Client Communications (Interim Letter)

"Now What?"

November 27, 2020

The election is behind us and the U.S. stock market has experienced a modest and short-lived vote of disapproval with its outcome, falling 3.5% in the first nine days following the event.  Putting the market’s recent behavior and its view of the future into a somewhat longer-term perspective, on a year-to-date basis through November 23, 2020 the S&P 500 Index has registered an impressive total return of 13.9%.  This is not behavior indicative of a potentially collapsing economy, whether one is convinced of a “fiscal cliff” calamity or simply not sure.  Perhaps the fear of an economic debacle resulting from the fiscal cliff is overblown.

It’s important to remember that financial markets are constantly discounting future outcomes.  So, it’s reasonable to conclude that the Obama re-election, the unproductive partisanship in Congress, the ongoing euro mess, etc., etc., are all factored into today’s market prices and that the world’s stock markets are not expecting dire outcomes. 

For many of our clients the current discomforting economic and political situation sets up an interesting “cognitive dissonance” situation vis-à-vis investment markets.  One might think that stock markets should be crashing by now – after all, we have been watching the news!  The fiscal cliff and sequestration, we are told, will push the economy back into recession two months from now.  Another baked-in-the-cake trillion dollar deficit in 2013 will ensure that nobody will lend us any more money and interest rates will then skyrocket, etc., etc.  For an in-depth analysis of fiscal cliff outcomes, I have included with this report a detailed research piece from BCA Research, our primary economic consultants.  BCA does an excellent job summarizing the current situation and extrapolating the impact upon GDP growth in 2013 under varying alternatives.

Pretty much everyone has a fair understanding of the scope of the country’s political and economic problems.  But the fact that global stock markets have all experienced surprisingly strong returns so far suggests that other factors have combined to counterbalance the gloom and doomers.

What follows now, in no particular order, are some observations of larger global or regional or country-specific economic trends which may be the kinds of contributing factors to the respectable 2012-to-date stock market returns.

I know that for every piece of good news there are other examples of bad news that could be mentioned.  Nevertheless, global equity markets continue to move higher.  It is my belief that most of the bullet points presented above share a common origin: increasingly aggressive reflationary policies by the world’s central banks. These policies have forced interest rate declines around the world.  Central banks have telegraphed that they will hold to stimulative policies for as long as necessary to help bring about stronger economic growth and, to date at least, global equity and fixed income markets have voted their approval.

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Now, back to the fiscal cliff and the need for serious entitlement and tax reform.  There are some influential members of Congress who bristle at the notion of reform “down payments” and continuing “kicking-the-can” non solutions.  These people have expressed the view that anything less than a serious plan of economic reform would warrant allowing the country to fall off the cliff, experience the full brunt of tax increases and sequestration contained in the present law and allow market panic to force needed reform.  The Europeans have amply demonstrated that market riots are required to force politicians to act responsibly and face down public anger over benefit cuts and tax increases.  Perhaps our time has come for the same treatment? 

Last week a congressional staffer heavily involved in the fiscal cliff negotiations placed the chances of a mutually agreed upon arrangement at no better than 50-50.  The inability to reach a deal could precipitate a sharp, emotional stock market selloff for a relatively short period of time.  This outcome would create, in our opinion, an attractive stock market buying opportunity.

Perhaps the American people should brace themselves for a series of market disruptions in the style of Europe where positive change only comes about when markets force politicians’ backs to the wall.  We have commented before on the way the European Central Bank bureaucrats make small, incremental concessions to the profligate euro members so as to keep markets one step below full-bore rioting.   Perhaps we also will need the discipline of near market riots to get our politicians to do the right thing by the country.  Time will tell. 

One of the most important points to keep in mind is that market riots in Europe and possible market riots in the U.S. are political in their derivation.  Thus solutions can occur rapidly and markets can move violently in response.  To restate – markets are not forecasting economic recession at home at this time.  There are no financial excesses to be purged; only political intransigence.  A grand compromise creating longer-term clarity for tackling our fiscal problems would, on the other hand, be the impetus for a possible stock market surge from today’s levels.

From the standpoint of managing your portfolio we have the following fiscal cliff choices:

  1. Make no changes in your portfolio.  Hope that Congress and the President will negotiate a compromise by year end to avoid the worst of the fiscal cliff negative economic outcomes.
  2. Hedge the equity portion of your portfolio at this time and for the next one to two months to protect against a possible investor panic if political negotiations fail.  This hedge could be accomplished through the purchase of put contracts on the S&P 500 Index.
  3. Purchase long term treasury bonds, or call options on long term treasuries as a further defensive measure against a collapse of the negotiations.
  4. Make a proactive bet on the success of the talks by increasing equity exposure at this time.

My personal inclination is to hedge against the possibility of a collapse of the negotiations or an agreement which just kicks the can down the road for a few more months.  As one of our portfolio principles is separate account management, we invite each of our clients to call us for further discussion regarding specific account investment strategy in this uncertain time.

Roger A. Sheffield, CFA