Crazy is probably the best word to use in describing 2020 and the first couple of weeks of 2021. One year ago, nobody would have predicted a pandemic, the political reaction to it, the economic lockdowns, the market drop, the market recovery, the claims and counter-claims about the election, and the general level of angst that still permeates our country right now. It has been an overwhelmingly “political” year in the sense of how much politics has dominated the conversation.
Republicans Vs. Democrats
That has exacerbated the very human tendency to predict what will happen with the economy and markets depending on whether your “team” has won or lost. Too many on both sides, and within the media, have predicted Nirvana if their side won and hell-in-session if their side lost. The chart below offers convincing proof that you cannot predict the economy based on who wins the Whitehouse.
Republican presidencies have had recessions and recoveries; Democratic presidencies have had recessions and recoveries. There’s just no correlation that offers any predictive capability.
The reason is foundational and fairly simple. Our system does not install a king or a dictator. Presidents have to work with Congress. The size of the Congressional divide (Rs vs. Ds) or the margin of why one side controls both the House and the Senate affects what Congress is willing to support and makes predictions based on party affiliation almost impossible.
That is not the same as saying that policies don’t matter. They matter a great deal. How policies affect current and future profits determines whether the economy is growing or contracting and by how much in either direction. It’s a very logical relationship: if policies decrease profits, the economy slows or heads south; if policies increase profits, the economy grows.
This is not an argument about whether a given policy is necessary. That is not the purpose of this commentary; it is simply an acknowledgment that there is a relationship between profits and economic growth and, therefore, the stock market.
Let’s review where the market is right now. The “fair” market value of the economy (that’s what the stock market is measuring) equals the present value of all reasonably projected profits. The S&P 500 is a broad representation of that (500 of the biggest companies), while the Dow Jones Industrial Average is a more concentrated representation (30 of the “key” industrial companies).
Present value is a complicated calculation, but essentially it is a process of determining today’s value of tomorrow’s profits. Common sense tells us that profits today are more certain than profits projected for 10 years from now. Lots can happen in 10 years, so we don’t value that future profit by as much as we value the profit we know about today.
To determine the present value of tomorrow’s profits, we “discount” them by the rate of the 10-year Treasury. Right now, that 10-year Treasury is around 1%. To be conservative, we use a 2% Treasury rate.
Based on this conservative approach, the present value of the S&P 500 is roughly 5,000. Today the S&P is trading at 3,800. The market is very undervalued, which we’ve been saying for quite some time. The reason it has been undervalued is uncertainty. It has been a crazy year, and people tend to pay less for things – like stocks – when they are uncertain. Collectively, investors have kept stock prices from rising to levels that would be “fair.”
Profit Levels Solid
We are confident that the stock market has a long way to go just based on current profit levels, which are very solid. Add in the fact that profits are projected to go up, and we believe the stock market is significantly undervalued.
This may seem like a strange statement considering the pandemic and lockdowns we’ve just had. As bad as Covid has been, it has forced us to innovate. We have all had to find ways to get stuff done in the midst of lockdowns and restrictions. Some companies, especially the smaller ones, have been hit very hard, but others could adapt more easily. They have found ways to produce and deliver their products and services more efficiently during the lockdowns.
That’s why the market downturn was relatively quick – the quickest recovery in roughly 100 years. Going forward, when lockdowns eventually end, these new efficiencies will enable tremendous future growth.
Today, the uncertainty of the 2020 election has been removed – we know who will take office on January 20th and who will sit in Congress. As the uncertainty is lifting, the market is rising toward its true fair value.
Promises Aren’t Policy
But what about the future in the hands of the new president and the new Congress? Don’t policies matter? Yes, they do. We can know the effect of a policy, but it is much more difficult to predict whether a given policy will be adopted.
If we know that the new administration – or any administration for that matter – will dramatically raise taxes, impose excessive regulations on industry, and massively inflate the currency, we’d be very confident in a significant recession occurring. But we can’t know what any administration will do; we may know what they have said they want to do, but that’s different from knowing if they will try it or if Congress will go along.
Going back to our historical presidential chart for a moment, Nixon proposed things that would have been great for the economy but ended up doing things that weren’t very good. Clinton pledged to do things that wouldn’t have been very good for the economy but ended up doing things that really helped. Good policy is a bi-partisan issue.
We believe the best metric for predicting what a Biden administration will do is by looking at the first term of the Obama presidency. President Obama came into office with a majority in the Congress and in the midst of a recovery. He had pledged to raise taxes; instead, he continued the Bush tax reductions and waited until 2013 before pushing through tax increases. Press reports of the time chronicled how he didn’t have the support in Congress (which his party controlled) to implement this policy until his 5th year.
We believe it is relatively certain that the Biden administration will increase taxes. How much and when are not knowable, although the probability is very high that they will not occur in 2021. We could be wrong, but current unemployment rests at 6% to 7%, and the unevenness of the economic recovery creates incredible pressure for Congress to go slow.
We won’t try to list all the specific proposals which comprise the campaign promises. Instead, we point out that the most obvious – increases in individual tax rates, corporate tax rates, and treatment of interest, dividends, and capital gains – are not likely to move beyond what they have been from the Reagan years until today. To use just one example, we had individual tax rates in the 39% range during 1993-2000 but did not suffer a recession, and we had them during 2013-2017 without suffering a recession.
Policies matter, but it’s complicated, and we’ll have to wait to see what actually is proposed, what is actually enacted, and judge the economic effects as all this rolls out. It won’t happen immediately, and there is no inevitability of a recession.
Keep Calm and Carry On
We’ve been through a lot already; just going back to 2008 (remember that recession?), our memories are current enough to realize that our economy is larger and better off today. We also need to realize that well-balanced portfolios will still prosper, and financial dreams are achievable over the long-term even in the midst of volatility, market corrections, and several changes in administrations.