Stock Prices & Looking Ahead to 2021

Sam Ngooi Uncategorized

During November and December, stock prices in the US and internationally made significant gains, which took the three primary US indexes to new all-time highs. Since the March 23, 2000 lows of 2,237 for the S&P 500, 18,591 for the Dow Industrials, and 6,860 for the NASDAQ Composite, the three indexes closed December at 3,756; 30,606; and 12,888, respectively. The percentage gains were 67.9%, 64.6%, and 87.9%, respectively.

As our regular readers are well aware, Park Piedmont’s usual response to changing stock prices is to take the position that no one really knows the reasons why, even after the fact. There are simply too many countervailing factors impacting the direction and extent of stock price changes. That said, given gains of this magnitude in a relatively short time frame (November and December), we thought it would be helpful to review some of the more likely current factors being discussed in the financial media (see also the more detailed discussion in PPA’s November Comments).

  • The discovery and anticipated widespread distribution and administration of vaccines against the coronavirus, even with new negatives like the apparent mutation of the initial virus and serious problems with the distribution of the vaccines.
  • Anticipation of an improving economy, and with it corporate profitability, in the not so distant future.
  • A small number of very large, technology-driven companies benefitting financially from current conditions, which in turn has driven their prices, and the NASDAQ index, to extremely high levels.
  • The extremely low interest rates offered to investors, which make bonds a less attractive option for positive future investment returns and stocks a more enticing alternative. (Though note this has been taking place since March 2020.)
  • Further, low interest rates typically act as a stimulant to the economy. These very low rates have made it easier for all bond issuers to borrow.
  • A newly elected Democratic president, working with a congressional Democratic majority in both the House and Senate, so that additional government help is expected (see 7B below).
  • A recent NY Times article adds some additional after-the-fact reasons: “Why the Markets Boomed in a Year of Abject Human Misery,” (NYT, 1/2/21, page B5). “The central, befuddling economic reality in the US at the close of 2020 is that everything is terrible in the world, while everything is wonderful in the financial markets….To better understand this strange mix of buoyant markets and economic despair, it is worth turning to the data,… some of which offer a coherent narrative about how the US arrived at this point, with lessons about how policy, markets and the economy intersect, and reveal the sharp disparity between the pandemic year’s have and have nots..” (A) incomes fell only 0.5% from March through November, because most jobs lost were low-paying jobs; (B) huge government assistance in the form of unemployment insurance and direct payment benefits, along with small business loans; (C) reduced spending, more saving, and the need to find places for this extra savings, some of which was the stock market, some housing… “Just because there may be some explanations for the 2020 gains does not mean these higher asset prices will hold… these patterns can reverse themselves; savings turn negative, inflation returns such that the Fed has to back off its easy money policy earlier than expected. But 2021 has yet to be written, and if 2020 teaches one thing it is that the story arc is more unpredictable than you would think.”

 

Looking Ahead to 2021 and the Trouble with Crystal Balls

In his first piece of 2021, Jason Zweig, the “Intelligent Investor” columnist for the Wall Street Journal (WSJ 1/9/21), offered the following hypothetical:

“Imagine that it’s Jan. 1, 2020, and you have a magic crystal ball. It tells you that coronavirus will spread like wildfire, killing nearly 2 million people worldwide and putting the global economy into an unprecedented coma for months. Now imagine that you are the only person alive who knows that and you get to make one trade on the basis of that information. What would you do?”

Zweig concedes, as virtually all of us would, that given those circumstances, he would have expected stock values to decline. As Zweig puts it, “We … know you would have shorted, or bet against, stocks. Who wouldn’t have?”

And yet, the stock market recovered surprisingly (in many cases, stunningly) well after bottoming out in late March. The S&P 500 ended the year up 16.3%; the Dow rose by 7.3%; NASDAQ, predominantly composed of tech companies, rose a whopping 43.6%. And the Vanguard U.S. Stock Index Fund, which represents all of the public traded companies in the U.S., rose 21%. The stock indices are at or near all-time highs.

So much for 2020. What does that mean for 2021?

By now, you can probably guess our answer: we don’t know.

But it may surprise you that PPA’s perspective – that we can’t know the future and so shouldn’t hazard guesses about it – remains something of an outlier in the financial industry.

As December turns to January, Wall Street firms renew their annual ritual of forecasting the year ahead — summoning data, explaining trends, issuing warnings. “These prognosticators are smart people and often have interesting things to say about what has already occurred in the markets and the economy,” writes Jeff Sommer in his recent New York Times column, “Your Guess Is as Good as Mine, or Theirs” (NYT 12/20/20, page BU5). “But as far as predicting the future goes, Wall Street’s record is remarkable for its ineptitude.”

As compiled by Bloomberg and reported by Sommer, around this time last year, “the median consensus on Wall Street was that the S&P 500 would rise 2.7 percent in the 2020 calendar year.” That, of course, turned out to be dramatically low.  A few months later, in April 2020, as the coronavirus stopped the global economy in its tracks, forecasters hit reset and issued another set of predictions. Per Sommer: “They said the market would fall 11 percent. But the market had begun climbing on March 23, the day the Fed intervened to stem panic. The strategists failed to register the change in direction. If you had invested, based on their predictions, you would have missed a great bull market.”

Woefully inaccurate predictions by Wall Street’s prognostication factory aren’t limited to 2020. According to Sommer’s own research, this kind of inaccuracy has been the norm for the past two decades! Sommer reviewed the median annual stock predictions made by Wall Street analysts each December, dating back to 2000. He found that “the median Wall Street forecast from 2000 through 2020 missed its target by an average 12.9 percentage points…”

For his part, Zweig, the Wall Street Journal columnist, reached a strikingly similar conclusion, writing that “analysts’ earnings forecasts, and investment strategists’ predictions of market returns, turn out to be wrong every year,” (italics in original). Zweig, reflecting on the extraordinary turbulence of last year, notes, “[t]o me, the lesson of 2020 isn’t that a giant, unpredictable ‘black swan’ can wreak havoc with the best forecasts. Instead, the lesson is that whatever seems most obvious is least likely to happen.” Zweig continues: “the only incontrovertible evidence that the past offers about the financial markets is that they will surprise us in the future. The corollary to this historical law is that the future will most brutally surprise those who are the most certain they understand it.”

What then do we recommend?

First, review your portfolio to ensure that your asset allocation remains consistent with your goals, risk tolerance, and time horizon. If they’re aligned, stay the course. If they’re not – or if you fear they may not be – we can help you make thoughtful, deliberate modifications.

Second, insofar as you’re able, ignore the day-to-day pandemonium and re-allocate that time to the people and activities you most enjoy. That will give you a far better return on investment of your most valuable asset: time.

Welcome to 2021!

Consolidated Appropriations Act

Sam Ngooi Uncategorized

Consolidated Appropriations Act

In our March 2020 Comments, we discussed the Coronavirus Aid, Relief, and Economic Security (CARES) Act that was passed on March 27, 2020 in response to the pandemic. We also addressed the parts of the Setting Every Community Up for Retirement Enhancement (SECURE) Act, passed in late 2019, that made changes to IRA rules.

We now review the changes included in the most recent stimulus bill, titled the Consolidated Appropriations Act (CAA) of 2021 and signed into law on December 27, 2020. We’ve added the CAA elements (in bold) to the presentation from March, both as a review of those important items and a way to track the current changes. As with the earlier discussion, this summary seeks to keep you informed about these efforts in general, as well as more specific programs that might have a direct impact on you, your family, and your community. It is based on our current understanding of the relevant programs, all of which are subject to revision over time. Before relying on any information provided below, please feel free to contact us to confirm whether anything has changed.

Tax-related

Retirement Accounts

  • CARES allows for penalty-free early withdrawals up to $100,000 from most retirement accounts (401k, Traditional and Rollover IRAs, SEP, SIMPLE). No change in CAA.
    1. Eligibility requires self-certification that individuals or their dependents have Covid-19 OR suffer from “adverse financial consequences” of the disease.
    2. Funds need to be withdrawn before the end of 2020.
    3. Can be repaid without tax consequence or penalty (typically, permanent withdrawals before age 59.5 incur taxes and penalties) within 3 years (as opposed to the current 60-day limit for IRA “loans”).
    4. If not repaid within 3 years, taxes due on withdrawals can be spread over 3 years.
  • SECURE allows for contributions to an IRA or 401K as long as you have earned income (prior rules ended contributions at age 70.5). No change in CAA.
  • SECURE raises the starting age for required minimum distributions (RMDs) from 70.5 to 72. No change in CAA.
  • SECURE requires Inherited IRAs to be withdrawn, and taxes paid for all IRAs except Roths, within 10 years for IRAs inherited after December 31, 2019 (old “stretch” withdrawal rules still apply for IRAs inherited before January 1, 2020). No change in CAA.
    1. RMDs eliminated for Inherited IRAs; withdrawals can be taken, and taxes paid, any time in the 10-year window.
    2. Exceptions apply for spouses, minor children, beneficiaries less than 10 years younger than the account owner.
    3. Rules don’t take effect until 2022 for inheritors of 403Bs (non-profit plans) and 457Bs (government plans).

RMD Changes: RMDs back in place for 2021 (except for Inherited IRAs as described above).

  • Required Minimum Distributions (RMDs) from IRAs, Inherited IRAs, and workplace retirement plans (401Ks, 403Bs) waived for 2020.

Roth Conversions: No changes in CAA, but stock market gains since March 2020 have in many cases reduced the potential appeal of Roth conversions.

  • With the significant stock market declines so far in 2020, conversions of tax-deferred retirement accounts (IRAs, including Rollovers, SEPs, and SIMPLEs) into tax-free Roth IRAs are worth considering.
    1. Conversion requires that taxes be paid on every dollar of converted amounts at ordinary income tax rates.
    2. But with lower asset values, current tax consequences will be reduced.
    3. Potential for tax advantages assuming long-term recovery in tax-free Roth IRAs.
  • New Inherited IRA rules under SECURE Act (see above) might make Roth conversions more attractive for these accounts.

Charitable Contributions

  • Cash contribution limitations raised to a maximum of 100% of 2020 adjusted gross income (from 50% currently) if you itemize deductions. Still allowed under CAA.
  • Maximum $300 deduction of contributions allowed if you don’t itemize. CAA retains $300 deduction for single filers and adds a $600 deduction for married filing jointly filers.

Deductions/Credits

  • CAA provides Employee Retention Tax Credit up to $7K/employee/quarter.
  • Meal expenses in restaurants 100% deductible for 2021 and 2022.
  • Lifetime Learning credit replaces Tuition and related Expenses deduction.

Investing

Rebalancing: No changes in CAA.

  • Consider buying stocks/stock funds if your current allocation to stocks has fallen below targets.
  • Dollar cost average back into stocks over time to avoid potential large additional declines and benefit from long-term recovery.

Tax-Loss Harvesting: No changes in CAA, but stock market gains since March 2020 have in many cases eliminated tax-loss harvesting opportunities.

  • Consider sales of investments with recent declines, coupled with immediate re-purchases of comparable investments (i.e., stock funds to replace stock funds) to maintain overall asset allocation.
    1. Realized losses can be used to offset gains elsewhere in the portfolio, as well as gains from real estate sales.
    2. Losses can also be deducted against $3,000 of ordinary income each year and carried forward indefinitely.
    3. PPA makes sure to avoid “wash sale rule”, which disallows losses if the same security/fund is purchased 30 days after (or before) the sale.

Benefits

Unemployment

  • Unemployment benefits administered by individual states. No change in CAA.
  • CARES Act provides for additional $600 per week for four months in addition to State unemployment benefits. CAA provides additional Federal benefits of $300 per week for 11 weeks.
  • Federal coverage extends State coverage by 13 weeks. Only applied to CARES Act.
  • Self-employed and part-time workers eligible in addition to full-time workers. No change in CAA.
  • Broad definition of who qualifies for coverage based on quarantines, stay-at-home orders, and required care for sick family members. No change in CAA.
  • People already on unemployment also eligible for additional benefits. No change in CAA.

Direct Payments: CAA provides $600 payments for each taxpayer and children under 17. Phaseouts mentioned below still in place.

  • Direct payments are based on 2019 tax returns, or 2018 returns if you haven’t yet filed for 2019, to determine the amount, if any, you’re eligible to receive.
  • Amounts received in 2020 and 2021 will be checked against 2020 tax returns and potentially increased if 2020 income is lower (but no funds will be re-claimed if 2020 income is higher).
  • $1,200 lump sum for each individual with 2019 adjusted gross income (AGI) less than $75,000.
  • $2,400 lump sum for each married couple filing jointly with less than $150,000 of 2019 AGI.
  • Amounts phase out for individuals up to $99,000 of AGI and couples up to $198,000 of AGI.
  • Additional $500 for each dependent child 16 or younger.
  • Social Security recipients not required to file return if they don’t typically.

Business Loans

  • Paycheck Protection Program (PPP): $349B in partially forgivable loans available to small businesses. “PPP2” provides new loans and second loans for participants in the first round of PPP loans.
    1. Small businesses defined as 500 or fewer employees, including non-profits. CAA keeps this limit for first loans but restricts second loans to businesses with 300 of fewer employees.
    2. Sole proprietors, independent contractors, and self-employed people all qualify. No change in CAA.
    3. Applications available now through lenders for small businesses and sole proprietors; 4/10/20 application start date for independent contractors and self-employed; application deadline is 6/30/20 or until program funding runs out (although additional funds might be made available in the future).
    4. Good faith certification of adverse coronavirus impact required. No change in CAA. Second loans require revenue reduction of more than 25% in any quarter of 2020 compared with any comparable quarter in 2019.
    5. No personal guarantees or collateral required; Small Business Administration (SBA) backs lenders; contact your bank or credit union to get started. No change in CAA.
    6. Loan amounts limited to 2.5 times average monthly payroll expenses from previous year; maximum of $10M. CAA restricts second loan maximums to $2M.
    7. 2-year maturity, 1.0% interest rate, interest payments deferred 6 months. No change in CAA.
    8. Loans forgivable based on eligible spending (payroll and other typical business expenses) during first 8 weeks after loan approval, assuming similar staffing and compensation levels as before CARES Act passed. CAA provides for loan forgiveness and deductibility of eligible expenses, which are expanded under the new law (now includes health spending for example). “Covered period” for expenses increased to 24 weeks. Simplified applications for forgiveness on loans of less than $150K.
    9. Salaries above $100K NOT eligible for forgiveness. No change in CAA.
    10. PPP loans could eliminate eligibility for other benefits, including payroll tax deferral, employee retention credits, and Economic Injury Disaster loans.

401K Loans

  • Loan maximums increased to lesser of $100,000 or 50% of the account balance (up from $50,000) until September 30, 2020. No change in CAA.

Real Estate/Education/Healthcare

Mortgage and Rent Relief

  • Varies by lender and State/locality; contact your lender and/or landlord for details. No change in CAA.

Education

  • Federal student loan payments and interest automatically suspended until September 30, 2020. CAA doesn’t extend student loan deferrals, but deferrals have been extended through January 31, 2021.
  • Private loan changes vary; contact your lender for details.
  • CAA simplifies the Free Application for Federal Student Aid (FAFSA) form.
  • CAA provides for tax-free educational assistance from employers through 2025, up to $5,250 per employee per year.

Healthcare

  • CAA fixes the threshold for medical expense deductions at 7.5% of Adjusted Gross Income (AGI), down from 10% previously.
  • CAA allows for carryforward of unused balances in Flexible Spending Accounts (FSA), which previously had to be used during the calendar year.

November 2020 Stock Prices

Sam Ngooi Uncategorized

During November, stock prices in the US and internationally made significant gains, which took the three primary US indexes to new all-time highs. Since the March 23, 2000 lows of 2,237 for the S&P 500, 18,591 for the Dow Industrials, and 6,860 for the NASDAQ Composite, the three indexes closed November at 3,622; 29,639; and 12,199, respectively. The percentage gains have been 62%, 59.4%, and 77.8% respectively.

Our usual response to changing stock prices is to take the position that no one really knows the reasons why, even after the fact. There are simply too many countervailing factors impacting the direction and extent of stock price changes. That said, given gains of this magnitude in a relatively short time frame, we thought it would be helpful to set out and discuss some of the more likely current factors being discussed in the financial media.

  • The continuing extreme negative impacts of Coivd-19 on the health, welfare and economic situation in the US and globally. For stock prices to rise so significantly for much of this period should indicate some more than offsetting positive news. The potential discovery and widespread distribution and administration of a vaccine against the virus Is one such possibility. But even if the end of the virus were clearly in sight (which is not the case now), stock prices at end-of-November levels would be anticipating an extremely rapid return to normalcy or even better than normalcy. Keep in mind that over the longer term, which should be the focus of investors (as compared to short-term trading), the main drivers of stock prices are the economic growth of the world’s economies, the future increasing profitability of the businesses that make up the investable markets, and their associated P/E multiples. Whether the kind of recovery being reflected in current stock prices is on the horizon is a true unknown, given the unpredictability of the future.
  • The stock price recovery being fueled in part by some number of very large companies benefiting financially from recent economic conditions (e.g., closures of offices and retail businesses). This might explain the extreme price gains of the large technology companies and the NASDAQ out-performance.
  • The activities of short-term traders, many possibly new to the financial markets, with a bias towards the upside. However, it would probably be very hard to verify such a bias.
  • The extremely low interest rates offered to investors, which make bonds a less than attractive place for positive future investment returns and stocks a more enticing alternative. These low rates have been providing support for both stock and bond prices for some time. While they might explain some of the recent gains since March, there did not seem to be any new news here to account for November’s outsized monthly gain.

A recent New York Times article cited in last month’s Comments discussing bonds (NYT 10/11/20, page BU11), puts the current situation this way: “Owning US Treasuries, the undisputed safest bond, means signing on for next to nothing in earnings for the next five to ten years, because the current yield of a bond is a solid estimate of future annual returns, and Treasuries that mature in ten years or less currently have yields below one percent… While the historical long term average annual return for intermediate-term Treasuries is 4.5%, based on current yields, a return below 2% is more likely… And that’s before factoring in inflation, running currently at 1.3%.”

  • Low interest rates as a stimulant to the economy. These very low rates have made it easier for all bond issuers to borrow. Particularly in the case of US and state and local governments, the low rates have allowed for more borrowing with less concern for harmful inflation, at least in the short term, until steady signs appear of an economic recovery from Covid-19. (See our October 2020 Comments).
  • Political Uncertainty/ Election Results. One piece of new news in November was the election results. Even though President Trump is still protesting and not conceding, it would appear most of the country and the world are assuming a Biden presidency starting towards the end of January. As our regular readers are aware, even if we know the election results, there is nothing inherently predictive about the impact on market prices, certainly not as time passes and other intervening events become more important.

 

Our advice remains the same: maintain asset allocations developed for your circumstances for the long-term, and review the allocations from time to time, with an eye towards rebalancing, based on significant changes in market prices and/or changes in your personal circumstances. Rebalancing means selling the better performing asset class and buying the weaker performer in a given timeframe.   

The Psychology of Money

Sam Ngooi Uncategorized

“Behavioral finance” is a relatively new but increasingly influential part of the financial world. Where traditional economic/finance theory assumes that consumers and investors regularly maximize their opportunities, behavioral finance acknowledges that this is not always the case. If you’re interested, excellent books on the subject include Thinking, Fast and Slow by Daniel Kahneman; Misbehaving by Richard Thaler; Nudge by Thaler and Cass Sunstein; and Predictably Irrational by Dan Ariely.

We at Park Piedmont have always tried to provide real-world, practical advice for clients. And we read a recent behavioral finance book, The Psychology of Money by Morgan Housel, with interest. (Housel works for the Collaborative Fund, a venture capital firm, and previously wrote for the Wall Street Journal and Motley Fool.) It’s a very readable (i.e., short and mostly to the point) summary of many important ideas in the behavioral finance/investing field; the chapter on being “reasonable” as opposed to “rational”, starting on page 113, is a notable example. The book also reflects much of the advice we provide.

Here’s a summary of some of the key concepts, along with our perspective:

Play the Right Game – Yours: There are millions of financial opportunities available, and almost as many people trying to pitch them to investors. But many of these opportunities are designed for trading, i.e. getting in and getting out quickly, hopefully at a better price. Housel explicitly distinguishes between trading and investing, as we regularly do in our monthly comments: “Short-term traders operate in an area where the rules governing long-term investing –particularly around valuation—are ignored, because they’re irrelevant to the game being played” (p. 171).

The larger point is to focus always on your needs and goals, not those of the often short-term-focused finance industry. As Housel puts it: “Few things matter more with money than understanding your own time horizon and not being persuaded by the actions and behaviors of people playing different games than you are… Everything that’s unrelated to [your goals] – what the market did this year, or whether we’ll have a recession next year—is part of a game I’m not playing” (p. 173).

Enough: In addition to the idea of playing your own game, we often discuss the concept of “winning” the game, and the implications for clients’ portfolios. Housel introduces this topic with a story that John Bogle, the legendary founder of Vanguard, once told: “At a party given by a billionaire, Kurt Vonnegut

About the Author

Sam Ngooi

informs… Joseph Heller, that their host, a hedge fund manager, had made more money in a single day than Heller had earned from his wildly popular novel Catch-22 over its whole history. Heller responds, “Yes, but I have something he will never have… enough” (p. 37).

Determining what constitutes enough is of course different for each person and family. But once that level has been reached, we typically recommend that clients reduce their allocations to the risky parts of the markets (stocks in particular) because there’s no further need to take on the additional risk. As Housel puts it: “If you can meet all your long-term goals without having to take the added risk that comes from trying to outperform the market, then what’s the point of even trying? I can afford to not be the greatest investor in the world, but I can’t afford to be a bad one” (p. 219).

Time Is Your Friend: A long-term perspective is beneficial not only because it helps to avoid the pitfalls of short-term trading. It also provides time for compounding to occur. Compounding refers to the idea of earning returns on returns over time; $100,000 earning 5% a year becomes $105,000 after one year, and $110,250 (not just $110,000) after two years. Assuming decades of returns (some of which will of course be lower than 5%, but some of which will be higher), the impact can be enormous. Einstein is famously reputed to have said that “compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” According to Housel, “good investing isn’t necessarily about earning the highest returns, because the highest returns tend to be one-off hits that can’t be repeated. It’s about earning pretty good returns that you can stick with and which can be repeated for the longest period of time. That’s when compounding runs wild” (p. 53).

We encourage clients to focus on the long-term period and goals that are relevant to each of them, and pursue market-tracking returns using low-cost index funds. We’ve written often about the benefits of indexing, and Housel provides several examples too, including the costs of buying and selling (p. 161), the frequent underperformance of actively-managed funds (pps. 195-6), and the added risk in trying to beat the market (p. 219).

Focus on What You Can Control: We’ve always considered indexing to be the most realistic way to benefit from long-term investing. But even given the low cost and tax efficiency of index funds and ETFs, your returns are still subject to the ups and downs of the markets. We can assume these markets will generate long-term returns going forward similar to the ones from the past 100 years or so, specifically about 6-8% for stocks and 3-4% for bonds, before taxes . But there’s no guarantee that these returns will recur, and even if they do, there can still be extended periods of underperformance in all markets. So we also recommend a focus on what you can control, which is the amount you save. As Housel describes it: “Investment returns can make you rich. But whether an investing strategy will work, and how long it will work for, and whether markets will cooperate, is always in doubt… Personal savings and frugality… are parts of the money equation that are more in your control and that have a 100% chance of being as effective in the future as they are today” (p. 104). He goes on to summarize his own investing strategy, which “doesn’t rely on picking the right sector, or timing the next recession. It relies on a high saving rate, patience, and optimism that the global economy will create value over the next several decades. I spend virtually all of my investing effort thinking about those three things – especially the first two, which I can control” (p. 220).

Focus on the Portfolio: Related to the indexing strategy is the idea of focusing on your overall portfolio, as opposed to a single account or investment. According to Housel: “You should always measure how you’ve done by looking at your full portfolio, rather than individual investments… Judging how you’ve done by focusing on individual investments makes winners look more brilliant than they were, and losers appear more regrettable than they should” (p.208).

In addition to indexing, we devote much of our work with clients to developing a well-diversified portfolio that will help accomplish each client’s specific goals. This high-level “asset allocation” is developed differently for each client, depending on the desired balance between income and capital preservation (the primary features of bonds) and capital appreciation (the primary feature of stocks). Once we develop an appropriate asset allocation, we then turn to “asset location”, which considers the amounts available to invest in the two main types of accounts. The first are “taxable” accounts, such as Individual, Joint, and Trust accounts, in which interest and dividend income are taxed when earned, and capital gains tax treatment is available when selling an investment. The second are “tax-deferred” accounts, such as IRAs, 401Ks, and other retirement plans, in which income tax is deferred until retirement, and all withdrawals during retirement are taxed at ordinary income tax rates (which are currently significantly higher than capital gains rates). Different investments are typically preferable in different accounts (e.g., stocks in taxable accounts and bonds in tax-deferred accounts), with the result that taxable accounts will often perform better, by design, when stock prices are rising, but worse when they’re falling. The portfolio perspective avoids these short-term distortions and helps investors to concentrate on the long-term returns that generate compounding over time.

Housel’s book does get repetitive at times, but we think there are enough good ideas in The Psychology of Money to merit a quick read. And if you do, please feel free to contact us to discuss it in greater detail. We’d love to hear your thoughts.

Bond Prices

Sam Ngooi Comments

As stock price volatility continues, both up and down (more down for September and October, after a major gain from the 2020 lows in March through August), investors tend to pay more attention to bonds as an alternative to stocks for their liquid investment portfolios. (Although our Comments are written as of the end of each month, we take note of a major gain in stock prices during the first week in November, coinciding with the election. Further discussion of the recent election follows.)

Three primary factors that impact bond prices are: (1) changing interest rates; (2) maturities; and (3) credit quality.

Changing Interest Rates: As bond prices for already-issued and still-outstanding bonds fluctuate in the marketplace (based on changing interest rates for newly issued bonds of similar maturity and credit quality), the interest earned on these outstanding bonds changes as well (expressed as “yield to maturity (YTM).” Buyers of bonds will earn the currently-quoted YTM if the bonds are held to their maturity. For example, the owner/seller of a bond bought three years ago with a ten-year maturity and 3% annual interest payment (referred to as a “coupon”) should receive a much higher price from a current buyer than that same buyer would pay for a bond with seven years to mature and a current YTM of less than 1%. The higher price is determined by calculating all the coupon payments to be received, and then adding the higher payment the buyer had to make compared to the maturity value. This explains why a decline in interest rates leads to higher bond prices, and conversely, higher interest rates lead to lower bond prices.

Maturities: Short-term (overnight) rates are set by the Federal Reserve; as maturities lengthen, the buying and selling of bonds by investors and traders establish interest rates and bond prices. Normally the short rate set by the Fed establishes a guideline for what longer maturity bond prices should be. At the beginning of 2020, the US Treasury ten-year bond had a YTM of 1.92%, and the much shorter three-month US Treasury had a YTM of 1.55%.   This spread of 37 basis points (“bps”, or hundredths of a percent) between the ten-year and three-month was itself unusual, because a ten-year bond has significantly more price risk than a three-month bond, and typically will have two percent or more yield spread to compensate the owner for additional price risk. The reason longer maturities have more price risk is that if rates go up and the bond owners hold ten-year maturities, they will have to wait ten years collecting lower coupons. If the maturity is one year, on the other hand, bond owners will receive their money back in one year, with the opportunity to reinvest sooner at the higher rates.

Credit Risk: This concept refers to the likelihood that the issuer of the bond will repay interest as scheduled and the principal of the loan at maturity. Bond issuers include the US government (which sell “Treasuries”), state and local governments (which sell municipal, or “muni” bonds”), and corporations. During February and March 2020, when the extremely negative economic effects of the coronavirus first became apparent, credit risk increased for many bonds, even previously creditworthy ones. The prices of existing bonds declined as interest rates increased, since bond buyers demanded more interest for lending their money to issuers. The Federal Reserve and Congress then made significant amounts of money available to help support the economy. Since that assistance/intervention, the YTM on the ten-year Treasury has declined to around 60 bps, and the YTM on the three-month Treasury has fallen to about 10 bps. The yield spread has widened to 50 bps from the 37 bps at the start of 2020, but the absolute amount of interest being paid has fallen to historic lows (recall that for YTMs to fall this low, bond prices must rise, so bond buyers would only receive the YTMs if the bonds are held to maturity).

Higher credit risk bonds (i.e., “junk bonds”) are issued by borrowers who are less likely to pay interest or principal, and therefore have to offer higher rates to induce investors to buy the bonds. While the higher coupons may seem appealing, they should be approached with caution, because the higher risk of default is real, and is the rationale for the higher initial coupon. The yield spread at any time between high credit bonds and junk bonds provides a current market assessment of the greater risks involved with low credit quality bonds.

PPA Comments: The idea of buying bonds with ten-year maturities that pay less than 1% interest each year provides an indication of just how little investment return is available currently from high-credit quality bonds.  The declining price risk arises when and if the economy improves enough for interest rates to begin to rise, in which case bond prices fall to give the buyers the then-quoted higher YTM. For some time period, the declining prices due to rising rates are likely to overcome the higher interest being paid, but this impact also passes over time, as prices stop declining and rates and yields stop increasing. Of course, the length of time of this cycle of rising rates and falling prices is always an unknown before the fact.

Further, low interest rates typically act as a stimulant to the economy. These very low rates have made it easier for all bond issuers to borrow and, particularly in the case of US and state and local governments, the low rates have allowed for more borrowing with less concern for harmful inflation, at least in the short term until steady signs appear of an economic recovery from the coronavirus.

As has been mentioned in many recent Comments, low interest rates provide little investment return to investors, especially when the associated price increases have ended. This perhaps encourages investors (and traders as well) to be more likely to buy stocks, with a greater opportunity for gain (and of course, decline).

A recent New York Times article discussing bonds (NYT 10/11/20, page BU11), puts the current situation this way: “Owning US Treasuries, the undisputed safest bond, means signing on for next to nothing in earnings for the next five to ten years, because the current yield (our note: YTM) of a bond is a solid estimate of future annual returns, and Treasuries that mature in ten years or less currently have yields below one percent… While the historical long term average annual return for intermediate-term Treasuries is 4.5%, based on current yields, a return below 2% is more likely… And that’s before factoring in inflation, running currently at 1.3%.” The balance of the article discusses allocations to bonds and other liquid asset classes.

 

Political Uncertainty/ Election Results: Even though the election in favor of Joe Biden and Kamala Harris would appear to be over, President Trump has mounted legal challenges and has not conceded. That said, even assuming the Biden/Harris victory, we continue to repeat the essence of our recent Comments: the presidency is only one of many factors affecting stock and bond prices. Even if we know who is going to be president, no one can predict what will happen during that presidency. Trump’s presidency is a perfect example (see July Comments). There is nothing inherently predictive about the connection between market prices and election results, certainly not as time passes and other intervening events become more important.

Our advice remains the same: maintain asset allocations developed for your circumstances for the long-term, and rebalance from time to time based on significant changes in market prices, which means selling the better performing asset class and buying the weaker performer in a given time frame.

Stock Prices

Sam Ngooi Comments

In our August Comments, we presented several investment definitions and principles that we consider useful in further understanding price changes in the financial markets. Interestingly, the price earnings (P/E) ratios we discussed in August have become a talking point in September’s media coverage of the volatility. Briefly put, some number of market analysts and financial media believe that stock prices have increased too much since their March 2020 lows, given the substantial increase of trailing P/E ratios (into the mid 30’s) for individual stocks such as Apple, Microsoft, Google/Alphabet, Facebook, and Amazon. The P/E of the S&P 500 index itself has also increased substantially, to almost 30.  And it’s become very difficult to make reasonable analysis of corporate earnings (the “E” in P/E), either trailing or projected, in the midst of the harsh economic effects of the coronavirus.

To review our August P/E discussion:  Stock prices change every day, based on the activity of buyers and sellers in the financial markets. Some of these market participants are long-term investors, looking to benefit from favorable long-term economic growth. Others are short-term traders and speculators, looking to make money over very short time periods, similar to gambling, regardless of whether prices are rising or falling.  From our August Comments: ”There are many factors that affect stock prices, but over time the most significant one is the profits (also referred to as ‘earnings’) of the company and the number of shares outstanding that have ownership of those profits. The relationship of one company’s stock price to that of another company, and the reasonableness of the stock price itself, can be examined by knowing the dollar amount of profits, and the number of shares the company has outstanding, and using these figures to develop the P/E ratio (price per share divided by earning per share).“

In the current stock pricing environment, for example, Apple’s price after its recent 4-1 stock split is lower than many other supercharged stocks. But Apple has the highest market value, at approximately $2 trillion, because it has so many shares outstanding and so much earnings to attribute to each share. Knowing the market price of a stock does not provide much useful information unless that price is coupled with the company’s dollar earnings, number of shares outstanding, and resulting earnings per share.  With all of that information, a P/E can be developed, which allows for fair comparisons and valuations of one company’s stock price to another.  The P/E of the S&P 500 index is developed in the same way, with the added complexity of calculating valuations for all 500 companies in the index.

Other factors that have been cited to explain either near-term gains or declines:

Very low interest rates for bonds. Again, from our August Comments: “When interest rates are low for bonds, as they are now, stock prices often move higher because the competing returns from bonds are low. But how high stock prices should go is of course an unknown, especially in times when the overall economy is doing so poorly, as it is now.”

Aggressive speculation. This speculation is often the work of short-term traders unconcerned with stock valuations. It also arises from trading options on individual stocks or the stock market, resulting in gains or declines, often within the same day. “In a market where buy and hold investors collide in a mosh pit with hedge funds, lightning quick computers, and now an army of new traders just learning the game, there’s room for debate about who’s moving prices. Also true of the market’s newest obsession: the role of equity options” (Bloomberg Business Week, 9/21/20, page 26).

Economic news. The latest economic news continues to be largely grim, as the coronavirus lingers on. This bad news has been in place for a number of months, so it is unlikely, on its own, to explain the September declines.

Lack of additional financial stimulus. Inaction by the federal government may have made the economic slowdown slower.  One reason for advocating less money to a new stimulus plan is to keep future budget deficits under better control, to reduce the likelihood of significant increases in inflation.  This factor, and the possibility that some stimulus could be added to the economy currently, appears to be driving significant day-to-day price fluctuations.  We would also note that however the stimulus issue is resolved, it can be a plus or minus for stock prices over time.

Notice also that index results year to date vary considerably, as the NASDAQ, dominated by the high-flying tech stocks with high P/Es, continues to massively outperform the modest gain for the S&P 500 stocks, the modest declines for the Dow Industrials (30 stocks), and the larger declines for International and Emerging Market indexes.  Whether that indicates that tech stocks have much room to decline, or the other stocks have much room to advance, is yet another unknown that will be played out over time.

Political uncertainty. Our final section on factors potentially influencing stock prices brings us back to our discussion of the upcoming election. The first presidential debate (August 29th) was overshadowed by the October 2nd news that President Trump, along with a number of his close advisors, had contracted the coronavirus. As of this writing, the president seemed on his way to recovery, but no matter what we hear about the prognosis, the medical event seemed to add even more uncertainty to a highly contentious election. As our regular readers know, and as we wrote in our August 2020 Comments, “we at PPA maintain that who is president is only one of several factors affecting stock and bond prices. Even if we know who is going to be president, no one can predict what will happen during that presidency.  Trump’s presidency is a perfect example (see July Comments). Even now, with Biden leading in the polls, stock prices have been rising for most of the past few months” (although not in September).

We will continue to comment on the election as the time gets closer, as it is likely to become a popular topic in the media. But we repeat that in our view, there is nothing inherently predictive about the connection between market prices and election results, certainly not as time passes and other intervening events become more important.

Our advice remains the same: maintain asset allocations developed for your circumstances for the long-term, and rebalance from time to time based on significant changes in market prices, which means selling the better performing asset class and buying the weaker performer in a given time frame.

Early Comments on the Upcoming Election

Sam Ngooi Uncategorized

With all that is going on in the world, there is an additional wildcard, namely the upcoming US presidential election. As our regular readers know, we at PPA maintain that who is President is only one of several factors affecting stock and bond prices. Even if we know who is going to be President, no one can predict what will happen during that presidency.  Trump’s presidency is a perfect example (see July Comments). Even now, with Biden leading in the polls, stock prices have been rising for most of the past few months.

During August, the coronavirus continued to spread health and economic misery; protests about systemic racial injustice intensified; and the Democratic and Republican parties held their respective conventions. None of this news appeared to slow the advance of US stock prices, although we have to acknowledge that the advances are primarily taking place with a small number of high tech stocks that appear to have benefited from the otherwise negative impacts of the virus.

We will continue to comment on the election as the time gets closer, as it is likely to become a popular topic in the media. But we repeat that in our view, there is nothing inherently predictive about the connection between market prices and election results, certainly not as time passes and other intervening events become more important.

Our advice remains the same: maintain asset allocations developed for your circumstances for the long term, and rebalance from time to time based on significant changes in market prices, which means selling the better performing asset class and buying the weaker performer in a given time frame.

Important Investment Definitions and Principles

Sam Ngooi Comments

The month-end August 2020 US stock and bond market investment results continued to be mostly favorable, even though the declines during the first week in September (3rd, 4th, and 8th) reduced these positive results somewhat. We think this is an opportune time to present certain basic investment definitions and principles that we at Park Piedmont (PPA) consider important to know.

Before doing so, we would like to note another significant August event: the Federal Reserve Board Chairman has “announced a major shift in how the central bank guides the economy, signaling it will make job growth preeminent and will not raise interest rates to guard against coming inflation just because the unemployment rate is low… laying the groundwork for years of low interest rates” (NYT 8/27/20, page A1).

Asset Allocation: the percentage mix of your investment portfolio among riskier assets, generally stocks, and less-risky assets, generally bonds. At PPA, we further divide the less-risky bond asset class into three separate categories: short-term cash equivalents (money markets, or MM); high-credit bonds (HCB); and high-yield bonds (HYB).

Stocks represent an ownership interest in a business. Stock prices change every day, based on the activity of buyers and sellers in the financial markets. Some of these market participants are long-term investors, and others are short-term traders and speculators. History indicates that stock prices vary, up or down, much more than the bond categories over almost every time period (the extent of price changes is referred to as “volatility”). The tradeoff for stock investors accepting more volatility is the opportunity for higher expected returns. In addition to gains/declines from price changes, many stocks pay dividends. Dividends are usually a return of some portion of a company’s profits back to the owners. While dividends are often much appreciated by stockholders, they do raise the question from the paying company’s standpoint as to whether the money is better used reinvesting in and trying to grow the business.

There are many factors that affect stock prices, but over time the most significant one is the profits (also referred to as “earnings”) of the company and the number of shares outstanding that have ownership of those profits. The relationship of one company’s stock price to that of another company, and the reasonableness of the stock price itself, can be examined by knowing the dollar amount of profits, and the number of shares the company has outstanding, and using these figures to develop the P/E ratio (price per share divided by earning per share). Working with simplified numbers, if the company has one million shares outstanding and has $1 million of profits, the earnings per share are $1; if the stock sells for $10 per share, the P/E is 10; at $15 per share, the P/E is 15; and at $20 per share, the P/E is 20.

The higher the P/E, the more profitable investors/speculators believe the company will be in the future. But as you should note, what a reasonable P/E should be for any company is constantly changing, and subject to the many varying views of the financial markets. Knowing past profits is one thing, but the problem with stock pricing based on P/E ratios is that the profits used are most often based on future forecasts, which is how Wall Street earns much of its living. PPA, on the other hand, typically ignores such forecasting as being an impossible effort to predict the unknowable future (as is the case for financial analysts’ attempts to predict the course of the ongoing coronavirus pandemic).

Stocks can be bought in individual companies, or in mutual funds/exchange traded funds (ETFs) that own a diversified portfolio of individual stocks. The diversification can be as narrow as within a specific sector of the broad stock market (e.g., technology or finance), or can be as broad as all the stocks in the world stock market. Stock mutual funds can be actively managed by portfolio managers trying to earn a better investment result for the fund owners than the result of some applicable benchmark. Stock funds can also be passively managed, in which case the fund invests in the stocks contained in the relevant benchmark and accepts the benchmark results. The issue with active management is that the managers frequently underperform the benchmarks, with an underlying tendency to do so because of the higher expenses charged by actively managed funds. ETFs are another type of index fund; they allow for intraday buying and selling, whereas mutual funds are priced at the end of each day. PPA uses index mutual funds and ETFs for almost all stock investments in client portfolios.

Stock splits have been in the news recently, as Apple and Tesla both split their stock. In a typical stock split, the owner receives additional shares, but the price of the stock declines to account for the additional shares, so there is no change in the company’s overall valuation just because there are more shares outstanding. To use a popular food analogy, if you have a whole pizza pie, and it is cut into quarters, you have more slices, but still the same overall amount of the pizza to eat.

When interest rates are low for bonds, as they are now (see below), stock prices often move higher because the competing returns from bonds are low. But how high stock prices should go is of course an unknown, especially in times when the overall economy is doing poorly, as it is now.

Bonds represent a promise by a borrower to repay money plus interest over time. A bond is a loan from the bond owner to the borrowing entity, which can be a government or company. Unlike stocks, there is a date when the original amount invested (referred to as “principal”) is to be repaid (referred to as a bond’s “maturity”). That maturity can be measured in years or days, depending on the terms of the loan. Bond prices change during the time they are outstanding prior to maturity, also based on the activity of buyers and sellers in the financial markets. But history indicates that bond prices change much less than stock prices, and that within the broad category of bonds, the extent of price changes varies based on bond maturities (also referred to as “term”), credit quality, and interest rate changes. The prevailing rate of inflation has a major influence on interest rates, which in turn has a major influence on bond prices. Typically, the higher the inflation rate, the higher interest rates need to rise to provide bond investors with a positive return adjusted for inflation. (Note however the Fed’s recent policy statement on interest rates and inflation, all related to job growth; NYT 8/27/20, page A1). Inflation is defined as the declining value of the purchasing power of money over time.

Short-term high-credit bonds, the shortest of which are money markets, have the least price change and smallest interest payments. The further out in time the maturity, the greater the price change while the bond is outstanding (that is, not paid off), but the higher the interest received (another investing tradeoff). The usual correlation between interest rates and the prices of outstanding bonds is that as rates increase (good for the investor), the price of the bond should decline (not good for the investor). Conversely, as rates decline, bond prices increase. So even if bonds are bought with the expectation that the initial principal will be returned plus interest, if the bonds need to be sold prior to maturity, there is a chance the investor will receive less than the initial principal.

The other significant wrinkle with bond pricing is their credit quality, which refers to the likelihood the bond issuing entity has/will have enough money to pay the interest and repay the initial principal at the maturity date. Credit ratings can change while the bond is outstanding; if the credit rating is lowered, the bond price almost always declines. At the beginning of the 2020 pandemic, many companies faced credit downgrades, even those thought to be good credits. The Federal Reserve stepped in and gave assurances to the marketplace that it would not allow large scale defaults. At that point, prices stabilized. A low credit rating at the time the bond is issued forces the issuer to pay more interest (these are called high-yield bonds), which is good for the investor, but not good at all if the issuer cannot make the interest/principal payments.

Bonds, like stocks, can be bought in the specific name of the issuing company or governmental entity (federal, state, and local). Mutual funds and ETFs, both actively- and passively-managed, are also available to bond buyers, with similar characteristics as discussed above with stock mutual funds and ETFs. There are times when investments are described only as mutual funds or ETFs, without identifying them as owning stocks or bonds, and this can cause confusion for investors. PPA uses almost all bond index and index-like mutual funds and ETFs for our clients’ bond investments.

One other point worth noting: if you own an individual bond, there is a specific maturity date when you are scheduled get your money back. If you own a bond mutual fund or ETF, by contrast, the bonds owned by the fund mature, but the fund itself typically does not. The fund takes the proceeds of maturing bonds and reinvests the money in bonds with similar maturity and credit quality characteristics. The major difficulty with owning individual bonds is not being able to determine the underlying current and likely future financial health of the issuer. Even though there are credit agencies that purport to do this, their advice can be flawed (the mortgage crisis of 2007-2009 provided a serious recent example of the failure of credit agencies). With mutual funds and ETFs, the investor relies on the fund managers to do an adequate job of ongoing credit checking, at least under normal circumstances, which is also an important caveat.

As you can see, there are many points of investment definitions and principles, even in the brief discussion above. In future Comments, we plan to present additional detail on indexed investing, which is the predominant way PPA invests our clients’ portfolios. While we encourage clients to be as knowledgeable as possible on these matters, PPA is of course available to provide additional assistance as needed.

Mortgage Refinancing

Sam Ngooi Comments

The historically low interest rates of the past year represent an attempt by the US Federal Reserve to stimulate a faltering US economy. The correspondingly low rates determined in the bond market have hurt investors who need income. But these rates have been a boon to borrowers, as the Fed intended. Now is therefore a very good time to consider refinancing loans, especially mortgages, which are usually the largest debt most households carry.

Thirty-year fixed-rate loans are available in the low 3% range, often with few or no closing costs. Rates for 15-year fixed-rate loans are in the low- to mid-2% range. You can contact your current lender and/or a mortgage broker to get specific quotes.

To help you assess whether a refinance makes sense, we present below a list of basic terms; some ideas for how to analyze the refinancing opportunity; and some practical considerations as you go through the process. Please feel free to contact PPA for additional details and help analyzing whether a specific refinance makes sense for you.

Defining Terms

The most basic features of a home mortgage are the rate and term. Rate refers to the annual percentage interest you pay on the total amount of the loan (also known as “principal”). Term specifies how long you have to pay back the principal and interest. Rates can be fixed, i.e. set for the full term of the loan, or variable, in which case the rate can change over time. Fixed rate loans typically have terms of 15, 20, or 30 years. Variable rate loans often have fixed rates for terms of three to seven years, then adjust each year based on market conditions. Rates are typically lower for “conforming” loans, which are below $510,400 for 2020, than for larger dollar amount “non-conforming” loans. For a typical fixed-rate, amortizing (see definition below) mortgage, each monthly payment you make consists of interest and principal, with payments early in the term consisting mostly of interest.

Another key concept is amortization, which refers to the repayment of principal on the mortgage. Amortization schedules show how a specific loan will be repaid over the relevant term. Different types of loans, such as “interest-only”, can lead to situations where a loan is not fully repaid over the term, but typical fixed-rate loans are structured to “fully amortize.”

Basic Refinance Analysis

Deciding whether to refinance usually depends on whether you can find a lower rate for a comparable term, or a shorter term with a comparable rate. The lower rate calculation is typically straightforward; if you can reduce your current rate significantly, and in turn lower your monthly payment, refinancing often makes sense. The shorter-term calculation can be more complicated because it often involves paying more each month than on the current mortgage (based on amortization over the shorter time period). Even so, shorter terms can save significant amounts of total interest over the full term of the loan, especially in today’s low interest rate environment. PPA advisors can help you with these pre-tax calculations, and it also makes sense to contact your tax professional for further advice.

The other key consideration in the current mortgage market is whether to pay closing costs and/or points to further reduce the interest rate. Closing costs include an appraisal of the property value, lender’s fee, and “title and escrow” charges, which allow the lender to secure and fund the loan. Points refer to an additional fee you can pay up-front to lower the rate. Payment of one point (1%, or 100 basis points) on a $500,000 loan, for example, would cost $5,000 (to be paid at closing), and in turn might decrease the rate on a 15-year loan from 2.5% to 2%. Lenders now also allow you to avoid closing costs if you’re willing to pay a higher rate over time (technically you’re still paying the closing costs, but they’re factored into the higher rate). This decision often comes down to whether you plan to remain in your current home long enough for the lower interest rate to offset the up-front closing costs or points. PPA advisors can prepare a basic “break-even” analysis to help make this determination. Consultation with your tax professional is a good idea for this analysis as well.

Practical Considerations

Once you decide to refinance, the lender will underwrite the loan. One of the main factors in underwriting is determining the value of the property, or “collateral”, which is typically done with an appraisal. Once the value has been determined, lenders establish a loan-to-value (LTV) ratio, which sets the maximum loan amount they’re willing to extend. A typical LTV these days is 70%, which means, for example, that you can borrow up to $350,000 on a house appraised for $500,000. (Different types of property, including cooperative apartments, or “co-ops”, and condominiums, often have different maximum LTVs based on the lenders’ assessment of risk in repayment of the loan.)

In addition to the property value, underwriting assesses the creditworthiness of the borrower. This typically involves review of one or more credit reports from the main credit rating agencies, as well as the borrower’s income, expenses, and other assets and liabilities (i.e., debt). Lenders require documents to verify these figures: for income, you’ll need to provide recent tax returns, pay stubs, and K1s (for partnership interests); for expenses, statements for property taxes and homeowner’s insurance; for assets, brokerage statements; and for liabilities, mortgage and, if applicable, other loan statements. These assessments have tightened up significantly since the late 2000s, when inadequately-underwritten loans contributed to the financial crisis of 2008-09. In general, you should expect to provide several documents for the last two calendar years, and several more if, for example, you own other property and/or over 25% of a company.

Depending on how quickly the borrower provides the required documentation, underwriting, loan approval, and closing (i.e., obtaining the funds needed to pay off the current loan and record the various documents in the public record) can take 90 days or more in this period of high refinancing volumes.

In conclusion, mortgage rates are now low enough to justify refinancing in many situations. Please feel free to contact PPA if you’d like some assistance either before, or during, your discussions with a lender or mortgage broker.

Financial Market Prices and “Real Economy” Disconnects & Upcoming Election

Sam Ngooi Comments

The US stock market has continued its significant and highly improbable advance from its recent March lows, even as the “real world economy” continues to post record breaking negative figures in many categories, including employment and most recently GDP (Gross Domestic Product), amid the continuing coronavirus.  Trying to make sense of this disconnect is now a favorite topic for the financial media. The following S&P 500 figures highlight the point:

Trump election, November 2016 (Base Period) 2,140    
Year-End 2019 3,231 +1,091 +51%
February 19, 2020 (All-Time High) 3,386 +1,246 +58%
March 23, 2020 (Low) 2,237 +97 +4%
July 31, 2020 (Current Close) 3,271 +1,131 +53%

Even a casual follower of stock prices also knows that these recent gains have been powered by a modest number of large high tech stocks (e.g., Apple, Amazon, Facebook, Microsoft, Tesla, Netflix), as evidenced by the NASDAQ Composite being up an astonishing 20% YTD. As long as stock market participants believe these companies can prosper in the midst of a pandemic and end up stronger at the end of the pandemic, it is at least possible that these upward trends can last.

Other explanations for the stock price advances include:

  • the Federal Reserve making it clear it will do everything it can to support the economy and the financial markets;
  • the Fed keeping interest rates low, so that investment returns from bonds will be low, providing stocks with the opportunity for growth, even with their downside risks;
  • the assumption that the US government will also continue to provide significant financial support to individuals and businesses, even with rising deficits, given the current absence of inflation;
  • sporadic optimism about medical advances to counteract the virus;
  • modest optimism regarding openings of various parts of the economy; and
  • speculation (discussed last month in detail, which still begs the question of why the speculation has been more on the positive side).

The June 15th issue of Bloomberg Business Week (BBW, front page) featured the title question, “The Great Disconnect: Why do stocks keep going up?”  First, we note that the S&P price referenced on the BBW cover at that time was 3,207 (6/9/20), which was up 43% from the March 23rd low, even in the face of the extremely disheartening news about the economy (5% GDP decline for first quarter; 14.7% unemployment for end of May; 16.3% retail sales decline for May); the virus (100,000 US deaths); and widespread protests over racial injustice.  Not only have stock prices continued to increase from June 9th (see chart above), but the bad news about the economy, the virus, and the protests has also continued.  We turn now to what BBW had to say on this subject, in a series of three separate but related articles in the June 15th issue (pages 24- 27).

The first BBW article, “Why Robinhood Day Traders are Greedy when Wall Street is Fearful,” states: “Wall Street strategists – who are as flabbergasted as the journalists – have found with vivid hindsight, the obvious explanations in the numbers. They have pointed to a surprise uptick in jobs, interest rates plunging, cheap valuations of certain kinds of stocks, and short sellers being forced to buy shares. But none of that fully explains what is happening in the minds and emotions of investors… Then there is the army of individual investors who have just stuck to their buy and hold plans, perhaps putting some money in stocks automatically with each paycheck (401k plans)…It’s a popular truism that the stock market is not the economy…[Traders] are often willing to ignore what’s happening in the world every day… Quoting Nobel economist Robert Shiller, “the stock market is just that – a market for shares of companies. It does have some relation to the economy, but it is not as strong as people think. It depends on the story and the story is always changing,” (Our note: there are shades here of John Maynard Keynes and the psychological dimensions of investing, discussed in our May Comments).

The second BBW article, “Pessimistic Pros Missed the Big Rally, and So Did Many Americans,” notes: “The Federal Reserve put a floor under the market by liberally making loans and buying bonds.  That mattered more to investors [our note:  traders?] than record job losses did…. The case for today’s high stock valuations is that profits will snap back as the economy reopens and that the Fed will continue to keep interest rates low, spurring growth and making stocks look attractive in relation to interest-earning securities such as bonds.”

The third article, “A Booming Stock Market Could Come Back to Bite the Recovery,” makes the point that the better the stock market is doing, the less likely Congress, the President, and even the Fed may find it necessary to continue their various stimulus efforts. This is not a reason for the gains, but a reason to beware the impacts of the gains.

As for bonds, their mostly higher prices make sense, because of the historic low interest rates being maintained by the Fed to help stimulate the economy.  But these rates are now so low that any further price advances for bonds may be difficult. So long as inflation remains under control, the Fed seems committed to retaining these ultra-low interest rates.

 

Initial Comments on the Upcoming Election

With all that is going on, there is an additional wildcard, namely the upcoming presidential election.  As our regular readers know, we at Park Piedmont Advisors maintain that who is president is only one of a number of factors affecting stock and bond prices. Even if we know who is going to be president, no one can predict what will happen during that presidency.  Exhibit A for this statement is Trump himself. At the time of his unlikely election in November 2016, the conventional wisdom was that if he won, stock prices would decline. That clearly has not been the case (see chart above). It took the coronavirus in early 2020 to slow down the 2019 stock price increases. Even now, prices are advancing rather than declining, while most early polls indicate a possible Biden win. There is also the related question of whether the same party can control the presidency and both Houses of Congress to effect truly meaningful change.

Another example of the possibly mixed impact of an election: if a Democrat were to win and roll back the recent corporate tax cuts, which some would consider a negative result for stocks, the new money available to the government could well go into stimulus construction projects that would be a positive to overall economic activity, corporate earnings, and stock prices. It is worth repeating that corporate earnings and a sustainable price/earnings ratio are valid reasons for stock price gains.

We will continue to comment on the election as the time gets closer, as it is likely to become a popular topic in the media. But we repeat that in our view, there is nothing inherently predictive about the connection between market prices and election results, certainly not as time passes and other intervening events become more important.

As for  the more general future, which is always an unknown, but even more so in the midst of the pandemic, we quote Warren Buffett from Berkshire Hathaway’s second quarter SEC filing: “We cannot reliably predict when business activities in our numerous and diverse operations will normalize. Nor can we predict how these events will alter the future consumption patterns of consumers and businesses we serve” (NYT 8/8/20, page A24),  If Mr. Buffett acknowledges that he doesn’t know, it seems safe to say that no one knows.

Our advice remains the same: maintain asset allocations developed for your circumstances for the long term, and rebalance from time to time based on significant changes in market prices, which means selling the better performing asset class and buying the weaker performer in a given time frame.