Market Outlook, 4th Quarter

October 6, 2020    |    Sage Capone

Key Points for Retirement Planning with Hawaii Investors 

  • Election: The historical evidence on Presidential elections suggest they have a much smaller impact on markets than most investors think.

  • Tech Stocks: Technology stocks have led this market higher but ran out of steam at the tail end of the third quarter.

  • Interest Rates: The Federal Reserve has made an important policy shift and communicated it expects to maintain ultra-low interest rates for several years.

Summary

There are three big areas of interest for Hawaii investors heading into the fourth quarter of 2020. The first is the election. The historical evidence on Presidential elections suggest they have a much smaller impact on markets than most investors think. The election is really a short-term issue for the markets to digest. For investors, short-term issues are just that, short-term with little impact on longer-term market results. The second is the correction in technology stocks. Technology stocks have led the market higher but ran out of steam at the tail end of the third quarter.

The question for Hawaii investors is whether this correction can derail the market recovery. This is an intermediate-term issue for the markets to work out but will be resolved before too long. The third is the implication of the Federal Reserve’s change in monetary policy to a “flexible average-inflation targeting” policy. If that term is new, it’s because it is new.

In brief, the Federal Reserve has made an important policy shift and communicated it expects to maintain ultra-low interest rates for several years. This policy shift is the longer-term issue and the relevant one for long-term investors to identify. The first two issues will be resolved before too long, while monetary policy will likely be the dominant theme determining asset class relative performance.

Election

Presidential elections evoke many headlines and emotions. Making investment decisions based on emotions rarely serves investors well. As an objective money manager, we try to remove emotion from the decision-making process. To do that, we rely on the objective data to help guide decision-making. The objective data is clear, there is no statistical difference between the market’s performance during an election year and any other year. [Figure 1]

Not only are returns not really impacted, but market volatility really does not change as the election nears. From January 1, 1964, to December 31, 2019, the S&P 500 Index’s annualized volatility in the 100 days before and after the election are both 13.8%. That is lower than if measuring the entire time period, which shows 15.7% annualized volatility. This might surprise investors because media and market pundits often discuss concern about heightened market volatility as the election nears.

That surprise or deviation from the actual data, is the emotion of the event that tends to augment sensitivity to any swing or move in the market. Therefore, it’s important to remove emotions from the decision-making process. The markets have been through many Presidential elections and it is simply a short-term uncertainty that the market will digest and move beyond like it always does.

Technology Stocks

Technology stocks have led the rally back from the lows earlier this year in March. It really has been the five largest technology stocks that have driven the rebound in the S&P 500. The top five stocks in the S&P 500 are: Microsoft, Apple, Amazon, Facebook, and Alphabet (formerly named Google). A point of clarification though, Amazon is technically categorized as a consumer discretionary stock, but it is commonly considered a tech stock.

The S&P 500 is what is called a capitalization-weighted index, which means the largest companies command the largest weight in the index. These 5 companies are so large, they now occupy more than 20% of that index, a concentration that is higher than anytime during the past 30 years. [Figure 2]

So, what happens to these five stocks really matters to the broader market. This concentration is a risk that will ultimately reverse at some point. For the year through September 18, these five stocks had returned approximately 28% while the other 495 stocks are down -3.4%! What this means is that most diversified portfolios would not keep up with the index while these five stocks are leading by that much. But this is by design, the academic research and industry standard recommends that investor portfolios should be much more diversified and not concentrated in a few stocks. The market will sort this out in the intermediate-term and reversion to the mean is likely win out.

Interest Rates

The Federal Reserve (Fed), the central bank of the United States, has announced that it will implement a “flexible average-inflation targeting” policy. This may sound like something to skip over, but it will be the main driver of asset class performance over the next several years. The Federal Reserve will now be trying to push inflation above its target (2%) for an undetermined time, making up for years of inflation below 2%. This may seem strange to investors that have been around for a while.

Ever since the late 1970’s, the concern over Fed policy has been how they are going to contain inflation and clamp down on it. Their main policy tool was raising interest rates to combat any inflation signs running above certain levels. However, they are now in the exact opposite camp trying not to contain inflation but encourage inflation to run higher.

There has been a lot of academic and economist research done that suggests expectations is the main driver of inflation (or deflation). What people think inflation will do drives real world responses and expectations to price changes. What this means is that the Federal Reserve is trying to communicate to everyone that it is going to maintain ultra-low interest rates for years, essentially below the rate of inflation.

The Federal Reserve put out their “dot plot” indicating where members expect interest rates in the coming years. The majority show no real change for short-term interest rates through 2023. [Figure 3]

The low interest rates and accommodative monetary policy stance is long-term supportive of further equity market gains. While this policy is meant to help the overall economy and to support full employment, it will simply take time for the economy to fully recover from the COVID-19 pandemic shock.

Nevertheless, markets are likely to respond quicker than the underlying economy. While the Fed helps to support the economic recovery for the next several years, markets are likely to find underlying support for higher prices well before all the economic news is good.

Honolulu Investors should not get distracted by the elections or the ebbs and flows of the top tech stocks. Rather, investors should realize that conditions are ripe for further economic recovery and further gains while Fed policy of ultra-low interest rates is supporting both.

As always, if you would like to discuss your portfolio or re-visit your risk profile, please do not hesitate to contact us for retirement planning and financial planning services.