Overview: Following is a reading companion to the November 12 video “Should the Election Results Impact Your Investment Strategy?” with Larry Swedroe, author and director of research for the BAM ALLIANCE. In this video, Larry discusses the state of the financial markets after the U.S. elections.
It’s not as if investors didn’t have enough to worry about with the Eurozone crisis, the slowing of the global economy, the instability in the Middle East and the concern about Iran’s nuclear program. Now that we know the election’s outcome, investors are turning their attention to the implications for government policy and how it affects taxes, regulations and other factors that impact the economy and the financial markets. While government policy always matters, giving the high level of uncertainty we have about these issues, government policy may matter more than ever.
Investors are concerned about the impact the election results will have on their portfolios, and what if any actions they should take. A good place to start with is what we do know. One thing we do know is that markets dislike uncertainty. When investors perceive more uncertainty, they demand higher risk premiums as compensation for the incremental risks. That drives stock prices down and is what causes bear markets.
The market’s immediate reaction: On Wednesday, the DJIA fell 313 points (2.34 percent), its sharpest loss of the year. And, in a flight to safety, the yield on 10-year Treasury bonds fell from 1.78 percent to 1.68 percent. The negative reaction continued on Thursday as the DJIA fell another 121 points (0.9 percent), and the yield on the 10-year Treasury fell to 1.62 percent. While the uncertainty over whether the Greek parliament would approve the austerity package required by the European Central Bank may have been a contributing factor (the Greek parliament did approve the package on Thursday), the reactions are likely explained by investors now perceiving more uncertainty about the ability to address the fiscal cliff and the potential impact on the economy if it’s not successfully addressed. It might also be that investors who were considering accelerating income into 2012 (to avoid the potential for not only higher tax rates in 2013, but to also avoid the 3.8 percent new affordable health care act tax), decided to act now, perhaps in an attempt to be the “first out of the barn door.” But, that doesn’t tell us what, if anything, investors should now be doing, which is what we will be discussing. We’ll begin by noting that investors are prone to making mistakes because of a variety of behavioral biases of which they are unaware.
We often make mistakes because we are unaware that our decisions are being influenced by our beliefs and biases. The first step to eliminating, or at least minimizing, mistakes is to become aware of how our decisions are impacted by our views and how those views can influence outcomes. The study “Political Climate, Optimism, and Investment Decisions” showed that people’s optimism toward both the financial markets and the economy is dynamically influenced by their political affiliation and the existing political climate. Among the author’s findings were:
- Individuals become more optimistic and perceive the markets to be less risky and more undervalued when their own party is in power. This leads them to take on more risk. They overweight stocks with higher systematic risk and exhibit a stronger preference for high market beta, small-cap, and value stocks. They also trade less frequently. That’s a good thing as the evidence demonstrates that the more individuals trade, the worse they tend to do.
- When the opposite party is in power, their perceived uncertainty levels increase and investors exhibit stronger behavioral biases, leading to poor investment decisions. The perception that economic uncertainty is high causes investors to be less likely to believe that a passive strategy (the one most likely to achieve the best results) will be profitable. That leads them to trade more actively. In an attempt to find managers that will outperform in uncertain markets, they select funds with higher expense ratios. The higher trading and higher expenses tends to lead to worse performance. This suggests that those who voted for Mitt Romney will become more subject to making these mistakes. Being aware of the tendency to make mistakes is the first step toward preventing them.
The next issue we need to address is the view that the election outcome increases the risk that we will fail to address the so-called fiscal cliff and that President Barack Obama’s policies are less favorable for the economic outlook. Since the underlying basis for most stock market forecasts is an economic forecast, we need to take a look at the value of economic forecasts. The question is: Do economic forecasts, which most stock market forecasts are based on, have any value?
Jan Hatzius, the chief economist of Goldman Sachs, provides the answer: “Nobody has a clue. It’s hugely difficult to forecast the business cycle. Understanding an organism as complex as the economy is very hard.” Keep in mind that the government produces 45,000 economic indicators each year and private data providers produce about 4 million. The following examples demonstrate the point:
- Economists often fail to predict recessions even once they have already begun. The majority of economists didn’t predict the three most recent recessions (1990, 2001 and 2007) even after they had begun.
- In November 2007, the great recession had already begun. Yet, economists in the survey of Professional Forecasters, a quarterly poll put out by the Federal Reserve Bank of Philadelphia, thought a recession was highly unlikely. The forecast was for growth of 2.4 percent for 2008, with only a 3 percent chance of a recession, and only a 1 in 500 chance of the GNP falling by more than 2 percent. GNP actually fell 3.3 percent. Even as late as October 2007, the minutes of the Federal Reserve didn’t even mention the term recession once.
- 1990, economists have forecasted a year ahead of time only two of the 60 recessions that occurred around the world.
What’s interesting is that despite poor track records, when we hear or read economists’ forecasts, they are typically precise, such as GNP will grow 2.4 percent. Instead, they should provide their forecasts in the form of political polls. For example, Obama leads 47-45, with a margin of error of 3 percent. In fact, the Philly Fed survey asks the economists what their 90 percent confidence interval is. A forecast might be something like “2.5 percent growth, and I’m 90 percent confident that GNP growth will fall between 1 and 4 percent.” That means that the forecaster believes that there is still a 10 percent chance of the GNP growth rate falling outside that range. It turns out that, since 1968, when the survey started, the growth of the economy was outside the 90 percent confidence range almost half the time! Like everyone else, economists are overconfident. It turns out that the correct 90 percent confidence level would have to be 6.4 percent wide, a margin of error of 3.2 percent in each direction. Keep in mind that the long-term growth of the economy has been about 3 percent. Thus, the margin of error in forecasts is as large as the average growth rate!
As Hatzius noted, the task facing economists is huge. First, it’s hard to determine cause and effect from statistics alone. Second, the economy is always changing; explanations for a particular business cycle may not provide any information about the next one. Third, the data they have to work with isn’t very good. For example, the initial estimate of GNP growth in the fourth quarter of 2008 was –3.8 percent. It turned out to be almost –9 percent. Between 1965 and 2009, the average revision was eventually 1.7 percent. As Nate Silver, author of The Signal and the Noise put it: “It’s hard enough to know where the economy is going. But it’s much, much harder if you don’t know where it is to begin with.”
Another problem is that to get a forecast correct, you have to forecast fiscal and monetary responses to economic conditions. For example, if the economy starts to go into a recession you have to forecast the actions governments and central banks will take to address the problem, and you have to also correctly forecast the effectiveness of those actions. And since the economies of the world have become more integrated, you have to also get the forecasts right for the rest of the world. The complexity of the problem is immense. Yet, investors expect precise forecasts, which is why economists make them. If they provide a 90 percent confidence range that is 6.4 percent wide, investors will believe that the economist isn’t confident in his or her own forecast and thus won’t trust it. Accuracy isn’t important to investors. Confident talking heads is what they seek. Investors want a clear crystal ball. They want to believe that there is someone out there who can protect them from bad things. Unfortunately, no such person exists.
William Sherden, author of The Fortune Sellers, related this story on the value of economic forecasts. In 1985, when preparing testimony as an expert witness, Sherden analyzed the track records of inflation projections by different forecasting methods. He compared those forecasts to what is called the “naive” forecast — simply projecting today’s inflation rate into the future. He was surprised to learn that the simple naive forecast proved to be the most accurate, beating the forecasts of the most prestigious economic forecasting firms equipped with PhDs from leading universities and thousand- equation computer models. Sherden then reviewed the leading research on forecasting accuracy from 1979 to 1995 and forecasts made from 1970 to 1995. He concluded that:
- Economists cannot predict the turning points in the economy. Of the 48 predictions made by economists, 46 missed the turning points.
- Economists ‘ forecasting skill is about as good as guessing. Even the economists who directly or indirectly run the economy — the Federal Reserve, the Council of Economic Advisors and the Congressional Budget Office — had forecasting records that were worse than pure chance.
- Increased sophistication provides no improvement in economic forecasting.
The most damaging of Sherden’s findings was that economists don’t provide accurate forecasts when accuracy is most important — at the turning points of the economy. While it might make little difference if you forecast a growth rate of 3 percent and it turns out to be 2 or 4 percent, it certainly makes a difference if you forecast continued economic growth and we are headed into a recession, or if you forecast a continuing recession and the economy is set to turn around. If you sell today, how will you know when to get back in, if the nation’s top economists cannot call the turning points? Here’s more evidence.
The 2009 study “How Accurate Are Forecasts in a Recession” by Federal Reserve Bank of St. Louis economist Michael W. McCracken, provided further evidence on the failure of economic forecasters to get it right when it is most important. Using as his database the Survey of Professional Forecasters (SPF), McCracken reviewed 26 years of quarterly, one-year-ahead mean SPF forecasts from the third quarter of 1981 through the third quarter of 2007. He found that forecaster errors were four times larger when the economy was in recession than when it was not. Just when you would like to know when it is safe to buy stocks again, forecasting skill (which is not good to begin with) deteriorates significantly. Since the underlying basis of most stock market forecasts is an economic forecast, the evidence suggests that stock market strategists who predict bull and bear markets will have no greater success than do the economists.
Before we turn to the question of what investors should be worried about, it’s important, especially in periods of heightened uncertainty, to keep a balanced perspective, which might prevent panicked selling, or what can be referred to as portfolio suicide. So, while there’s certainly plenty to be worried about, there is also plenty of good economic news that should not be ignored. Here’s a brief list beginning with the employment picture:
- We added 171,000 jobs in October, soundly beating the most optimistic forecast from a Bloomberg survey, which projected a gain of 125,000.
- Factory orders rebounded from a 5.1 percent drop in August to rise 4.8 percent in September. This was the biggest gain in a year.
- Demand for core capital goods rose 0.2 percent in September and 0.3 percent in August.
- The housing industry, the epicenter of the recession, is recovering. Home prices showed positive signs in more ways than one. The S&P/Case Shiller home price index rose by 2 percent in August from a year earlier. In July, prices rose in 16 cities, while in January, prices rose in only three markets. The median price of a new home sold in September 2012 was $242,400, up 10.3 percent from $217,000 a year ago.
- The construction of new houses jumped 15 percent in September, surging to its highest level in four years. The 872,000 housing starts beat all forecasts in a Bloomberg economic survey, which ranged from 735,000 to 800,000. In addition, home builders were getting more optimistic about house construction. The National Association of Home Builders/Wells Fargo builder sentiment index increased to 41, which is the highest level since 2006 and the sixth consecutive gain for the index. Through the first nine months of 2012, new home sales are up 21.8 percent from the first nine months of 2011. In addition, at the end of September, there were only 145,000 new homes for sale in the U.S., down from 160,000 for sale at the end of September 2011. At the current sales pace, there is only 4.5 months’ worth of inventory on the market — the lowest level in seven years.
- Interest rates continue at record low levels, and the Federal Reserve has stated its commitment to a zero-rate policy through mid-2015. Helping housing, 30-year mortgage rates are just 3 percent and 15-year rates are not much above 2.5 percent.
- The Thomson Reuters-University of Michigan consumer sentiment index is at its highest level in five years. The index hit 82.6 in October, up from 78.3 in September.
- Personal spending rose 0.8 percent in September, while personal income rose 0.4 percent.
- Defying “expert” forecasts, energy prices continue to fall. Benchmark crude oil prices are now about $84.50 per barrel. From January through June, it basically traded at more than $100 a barrel, hitting a peak of about $109 in February. This will help to keep inflation down and put more money into consumer pockets — a drop in energy costs acts just like a tax cut.
- The U.S. is experiencing an energy boom, at least on private lands. Domestic oil and gas production has increased dramatically, helping to lower energy prices and reduce our dependence on foreign sources (thereby improving our balance of payments and helping the value of the U.S. dollar). In addition, the new hydraulic fracturing technology has opened up vast new sources of natural gas production, which has driven down prices and is now leading to a resurgence in U.S. manufacturing, as we have the lowest energy costs in the developed world.
- The fiscal health of 48 of the 50 states has improved dramatically as they have taken significant steps to address their deficits. State tax revenues were up 3.2 percent in the second quarter compared with the year-ago period and have risen 10 straight quarters. Only California and Illinois continue to live in a dream world where you can make promises you cannot keep.
- Corporate balance sheets are very strong, with companies sitting on $1.5 trillion, the largest cash hoard in history. With all that cash, if Congress can successfully address the fiscal cliff and remove much of the uncertainty, a surge of spending could result. In addition, more than half of companies in the S&P 500 beat their earnings estimates, despite more than 60 percent missing their revenue forecasts. That leaves valuations at very reasonable levels with the S&P 500 now trading at about 14 times earnings. And with Treasury bill rates at effectively zero, from a historical perspective, stocks could be considered cheap on a relative basis.
As you can see, there’s plenty of good news that is mostly being ignored. With that said, there are issues to be worried about.
Perhaps the largest concern investors have coming out of the election relates to our debt burden. It turns out that it’s correct to be worried. It’s why stocks were not trading at historically high valuations even before the election. A recent study measures the negative impact a high debt-to-GDP ratio has historically had on world economies, and the results haven’t been favorable. Professors Carmen Reinhart and Kenneth S. Rogoff and economist Vincent Reinhart examined the debt-to-GDP ratios of advanced economies for the period 1800–2011. Specifically, they looked at periods where debt-to-GDP exceeded 90 percent for at least five years, as prior studies have shown that to be the point when it starts to have a negative effect. (The U.S. passed that point in 2010.)
Perhaps the most important finding is that high levels of public debt have been associated with lower growth. The vast majority of the episodes — 23 of the 26 — coincided with substantially slower growth, and average annual growth was 1.2 percent lower during periods with debt-to-GDP levels above 90 percent (2.3 percent growth) than below 90 percent (3.5 percent growth).
Another issue is that these episodes tended to last a long time. The average duration was 23 years, and 20 of the 26 episodes lasted more than a decade. The long duration suggests that even if such episodes were originally caused by a traumatic event such as a war or financial crisis, they took on a self-propelling character. It also implies that the cumulative shortfall in output from debt overhang is potentially massive — with an average duration of 23 years, the cumulative effect of annual growth being 1 percentage point slower is GDP that is roughly one-fourth lower at the end of the period.
Adding to the concerns is that today’s high debt burdens don’t include the actuarial debt implicit in underfunded old age pension and medical care programs. The authors note that the public debt overhang problem that already affects some advanced economies has the potential to affect many others including the U.S. sometime soon, with consequences possibly as large as the ones studied. The reason is that “public debt is projected over the next decade or two to rise from its already high levels in many advanced economies, as the contingent liabilities now built into old-age programs come to pass. At present, the momentum is for public debt to become substantially worse over time, even when or if more sustained and rapid economic growth resumes.”
High debt burdens negatively impact growth because they tend to discourage private investment. Raising taxes or ramping up inflation to deal with the debt both have a negative impact on investors’ willingness to invest. High levels of public debt also call into question whether the debt will be repaid in full. That can lead to a higher risk premium, and that’s associated with higher long-term real interest rates, which in turn has negative implications for investment as well as for consumption of durables and other interest-sensitive sectors, such as housing.
However, there’s an old saying “That which cannot continue, will not.” Ultimately, governments will be required to change policies as current fiscal policies can’t be sustained over the long term (as Greece has learned). The evidence also suggests that we should be wary of arguments for any further short-term fiscal stimulus, as the long-term secular costs of high debt service could easily outweigh any potential short-term benefits. And that leads us back to the issue of the fiscal cliff, the issue that is creating much of the uncertainty. The question is not only will we be able to address it, but what are the impacts of the chosen solution? In other words, do sharp reductions of deficits and government debts cause economic problems?
Given that many countries, including the U.S., will eventually have to reduce their public debts, this question is at the forefront of the current policy debate. A debate is currently raging as to whether austerity in Europe is helping or deepening the economic crisis there. A recent research paper by the National Bureau of Economic Research shows that spending cuts have been far better received by world economies than raising taxes.
The authors based their study on fiscal consolidation plans (tax increases and spending cuts) that were announced (and then implemented or revised) by 17 developed countries over a quarter century (1980–2005), looking at those designed to reduce a budget deficit and to put the public debt on a sustainable path. The authors concluded that how the economy responds to fiscal contraction depends crucially on how the consolidation occurs. The following is a summary of their findings:
- Spending-based adjustments can be successful and have been associated with mild and short-lived recessions, in many cases with no recession at all.
- Tax-based adjustments have been followed by prolonged and deep recessions.
- The difference in responses to the two types of adjustments is remarkable in its size and can’t be explained by either different monetary policies or different states of the economic cycle.
- The different responses are mainly due to the response of private investment, rather than consumption growth.
- Business confidence (unlike consumer confidence) picks up immediately after spending-based adjustments.
The authors attempted to explain the outcomes. Some explanations could be the “standard” ones, such as the distortionary supply-side effects of taxation and wealth effects associated with expectations of lower taxes in the future thanks to spending cuts. Prior research has shown that the spending cuts that have been especially favorable to growth are those that have been accompanied by supply-side reforms, goods and labor market liberation, and wage moderation. These accompanying reforms may signal a “change of regime” toward a more market friendly policy stance, less taxation, liberalizations and so on. They also found that the most favorable outcomes are those in which current spending, rather than public investment, is reduced.
The authors also found a reduction in government spending has a positive wealth effect on individuals (via the reduction in future expected taxation), causing consumption to expand. As a consequence of the positive wealth effect, labor supply shifts upward, hours worked decrease and the real wage increases. However, an increase in taxation will reduce output as the negative wealth effect on the demand side (both on consumption and on investment) is combined with the negative effect of increased distortions on the supply side.
The authors add that confidence could also play a role in investment decisions (and perhaps on consumption as well). Consider an investor unsure about future tax rates. The announcement of a permanent spending cut could eliminate such uncertainty and lead to an increase in investment. Of course, it matters whether the spending cuts are perceived as permanent or transitory. In particular, wealth effects will be larger for permanent spending cuts, and the elimination of uncertainty regarding fiscal sustainability is also relevant. On the contrary, stop-and-go policies may increase rather than decrease uncertainty.
The study helps explain the market’s initial reaction to the president’s re-election: The markets are concerned that there is not only less likelihood of the fiscal cliff being addressed, but they also fear that even if it is addressed, more of the reductions in the deficits will come from tax increases rather than spending cuts.
We need to cover another essential point. All of the information about the risks of the fiscal cliff and of the potential for negative impacts on the economy are now well known. Thus, they should be incorporated into prices. In other words, it’s too late to act now unless either you know something others don’t (and that’s not likely) or your crystal ball is clear (there are no such things, just overconfident forecasters). And remember, if you decide to sell, and even if that turns out to be the correct decision, you must also get a second decision right. Unless you can achieve your goals with a 100 percent allocation to safe bonds — and there aren’t many who can do that, especially at the current historically low rates — you will have to get the buy decision right as well. And it’s important to understand that there will never be an “all clear” sign that will let you know it’s once again safe to buy. Consider that from the lows of March 2009, the market returned over 100 percent. Yet, investors were pulling out hundreds of billions from stock funds because it never appeared to them that it was safe once again to buy stocks. The evidence demonstrates that playing that game is highly unlikely to be productive.
Let’s turn our attention now to what might happen with regard to the major issue we are all concerned about, the fiscal cliff. While no one knows what will happen, here are some thoughts about what might be possible, if not likely. While we have a long-term structural problem, the immediate issue is to prevent the implementation of $1.2 trillion in automatic spending cuts. Given the concern of the impact of such a cut while the economy is growing slowly, it seems that at the very least we will get a “kick the can” approach in the short-term while Congress works on a “grand compromise.” Any deal would also need to address the issue of lifting the national debt ceiling or we will have a repeat drama early next year. Keep in mind that deadlines seem to be the only time we get Congressional actions these days. So getting a deal done right at the deadline is certainly a possibility. Any deal will likely be along the lines of the Simpson-Bowles commission, with something like $3 in spending cuts for each $1 in additional revenue. Based on the historical evidence we discussed, the emphasis on spending cuts rather than tax increases would be the right approach. In particular, it seems likely any deal will seek to raise revenues while minimizing actual tax rate increases. In other words, while tax rates might not rise, effective tax rates will. For example, either there might be limits on the total amount of deductions one can take (as Romney proposed), or there will be a cap on the rate at which they can be taken (such as 28 percent as the president has mentioned). We may also see limits, particularly for higher income individuals, on the ability to contribute to tax-advantaged accounts. The special treatment private equity and hedge fund managers receive on what is known as “carried interest,” allowing it to be taxed at long-term capital gains rates instead of ordinary income tax rates, could disappear. Another target might be the special treatment the income generated in life insurance policies receives. In addition, another compromise might be to keep tax rates at current lower levels, while eliminating the special treatment of dividends and capital gains. As we saw under former President Ronald Reagan, he traded off lower rates for a merger of the income and capital gains rates. Or, the special treatment of dividends could be eliminated.
So, what should you do with all this information? Smart investors know that the winning strategy is to avoid focusing on managing returns, because there are no clear crystal balls, and you cannot manage the uncontrollable/unforecastable. There is an overwhelming body of evidence that demonstrates that active management is a loser’s game, one that’s possible to win, but the odds of doing so are so low you shouldn’t try. Thus, smart investors do the following:
- They have well-thought-out plans that have already incorporated the virtual certainty that there will be bear markets, and that they cannot be forecasted with anything close to precision.
- They focus on the things they actually can control: the amount of risk they take, diversifying those risks as much as possible, keeping costs low and tax efficiency high.
- They stay the course, adhering to their plan, rebalancing and tax managing along the way, ignoring the noise of the market (along with all the investment porn put out by Wall Street and the financial media).
With that said, there are a few actions that seem prudent to consider. First, consider accelerating income into 2012, in order to take capital gains at current low rates (these rates are highly likely to rise, possibly even to be the same as the ordinary income tax rate), to avoid the 3.8 percent health care act tax, and to avoid a possible increase in ordinary tax rates. Second, given the high likelihood that there will be at least some reduction in the level at which estates go untaxed (currently $5.12 million), consider actions that will shift assets in a way to avoid the estate tax (such as gifting to children). In addition, it seems likely that the gift tax exemption, currently the same as the estate tax exemption, will be lowered. Third, you might consider deferring deductions, such as charitable giving, property taxes and your last mortgage interest payment, into 2013. The risk is that any tax reform done in 2013 could limit the value of deductions. And finally, given the potential for higher tax rates you might consider changing your contributions to retirement accounts from a Roth-type election to a traditional-type election in 2013. As always, you should consult your CPA, or other tax advisor, before taking any action.
The bottom line is that if your investment strategy balanced your ability, willingness and need to take risk before the president’s re-election, it should see you through this temporary period of uncertainty. Remember, investing is a long-term proposition—much longer than one or two presidential terms.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2013, The BAM ALLIANCE