The stock market settled down in the first two and a half months of the second quarter from the extreme volatility we experienced in the first quarter. With the exception of a few days in May, the S&P 500® Index stayed above the March 31, 2016 level which kept the major stock index barely in positive territory for the year.
Many of the stocks we purchased in our managed account strategies during the first quarter swoon continued to perform well in the second quarter. As the fear of rate hikes from the Fed and fears of worsening economic data waned, stocks plodded higher. Our prediction that oil would start to rise in price in March proved to be pretty accurate. Oil moving higher in price really was the catalyst for stocks to rebound as strongly as they did. It signaled that economic activity was picking up and that the economy was not heading for a recession.
As we look forward, there are many reasons to be concerned about the direction of stock prices with the presidential election, Fed policy meetings and fallout from BREXIT to name a few. As contrarians, we see this concern and the negative sentiment associated with it, as a positive sign for stocks as the underpinnings of the economy continue to improve. To understand why we feel this way, let’s take a look at what has so many people concerned about the future and why we think there is a silver lining to it.
BREXIT
The quiet and generally positive tone of the markets in the first part of the second quarter gave way to the shock of BREXIT in the final week. Our view was that the vote was going to be very, very close but that the “IN” vote would prevail and mean that the U.K. would remain in the EU. That said, we felt that regardless of the way the vote went, the fallout would not have a long tail to it. In other words, whatever volatility followed the vote, it would not last long. The U.K. has never been a fully-integrated member of the EU and, therefore, an exit would not have the dramatic impact that a Spain, Italy or France exit would have on the collective. Furthermore, the U.K. has a very large trade deficit with the EU. This means that the U.K. buys more from the EU than it sells to it. So, even with a BREXIT, the EU will want to keep a strong trade relationship in place to benefit from having the U.K. as a trade customer.
Once the vote was counted and the BREXIT camp had won, all hell broke loose. If you listened only to the news reporters, you would have thought the U.K. had just voted to dissolve itself as a country and dissolve into the North Sea. Leave it to the news industry (Never forget it is a for-profit industry that benefits from major news stories.) to wax dramatic over the vote.
The >5% drop in the U.S. stock market over the two days that followed the vote suggests that large investors were caught out “over their skis” and had to unwind their trades. The effect of the dramatic drop in value of the British Pound had a lot to do with the volatility in stocks.
The drop in stock prices dried up in two days and bids came back into the market. Stocks steadily climbed through the end of the quarter effectively neutralizing the drop that followed BREXIT. This type of recovery signals to us that as we head into the third quarter, the path of least resistance for stocks (in the short term) is higher.
The U.S. Presidential Election
With the election taking place in November, we will likely refine our view many times over. Nonetheless, here is our current prediction on how the election will go and its impact on markets.
We expect Donald Trump to win the election despite being behind in the most recent public polls. Recent history suggests that two-term presidents are the norm and a shift to the other party is just as normal. George H.W. Bush’s victory is the exception but likely only because Michael Dukakis stole defeat from the jaws of victory. Regardless, we believe the momentum in critical states will lead to a Trump electoral victory in November.
Once the polls begin to reflect a Trump victory is likely, we expect stocks to sell off. Mr. Trump’s protectionist tone will weigh heavy on the markets regardless of what his policies actually are once elected. While stocks selling off is a negative to those who own them, it is represents an opportunity to those looking to buy them. In our case, we expect to take profits in our managed client accounts as the election nears so that we have cash in reserve to “buy the dip.”
Any dip, and we expect this dip could be on the order of 10%, will represent a tremendous buying opportunity for those looking to buy stocks. This we believe to be true regardless of who wins the election. This is because we expect, finally, some fiscal stimulus from the White House. The bar is set quite low for either candidate in terms of what the nation believes can be accomplished. This is positive as it means it will take only a small amount of stimulus to have a significant effect. The Federal Reserve, which controls monetary policy, has been doing most of the “heavy lifting” in terms of government stimulus. The Fed is screaming loudly to Congress and the White House that they are getting tired and are ready to take a break. We expect Congress and the new President to do exactly that. The impact on the stock market will be extremely positive and set the tone of the market for many years to come.
While we are extremely optimistic that fiscal stimulus will finally be felt, we expect there will be some misfires first. As the new president gets his/her sea legs, the stock market will likely get whipsawed and may even react to a shallow recession during the first 100 days. Our conviction that a correction in stock prices will occur before the end of the year was deepened following the BREXIT vote.
It is important for our clients to understand that our view that Trump will likely be our next president is in no way an endorsement or warning. We are charged with managing other people’s money and therefore we must do so without any personal bias affecting the decisions we make.
Federal Reserve
The Fed will continue to be a major factor in determining the direction of stocks well beyond the presidential election. This makes their actions just as important as those of the President.
We have suggested to clients for many quarters that the Fed is on hold until they see the proverbial “whites of the eyes” of inflation. The commodities and precious metals market has provided an indication that deflation is the real threat and not hyper-inflation. As the Fed approached their decision to raise interest rates in December, a decision they had to make for political more than economic reasons, markets reacted negatively. Specifically, oil and gold prices dropped signaling deflationary forces were gaining strength. This reaction to a slight increase in interest rates likely spooked the Fed and caused them to back away from any further tightening until later in the year.
If the fiscal stimulus we expect to come from Congress and the President takes shape, the Fed will finally be able to plan for a steady stream of rate increases without derailing the economy. While we believe it is possible there will be one rate increase this year (maybe September), we will not be surprised if the Fed remains on hold for a few more quarters. After all, the Fed has many more tools at their disposal to rein in inflation than they do to inject stimulus. Thusly, we expect them to keep the reins very loose.
The 17-year Cycle
Our long-term outlook for stocks is predicated on the notion that the stock market follows a 17-year cycle that alternates between periods of growth and stagnation. The end of growth periods are marked by things such as broad-based enthusiasm for stocks, low government deficits and excessive corporate expenditures. The end of stagnate periods are marked by a general malaise among investors and large cash reserves at banks and on corporate balance sheets.
The current cycle is of the stagnate variety having begun in the year 2000. Similarly characterized as other historical stagnate cycles, we believe this cycle will give way to growth.. We believe it will also give way to a cycle of growth very soon.
Charts
To lend support to our view that stock prices are poised to move higher rather than crash, we submit the following charts:
Residential Construction Spending
This chart shows that the spending on new home construction just recently returned to the level of 2001. In light of the fact that the population has grown significantly over the last 15 years, spending is likely to continue to grow steadily for some time to come. The impact of residential spending on economic growth cannot easily be overestimated.
To further support our view that the housing market is ready to accelerate, the chart below plots the relationship between housing supply and demand. As you can see, the relationship between supply and demand for housing is highly correlated with supply lagging. Since 2012 the demand for housing has accelerated much faster than supply. We expect supply to catch up rather than for demand to fall back.
Election Year Stock Performance
Keep in mind the fact that past performance never guarantees future results. In this chart we see how stocks have performed from the end of May through December during presidential election years. In the far right column you can see that performance has been reasonably strong during these periods. Source: Standard & Poors.
Supply and Demand
While the following chart might suggest to some that things are setting up for a repeat of the financial crisis of 2008, we see something different. First, the “flattish” stock performance over the last 18 months might be partially explained by corporate buybacks offsetting retail investor selling. This we believe is true. However, when corporations buy back stock it is no longer in circulation like it is when retail investors buy stock. This means when retail investors turn back to stocks, which we believe will happen soon, there will be less stock available to buy. The dynamic between supply and demand alone will provide upside to stock prices.
Megaphone
In the chart below, we see the two periods 1962-1984 and 1999-present highlighted. We think this is a great visual illustration of how we believe our 17-year cycle will play out. In the first shaded area we can see a market that bounced around but never was able to break above the upper line of the “megaphone” for more than a decade. Once it did, the market moved substantially higher. A similar pattern has developed since 1999. This is consistent with our view that we are on the verge of a multi-year breakout to the upside in equity prices.
Generational Buy
Here we see a chart of the equity market from 1910- present. This, too, is consistent with our view that in March of 2009 investors were presented with a “generational buying” opportunity. In other words, it is unlikely that we will see such an opportunity again for a generation. While that moment is in our rearview mirror, the chart also suggests, and we agree, that there is plenty of room for the market to run to the upside from here.
We think it is beneficial for our clients to understand how our long-cycle philosophy acts as an overlay on our view of the markets during times of high volatility. Changes to portfolio strategy are not made in isolation. Rather, they are made within the context of our market expectations, which are shaped by our daily surveillance of the markets through a long-term-cycle lens.
Conclusion
We expect the strength in stocks following the initial decline that followed BREXIT to continue into the third quarter. A “goldilocks” scenario of continued economic improvement with little chance of a Fed rate hike will offer the best environment for stocks to rally. As is the case with any steady move in either direction, stocks will over shoot. In this case, we expect stocks will “overheat” later in the quarter warranting caution. In our managed accounts, we will look to sell stocks into this strength which will increase our cash position. If weakness in stocks follows, we believe we will be well-positioned to move back into stocks at lower prices in preparation for a more sustainable rally to follow.
The election will present what might be a U.S.-version of the BREXIT event. We will be keenly watching markets for signs that this is the case. If a major selloff does occur, as we expect, our focus will be on capital preservation as we described above.
While we understand the strange looks we may get when describing our optimism following the election, we believe that fiscal stimulus is on the way. As this fiscal stimulus takes a hold, the aggressive monetary stimulus put forth by the Fed can be pulled back. We will be watching intently for this handoff to occur.
P.S.
We would also like to announce the addition of a new team member. Sara Steinrock joined the firm in May as our Client Service Manager. She is a Columbus native and joins us from MainSource Bank where she was the assistant branch manager of the downtown Columbus office.
Sincerely,
Kessler Investment Group, LLC