Post Election Update: What We Know

"Market timing can completely eliminate the long-term advantages of investing in the first place" - Scott Lummer, Savant CEO, CIO

Highlights:

• Very little is known about specific new economic policies that will be undertaken

• Recent growth in GDP and forecasts of corporate earnings are good news for the market

• Increases in interest rates have caused short-term losses, but will be compensated for by increasing yields

There’s still much we don’t know about key economic and foreign policies that the new president will undertake. Certainly things will change, but as we said in our commentary last week, it will likely be six to nine months before we get a clear picture. Until then, we should expect higher than normal volatility in the stock market (although that hasn’t been the case since Wednesday). Many in the financial press are presenting their speculations, not just about potential policies, but about the impact of those policies on the economy. Candidly, we don’t put a lot of faith in those speculations, which run the gamut from exceptional economic growth and prosperity to recession and high inflation.

Instead, we’ll focus on three things that we know:

• Buried in the news in the weeks leading up to the election, The Commerce Department announced that real GDP (adjusted for inflation) grew at a 2.9% rate last quarter, which exceeded most economists’ expectations and is the strongest quarterly growth rate in the past two years. This is indeed good news for the stock market, and yet has seemed to be absent from most financial reporters’ analysis of the market.

• Earnings per share of S&P 500 companies, as forecasted over the next four quarters (twelve months) by security analysts, are 33% higher than the past twelve months. That isn’t a typo – projected earnings growth over the next year is expected to be 33%. Part of the reason is that earnings over the past year have been depressed (in part because of losses in the energy sector), but still, 33% growth is a lot. Skeptical readers may immediately say that security analysts are overconfident, but the fact is more often their forecasts underestimate earnings than overestimate them. Again, those forecasts are good news for the stock market.

• Interest rates have risen by about 0.4% since the election. This increase stems from several factors, including the previously cited news about GDP and earnings forecasts, belief that potential tax cuts and increased infrastructure spending will increase the national debt, and concerns about increasing inflation (which, in turn, can result from increased debt and economic growth).

Before discussing what else we know, we want to focus on the impact of interest rates on bond market returns. An across the board increase in interest rates means two things. The immediate impact is a decline in bond prices, and of course, that’s happened over the past week. The shorter the maturity, the less severe the decline, which is precisely why we’ve recommended short and intermediate bonds for our clients. The second impact, which is good for investors, is that over time, they’ll earn a higher level of income on their bonds. How fast they’ll receive that rise in income is dependent again on the maturity of the bonds – the shorter the maturity, the quicker the increase in yield will occur. Two years ago, we posted a nerdy math-filled commentary that showed that as long as the time horizon of your portfolio was longer than the average maturity of the bonds, the net impact of an increase in interest rates was positive overall. For our clients, that means if your average investment horizon is longer than five or six years, you need not fear the long-term impact of an increase in rates.

Beware of Market Timing Finally, during times of increased uncertainty, many investors let their fears get the best of them, and they pull their money out of the stock market and invest in cash. Of course, that leads to the question of when do those investors invest back into the stock market. Anecdotally, the answer is, typically after the market has had a large run up, meaning those investors have missed that increase in value.

Let’s look at the long-term risk of timing the market. Suppose you were an investor in the stock market way back in 1925, investing $1,000. If you were a calm investor, never timing the market, you’d have earned a return of 10.0% per year, and your investment account would be worth $5,701,000 – such is the magic of long-term compounding. For comparison sake, an investment in cash over those same 91 years would have earned 3.5% per year, and your account would have been worth $22,000 – such is the lack of magic of compounding at a low rate.

Now suppose you were a market timer during those 91 years, and just happened to miss out on the top 4% of the months in which the market went up – only 4%. How much could it hurt? The answer is your overall return would be 3.5%, and your account would be worth $22,000 -- $5.7 million less than if you hadn’t market timed. Of course, you would have been a very unlucky market timer, but our point is investors face tremendous risk when they time in and out of the market. Hence, the last thing we will say we know is:

• Market timing -- occasionally pulling out your money of the stock market -- can completely eliminate the long-term advantages of investing in the first place.

It’s for that reason that we strongly advise against timing the market. As long as you have a portfolio structured according to your objectives and risk tolerance, you should maintain a consistent allocation.