An election year follows a great year. What now?

The stock market had its best year since 2013.  The sharp selloff of December 2018 seems like a distant memory.  The market had only two down months in 2019.  Technology stocks led the way, but interest rate sensitive stocks and consumer staple stocks were also strong.  For those who think the market is irrational, there are plenty of stocks that have not kept up – which suggests that investors are still distinguishing between attractive companies and others in this ever-changing environment.  The health care sector lagged, and the energy sector lagged badly.

Your portfolio did very well, as detailed in the attached summary.  Microsoft and Apple were star performers, returning 57% and 88% respectively.  Microsoft is making huge strides in cloud computing and Apple has been cheap relative to other technology stocks.  Those two stocks alone accounted for nearly 15% of the S&P 500’s gain this year.  We’d love to own more of these stocks, but part of our job is to keep you appropriately diversified and reasonably protected against any unanticipated and potentially sharp downturns.  For instance, Apple was lower in two of the past five years.

Procter and Gamble was another big winner, and has continued to rally despite being quite richly valued relative to its own historical metrics.  KKR also did well as alternative investments continue to grab an ever-larger share of the capital markets, in part because the number of publicly listed stocks has been shrinking substantially.  From 1996 to 2016, the number of publicly listed companies in the U.S. fell by half, from 7,300 to 3,600 according to Credit Suisse.  Initial public offerings have fallen even more dramatically in the same time frame.

Certain of our holdings were a bit disappointing.  We own Exxon Mobil, which returned only 2.3% this year.  Dupont was also weak, but the newly constituted firm did not start trading as a stand-alone entity until May 31.  There is a strong argument that the stock is worth $80 per share ($64 now) based upon a sum-of-the-parts analysis, and its current executive team has a track record of realizing such value elsewhere.  Some of the big pharmaceutical companies had a sub-par year due to a combination of political concerns and litigation fears.  Other quality stocks, such as Verizon, offer a generous 4% dividend yield and contribute to portfolio stability, but are a drag on performance in strong years.

As an interesting aside, Warren Buffett’s Berkshire Hathaway returned only a modest 10.9% this year.  The total return for the S&P 500 Index was 31.48%.

Even in the best of times, we want to be mindful of risk.  Stock markets do go down.  There is always the risk of a significant correction when the market is richly valued and / or when interest rates have a lot of room to rise.  For now, there are many good reasons to remain positive on the market’s outlook – but without losing sight of risk management.  We continuously monitor the earnings and competitive position of each of our holdings. Valuation seems reasonable, as discussed below.

Economic Outlook.  Recessions have often been caused either by higher energy prices or tight money.  Oil prices have been weak.  Core inflation is at 1.6%, so there is no need for tight money.  Banks may not enjoy profitable lending spreads, but money is cheap.  Corporate spreads are tight to Treasuries, meaning that it is not expensive for corporations to borrow.  GDP data will benefit a bit as imports have dropped – in part due to the trade situation.  Pundits have been talking for months about a recession due to the flatness (or occasional inversion) of the yield curve, but there is little evidence of a recession.

Election Year Influences – Historical Perspective.  It is also true that the stock market has often been strong in presidential election years.  When we look at history, that is particularly true when an incumbent is up for re-election.  This makes intuitive sense, because an incumbent president has an incentive to stimulate the economy and in so doing, promote a bullish trend in stocks.  But even though there is a 6% gap between presidential years with an incumbent on the ballot versus none, that may not be statistically significant given the limited sample, overall variability of stock market returns, and the fact that the gap would be only 3% but for 2008.  The details of each election cycle are shown on our website here. Worth pondering.

Is it different this time?  We cannot help but wonder if most of the available stimulative measures have already been taken.  If so, did this Administration do too much too soon – and should that become the market’s perception, could it mean a decline in 2020?  Hard to tell, but we already have trillion-dollar federal deficits in boom times, and it is hard to imagine Congress adopting a more profligate fiscal policy.  On the monetary side, the Fed eased fairly aggressively in an environment of full employment and low inflation.  The Fed Funds rate is already targeted at 1.75%%.  How much lower can it go?  And even if it goes lower, a marginal decline in rates from these levels may be inconsequential.  Money is so cheap to borrow already that another ¼ point is not going to stimulate much new demand for money.

Additionally, there is the trade war.  We seem to have reached a round one agreement that has boosted the market into year-end.  It provides us with a unilateral ability to impose tariffs if we feel the terms have been violated.  There is potential for more upheaval in the market due to trade tensions.  At the risk of sounding too conspiratorial, there may be a strategy of an “October surprise” strategy of providing some last-minute momentum before the election.  Events could easily unfold this way unless weakness in stocks puts pressure on the Administration to reach an accord sooner.

All that said, there is good reason to expect a continuation of the current state of things early in the year.  As the year unfolds, the market is bound to be impacted more and more by presidential politics and the prospects of the candidate who are most friendly and unfriendly to free market forces.  For instance, health care stocks in general would not do well if Elizabeth Warren is seen as the likely Democratic nominee.  Financial stocks would face challenges too.  On the other hand, energy stocks might actually do well in that her proposed fracking ban would cut production dramatically.

Probabilities associated with various tax proposals will also likely impact the overall market.      If the Democrats manage to win the White House and take control of the Senate, the odds increase of a difficult market environment due to some far-reaching tax and regulatory proposals that would suddenly have a real chance of coming to fruition.  The Democrats need to pick up four Senate seats for outright control, and three seats if they have a VP to break ties.  Their best prospects are in:  Colorado, North Carolina, Arizona, and perhaps Maine and Iowa.  Of course, this also means that the Democrats cannot afford to lose any seats, and Sen. Doug Jones faces a very tough re-election bid in Alabama.

The Senate matters to the prospects for the tax changes sought by leading Democratic presidential candidates.  With control, a wealth tax could pass.  Of course, control by a one vote margin certainly does not mean that a wealth tax gets enacted, but it does change the equation and sharply increases the odds of higher taxes on investment income – potentially including an annual tax on unrealized capital gains.  That would put taxation of unrealized gains on equal footing with taxation of dividends. This disparate treatment is one of several reasons that low dividend growth stocks have outperformed high dividend value stocks in recent years.  With a different tax regime, this pattern could reverse or at least be less pronounced.  We will do our best to stay a step ahead of the crowd when it comes to risk assessment and portfolio positioning.

Market Valuation.  Reasonable estimates indicate that the S&P 500 stocks will earn about $141 this year.  Here are the closing levels and corresponding earnings for the S&P 500 in each of the last five years, together with the ending ten-year Treasury rate and market’s total return in the year ahead:

SPX index SP500 EPS P/E Earnings yield 10 Year rate Next Year Return Earnings Premium
2019 3230.8 141.00 22.9 4.36% 1.92% 2.44%
2018 2506.9 132.39 18.9 5.28% 2.69% 24.22% 2.59%
2017 2673.6 109.88 24.3 4.11% 2.40% -4.38% 1.71%
2016 2238.8 94.55 23.7 4.22% 2.45% 21.83% 1.77%
2015 2043.9 86.53 23.6 4.23% 2.27% 11.96% 1.96%
2014 2058.9 102.31 20.1 4.97% 2.17% 1.38% 2.80%
2013 1848.4 100.20 18.4 5.42% 3.04% 13.69% 2.38%
1999 1469.2 48.17 30.5 3.28% 6.58% -11.89% -3.30%

You can see from the bolded PE numbers that a current PE ratio of over 20 certainly does not preclude good returns in the following twelve months.  Moreover, interest rates are lower now than in any of those years, and so a higher PE ratio is that much more justified.  Stated another way, the spread between the earnings yield on stocks and the yield on ten year Treasuries is more attractive now than in many years that provided double digit returns.  You need a PE ratio of 50 to equate to a Treasury note yield of 2% – not that we see a PE of 50 on the horizon.  One reason we don’t see it is because if rates rose from 2% to 3%, the PE equivalent would be only 33.3 – a huge drop from 50 – and thus not the kind of risk that investors would likely undertake.

But how does valuation today compare to the months before the tech bubble bust of nearly 20 years ago?  Back in March 2000, interest rates were much higher – three month Treasury bill yields rose in the first quarter to about 5.9% and the ten year Treasury notes fell in the first quarter of that year and were yielding just over 6% – about double what they are today.   The PE ratio was also considerably higher than it is now; we show the S&P 500 at 1469 at the end of 1999 while year-end operating earnings were $48.17 – that translates to a PE ratio of 30.5 and an earnings yield of 3.28%.  So the earnings yield on stocks back then was considerably less than the yield on Treasury bonds; today that relationship strongly favors stocks.  To get a bit more in the weeds, some analysists would say that high PE ratio back then was due to a few stocks with stratospheric PE ratios and thus the measure was distorted then.

What Could Go Wrong?   In any year, it is easy to make a list of what could go wrong.  Trade wars, terrorism, focus on the domestic budget deficit, a flash crash, domestic political instability resulting from impeachment or a close election, or something out of the blue; remember a few years ago when a banking crisis in Cyprus caused a brief stock market panic?  That is why managing risk is an important part of our job.   But as we illustrated in our letter of last April, the total return from stocks has been on a pretty steady upward climb for decades – sometimes more from dividends, sometimes more from price appreciation – and by no means in a straight line.  Regular and lognormal charts can be viewed within that letter on our website at  It is a good reminder that staying the course has paid off throughout our lifetime.  A lot could have gone wrong this past year too – and if we worried too much about short-term headlines we would have missed a huge rally.

We will do our best to balance risk and reward in the year ahead.  While we strive to limit turnover, we constantly look for new opportunities.  We appreciate your confidence and are grateful to have such a loyal and growing client base.  We’re pleased to have expanded our capabilities this year with two outstanding new investment professionals – Jason Rapp and Brian Arena.  With our expanded capacity, we are grateful for any referrals you might provide for friends or colleagues who would benefit from our services.

Wishing you all the best for 2020,

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