Post Election Commentary

“Investing isn’t about beating others at their game. It’s about controlling yourself at your own game.”

–Jason Zweig, Wall Street Journal

This has been a strange and regrettable year. I am saddened by the loss of life and enormous economic damage caused by the pandemic. It has amplified the social, political, and economic divide in our country and forced an unprecedented fiscal and monetary response. It is unclear how long it will take us to fully recover, but we do know the actions of the next administration and congressional leaders will play a big role in determining the outcome.

It was precisely for this reason that we waited until after the election to finish writing and publish this commentary. Finally, almost four weeks after the election, we now know with certainty that Joe Biden will be sworn in on January 20th as the 46th President. However, we are still waiting on the outcome of the Georgia special election in January to determine which party will control the Senate. We recently published a piece that analyzed historical returns during different presidential and congressional party combinations that is worth a quick read as you consider how the outcome of this election may impact the market.

The new administration will need to move quickly to address the pandemic as well as coordinate economic recovery and relief efforts; all of which may be easier said than done, especially if Congress remains divided. While news on the vaccine front has been especially optimistic, there will be logistical challenges vaccinating the US population. However, we are highly confident these will be addressed, our country will move past this unprecedented time, and eventually recover and prosper again.

Needless to say, it has been a stressful period adjusting to life and managing a business during a pandemic. Thankfully, the company was well prepared having already embraced virtual collaboration tools and implemented the necessary systems to support a remote workforce. I am extremely proud of our entire team. Their dedication under such challenging circumstances has been very impressive. Our focus on your family’s financial well being has been a respite from this day-to-day dystopia, and we are especially honored during this time for the trust and faith you continue to place in us.

The Market

Despite stocks dropping over 30%¹ in the first quarter, they have recovered over 60% from the bottom.² Year to date through the end of November, US Stocks (S&P 500 TR Index) were up 14.02%,³ International Stocks (MSCI AC World ex-US NR Index) were up 5.40%,⁴ and US Bonds (Bloomberg Barclays Aggregate TR Index) were up 7.36%.⁵

This is an unprecedented time for the world and financial markets. The economy has been significantly impaired, while US stock and bonds are trading at or near all-time highs. Record fiscal stimulus and central bank bond purchases have pushed interest rates to near zero.

10 Year Treasury Rate

In this environment, equities become more attractive from an asset allocation standpoint. As a result, investors may be compelled to increase their exposure to equities when, by historical measures, they are trading at elevated valuations. From this position, it is hard to see bonds providing much in the way of future returns, or as protection for equities unless interest rates go negative.

For conservative investors with high bond exposure, low bond yields threaten the income and stability of principal they have come to expect. Buying dividend paying equities may help to replace the lost income, but in the process, exposes investors to substantial market volatility at a questionable time.

This precarious environment creates a risk management problem that Blue Square’s proprietary approach is positioned to address. This year’s unprecedented market crash and subsequent recovery, brought about by unanticipated circumstances (isn’t this always the case), is a reminder of why we believe so strongly in our systematic rules-based methodology. Unswayed by emotions, we stuck to our process that seeks to protect capital during significant market declines and capture our fair share during up markets.

The Economy

We are all familiar with the mantra “Don’t fight the Fed.” We experienced it earlier this year when the Fed launched a program to aggressively buy US bonds causing a massive rally in the markets. We are taking their latest pledge to boost inflation very seriously — especially in tandem with the political push to bring back some essential manufacturing to the US as a result of supply chain constraints during the pandemic. While this may take some time, it will likely cause the cost of these goods to rise, as domestic production is more expensive than manufacturing overseas.

The good news is Biden has experience navigating economic turmoil, having helped resurrect the economy after the 2008 credit crisis. His selection of Janet Yellen for Treasury Secretary is also encouraging, as they both have invaluable experience that they can leverage to address the current set of challenges we are facing.

As a result, portfolio diversification is increasingly important across asset classes, countries, currencies and commodities. However, diversification is not always enough. For example, in the charts below you can see that in times of large global economic shock asset correlations tend to converge. This spike in correlation renders diversification less effective as the primary tool for managing risk, as these assets decline in tandem.

Rolling 90 day correlation between US Equities and US Bonds

Rolling 90 day correlation between US Equities and Gold

In times like today, when equities seem to go up every day, many investors start to speculate due to FOMO (fear of missing out). This is precisely the time when discipline is essential. We have written before about the pitfalls of following the herd or the predictions of leading experts. What we have found is that even the best of experts are often wrong, which is why basing investment decisions off these predictions can prove to be harmful to investor portfolios.

It is for these reasons that we strongly believe investors should always be prepared for a wide variety of outcomes as nobody can predict the future, but you can prepare for it. While this doesn’t always lead to the best outcome over any particular period, we are confident that this strategy will continue to enable us to reduce losses and better help investors meet their goals over full market cycles.

What Have We Done

Since the end of the second quarter, the US markets have risen steadily and we have redeployed cash into US Large and Mid-cap stocks. International markets have lagged slightly behind the US, but we are now fully invested in both Developed and Emerging Markets.

Internationally, we continue to focus on China/Asia and look to increase our exposure there for a number of reasons: we believe capital flows will continue to move overseas as investors look to mitigate domestic portfolio concentration risk, valuations are more attractive, and those economies have been more resilient as they have done a better job managing the pandemic.

Regarding bonds, we continue to take a diversified approach with exposure to TIPS (Treasury Inflation Protection Securities), intermediate, and long dated maturities. As we have discussed numerous times, we believe that bonds are not attractive with yields close to zero unless yields turn negative. While we don’t see that probability as high, you cannot ignore the fact that most of the developed world currently has or recently had negative interest rates. Since we also risk manage bonds, we are comfortable with our current exposure that positions us to capture our fair share of return if yields turn negative. However, if yields rise, we will look to raise cash in the intermediate and long maturity bonds we own.

We believe the unprecedented fiscal and monetary stimulus that was required to offset the economic damage continues to justify maintaining our exposure to Gold in our Balanced and Growth allocations. Gold has had a significant rally YTD although it has recently experienced a pull back on optimism of a vaccine. While we are hopeful that by the summer of 2021 we will be back to a more normal way of life, the efforts required to heal the economy should continue to be supportive of further gains in Gold. Having said that, we will continue to risk manage the exposure if the opposite outcome occurs.

What Comes Next?

We remain confident heading into the end of the year that our conservative, rules-based approach will help us navigate this storm. As we have mentioned before, we believe that many financial firms will not be properly positioned for what lies ahead. In our opinion, traditional forms of risk management, such as diversification, will only go so far should conditions deteriorate substantially across markets.

Please feel free to share this market commentary with those you believe would benefit from it and know we will do our best to be available to assist anyone you refer to us. As always, we know and respect the enormous amount of trust and faith you have placed in us, and I assure you we are more than up to the task. Please feel free to reach out at any time – we are all here for you and eager to assist however we can.