Financial markets suffered through a "risk off" session on Friday, capping a "risk off" week that itself capped the worst month across the marketplace since the meltdown in March. Ugly. Toward the end of October, (Never trust October, just don't do it.) it was not just equities that the marketplace had on the ropes, but much of the dollar denominated commodity complex as well, not to mention longer dated Treasury securities. Fight to quality? Define quality.
Just what was the catalyst, or were the catalysts for such investor behavior probably is not too hard to figure out. All of the market threats that appear to be coming home to roost at the same time did not just wander in out of the blue. They were all expected to one degree or another. Still, most of us chose to whistle, while we walked past the graveyard thinking happy thoughts, rather than make a serious attempt to truly ascertain the varied risks to not just our markets, but the broader economy and what a "pricing" in, of increased risk might look like.
What We Knew
We all knew that it was very likely that the SARS-CoV-2 coronavirus that causes Covid-19 would likely spread more rapidly as summer turned into Autumn, as populations in northern climes prepare for roughly six months of being indoors far more than they are outdoors. Still, we hoped that just maybe this would not be the case. Maybe the virus would just dry up, and go away. Anyhow, we seemed to be so close to a number of vaccines and/or therapeutics. The good news is that we are so close. But... so close in science is not measured in weeks or months. There are always hiccups.
These hiccups slow down rollouts of such medicines, and this slows down economic recovery. We all know how awful the economic collapse created by this virus has been. We also know how nearly miraculous the recovery, at least on the national level has been. This recovery, which was largely manufactured through aggressive policy response does look like a "vee" shape on a chart. Unfortunately, true "vee" shapes and "reverse square root" symbols look a lot alike on the way up. Until one keeps going (not the one we're on), and the other runs out of fuel. That road (the one we're on), then either moves sideways or actually contracts from that point.
We all knew that to avoid this sideways to downward trajectory in economic activity that responsive policy would have to be renewed. The Federal Reserve has been fantastic. No stones can be honestly thrown in that direction. That body has not just been aggressive in maintaining conditions of liquidity, and in the purchase of both Treasury and mortgage backed assets, but has also been quick to correct course when programs created seem less successful in practice than on paper. For some reason, as Congress continually let the American people down on stimulus, vast numbers of individuals remain unable to fully participate in the economy. Markets expected to see increased fiscal support in the future as a positive, or at least not as a negative. Until this awful virus put multiple European nations back into lockdown. Until the spread here in the U.S. put dozens of U.S. states in the position of at least having to consider something similar. Oh, and there's more.
Lastly, and this is just as important as is everything else mentioned above, would be "electoral risk." No, I do not think that the markets fear the election of former Vice President Joe Biden at the top of the ticket. We also already know that markets are quite comfortable with the incumbent. Should one of the two be elected decisively and the other gracefully concede either on Tuesday evening or Wednesday morning, I think the markets could avoid further unnecessary disruption. Should the electoral outcome at the top of the ticket and perhaps even worse, political control of the U.S. Senate appear opaque for some time... a week, or even longer, there is no way to avoid a market that will price in more than it already has.
There are likely some sizable negatives even amid outcomes that some will see as positives. The outcome most often spoken of, the "blue wave", would probably bring with it a larger more easily passable stimulus bill. That's a positive. With it though will come increased income taxes for some, higher corporate taxes, and a tougher regulatory environment. These impacts will slow job creation, not to mention economic growth. Then there's the "big one" for the markets. Taxing capital gains as ordinary income. This is probably the number one reason why investors sold big tech last week, despite largely impressive earnings releases. Amazon (AMZN) , Apple (AAPL) , Facebook (FB) and Tesla (TSLA) all faced the music late last week. This possibility will force those with large profits to take those profits this year under this tax regime, while also greatly discouraging future investment. I did add to Apple on Friday, and wanted to add to Amazon, but my $2970 bid never got that close. Adding amid uncertainty does cause some trepidation.
Capital gains taxes will be a huge issue. Why should capital gains not be taxed as ordinary income? Simple. They are not earned in the same way. At most jobs, you work a day for a day's pay. Your employer does not tell you what you owe him or her after putting in a hard 10 or 12 hours. At this job, some days, weeks, or even months, even if you work hard... you will lose money. Does the government want to share with investors the risky side of the business? Then maybe we talk. What, suddenly lost interest? You want to socialize my efforts when I win, you better subsidize my efforts when I lose. What about a down year? Am I getting a check that year?
The other possibilities would appear to be a reelection of the incumbent at the top, but with an entirely blue legislature. That sounds like not only will nothing get done, but also like a political environment from "heck" going forward. Then there is the status quo. Not good, but workable if both sides realize that they put themselves in this position. They will not. They will blame each other. You see, there is no sure, best way out of the mess that this nation (and the whole planet to be honest) is in.
Still, the worst case for us in the markets, and for the nation, would be an election that appears not to be decided by either the people or the states but in the courts. Remember how awful the mood, and the markets were as this nation waited on Florida in the year 2000. That one ultimately went to the Supreme Court. This would be nastier. This time half of the electorate will cry foul.
The Week Ahead
Talk about busy? Yes, you and I will be very busy this week. Not only do equity markets set about the month of November either in or close to a technically oversold condition. Not only is Tuesday (tomorrow) the actual Election Day even though so many have already voted, but it is still "earnings season." With 64% of the S&P 500 already having reported their third quarter results, another 129 are expected to go to the tape this week. So far, according to FactSet, 86% have beaten earnings expectations, while 81% have topped forecasts for revenue generation. The blended (reported/expectations) rate for earning growth across the index has been improving weekly, and is now down to -9.8%. By the way, last week's drubbing took forward looking PE ratios all the way from above 22 times down to 20.6 times. Far more palatable for some, but the five year average still stands at 17.3 times.
Beyond Election Day, the FOMC had scheduled their next policy decision for Thursday afternoon, surely thinking that two days would be enough time to know what direction the country was headed in. Maybe they'll be right. In any event, the Fed will have to reassure the public, especially after failure at the legislative level, to do what they can which will likely result not in any changes made to the $120 billion a month quantitative easing program, but perhaps in how average maturity is targeted.
Lastly, if you can believe it, this Friday is October "Jobs Day". What else could happen? The Jets could win a game. Now, stop that, this is supposed to be a serious morning market note.
- Worst case... electoral uncertainty. Well, actually catching this virus, but for the markets... electoral uncertainty.
- Second worst case... economic slowdown with fiscal support still delayed.
- Largest single threat... increased capital gains taxes.
- Short-term positive... markets closed October oversold.
- Posture.... mostly defensive. Willing to add to investments, but not take on new trades.
- Are markets in correction? I honestly don't know. I will let you know when I think I know.
Economics (All Times Eastern)
09:45 - Markit Manufacturing PMI (Oct-F): Flashed 53.3.
10:00 - ISM Manufacturing Index (Octt): Expecting 55.7, Last 55.4.
The Fed (All Times Eastern)
Fed Blackout Period.
Today's Earnings Highlights (Consensus EPS Expectations)