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Election, Our Process, Housing, the Fed, and Bonds - MMM Week 24

Last week's Musings focused more on the big picture and my message to clients and advisors on where we go next. With that focus a lot of my random thoughts last week were on the long-term impact COVID will have on our economy, the markets, and our lives. We will have a lot more on that in the months ahead, but we all need to keep in mind that many things will feel "different", but what doesn't change is the way our brains make decisions. We all have inherent biases when we make decisions. There isn't anything wrong with that, it's what makes us human.

Our hearts and brains are often conflicting.

via GIPHY

Here's what's on my mind as we start Week 24 of the COVID19 Pandemic:

An Election Like No Other

With the Democratic Convention last week and the Republican one this week, we can say we are now officially in election season. It seems like we've been there for at least 2 years given how early candidates started campaigning against President Trump, which led to what seemed like 2 years of campaigning by the President. Emotions are clearly high.

Last week we had 3 clients request to go to cash until after the election. The message came from their advisor and I didn't get a chance to talk to the clients. The advisors know one of my top rules in investing – do not let your political beliefs influence your investment decisions. I need to get a message out to all of our clients soon. I don't know what the outcome will be, or what the reaction will be from the market. I've done this long enough and studied enough data to know the market does not always behave like we think it should.

Ned Davis put together some data that may help guide us. There are two key takeaways:

1.) Nobody can confidently predict the outcome of the election.

2.) Even if you get it right, the market may surprise you next year in its reaction.

First, let's look at the average cycle. I put arrows on there to highlight our two possible outcomes with a line marking where we are currently. Do you trust the polls or your opinion to make a decision that can cost you significant amounts of money (or missed opportunities)?

Even if the President loses, the following year could bring a sharp recovery higher.

My opinion, is Republicans are fighting an uphill battle. COVID has widened the gap between the "haves" and "have nots". If the economy remains weak, we could see a swing to total Democratic control, but that doesn't mean you should go to cash if you think I'm right.

A Divided Economy
The stock market is capable of ignoring a lot of things. Since the economy beganto re-open it has made a huge move higher. This is despite the fact theSTRUCTURAL damage done by the economic shutdown has pushed the weak businessesand consumers over the ledge. This was bound to happen during the ne…

Going to cash because you think Biden is going to win. Remember, the predictions were Clinton and Obama would be terrible for markets and the economy. They might campaign on one platform, but getting things done in Congress is a different story, especially when Wall Street starts talking in their ear about how bad their policies could be for the economy.

I will say if you are a Christian and looking to make a bigger impact with your investment dollars, rather than "going to cash" because you are worried about Trump losing, our Cornerstone Models could be a far better way to support your beliefs. Each month Courtney posts an update on what our Cornerstone partners are doing with our investment dollars in the models.

Cornerstone Impact Update - COVID, Amazon, and Resources
We love working with our Cornerstone partners! This month’s update focuses onways our partners are speaking out on important topics. EventideThe Chief Investment Officer for Eventide funds, Dr. Finny Kuruvilla has one ofthe most impressive resumes for any of our portfolio managers. In our offic…

Trust Our Data Driven Process

This year has once again proven the value of our data-driven process. The relative sense of calm around our offices as the market was collapsing and then rocketing back higher was something I am most proud of. While fielding calls and emails from clients and advisors asking what to think of (fill in the blank headline), the message was simple – "we've been here before and our plan is working as it should."

I cannot emphasize enough how important our process will be going into the election. We don't have to predict who will win or what the impact will be on the economy or markets. We will follow the data and our process. Here's a reminder of what that process has looked like in 2020.

Here's a short webinar we ran earlier this summer describing our process.

The Value of SEM’s Behavioral Approach in Uncertain Times
Given all the uncertainty we are facing in 2020 and beyond, the value of SEM’sBehavioral Approach has become apparent. This short webinar discussed howinvestor emotions determine stock prices, behavioral biases we face as humans,and how our approach has us prepared for the unknowns ahead.

Or here's a more fun look at the way we manage money.

Just Guessing
Being a data driven, scientifically-minded investment manager, we’ve always beenuncomfortable making decisions that did not have a solid basis. Our study ofbehavioral finance and market history, as well as nearly three decades ofexperience managing money tells us our brains often can play tricks …

In last week's Chart of the Week, I showed the different paths you could have taken in 2020. In my opinion it is impressive that on both ends of our risk spectrum our models have performed the same or better than the S&P 500.

Many paths to all-time highs
The S&P 500 index hit an all-time record high on Tuesday. Many people arecelebrating what is officially the shortest bear market in history. A typicalbear market sees stocks losing 35-55% over 12-18 months and then taking 5-8years to fully recover those losses. I’ve argued since the beginning thi…

A Bull Market in Housing

One of the biggest impacts we've seen from COVID is the realization that businesses can function without their employees in the office. This along with insanely low interest rates on mortgages has led to an explosion in suburban housing markets. Building Permits have nearly recovered all of the losses in 2020.

I've always looked at Building Permits as one of the best leading indicators as the amount of economic activity that goes into building and moving into a new home is significant. One thing we will have to watch is if we have an air pocket in the economy with the change in unemployment benefits and the decreasing likelihood of another round of stimulus checks. This could lead to some fresh bankruptcies and business closures, which could lead to more unemployment.

No Recession in Income
The most often asked question during my client and advisor presentations thepast four months has been “why is the stock market rallying so much with so manypeople out of work?” Ignoring the long-term impact on economic growth due to theballooning debt obligations, the CARES Act has played a major…

We Still Have the Fed

I mentioned last week how I'd be watching the Fed's Balance Sheet closely. They release the data each Thursday. We saw 10-year Treasury interest rates spike two weeks ago on the heels of 6 out of 8 weekly declines in the Fed's Balance Sheet. Last week they were more active in their purchases, boosting their purchases by nearly 1% ($54 billion). They were most active in the Mortgage Backed Security and Treasury markets. We subsequently saw a nice decline in 10-year Treasury yields.

Their purchases are "open-ended", but it doesn't mean we can count on them to save everything, which brings me to my last point.

Dangers and Opportunities in Bonds

The Fed shocked everybody in the spring when they announced they were setting up programs to buy corporate bonds, including some select "junk" bonds. Junk bonds (aka high yield bonds) are rated BB and below and have higher yields because they are much more at risk of not paying their money back. The Fed's programs allow them to buy bonds rated as low as BB, but only if the issuer was rated BBB (lowest investment grade rating) or higher before COVID19 struck our economy.

In other words, they can buy bonds of companies who were healthy pre-COVID, but were hit hard due to the widespread shutdowns. Those companies already weak are not on the Fed's purchase list.

Here is a chart illustrating the wide divergence in the bond market. You can see the huge difference in yields between both "investment grade" (BBB) and BB. There is an even bigger difference between what the Fed can and cannot buy. If you look closely you can see yields moving higher in all high yield categories. As I mentioned earlier, the air pocket we are likely to see in the economy will probably lead to more bankruptcies, layoffs, and defaults.

We are currently invested in high yields in our Tactical Bond and Cornerstone Bond models, although two weeks ago we sold a bit of our exposure.

You Missed It!
I’ve been managing money for over 25 years. With advisors and clients across thecountry and now the ability to hold client meetings online I can usually get apretty good feeling for investor sentiment. I used the word “animal spirits[/monday-morning-musings-week-13/]” to describe investor sentime…

These models have made some sizeable gains since mid-April, but are now watching closely for more stress. At that point they will move back to lower risk investments and wait for the next opportunity. That opportunity could be HUGE.  

(Delayed) Opportunities Emerging
The virtual ink had barely dried on my “time to get excited about valuations[/time-to-get-excited-about-valuations/]” post when the Federal Reserve didwhat, up until that point, most of us thought would never happen. They announcedthey would not only be buying junk bonds, but also junk bond ETFs.…

I'm not sure when that comes, but history, data, and economic logic tells me we will see mass defaults in high yields (which also won't be good for the stock market). As we've shown over the past few decades, we'll be ready. Will you be?

Continuing the Experiment

I've been documenting the difference between Virginia and Arizona since the beginning of the pandemic – both having nearly opposite responses. As I've said before, there are a lot of variables in this experiment and we won't truly know what worked and what didn't work until scientists can study the virus more.

Keep in mind when looking at the charts below that Arizona has nearly 2 million LESS people than Virginia does.

With the increased restrictions in Arizona, their deaths per day has drastically fallen; however, it's still almost double what Virginia is seeing.

Using the percent positive tests normalizes the number of cases. More testing = more cases. After mandating masks and imposing more restrictions in July, Arizona is now back to around 10% positive tests.

Virginia saw an increase in percent positive tests after beginning "Phase 3" in early July. In August the Virginia Beach region had new restrictions in place, and we are now seeing the percent positive tests decrease again.

With many schools opening up and having varied procedures, we will have more data in the coming weeks.

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New Kent, VA
Jeff joined SEM in October 1998. Outside of SEM, Jeff is part of the worship team at LifePointe Community Church where he plays the keyboard and bass guitar. He also leads a small group Bible study.