Does the Market Have a Political Preference?



Does the stock market favor one political party over another? One might assume the performance would be roughly in line over a long period of time under both Democratic and Republican administrations.  Surprisingly, history tells a different story. Going all the way back to 1932 with the election of Franklin D Roosevelt, there have been 7 Democratic and 7 Republican administrations.  This encompasses a period of time that includes the recovery from the Great Depression, World War II, an oil embargo, the Dot-Com Bomb, the Global Financial Crisis, and of course, most recently, a global pandemic.  In short, there have been plenty of economic disruptions or crises with both parties at the helm of government.   A commonly-held belief is that Republicans are the party of fiscal responsibility, lower taxes, increased job prospects, and lower deficits while Democrats focus on the expansion of social welfare programs that carry a higher price tag, resulting in higher taxes and/or deficits. Do these conventions hold up?

According to the data, over the last 9 decades, the Republicans have lagged their counterparts in terms of economic growth (as measured by GDP and job growth) and stock market returns.  Below is a chart of annualized GDP (Gross Domestic Product) growth by administration.

 

One need not be a statistician to see the stark contrast.  According to Blinder and Watson[1], “The US economy has performed better when the president of the United States is a Democrat rather than a Republican, almost regardless of how one measures performance.” 

Another way to view this is just looking at the headline numbers:



Now, let us take a look at how markets have performed under both Republican and Democratic administrations:

 

Again the data suggests that, historically, the stock market has performed better during Democratic administrations. 

Obviously, this does not prove cause and effect, nor does it show that there is a linear relationship.  The timing and severity of the crises outlined above has had a significant impact on the steepness and duration of market drawdowns.
 
This data does, however, complicate the argument about fiscal austerity versus stimulus.  As the Biden administration contemplates a $1.9 trillion recovery package, concerns about the debt level alone may be overblown if we are to look at history as a guide.  


[1] Blinder, A.S. and Watson, M.W., 2016, Presidents and the US Economy: An Econometric Exploration, American Economic Review, 106(4)

Is Value Dead?

Given recent performance, some clients have raised the question about whether the value premium is “dead.”  As evidenced-based investors, we typically turn to the data to demonstrate and reinforce that value is one of the single most important factors in investing.  In fact, next to the equity premium itself (the stock market minus one-month Treasury bills), the value premium is, perhaps, the most persistent and significant.  From an economic perspective, if you believe and expect that there are differences in expected returns across stocks, one can easily extrapolate that there is a value premium.  This means that stocks with high discount rates are expressed as lower prices, which in turn, means that lower priced stocks tilt toward higher expected returns.  However, the value premia are highly volatile and can appear quite suddenly.  This means if you are not invested in these stocks, you will miss that momentum change and the corresponding upward movement of these stocks. 

You certainly would not have been faulted for dialing back on value over the past decade as it has been in somewhat of a bear market, especially when compared to growth stocks.  In the chart below, you can see how value has performed over a very long time horizon.  No asset class performs in a linear fashion as is evident in the graph.  However, a preponderance of years dating back to 1937 in the US, show the value premium has been accretive to those that had this exposure in their portfolios.

According to a recent communication from Bank of America, there are “several reasons” why investors believe there will be a comeback in value, including:

  • In 14 of the last 14 recessions, value stocks led in the recovery, and economists believe that we are nearing the GDP growth trough
  • Profits drive style cycles, and profits forecast indicates trough growth in Q2 2020. In every profits recovery except two (post-Tech Bubble and 2016), the trough to peak in corporate profits growth saw value lead by a large margin
  • Value is currently deeply neglected
  • Value stocks trade at record levels of cheapness relative to momentum stocks; furthermore, growth factors trade at a record premium to the market on almost any measure

Finally, the top stocks in the market, FAAMA (Facebook, Amazon, Apple, Microsoft and Alphabet) account for roughly 40% and 20% of the NASDAQ and S&P 500 respectively.  These are unsustainable valuations and will likely lead to lower expected returns of these growth stocks over time.  Therefore, value may well be about to see the light of day…again.

This time isn’t different – Reports of value securities’ death are greatly exaggerated

Derive the intrinsic value of a company and compare it to the market price.  Buy if cheap and sell if expensive.[1]  Benjamin Graham and David Dodd wrote these words in their magnum opus, Security Analysis Principles and Technique in 1934. 

Essentially, they identified a way in which to move asset purchases from the realm of speculation to mathematical calculation.  Much later, Basu (1977) first published his academic paper on the superiority of value strategies in comparison to the general market.  “To the extent low P/E portfolios did earn superior returns on a risk-adjusted basis, the propositions of the price-ratio hypothesis on the relationship between investment performance of equity securities and their P/E ratios seem to be valid.”[2]  There’s been a prodigious measure of articles on the decline of value securities in the financial press over the past decade.  Have value stocks really lost their vigor?  According to Dimensional Fund Advisors, “Value stocks have underperformed growth stocks over the past decade. In the US, the annualized compound return has been 12.9% for value stocks, or those trading at a low price relative to their book value. That contrasts with 16.3% annualized compound return for growth stocks, or those with a high relative price.”[3]  This doesn’t necessarily mean that value stocks have underperformed, but rather that growth stocks have significantly outperformed.  In the graph below, it should be clear that value stocks are well within their margin of error in respect of expected return assumptions.  What should also be evident from the graph is the extent to which growth stocks have outperformed in recent history, thus creating a ripe opportunity for inaccurate causal inferences or generalizations suggesting this era is “different”.

As of June 30, 2019. In US dollars. Fama/French indices provided by Ken French. See Index Descriptions in the appendix for descriptions of Fama/French index data. Eugene Fama and Ken French are members of the Board of Directors of the general partner of, and provide consulting services to, Dimensional Fund Advisors LP. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results.

“Undervaluations caused by neglect or prejudice may persist for an inconveniently long time, and the same applies to inflated prices caused by overenthusiasm or artificial stimulants.”[4]  It shouldn’t come as a surprise that having a 10-year negative premium, much like the last ten years in value, is not an unusual event.  It’s happened before in the US.  Furthermore, according to Research Affiliates, “If valuations were to mean-revert today, value will outperform growth by 35.3%.”[5]

As an investor, what is the appropriate course of action based on the information above?  For tactical investors, paring back growth equities might be a prudent decision.  However, if you’re investment horizon is long-term and you don’t need funds/income currently, make sure you’re rebalancing your portfolios according to your investment plan.  The great economist John Maynard Keynes once opined, “In the long run we are all dead.”  However, in the world of investments, in the long run, investments will achieve their expected returns.

Risk Warnings and Important Information

This article is for information purposes only and is not intended to be relied upon as a forecast, research or investment advice. The value of investments can fall as well as rise.  You may not get back what you invest. Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a reliable indicator of future results.

Although the information is based on data which MASECO considers reliable, MASECO gives no assurance or guarantee that the information is accurate, current or complete and it should not be relied upon as such.

[1] Graham, B., Dodd, D.L. (1934).  Security Analysis Principles and Technique.  New York and London. McGraw-Hill Company Inc.

[2] Basu, S. (1977).  INVESTMENT PERFORMANCE OF COMMON STOCKS IN RELATION TO THEIR PRICE-EARNINGS RATIOS: A TEST OF THE EFFICIENT MARKET HYPOTHESIS. The Journal of Finance – Vol. XXXII, No. 3., pp. 663-682.

[3] Dimensional Fund Advisors.  https://us.dimensional.com/perspectives/value-judgments-viewing-the-premiums-performance-through-historys-lens

[4] Graham, B., Dodd, D.L. (1934).  Security Analysis Principles and Technique.  New York and London. McGraw-Hill Company Inc.

[5] Kalesnik, V., PhD, Reports of Value’s Death May Be Greatly Exagerated, Fall 2019, Research Affiliates Investment Symposium

Understanding Inverted Yield Curves and What They Mean to You

In March of this year, the US bond yield curve inverted. What does that mean? We must take a step back and understand what and how bond yields or interest rates are determined. The term structure sets forth the relationship between bond yields (interest rates) and different terms or maturities. When this is formally plotted out into a graph, we have what is known as the yield curve. This in turn plays a key role in market participants’ expectations of future changes in interest rates. Generally, yields or interest rates increase with longer maturities. This is what economists call a normal yield curve. In commodities the term is contango, where spot or current prices are lower than future prices. As was mentioned above, the US Treasury yield curve is currently inverted. That means that short term rates are higher than long-term rates. Again, in commodities this is known as backwardation, which is the opposite condition to that when prices are in contango. Please see the figure below as of 12 June 2019.

 

Current Yields

Source: https://www.treasury.gov/resource-center/data-chart-center/interest-rates/pages/textview.aspx?data=yield

As evidenced in the chart above, 1-month rates are higher than all those longer-term rates until you get to 20-year US government bonds.

What is the day-to-day impact for individuals and businesses? First, as the yield curve started to flatten earlier this year, and inverted for a short time in 2018, the Federal Reserve became much more dovish on hiking interest rates at the pace they initially set out in the 4th quarter of 2018. When the curve inverted, this has historically been a precursor to an impending recession. To test this hypothesis, a search of the US Treasury website shows that in the last 50 years, an inverted yield curve, one in which the majority of longer-term yields have been lower than shorter-term yields, has turned into a recession between 6 and 24 months following the inversion. From and economics standpoint, a recession means two consecutive quarters of negative Gross Domestic Product (GDP) growth. There are also times where just some of the longer-term rates are lower than the shorter-term ones. These periods have not been accurate predictors of an impending recession.

For businesses, they could find it more difficult to expand their operations due to higher borrowing costs on short-term loans. This is also true for consumers. Furthermore, consider households that have adjustable rate mortgages or ARMs. This means that in each anniversary of their loan, rates will jump. This situation applies to any debt instrument, including bonds. As an economy enters a recession, there will be a behavioral tendency for investors to seek shelter in safer investments. That means investors will move toward bonds, which will in turn increase bond prices and lower their yields. Unemployment will rise as businesses borrow less and the downward spiral of the economy will continue until some floor is met. As investors, it’s important to understand that these are temporary and expected occurrences in any economy. Investors need to be vigilant in maintaining their diversified portfolios and to continue to rebalance should equities decline in value.

Risk Warnings and Important Information

This article is for information purposes only and is not intended to be relied upon as a forecast, research or investment advice. The value of investments can fall as well as rise. You may not get back what you invest. Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a reliable indicator of future results.

Although the information is based on data which MASECO Asia considers reliable, MASECO Asia gives no assurance or guarantee that the information is accurate, current or complete and it should not be relied upon as such.

MASECO Asia Limited (CE# BHR224) is authorized and regulated by the Securities and Futures Commission of Hong Kong to carry out Type 9 Regulated Activities.

Are We Close to CAPE Fear?

Way back in 1934, Benjamin Graham and David Dodd published a famous financial analysis tome called Security Analysis. They argued that one-year returns are too volatile to make any informed decision on the future of a firm’s stock price.

It was suggested that using data of five or even ten years to smooth the returns was a far better predictor of a security’s forward-looking price. If we then fast-forward to the 1980’s, “Stock Prices, Earnings and Expected Dividends” was published by John Campbell and Robert Shiller. They determined that “a long moving average of real earnings helps to forecast future real dividends” which are correlated with returns on equities. Shiller would eventually go on to use Graham and Dodd’s analysis as a way to value the stock market. Shiller and Campbell used market data from both estimated and actual earnings reports from the S&P index and found that the lower the CAPE (cyclically-adjusted price earnings), the higher the investors’ likely return from equities over the following 20 years.

Below is a graph of the CAPE over time and in relation to the current value of the S&P 500. As a point of reference, in the 20th century, the CAPE had an average value of 15.21 (Shiller, 2014). The rather disconcerting point is that as of the end of Q1 2019, the CAPE is double the long-term average.

Source: Online data from Robert Shiller, http://www.econ.yale.edu/~shiller/data.htm

Data as at May 2019

The graph below is a new version of Shiller’s CAPE which takes into consideration recent structural changes. As Shiller states on his webpage, “As of September 2018, I now also include an alternative version of CAPE that is somewhat different. As documented in Bunn & Shiller (2014) and Jivraj and Shiller (2017), changes in corporate payout policy (i. e. share repurchases rather than dividends have now become a dominant approach in the United States for cash distribution to shareholders) may affect the level of the CAPE ratio through changing the growth rate of earnings per share. This subsequently may affect the average of the real earnings per share used in the CAPE ratio. A total return CAPE corrects for this bias through reinvesting dividends into the price index and appropriately scaling the earnings per share.” This shows an even greater disparity between the long-term average and the current level.

Source: Online data from Robert Shiller, http://www.econ.yale.edu/~shiller/data.htm

Data as at September 2018

History has shown that when the CAPE is high, as it is now, it is suggested that buying equities when the stock market is expensive dampens subsequent returns. A review of current CAPE values in the US, developed ex-US, and emerging markets shows that greater relative value lies in the emerging market space. On the other hand, as CAPE is not a good predictor of short-term returns, returns from this current cycle can still be high; it’s impossible to predict the stock market return over the next 12 months based on valuation factors.

The last US recession ended in Q2 2009. The boom and bust, (better defined as expansion and contraction) business cycles of the U.S. economy averaged 38.7 months in expansion and 17.5 months in contraction between 1854 and 2009. According to the National Bureau of Economic Research, there were 33 business cycles between 1854 and 2009, with each full cycle lasting roughly 56 months on average. A recession from an economic standpoint consists of two consecutive quarters of negative GDP (Gross Domestic Product) growth. To put our current cycle in context, we are currently in month 119 (as of April 2019) of expansion.

If one combines the current degree and length of expansion in the US with an exceptionally high CAPE, it’s not a far leap to expect weaker growth for US markets over the medium term with the prospect of a recession being unsurprising from a historical standpoint. However, as we know, past events and performance are not necessarily predictive in nature.

Risk Warnings and Important Information

This article is for information purposes only and is not intended to be relied upon as a forecast, research or investment advice. The value of investments can fall as well as rise. You may not get back what you invest. Investments involve risks. The investment return and principal value of an investment may fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original value. Past performance is not a reliable indicator of future results.

Although the information is based on data which MASECO Asia considers reliable, MASECO Asia gives no assurance or guarantee that the information is accurate, current or complete and it should not be relied upon as such.

MASECO Asia Limited (CE# BHR224) is authorized and regulated by the Securities and Futures Commission of Hong Kong to carry out Type 9 Regulated Activities.

The Government Shutdown: There’s more at stake than just a wall

When the President of the United States opted not to sign into law a bipartisan bill to fund several government agencies (a bill which was overwhelmingly supported in both the House of Representatives and the Senate), the US Government entered a partial shutdown at midnight on the 22nd of December.    A government shutdown isn’t a unique event anymore.  Shutdowns go all the way back to President Carter, and the only period in which there wasn’t a shutdown was during the George W Bush Administration. Now in its third week, the current shutdown is the longest in US history.

What is the real impact of a shutdown from an economic perspective?

Let’s start with the actual employees that are impacted by the shutdown. The current shutdown impacts roughly 800,000 federal employees comprised of nine federal departments:

  1. Department of Treasury
  2. Department of Agriculture
  3. Homeland Security Department
  4. Department of the Interior
  5. Department of State
  6. Department of Housing and Urban Development
  7. Department of Transportation
  8. Department of Commerce
  9. Department of Justice

Many of these employees, such as the Transportation Security Administration, will have to work without pay. These are the individuals that help protect the US and travellers to the US at airports around the country.  So how does this impact them?  According to Northwestern Mutual’s 2017 Planning and Progress Study[1], roughly 70% of US workers  live pay check-to-pay check.  This statistic inevitably includes a (significant) portion of the TSA workers.  Credit card bills, mortgages, utilities, rents, etc. are likely to become delinquent due to the cash flow constraints of these workers.  And these are just some of the knock-on effects.  In some states, the federal government is the major employer.  In cases such, there is a further erosion of the supporting community, such as restaurants, shops and banks, as patronage will be lower due to the federal workers having limited resources to put back into local commerce.

There are also more macro-related issues surrounding shutdowns. In the US, for instance, interest rates have been rising due primarily to the strong economy and the increasing level of inflation.  This has already made borrowing money more expensive with regard to mortgage repayments (those that have a variability aspect to them), consumer debt, auto leasing, etc.  The shutdown exacerbates the situation by making the economy more unstable.  The US hasn’t been in a recession since June 2009, which marked the end of the Great Recession or better known as the Global Financial Crisis.  Shocks to the economic system such as a government shutdown could be a catalyst for propelling the US into a correction or recession. We saw some of these fears play out in the US stock market in late December/early January.

Credit concerns are another aspect to the government shutdown. According to Standard & Poor’s, the US credit rating stands at AA+.  Both Moody’s and Fitch have the US at Aaa and AAA respectively.  A protracted shutdown could lead to a downgrade of that rating.  If that happens, interest rates will rise, bond debt will worsen, and the dollar could potentially see a real weakening against the global market basket of currencies.  This would result in a higher cost for imports.

Investing globally will help soften the blow of any negative impacts from the government shutdown. But, as the old adage goes “When General Motors sneezes, the stock market catches a cold.”  Now simply replace General Motors with the United States and the stock market with the global economy, and you have a recipe that isn’t very appealing.

[1] https://news.northwesternmutual.com/planning-and-progress-2017

What’s Going on in Emerging Markets?

After 2017, a year in which emerging markets gained more than 35%, investors are very concerned about the performance in 2018. Year-to-date, emerging markets are down nearly 8%.  If valuations in the space are at multi-decade lows, what can explain this seeming discrepancy?  It turns out there are several factors contributing to weak performance so far this year.  First, although it is easy to assume it has little effect, the US dollar has strengthened significantly in 2018.  In local EM currency terms, the dollar has rallied nearly 10% in some instances (compared to 4% in dollar terms)[1].  Some of these countries (e.g., Turkey, Argentina, and others) are actually seeing bear market territory for their securities in US dollar terms.  Emerging markets tend to underperform historically when the US dollar gains strength.

The next factor is the move towards protectionist policies on an international scale, and in particular, by the US. Further exacerbating the situation, Trump, has instituted a non-systematic trade war with multiple countries, some of which are emerging market economies.  As an example, Trump has targeted Turkey which is a key EM economy and is intricately connected to many other emerging market economies in the vicinity.  The threat of tariffs has had a detrimental impact on EM economies that sell to the US (i.e., EM exports will decrease causing an increase in unemployment in these countries).

A third factor is the rebound in commodities, particularly oil. If you look at current oil prices (Brent, WTI) compared to last year over the same time, oil has moved nearly 50% higher.  This has a more negative impact on emerging markets because it makes manufacturing costs higher.

Although the above points paint a not-so-rosy outlook on emerging markets as an asset class, many emerging market economies have improved their current account deficits and strengthened their overall financial position. It is also important to view EM in a worldwide context.  From a CAPE (cyclically adjusted price earnings) perspective, emerging market countries are poised to outpace the rest of the world over the next 10 to 15 years.  The United States has had its longest bull market in history, and prices haven’t yet receded.  The last recession in the US ended in June 2009.  This means the US is on its nearly 37th quarter (111th month) without a recession.  With the average economic cycle lasting between 5 – 7 years, the US is poised not only for a recession, but its equity market has and continues to be highly, if not, fully valued with a CAPE near 40%.

From a long-term investment view, attempting to call the top of the US market (or the low of emerging markets, for that matter) is a fool’s errand, likely amounting to nothing more than a blip over the long haul. As history and academia teach us, it’s very important to never attempt to time markets; it is a losing proposition. Where we are in the current business cycle is no different.  Emerging markets remain an important part of a global asset allocation strategy, but investors must expect higher than average volatility in this asset class since it is less stable than other developed markets.

[1] http://www.morningstar.co.uk/uk/news/170562/2018-a-very-tough-year-for-emerging-markets.aspx/

 

The Economics of Tariffs

Recently, President Trump unilaterally decided that the US is going to institute tariffs on both steel and aluminium. Tariffs have been used in the past by previous administrations and, indeed, other countries around the world. Tariffs, or customs duties, are taxes on imported products, usually in an ad valorem form, levied as a percentage increase on the price of the imported product. Tariffs are one of the oldest and most pervasive forms of protection and barrier to trade.

Who benefits from such a tax? In this case, steel and aluminium manufacturers. Who loses? Everyone else. In the US, the working population is estimated to be around 145 million. How many workers are employed in the steel and aluminium industry? That number is about 200 thousand. Doing the math, this tax will favour roughly 0.14% of the overall labour force. So, Trump is taxing the users of these materials whilst protecting those who manufacture the products.

Who pays for these taxes imposed on exporting countries? Everyone. Meaning, a 25% increase in steel imports will mean that consumers in the US will pay an additional 25% on steel inputs. That means new cars, beer, watches, household appliances, etc., will be more expensive. Why would a country assess such a punitive additional cost to consumers? In this writer’s humble opinion, for optics to look tough to the voting population (if the country is somewhat democratic). Anyone who has a rudimentary understanding of economics will likely agree that tariffs are generally bad for the economy. Furthermore, there is a strong likelihood of retaliation from exporting countries which could trigger a costly trade war. Europe, for example, has promised to put tariffs on Harley Davidsons, bourbon and blue jeans. These are specifically targeted at the home states of particular members of the US Congress.

As an investor, do tariffs impact your portfolio? Yes. It’s unlikely that increased costs, i.e., tariffs, will not have a negative impact on an investable portfolio. The US accounts for nearly 25% of world gross domestic product (GDP), which means the impacts of these increased expenses will spread throughout much of the world. In turn, these increased prices will have knock-on effects on businesses worldwide. Taxes are ultimately paid for by consumers as businesses pass these costs into their end products (goods and services).

What should an investor do? The primary defence against specific political risk, such as tariffs, is to make sure your portfolio is diversified geographically, as well as amongst sectors and industries. This will help mitigate the risk from any government or region as best one can.

Winter is Coming?

It’s hard to imagine that there is much value left in US and other developed nations’ equities.  The Global Financial Crisis (GFC) ended in March 2009 and with it, the last bear market.  The current bull market is about to enter it’s ninth year.  According to the National Bureau of Economic Research, since 1945 there have been eleven business cycles as measured from peak to trough.  The average cycle has lasted 5 ½ years.  Furthermore, the average bull market has been 97 months (8 years).  While the average duration for a bear market since the 1930s has been 18 months.  With that backdrop, it’s an interesting time to be investing in equities.

The Big Win

Richard Thaler of the University of Chicago was awarded the Nobel Memorial Prize in Economics in 2017. At the announcement of his award, it was stated that he “has incorporated psychologically realistic assumptions into analyses of economic decision-making. By exploring the consequences of limited rationality, social preferences and lack of self-control, he has shown how these human traits systematically affect individual decisions as well as market outcomes.” To the retail investor, behavioural finance remains one of the most destructive forces on an individual’s portfolio. Individual investors often fail to act rationally based on numerous influences in the market. Biases include:
1) overconfidence – believing the market will just continue to rise or fall;
2) hindsight – believing that past performance is indicative of future movements;
3) familiarity – working in (e.g.,) the auto industry and diversifying or investing in that area alone; and
4) unrealistic expectations – expecting, for example, a 10% return on a portfolio that has a large percentage of fixed income.
It’s an important statement from the Nobel Foundation to recognize yet another behavioural economist. Past winners include George Akerlof, Robert Fogel, Daniel Kahnemam, Elinor Ostrom and Robert Shiller. As David Booth stated, “The most important thing about an investment philosophy is that you have one you can stick with.” This statement helps beat back the behavioural biases that each of us are seemingly imbued with on a regular basis. What makes these biases so difficult to overcome is down to the fact that they are psychologically motivated. If it were, say, simply investing in a mathematical way, it would be easy. That’s what quantitative money managers do and it lends itself to a simple algorithm (that is, if algorithms are simple). A computer program is much easier to control than one’s own psyche.
One way to combat these psychological impediments is to endeavour not listen to the talking heads on TV or the countless “financial” blogs, publications, magazines, etc. It’s not easy to keep at bay all the influencers out in the marketplace trying to tell you what you should be doing. However, most, if not all of these publications or programmes, are simply trying to sell something like air time on TV or ad space in a magazine. Think back to what David Booth said. Put a plan together and DON’T deviate. If you need funds from your investments, plan in advance. Otherwise, short-term market ups, downs and flat lines have little effect on your portfolio over the long-term.

Mark Scher CIMA®
Senior Wealth Manager