Of course the elections will matter to the markets; but, not that much. The partisan divide and the sad state of affairs of the last week are giving us a preview of the next five weeks and thereafter. Shrill political ads full of half-truths on both sides will fill the airwaves, social media, etc. I, for one, have had enough! And, clearly, market participants have heard so much of this since the 2016 elections that they are inclined to ignore it and they are right to do so.
It is very unlikely there will be a “blue wave.” And, certainly, it is unlikely there will be a “red tide.” The highest probable outcome is an incremental change in the blue direction. It is unlikely there will be a mandate. But, there is a fair possibility of a divided government. A divided government will not undo the tax cuts, deregulation, nor the more business friendly Federal government that has supported improved economic growth and higher stock prices. The elections add to uncertainty. Uncertainty is uncomfortable. Frankly, uncertainty is the usual case. Serious investors are looking through the noise at the fundamentals.
So, what are the fundamentals? The ones that matter are sentiment, money, and valuation. In the short run, sentiment matters most. Markets can get “overbought/oversold.” There are times when there is a lot of money on the sidelines and times when there is little. Right now, there is little. The Investors Intelligence Survey of Advisors shows over 40% more Bulls than Bears on US stocks. That is an extreme position that in the past has almost always indicated a correction is likely.
As for money, we have had money supply expansion by all the central banks in the developed world, including an unprecedented thing called “quantitative easing.” That is buying bonds with “printed” money. That is changing. The Federal Reserve has started to “normalize” monetary policy. Fed Funds overnight interest rates are rising. A “normal” Fed Funds rate can be expected over the next couple of years. That could be 3.5% - 4%; almost double today’s level. And the Fed is selling bonds, not buying. Other central banks are considering similar tightening moves. Asset prices (i.e. stocks, bonds, real estate, art, etc.) have enjoyed easy money for a very long time. The next few years will not be so easy. Monetary factors point to a more difficult time over the intermediate term.
Valuation is the one fundamental that remains positive for stocks. Corporate profits have exploded thanks to the tax cuts and faster economic growth. Earnings are going to grow some 20% this year. Forecasts for next year are for about 10% more. So, the price/earnings ratio of the Standard & Poors 500 is still in the mid-high teens on next year’s expected earnings. The valuation of the stock market is not at an extreme level. That means a 20% decline, a so-called bear market, is not likely soon. Valuation is the most important factor in the long run.
This is what serious investors see. There is a high likelihood of a short term correction. Maybe the elections will be blamed for it. But, valuation indicates it will be contained. The S&P is up about 8% year to date, maybe it corrects back to where it started. In the next few years though, stocks should do okay. However, with interest rates rising, don’t expect stocks to return more than 5% - 7% per year. That will still be better than bonds.
Meanwhile, this morning it was announced that a new trade agreement among the US, Mexico, and Canada has been completed which replaces the outdated NAFTA agreement made in 1994. The most important part of the new agreement is the $16 per hour minimum wage in Mexico for workers in the auto and auto parts manufacturing business. This wage is pegged to the US dollar and cannot be reduced by devaluing the peso as has happened in the past. And, it must be paid on cars and parts shipped into the US. This is a win for our pro-business, nationalistic administration. And, it is a big win for American workers!
As Warren Buffet reminds us, a few hundred elected people in Washington D.C. cannot stop the cleverness and industry of 350 million people in a free country. The markets and life will go on after November 6.
A note from WSC and WAMI . . .
Robert C. Davis is a Chartered Financial Analyst and is affiliated with Woodlands Asset Management, Inc. as a consultant. Founding partner of Davis Hamilton Jackson and Associates, a Houston based investment advisory firm; Bob is now retired and living in Chappell Hill, Texas. He now lends his expertise and knowledge of the markets to our company and customers. We hope you find it interesting and insightful.