November 10, 2019

I spent the last 2 blogs writing about fee compression in the online brokerage space. If you didn’t get a chance to check those out, you can do so here and here.

For October, the S&P 500 was up 2.04% bringing the total year-to-date return to 21.17%.

Over the past couple of months there has been a change in the underlying constituents that are driving the returns of the overall index. Much of the 2019 rally was driven by high-priced “momentum” stocks but in September and October this shifted to the more of the stable growth if not outright value style stocks in the index.

Due to this regime change we have seen more portfolio turnover in our models than we have in quite some time. This means we have stopped out of several of our best-performing positions (for gains overall) and have been replacing those with new holdings. Unfortunately, this also has led to some underperformance for our Appreciation Strategy during the transition. We presently hold more cash than we want, but many signals are telling us to be cautious heading into the end of the year. For example, the smart money vs dumb money spread as tracked by sentimentrader.com just reached an extreme that suggests more upside in the very near term, but perhaps at the expense of a meaningful drop after that:

Our Income Strategy has largely benefited from this shift (away from momentum) along with the continued deterioration of interest rate markets around the globe. Although, the amount of negative-yielding debt has recently pulled back from all-time highs of over $17 Trillion. Even still, interest rates are historically extremely low, and could easily be headed much lower from here.

In speaking with a private fixed income manager who focuses on 1st lien sort of private loans he reminded me this week that the Federal Reserve bank’s balance sheet is still a very small percentage of our country’s GDP relative to many other developed nations. This latest round of “not” QE (Quantitative Easing) could be just the start. If the Fed is back to growing its balance sheet, then asset prices around the globe are poised to rise further.

The Tax-Free Income Strategy has simply had a phenomenal year with around 1/3rd of its gain coming in the form of tax-free interest.

With October out of the way, and the worst December on record coming last year in 2018 when the S&P 500 was down 9.18% for the month, there are plenty of reasons to be optimistic about a strong finish to 2019. (Two bad Decembers, or down years in a row would be statistical outliers.) But also, the other side of that is that there are always reasons to be nervous, too.

Plenty of folks are up this year and will see no reason to take unnecessary risks into the end of the 4th quarter so they may take some profits. Other fund managers are behind their benchmarks for the year and may try to overextend themselves buying in an effort to play “catch-up”. Still others will not want to pay tax on their capital gains this year and will look to hold off on any selling until the calendar changes to 2020.

The big item on the horizon though in my mind is the 2020 presidential election. We are now within 12 months from the big day and it seems to me that Mr. Trump has been using the trade war with China and his tweets related to that as a way to essentially keep pressure on the Federal Reserve and keep a lid on the stock market.

Why keep a lid on the market? So you can let it off when it is convenient!

With only 12 months to go until the election, Mr. Trump appears to control the narrative for both situations and could very easily back off on his stance toward either and claim victory propelling the markets to new all-time highs that are beyond anything we can even imagine today.

Or he could fail to win reelection and if the talking heads are correct, we will see a 25% drop in the markets upon the election of basically any democrat running for office.

As if any of us actually knows anything. Case in point: the most recent presidential election.

I spent some time reviewing news articles from election night 2016, and some other articles published leading up to and then also published after the election. The consensus was that Trump was a long shot to win (like Brexit) and there were plenty of folks on Wall Street supporting Hillary Clinton as the “devil you know”. These were folks like Warren Buffett, Mark Cuban and hedge fund titan David Tepper. Even Jamie Dimon, the CEO of JP Morgan Chase bank hinted at his expectation that Clinton would win when he said, “I hope the next president, she reaches across the aisle.”

Interestingly, even though Wall Street seemed to prefer Clinton in many respects, and all the polls basically predicted a Clinton victory, the evidence shows that the S&P 500 was down almost 5% in the 3 months leading up to election night.

The overnight market for S&P 500 index futures contracts was extremely volatile. While trading started out very smooth and futures even climbed for the first few hours - that all changed dramatically as results began to come in, in favor of Mr. Trump.

So, to recap, markets were saying they expected Hillary and were mostly comfortable with that outcome, yet prices were falling for 3 months. Nobody was really predicting a Trump victory.

As it became more and more clear that Mr. Trump was going to win the election, the sell-off in futures accelerated and reached a low right around the time that John Podesta took the stage at the Clinton celebratory event to tell the crowd to “go home”. That was essentially the moment of maximum pain. It was the ideal time to “go long” stocks. And almost nobody was saying so.

Even today, I have yet to hear of anyone who called that action in advance. I know plenty of folks who traded it and made plenty of money, but anyone who had suggested the order of events and how the market would react in advance would have been laughed at. It’s the kind of stuff that “you just can’t make up”. But its true. (I traded the VIX that night and exited from my cell phone on the way to the airport in the morning!)

And so, when I hear people say, “a Warren presidency will cause a 25% drop in stocks!”, I basically just chuckle. Who knows? Not me. Not the bozos on TV nor the richest of the rich, either.

What is frustrating to me is that it even matters. The person in the White House ought to do what they can to stay out of the markets and let them be “free” to whatever extent that is possible. Truly free markets are a great guide for legislators to follow as they look for ways to improve the quality of life for the citizens they were elected to serve.

In summary, I don’t know what to expect from the next week, month, quarter or year. But I do know that about 70% of all those time-frames on a historical basis are positive. So, our base-case is that markets will rise with about a 70% chance over the next time-frame.

Of course, that means a 30% chance they will fall – and when markets fall, they tend to fall hard and fast. I tend to think the bias in the final year of an election-cycle (Nov-Nov of final year of term) as an extra positive bias, and the statistics would support my thesis with about 80% of those years being positive.

However, caveat that with the fact that December is historically the best month of the year for stocks and the third year of an election cycle is typically the best year of the four and look no further than last year’s December pummeling and annual loss to know that statistics aren’t gospel.

Here is the recap since August 2016, in a picture. There have been 5 separate pullbacks of 8% or more since the election. And since January of 2018, 22 months ago, the S&P 500 has risen only 8%.

We are staying long and minding our trailing stops. We know that over any and all time frames, these rules keep us invested in our winners for the long haul and get us out of our losers quickly. We can’t know in advance which picks will be our best performers – it boils down to following a process to eliminate those that aren’t.

Shane Fleury, CFA

Chief Investment Officer

Elevate Capital Advisors & Elevate Ventures

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