• Bill Bullock

2020 Third Quarter

With the S&P 500 up 8.93% and the Russell 2000 (small-cap index) and the MSCI EAFE (foreign index) up 4.93% and 4.80% respectively, the third quarter was strong for stocks. Bonds cooled off and were only up 0.62% as represented by the Bloomberg Barclay’s US Aggregate Bond index. While diversification can be helpful during volatile times, it can also hold us back if one area of the market does better than another. For example, our mid and small-cap US stocks and our foreign stocks are all still in the red so far in 2020. As I write this, however, we have seen the Russell 2000 rise 8% in the first eight days of October – more than triple the S&P 500. I believe mid and small companies are selling at bigger discounts and have more room to run.

The forward price-to-earnings (P/E) ratio for the S&P 500 is currently at 25.75. This means that it would take 25.75 years of expected earnings to pay for the S&P 500’s current price. As you know from my previous quarter-end letters, the S&P 500 historical average P/E is 15. Thus, prices are well ahead of earnings at the moment. So why does the S&P 500 continue to rise? The ultra-low interest rates are one factor. Low interest rates force investors to buy stocks for yield and when this demand increases, stock prices also rise (P/E numerator). Also, due to COVID-19, many of the companies that make up the largest 500 companies in the United States are struggling. Investors buying the S&P 500 today believe current losses are temporary and that firms will be growing their income again soon. Thus, the P/E denominator may be artificially low due to COVID. As earnings increase and the price stays the same, you will have a contracting P/E ratio which will bring high valuations back to their historic norm of 15 again.

The upcoming election is certainly grabbing the headlines. The irony of it all is that I have often believed that the Federal Reserve has a more direct influence on the stock market than the president. It is true that the president can help provide for a more corporate friendly environment, but the Fed certainly has a more direct market impact than the president over the long-term. In the Goldman Sachs Market Pulse September newsletter, they state that “the strength of the relationship between election outcomes and equity returns is rather weak, statistically speaking.” Goldman then lists a Democratic president with a Democratic Congress, a divided Congress as well as a Republican Congress. The strength of relationship is 0.00-0.01 with 1.0 being a strong relationship for all three categories. With a Republican president, the range was 0.00-0.02 for all three categories. In other words, there is next to no relationship between election outcomes and equity returns. There are just too many variables that go into equity returns for election results to matter.

In another study, Vanguard compared election years to non-election years going all the way back to 1860. The average return during election years, which included 40 periods, was +8.9%. The average return during nonelection years (120 periods) was 8.1%. The second half of this piece discussed the S&P 500’s volatility 100 days prior to a presidential election and 100 days after. The annualized volatility for the entire time period is 15.7%. The annualized volatility 100 days prior came in at 13.8% and it came in at 13.8% 100 days after as well. The conclusion is that the markets are calmer 100 days before and after an election than normal non-election times.

The bottom line? Let us continue to be patient. Let us continue to check our emotions regarding one candidate over another and not try to time the market one way or the other. We should instead focus our attention on the long-term and on our low-cost diversified portfolios. Hang in there and stay safe!

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