In this Update:
- Originally expected prior to the election, no additional stimulus has yet been passed.
- Nixon’s campaign saw many parallels to present day, but FDR’s presidency could be looked at one of the most chaotic times, which saw stocks rise from start to finish.
- COVID 19 cases continue to rise globally, and some countries have begun issuing nationwide lockdowns, such as England and France.
- Markets as a whole do not appear expensive when adjusting for the few names seeing meteoric prices, skewing much of the indices’ performances.
Volatility Rises – Stimulus Uncertain
Over the past week we saw increased stock volatility as hopes for another stimulus package before the election faded. Over the next few weeks market volatility could accelerate, which is simply major swings in prices. March of this year saw some of the highest volatility levels not seen since the financial crisis back in 2008-2009. We do not believe such extreme swings will occur simply due from an election. It could very possibly be dramatic and make for some great headlines. However, the market seems more focused on stimulus or the lack thereof than the elections results. Uncertainty also adds volatility within the markets, and there is a good chance we won’t know for sure who won this election for several days or even weeks. Many are expecting this, so it may not be such a shock to the system temporarily as was the Bush/Gore “hanging chads” situation in 2000.
It was originally expected to have seen some form of additional stimulus from the government prior to the election, however with the adjournment of the Senate, no package has come. A stimulus package does not seem likely in the short term, especially if the election sees a Biden win who would not assume office until January. Also, the Fed will most likely stay dormant on any accelerated easing programs for the time being. Post-election, we imagine the Fed will act if anything deteriorates again like we saw in March. However, the Fed is only vital in greasing the wheels of finance, not giving relief to those who may be unemployed or seeing other personal struggles.
2020 Election and a Little History
With the election now at hand and headlines ablaze with political unrest, it’s easy to feel as though times have never been this uncertain. We thought it might be helpful to look back at two past administrations and events during the last century and discuss how stocks performed during those periods.
First, let’s look at Nixon’s run for office, which has some similarities to the current environment in terms of politics. That election year was marked by the assassination of Martin Luther King Jr. and subsequent riots across the nation, the assassination of Kennedy, and widespread protests against the Vietnam War across university campuses. Nixon ran on a campaign that promised to restore law and order to the nation’s cities and provide new leadership in the Vietnam War. A year later, he would popularize the term “silent majority” to describe those he viewed as being his target voters. Humphrey, his opponent, promised to continue Johnson’s war on poverty and to support the civil rights movement. Humphrey trailed significantly in polls taken in late August but narrowed Nixon’s lead after Wallace’s candidacy collapsed and Johnson suspended bombing in the Vietnam War. Nixon narrowly defeated Humphrey by 500,000 votes (seven-tenths of a percentage point). In his victory speech, Nixon pledged that his administration would try to bring the divided nation together. (https://en.wikipedia.org/wiki/Richard_Nixon)
Besides the similarities of Nixon and Trump’s political environments, an inverse policy exists related to China. Prior to Nixon’s presidency, the US did not recognize the People’s Republic of China. Nixon’s presidency focused on opening relations between China and the US, which Trump’s administration is now condemning those efforts and warning the globe of Chinese and Russian authoritarianism.
With all those current parallels aside, if we were to look at another presidency that we believe was one of the most volatile in terms of global politics and governmental interventions in the last century, Franklin Roosevelt’s presidency would definitely be a front runner. The world and American economies were either in or coming out of severe depressions. The First and Second New Deals were passed to try and stem off the struggling economy and shore up the banking system. During the First New Deal, Roosevelt issued an executive order essentially forcing Americans to “sell” their gold to the US Treasury. The Second Deal included the Social Security Act, which would become one the most aggressive tax on American’s income to date, originally starting at a 2% tax on total pay up to limitations on some jobs and eventually becoming a 15% tax up to limitations of pay on almost all jobs today.
The world would go to war and Roosevelt would pass an executive order to relocate hundreds of thousands of Japanese-Americans simply due to their ethnicity in fear of them being spies. After failing to increase taxes, Roosevelt would issue an executive order to tax income over $25,000 at 100%. Congress rescinded the order, but eventually passed the Revenue Act of 1942, which included a 94% top tax rate. Roosevelt would go on to be the only president to be elected for three terms, although dying to a shocked America during his third. Roughly four months after his death, America would drop two of the most powerful weapons on largely populated Japanese cities, Hiroshima and Nagasaki, killing over 110,000 people in three days and significantly more in the following years due to radiation exposure.
So, with all of this chaos, after the conclusion of what would have been Roosevelt’s twelfth year in office in 1945, the total dividend reinvested compounded return for what is known as the S&P 90 would have been roughly 13.23% from 1933 to 1945. The best year being 1933, seeing a 54% increase, and the worst year being 1937 with a 35% drop. The other years varying in-between. It should be worth noting though, Roosevelt’s presidency came after the worst depression and stock performance in this century, with massive stock losses for four years straight before he entered office. And, what about Nixon’s presidency? Nixon’s in-office annual return of the S&P 500 would have -3.41%, but it was marred by two recessions and an early resignation that was a result from the Watergate Scandal. If investors held on and include Ford’s succession until the next election, the average annual compounded returns would have been 4.11% for the full two term period (1969 to 1976).
Our point in illustrating this is to keep you focused on the long-term. Is this really the most uncertain and volatile times we have experienced? We would make the case that it may not be and there have been more dire and uncertain times we have survived in the past.
We are value investors, and we believe in remaining invested in attractive businesses, no matter what that future brings and regardless of who sits in office. When we invest in stocks, we are purchasing pieces of businesses that we believe are undervalued. Therefore, we do not foresee at the current time any environment that we would not want to own any businesses whatsoever, even in the midst of a global recession caused by lockdowns in response to a pandemic with an impending volatile presidential election upon us. There are times we tend to be more heavily invested in stocks, but this is dependent on each clients’ personal risk tolerance and goals as well as the current state of the economy. For example, we were more cautious and less weighted towards stocks back in January in belief of an impending recession. This led us to underweight stocks, however every portfolio still held stocks, only varying amounts based on risk.
We do not forecast a doomsday for either outcome of the election. Under a Biden presidency, we would expect most income levels to be hit with higher taxation at some point, assuming Congress passes new tax increases, which will have some long-term erosive effects to individuals’ wealth. Corporate taxes would also likely rise, affecting corporate profits and stock valuations. However, some of the policies proposed by his campaign, if passed, could provide the markets with immense liquidity due to a much larger stimulus amount than if Trump is re-elected. This could give financial markets a boost in the short run. If taxes remain unchanged for 2021 coupled with the wave of potential increase in spending, the US could experience a near-term stimulative effect. Unfortunately, the party could be short-lived as the US will eventually have to pay these immense bills along with what’s already been paid out due to the pandemic alone, which could be even more meteoric if a “blue wave” comes. And no matter how high taxes go, the numbers just do not balance. This is why we continue to see inflation in the US’s future. We would be more concerned with potentially rising long-term interest rates, which we have already started protecting client bond/fixed income portfolios in the event rates rise.
Under a Trump re-election, we believe there would be more of the same, except the stimulative effects will continue to come with lower taxes for all Americans. Keeping the Trump tax policies in place, families will continue to enjoy the larger standard deduction and lower overall tax rates. Growth may be higher for the proceeding four years under Trump; however, the US budgets will continue to have gaping holes at current projected deficits. In terms of further stimulus, it seems unlikely to see anything as explosive in spending as under Democrat control, however it seems possible that something would eventually come, especially if the economy falters moving forward. Inflation would still remain a concern in the future as well.
COVID 19 Back at Center Stage
Oh, and we can’t forget to mention the virus, which has been seeing upswings in almost every part of the world. Countries like Germany have reinstated restrictive measures that could have catastrophic impact on certain industries. England and France have escalated their restrictions to a nationwide lock down. As time passes and the contagiousness of the virus is apparent, it would seem the virus will have to eventually be accepted. In pandemics of the past, we did not have this large amount of data collection occurring, so it is difficult to directly compare. Nonetheless, we would have still seen continued large outbreaks if they were as contagious, which were very few. Relative to recent previous pandemics, this pandemic is far less deadly but much more contagious and therefore harder to contain. We are beginning to see the possibility that the virus could be here to stay and contained by an eventual vaccine and/or advanced therapeutics. This would be extremely comparable to the acceptance of the flu and targeted predominantly at the elderly population. The data continues to point to the elderly and those with compromised immune systems as those who are at the highest risk. Hospitalizations have seen an uptick recently, which is always concerning. However, the daily fatalities continue to remain relatively stable. The virus on a perpetual rampage does pose longer term risks over the next few years to slower economic growth as sporadic actions by various world governments hamper businesses, however we remain focused on the decade ahead and still believe that life will resume in the future. It could take years, as no one knows at this point, but we believe it will resume.
Some Stocks Witnessing Excessive Valuations
We continue to be concerned by some of the valuations observed in some stocks, which is currently justified away by a story rather than financials. It is our opinion and from lessons in history, extreme risk for investors lie in these names. And as expressed before, we wholeheartedly believe in the story, but we’re concerned that investors are completely ignoring the price being paid for certain stocks. And as value investors, price is one of the most important variables. But, let’s look back at a case study that illustrates this theory. Back in another time of elevated valuations, we saw a star company that was believed to eventually rule an up-and-coming landscape-smartphones. It was 1999 and the company was Qualcomm, which some of you may have heard of before. The story was simple: smartphones will be owned by nearly everyone in the developing world and Qualcomm will dominate smartphones with various chips and technologies.
Not only was the overall story right; the company absolutely dominated. Qualcomm’s revenues skyrocketed nearly fourfold over the following decade, nearly tenfold over fifteen years, doubled net margins to almost 40% in 2005, and nearly monopolized the mobile market. In 1999, the stock (QCOM) had skyrocketed over 3,000%. But, from its peak in January of 2000 to its low in mid-2002, the stock had cratered roughly 85%. Now, this was obviously during a period of a tech bubble, which can only be observed in hindsight. But, if QCOM really became that amazing company that was prophesied, what happened to the stock? Well, we believe, investors eventually cared what price they were paying, with some recognizing that the 2000 high valuation already priced in the next decade of dominant growth. And as with many downturns, those investors that were simply buying the story and the fact that the stock was rising eventually began selling, which exacerbated the decline. And those investors who waited to buy in 2002, got one heck of a deal.
We are not projecting such massive declines to occur in some of these high valuation names, we’re just pointing out to periods we believe show it as a high possibility that investors have started to ignore normal valuations and purchase certain stocks simply because the stock price is rising. And it appears that history may repeat itself.
Today, a company that we believe is on the cutting edge of the future in Artificial Intelligence, which we think will be a dominant landscape for the decades ahead, is trading at similarly elevated multiples that Qualcomm did in 1999. The company is NVIDIA (NVDA), and for today, they dominate the AI market. NVIDIA is currently experiencing robust revenue growth and relatively high net margins at 25% and roughly 75% of their revenues coming from Asia. Will its growth continue? We personally believe so, but let’s use numbers to illustrate our point. Let’s assume the company matures in the future and still trades at an elevated 30 multiple and eventually enjoys 30% margins. What revenue level would it take to see its current valuation? Over $36 Billion. NVIDIA is currently running at $15.5 Billion. So, investors are paying for the company to more than double the current revenue. Will the company achieve this growth? It seems likely. But that’s what you’re already paying for today at those lofty assumptions. And more importantly, what if investors do not want to pay such high multiples in the future? If we assume a 20 multiple instead, NVDIA then needs $55 Billion in revenue to justify its current valuation. We believe investors will eventually look at the price they’re paying, especially in an industry that can rapidly change.
As a result of the pandemic, we do agree that it has accelerated technology adoption, even pulling forward demand by a large magnitude. We see many efficiencies in this and an overall net benefit to many. But we continue to see many of these obvious players’ valuations priced with the assumption of continued dominance. And, if we know one thing about high margins and high demand, it incites competition. And with technology specifically, the landscape is constantly changing, if not faster than ever, making it difficult to predict the far future with any reliability not to mention what the companies’ stock prices do regardless of the outcome. All we can rely on is today’s prices, what it says about the future, and if it seems fair. And for clients, we do not believe the risk is well balanced by reward.
As always, we appreciate the privilege to serve each and every one of you and look forward to working together in the years to come. Please don’t hesitate to call or email at any time if you have questions, concerns, or we can be of further service in any way. Also, if you have not yet done so, please call or email to set up a year-end review, either online or in-person.
God Bless,
Your TEAM at F.I.G. Financial Advisory Services, Inc.
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Looming Risks Overlooked