Here are the key topics that we cover this month:
- Summer doldrums are here
- This is not your parent’s S&P 500, nor will it be your kids!
- While banks are under stress, many are strengthening their balance sheet & capital ratios
- There’s no such thing as a free lunch
- Mortgage rates are at record lows. Is now the time to refinance?
- CARES Act renewals needed this week to avoid major headwinds
- Early data is showing Covid “Wave 2” maybe winding down
- A Biden Presidency & your money
- Major student loan services changes are coming in December 2020
- Where will the equity markets go next?
Summer doldrums are here
The summer doldrums refers to the perception that the period between July and Labor Day is particularly dangerous for investors because many are away on vacation and, as a result, volatility is higher because liquidity is lower than it otherwise would have been.
Taking a longer-term look at the S&P 500 shows a similar trend of subpar performance in the short to intermediate-term. Below is an annual composite chart of the S&P 500 for all years since 1980. What’s interesting to note about this chart is that on an average basis, the peak for the summer comes on 7/17, and from there, the S&P 500’s YTD performance doesn’t top the level from 7/17 for another 58 trading days until 9/13. As is apparent in the chart, you can see that this is also the longest period throughout the calendar year that the S&P 500’s average YTD change doesn’t make a high for the year. While the S&P 500 tends to make a modestly higher high on 9/13, the period from 9/16 through 11/1 has historically been the second-longest stretch where the S&P 500’s average YTD change goes without making a new high.
For the entire 40-year period, the S&P 500’s average change has been a gain of 0.05% (median: 0.70%) with positive returns 60% of the time. In those 40 years, though, there have been four years (1990, 1998, 2001, and 2011) where the S&P 500 was down over 10%, while there were three years (1982, 1984, and 2009) where the index was up over 10%.
Whenever we discuss seasonality trends in the market, it’s good to have a baseline estimate of how the market historically acts during different periods, but we always stress that these types of trends are often trumped by other factors. Therefore, they should only be used by investors as one of several tools in developing their outlook. Returns can and do vary significantly on a year-by-year basis. This summer, less people are taking vacations and vaccine news will likely be the key driver of market returns during a historically quiet period for the S&P 500. As we have previously stated, we expect this summer market returns will not turn out to be too exciting as we go through a period of consolidation between the recent market movements with earnings forecasts and vaccine trials.
This is not your parent’s S&P 500, nor will it be your kids!
It is easy to lose sight that the list of companies that make up the S&P 500 is constantly changing. We have also found that the pace of change has picked up after the 2008 housing crash. From 1964 to 2007 there were 188 companies removed/added to the list. We were shocked to see that there have been 220 removed/added since 2007! As you can see from the graph below the rate of change has picked up significantly.
Our economy is going through a recession that is especially hurting the travel industry, restaurants, energy producers and retail companies. Inclusion in the S&P 500 is primarily predicated on the market capitalization (value per share x number of shares outstanding) of a company’s stock price. The economic impact on certain companies has caused their share prices to plummet and put them at risk for removal from the index. Iconic names that have already been removed in 2020 include Harley-Davidson, Nordstrom and Macy’s. We are only halfway through the year and we are certain more changes will happen before 12/31. Similar industry specific changes took place after the housing crash of 2008 with removals of Fannie Mae, Freddie Mac, Lehman Brothers, Wachovia Bank, RadioShack, Janus Capital Group & Ambac Financial.
Many of the companies that lagged the overall economy during the recession are going to be removed from the S&P 500 and some will even be left for dead/bankruptcy while they are replaced with stronger growing companies. This natural turnover of the S&P 500 helps to reflect the evolving makeup of the US economy. Many of the household names that you know today will eventually be replaced just like Eastman Kodak. This evolution is partially how the S&P 500 can continue to climb to new levels as areas of the economy fail to recover.
While banks are under stress, many are strengthening their balance sheet & capital ratios
The end of June, The Federal Reserve Board released the results of its stress tests for 2020 and additional sensitivity analyses that the Board conducted considering the coronavirus event.
“The banking system has been a source of strength during this crisis,” Vice Chair Randal K. Quarles said, “and the results of our sensitivity analyses show that our banks can remain strong in the face of even the harshest shocks.”
In addition to its normal stress test, the Board conducted a sensitivity analysis to assess the resiliency of large banks under three hypothetical recessions, or downside scenarios, which could result from the coronavirus event. The scenarios included a V-shaped recession and recovery; a slower, U-shaped recession and recovery; and a W-shaped, double-dip recession.
Under the U- and W-shaped scenarios, most firms remain well capitalized, but several would approach minimum capital levels. The sensitivity analysis does not incorporate the potential effects of government stimulus payments and expanded unemployment insurance.
During the third quarter, no share repurchases will be permitted. In recent years, share repurchases have represented approximately 70% of shareholder payouts from large banks. The Board is also capping dividend payments to the amount paid in the second quarter and is further limiting them to an amount based on recent earnings. As a result, a bank cannot increase its dividend and can pay dividends if it has earned sufficient income.
In the near term, the banking sector is going to be under stress. However, in the long term, there are a few names that continue to be leaders and will come out of this environment even stronger than they were pre-Covid. From our recent calls with the mangers of our funds, we have heard across the board that they have been making slight adjustments to improve the quality of any exposure to the banking sector. As noted above, many of these banks are paying a dividend, so investors are getting paid to be patient. However, as we will also discuss this month, falling mortgage rates are going to put a further pinch on earnings potential.
There’s no such thing as a free lunch
We knew the government was going to step up big to help counter act the financial damage they were causing from a national shut down. As we progress through July, we now have three months of supply and demand data during Covid. The following commentary from Brian Westbury, Chief Economist at First Trust, provides a great insight into the current disparity.
“There is no such thing as a free lunch.” It’s been attributed to many different people, Milton Friedman and Robert Heinlein, among others. Regardless of who said it, we think it’s one of the most basic economic truths.
A lunch has to come from somewhere, and once it is consumed, it’s not available for someone else to consume. ‘Another way to say it, someone needs to produce what we consume. Supply comes before demand. Without supply & without production, we have nothing to bring to “the market” in exchange for something else.
Recent reports show a huge gap between supply and demand, a gap that can’t go on indefinitely. Retail sales in the US, a measure of demand, fell off a cliff in March and April, bottoming 21.7% below the level in February. Since then, retail sales have rebounded sharply, rising 18.2% in May and 7.5% in June. Amazingly, retail sales are now 1.1% higher than a year ago, during a time where unemployment has climbed from 3.7% to 11.1%.
By contrast, industrial production, one proxy for supply, hasn’t done as well. Industrial production fell a combined 16.6% in March and April and has since risen a more modest 6.9% combined in May and June, leaving it down 10.8% from a year ago.
How can Americans go out and buy more when they’re making less? The answer: borrowing from the future through government deficits. Government transfer payments in April and May, combined, were up 86.7% from a year ago due to COVID spending on “tax relief” checks that have been sent out by the IRS, as well as a surge in unemployment compensation, mostly because of more people collecting benefits, but also because benefits were increased substantially.
As a result, government transfer payments made up 30.6% of all personal income in April and 26.4% in May. Let’s say that again…government made up over 25% of all personal income in May!! From 2015 through February 2020, government transfers averaged roughly 17% of all consumer income. Prior to the Panic of 2008, transfer payments averaged 14%. This year, government transfer payments have been so generous that they’ve more than offset declines in wages & salaries and small business income.
Retail sales have maintained while the personal saving rate has surged! The personal saving rate is the share of our after-tax income that we don’t spend on consumer goods or services. It hit 32.2% in April, the highest level on record – by far – going back to at least 1959. The next highest level was 17.3% in May 1975, and the average rate last year was 7.9%. The saving rate remained at a still elevated 23.2% in May.
The fact that people are not rushing out all at once to spend their transfer-padded incomes has helped keep inflation in check. The gap between consumer spending and production has also come in the form of big reductions in business inventories, a reduction that can’t continue forever (eventually, we’d run out of inventories to reduce).
Companies have been working down inventory levels for over a year now. Low to no inventory levels are causing consumers to finally feel the inconvenience of delays on their orders. Even Amazon has had to walk back the ability to do Prime delivery on many items. Something has to give… consumers need to stop buying or the companies need to start stocking up their inventory. We can attest to clients increasing their savings levels and even using the extra savings to pay down debt and invest for the future.
Mortgage rates are at record lows. Is now the time to refinance?
Mortgage rates have pressed below 3% and continue to fall. As a result, mortgage purchase applications remain relatively elevated, but the real action is in refinancing.
When interest rates fall, borrowers have an incentive to refinance their loan to a lower rate and reduce their monthly payment. Refinancing application volume is having its third major surge this century! Typically, it makes sense to refi a mortgage when the rate reduction is at least 1%. This reduction is typically enough to offset the closing costs of the refi over a 12-24 month period.
If you were not aware, Fannie Mae currently buys mortgages to pool them together with other mortgages so they can sell the bundled group together in large bond issues. This diversification of mortgages theoretically reduces the risk exposure to a particular bad loan or region (2008 clearly proved this theory wrong).
Less than 3% for a 30-yr mortgage may sound attractive. The unfortunate reality is that consumers aren’t getting very good deals on rates. Borrowers rates are roughly 1.3% above where Fannie Mae buys mortgages for pools, versus a ~0.5% difference pre Covid-19. If the Fannie Mae rate difference shrinks back to the pre-Covid environment, mortgage rates could fall as low as 2% without any change in benchmark risk free rates.
If a bird in the hand is worth two in the bush, it makes sense to refi today if you can drop your rate enough to cover any refi costs. If the refi doesn’t make financial sense just yet, you may get a chance to refi if rates drop further later this year.
The particulars of each mortgage make a difference and we are happy to assist with the analysis.
CARES Act renewals needed this week to avoid major headwinds
The nation is slowly re-opening and financially recovering. The steps taken by the Federal Government have helped to avoid a horrific depression, many of these programs are set to lapse. We have been having a weekly call with our contact in DC and we expect that the powers that be on Capital Hill will act to extend many of these programs so the country can continue to financially heal. The following is a brief list of programs set to expire:
- $600/week extra unemployment pay… This subsidy is set to expire the last week of July. While the benefit maybe extended, the excess benefit is likely to be reduced.
- Eviction protection… nearly 7 million households are currently protected until July 24th by the temporary moratorium on evictions from federal subsidized housing.
- Foreclosure protection… Federally backed mortgages account for 70% of the outstanding mortgages and these households are eligible for two 180-day forbearances on their mortgage.
- Student loans… Federal student loans have been suspended, including interest accrual through the end of September 2020.
- The Paycheck Protection Program (PPP) has already received additional funds and multiple additional extensions. Further enhancements are being discussed including the automatic forgiveness of all loans for less than $150k and allowing certain businesses who have been hardest hit (>50% drop in sales) to apply for a second PPP loan.
Early data is showing Covid “Wave 2” maybe winding down
It’s increasingly looking like “wave 2” of Covid in the US peaked at some point in early July and is now on the downslope. The first US Covid wave centered around the northeast corridor and the Midwest took 4-6 weeks from start to peak and then another two months to make its way down the backside of the mountain. The second US Covid wave centered around the south and southeast began in early June, and it’s looking like it peaked in early July over a roughly 5-6 week period. We would now expect a gradual slowing of cases in the current hotspots similar to what we saw in the northeast during the first wave. (Note that wave 2 is really wave 1 for the current hotspots.)
In a review of Google search trend data, we can clearly see the two waves of search trend data for “covid symptoms” over the last 12 months in the US. A look at US search trends for “covid symptoms” over just the last 90 days shows a peak in early July and a gradual trend lower beginning. We see a similar peak in early July and now a gradual move lower for the three hotspot states of California, Texas, and Florida.
Once investors are confident that the current US wave has peaked, we expect the “re-open” investment plays to take on a leadership role once again. In fact, Dallas Federal Reserve Mobility & Engagement Index, which tracks the degree to which Americans are moving around using a mobile device dataset. This index has almost perfectly tracked stock prices on roughly a three-week lag, providing a compelling example of why the stock market gets so much credit as a leading indicator of economic activity in general. The continued recovery of this index is suggesting that the economy should continue to improve in August.
It’s a virus that’s not going to just disappear, so expect new waves to occur. Potentially around the reopening of schools. Ideally, the US won’t see a third wave until the first of the vaccines are available, but even if a new wave occurs prior to a vaccine, the progress that has already been made on treating and defeating the disease should make it so that each successive wave is less damaging than the prior one.
A Biden Presidency & your money
Joe Biden’s average polling lead over President Trump is larger than any other pre-presidential election over the last 25 years (Bill Clinton vs. Dole). Big polling leads tend to erode over time and this year may not be any different. Lets not forget that Trump trailed Hillary Clinton in 2016 prior to the final November election results. The US’s ability to get through Covid-19 and re-open will likely be the key driver of Trump’s ability to get re-elected.
Over the next few months, the presidential election will gain a larger share of the media and unfortunately also advertising. We are collaborating on research to help answer client questions on the potential financial impact of a Biden Presidency. For July, we will focus on taxes and drug pricing.
Raising taxes… In June, Biden came out swinging during a digital fundraiser by saying “a lot of you may not like it, but I’m going to close loopholes like capital gains and stepped-up basis.” If elected, it is unclear if these changes would take place immediately in 2021 or would be delayed until the economy is on more solid ground post Covid-19. Here are a few of his changes Biden is contemplating and how they may impact clients.
Capital gains rates will no longer be given preferential rates of 0% to 20% and instead be taxed at ordinary income rates. This change will impact the decisions on liquidating highly appreciated securities, businesses, rental property and collectables. Under 2020’s tax table, this change would increase the tax rate by 3-22%. With the majority of families seeing an increase of ~10%. We are already having conversations with clients who are considering liquidating assets and deciding if they want to take the gains in 2020 or run the risk of higher capital gains rates in 2021 which may be further compounded if the rates for ordinary income tax brackets are also increased.
Biden is considering a reduction of the deductible amount for expenditures on employers’ contributions for employees’ medical insurance premiums and medical care, a preferential rate structure for dividends, benefits for tax-qualified retirement saving accounts, and deductions for charitable contributions. As a business owner and advisor to many small businesses, I am concerned that a reduction of these expenses will cause a further reduction of benefits being offered to employees.
An elimination of the setup in basis at death allows assets to pass to heirs without paying capital gains. The topic does not significantly impact families who have the majority of their assets in retirement plans. However, it becomes tricky when a family holds highly appreciated and illiquid assets like businesses, antiques, real estate and farms. North Star can assist with additional planning to provide liquidity to the estate to avoid a forced sale of assets to pay taxes.
Biden has said he will raise corporate tax rates to 28%. This would raise rates to a level below the 35% rate prior to Trump’s reduction to the current 21% rate. Goldman Sachs estimates that Biden’s corporate tax increase would reduce the S&P 500’s earnings by 12%. This change will not only hit corporations, it will also ripple through the values of all equity holders in Traditional & Roth IRAs, 401(k), 403(b), pensions 529s…
A reduction of the estate tax exemption allowed when passing assets to heirs. Currently inheritances of up to $11.4M per person or $22.8M per couple can be passed before having to pay a 40% federal estate tax. It is expected this amount will be reduced (potentially in half), but the true number of families impacted by the change will be small and there are planning tools that we can implement to offset these changes. Many states “piggy-back” their estate tax levels off the federal numbers. So families who are impacted, may see a second tax hit at the state level.
Of course, all of these changes are in addition to the recent removal of the stretch IRA provision and other proposed tax increases like the financial transaction tax. While death and taxes are two certainties in life, we currently sit at 50-year lows in tax rates. It seems inevitable in a post Covid-19 world that taxes are increased (in many different ways) to help pay for the Trillions of dollars that have and will be injected into the economy.
Drug pricing… The following is an excerpt from our friends at Morningstar on this topic:
The Affordable Care Act is being debated at the U.S. Supreme Court level, with a decision on whether it should be overturned expected by next spring.
Biden’s moderate position and status as the presumptive Democratic presidential nominee reduces the likelihood of significant drug pricing policy changes, despite more-aggressive reform recommendations from the Biden-Sanders unity task force. This also reduces the likelihood of a major policy-related impact on drug innovation.
We see a less than 10% probability of a “Medicare for All” system within the next decade, and we don’t include it in our analysis/forecasts.
The changes most likely to pass that could realistically influence drug pricing are those encompassed in the Senate’s proposed Prescription Drug Pricing Reduction Act, but we believe this bill holds a less than 50% chance of passing, based on mixed support by both parties, and we haven’t included it in our models. If it is passed, we estimate a 5% aggregate hit to U.S. branded drug sales from Medicare inflation price caps and Part D redesign.
Major student loan services changes are coming in December 2020
In a recent press release, the Department announced that it signed servicing contracts with five new companies who will take over much of the federal student loan portfolio:
- EdFinancial Services
- F.H. Cann & Associates LLC
- MAXIMUS Federal Services Inc.
- Missouri Higher Education Loan Authority (MOHELA)
- Texas Guaranteed Student Loan Corporation (Trellis Company)
Some existing student loan servicers such as Nelnet and Great Lakes have not been awarded new servicing contracts. This means that millions of student loan borrowers could end up having their student loans transferred to one of the new loan servicing companies listed above. The following are a few proactive steps that you can take before changes arrive in December.
- Download all payment records
- Retain copies of all correspondence
- Public service borrows will need to certify their employment
- Monitor payments for any potential over/under payment errors
- Monitor your credit report for erroneous data caused by the transition
Where will the equity markets go next?
Overall, while the situation has been bad, it continues to get less bad each day.
Our vision and communication has not changed since 2010. We still believe we are in a secular bull market, which typically lasts around 15 years. Historically, it is not uncommon to have a bear market (which essentially occurred in Q4 of 2018) or even a brief recession (which we are experiencing right now) during a secular bull market. Markets will trade on fear or momentum from time-to-time. In-between earnings reports, the markets may even trade on a single data point (like the new cases and death count of COVID-19). Eventually, the markets return to trading on fundamentals. We believe that fundamentals are starting to return and equities are looking at earnings 12-18 months out instead of the traditional 6-9 months.
No one knows for sure what the second half will bring, much less 2021 and beyond. But we think that, like in the past, those who have faith in the future will be rewarded.
We are passionately devoted to our clients’ families and portfolios. Let us know if you know somebody who would benefit from discovering the North Star difference, or if you just need a few minutes to talk.
As a small business, our staff appreciates your continued trust and support as we all work through these stressful and trying times for our country and world