by Brad M. Weafer, CFA Chief Investment Officer
It is election day in the United States and tonight the country will watch state by state as results roll in. Over the course of the preceding two months, the U.S. stock market has been weak. Day to day headlines have frightened jittery investors trying to handicap the election and anticipate what the outcome will mean for stocks. The foremost questions we hear from clients, “what does it mean for markets and how will we position portfolios in the event the incumbent political party loses the White House”. The tone and emotion contained within these discussions is quite suggestive of the personal political views held under the surface. Political headlines splashed on news outlets and social media is troubling to say the least. Betting odds on who will win the presidency have shifted meaningfully over the previous month. Investors and citizens alike are refreshing their memory on the rules governing the electoral college.
The year is 2016, not 2020. I think about this memory often. As stewards of capital, BFM has the difficult job of assessing the probability of various outcomes (political and otherwise) and predicting the resulting impact on markets. Those scenarios never occur in a vacuum. Consider the 2016 case again. The consensus opinion heading into that election was a Donald Trump win was bad for markets. His approach and tactics were, and remain, polarizing. At the time, many clients were very concerned about the prospects of a Trump presidency. The possibility of a Trump victory grew as election day approached. When the results came in, overnight futures fell sharply, as if to confirm that fear. But a funny thing happened the next day. With the uncertainty of the election over, investors started to assess the reality of the situation, rather than solely focus on fear associated with one man. The election was more than the presidency after all. Almost instantaneously, attention shifted to the implications of an all Republican led government. In this immediate aftermath of the first day declines, stocks began to rally. The “obvious” beneficiaries of a Republican regime became the leading stocks in the markets, at least for a time. Energy companies outperformed significantly early on, given hopes of deregulation. Cyclical companies that would have been bolstered by increased infrastructure spending also did well. On the flip side, the tech leaders of Silicon Valley were the weakest performers early on, with the “FANG” (Facebook, Amazon, Netflix, and Google) down on average 8% in the five trading days post-election. The two months following the election were a difficult time for investors like us that favor high quality companies that can do well in good and bad economic scenarios. The “obvious” trade did not last, however. Fast forward one year, energy was one of the worst performing sectors, as the true drivers of earnings power (namely oil prices in this case) mattered much more than any politics could. Cyclical companies also began to lag the broader market as hopes for a successful and timely infrastructure package waned. The large dominant technology companies that saw shares significantly decline following the election, went on to a 4 year period of significant outperformance as the trend of increased digitalization of how we live, work, and play, far outweighed any other concerns.
What are lessons we learned during this episode? First, forecasting the future is hard, some might even say it is folly to even attempt it. Second, when a risk or an opportunity seems obvious, there is a likely chance it has at least in part already been discounted by investors. Lastly, and maybe most importantly, while policies can have an impact on company’s fortunes and investor sentiment, there are often much more important factors that drive corporate earnings that are the true driver of stock prices.
Fast forward to today. For months investors have debated what potential party combinations of President and Senate will mean for important policies going forward. Early consensus has formed around a few themes. First, a Biden win and Democratic led Senate increases the prospect for increased fiscal stimulus to provide more assistance to struggling workers and businesses suffering due to the COVID-19 pandemic. This would be supportive of economic growth and earnings near term, a positive. This outcome also likely increases the odds for higher taxes on corporations and wealthier workers at some point, a negative. A Biden win and a Republican Senate likely lowers the chance of and/or limits the size of the potential stimulus, but also lowers the odds of a tax increase. A Trump victory with a Republican Senate and Democratic led house is a return to the current status quo. This likely still results in some form of stimulus, but also more of the gridlock in D.C. we are becoming accustomed to. If nothing else, business leaders will be presented with these same prospects of change. They can now make more decisive decisions with more information than they had a week ago. Just lifting the uncertainty of the outcome is a general positive.
With that backdrop in mind, how do the lessons of 2016 and history help us today? By the time you read this on November 4th, we will likely know which party controls Congress (for the next 2 years at least). We will at minimum be closer to knowing who the next President of the United States will be and hopefully will not have to wait too long for a definitive answer. Depending on those outcomes, we can form opinions on the probability of all sorts of public policy as discussed above. If that sounds ambiguous, it should. There is very little certainty associated with any of these scenarios especially while the cloud of the coronavirus hovers above all else.
We play the same game of scenario analysis every four years of a presidential cycle, more often when you consider midterm election results. Despite all the attention, and how momentous these policies appear, history tells us that the parties in power do not play a dramatic role in the outcome. An analysis by Fidelity suggest that there is only a few percentage points per year difference in the return of the S&P 500 based on the most disparate outcomes of the potential outcomes of an election (see the table below).
The obvious question left still unsaid, how do we construct portfolios today considering all this? It is instructive to look at another recent experience to help us answer that question. In early 2020 the U.S. economy was strong. Unemployment sat in the low single digits, as low as any point in my lifetime. In 2019, the S&P 500 finished 30% higher than it started the year. Investor sentiment was jubilant. Times were good. Few people took notice of a virus that started in a part of China and even fewer people had likely even heard of it. Those small few that raised the red flag of the virus early were considered alarmists. The risk to the U.S. economy and stock market was anything but “obvious.” Sitting here today, it is hard to believe how much has changed in the intervening eight months. We cannot predict the outcome at the polls today, or the policies that will be enacted, with any more accuracy than we could have predicted the U.S. economy shutting down to fight a pandemic. What we can do, however, is own companies with solid business models, supported by excellent profits, running conservative balance sheets designed for any situations, run by capable and trustworthy people that can manage to specific business risks. I feel more confident that Microsoft’s software products are as indispensable whether we are working in an office or working from home. Businesses and consumers will continue to pay for those services in almost any scenario. I also feel confident that recession or economic expansion, people will still drive cars and get in accidents. When they do, Copart will be the best run and most trusted partner insurance companies will have help them auction the salvaged vehicles. There are similar stories to Microsoft and Copart embedded up and down our portfolios. Our due diligence on all these companies is what provides the belief that they can reasonably manage through whatever the world throws at them. Sometimes our judgement is tested, and we are proven wrong. For example, a shutdown of all live events and elective health care procedures were not consequences we considered at the beginning of 2020. When we recognize mistakes like this, we are not too proud to move on and find companies that inspire more trust in their prospects.
The future is always uncertain. On this day we are all focused on political outcomes above most else. I hope the future is more focused on finding an effective vaccine for the virus. By this time next spring I hope our conversations are less about politics, and more on how we can manufacture and distribute a vaccine. I hope we are discussing the optimistic promise of the end of the impact on our portfolios and daily lives. We will most certainly face risks later, ones we cannot fathom or expect in advance. A portfolio of exceptional companies gives investors the best prospects of facing that uncertainty in advance.
Market Commentary Disclaimer: This publication is for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. The information contained herein is the opinion of Boston Financial Management and is subject to change at any time based upon unforeseen events or market conditions.