some arbitrary level of return, regardless of the allocation, leads to disappointment and unintended consequences that are far worse than reduced returns.
We will continue to utilize balanced portfolios and “take what the markets give us”. Long-term comprehensive financial planning considers those returns and makes adjustments in the interest of meeting life goals, which are far more important than target returns in a portfolio. In the words of financial planner Ben Carlson, we’ll work to make sure our clients’ expectations are better aligned with reality.
A Very Long Hold
Despite the increase in short-term trading (which, just a reminder, is not investing but is speculating and gambling), many investors still search for investments they can hold for a long time and which pay decent ongoing income. In these times of rapid change and very low interest rates, these goals are harder to achieve without greater risk.
But it occasionally happens.
Laura’s great-grandfather was a prominent and successful attorney in the Bay Area and like many successful Americans in the early 1900’s, he took his family on a “grand tour” of Europe. They planned to be gone for nearly a year, and he was not sure what his prospects would be when they returned, so before leaving he invested in some oil properties in Kern County, California. This was an “operating interest” which had rights to a portion of the revenue produced and responsibility for operating costs but not other costs such as financing. The original operating interest was less than 5% of the project.
The investment was split over the next three generations, so Laura now owns just 3.33% of her great grandfather’s original interest. And it is still making monthly royalty payments over 100 years later, depending on the price of oil and the amount pumped. Her share of the monthly payments has been between $250 and nearly $1,000 over the last several years. It’s an understatement to say that this investment has been incredibly lucrative for the family, regardless of the amount invested back then.
Unfortunately, the story does not end well for everyone. In July 2020 the current operators of the field filed for bankruptcy. Over the years the field has changed ownership many times, with debt accumulating along the way, but the operating interest continues to pay as long as oil is pumped at a price above operating costs. Owners of debt issued by the owners (who own many producing wells) will not fare so well, with the initial proposed restructuring plan showing holders of $1.3 billion of debt being repaid less than 35% and holders of $3.2 billion of debt recovering less than 3% of their claims. Ouch!
In the meantime, we will enjoy the family legacy. If the field stops producing and the royalty payments stop, maybe we should make a trip to Kern County and toast our good fortune.