Bob Farrell has been studying and writing about markets for more than 60 years. He spent 45 years with Merrill Lynch as chief market analyst and senior investment advisor. He also created the first regular report on theme investing during his last ten years at Merrill. He became famous for his Ten Rules of Investing.

  1. Markets tend to return to the mean over time

When stocks go too far in one direction, they come back. Euphoria and pessimism can cloud people’s heads. It’s easy to get caught up in the heat of the moment and lose perspective.

  1. Excesses in one direction will lead to an opposite excess in the other direction

Think of the market baseline as attached to a rubber string. Any action to far in one direction not only brings you back to the baseline but leads to an overshoot in the opposite direction.

  1. There are no new eras — excesses are never permanent

Whatever the latest hot sector is, it eventually overheats, reverts to mean, and then overshoots. Look at how far the emerging markets and BRIC (Brazil, Russia, India and China) nations ran over the past 6 years, only to get cut in half.

As the fever builds, a chorus of “this time it’s different” will be heard, even if those exact words are never used. And of course, it — Human Nature — never is different.

  1. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways

Regardless of how hot a sector is, don’t expect a plateau to work off the excesses. Profits are locked in by selling, and that invariably leads to a significant correction — eventually.

  1. The public buys the most at the top and the least at the bottom

Watch Investors Intelligence (measuring the mood of more than 100 investment newsletter writers) and the American Association of Individual Investors survey.

  1. Fear and greed are stronger than long-term resolve

Investors can be their own worst enemy, particularly when emotions take hold. Gains “make us exuberant; they enhance well-being and promote optimism,” says Santa Clara University finance professor Meir Statman. His studies of investor behavior show that “Losses bring sadness, disgust, fear, regret. Fear increases the sense of risk and some react by shunning stocks.”

  1. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names

Hence, why breadth and volume are so important. Think of it as strength in numbers. Broad momentum is hard to stop, Farrell observes. Watch for when momentum channels into a small number of stocks (“Nifty 50” stocks.  Think FAANGM).

  1. Bear markets have three stages — sharp down, reflexive rebound and a drawn-out fundamental downtrend

Even when these sporadic rallies end, we have yet to see the long drawn out fundamental portion of the Bear Market.

  1. When all the experts and forecasts agree — something else is going to happen

As Stovall, the S&P investment strategist, puts it: “If everybody’s optimistic, who is left to buy? If everybody’s pessimistic, who’s left to sell?

  1. Bull markets are more fun than bear markets

Especially if you are long only or mandated to be full invested. Those with more flexible charters might squeak out a smile or two here and there.

 

US Economy

 

  • Homebuilder sentiment is at record highs as demand for new houses soars.
  • Most home prices across key metro areas have rebounded above the 2008 peak. Property markets in cities such as San Francisco and Denver appear frothy.
  • High-frequency indicators continue to signal slower economic recovery.
  • The NY Fed’s measure of nonmanufacturing activity has been showing improvement but has not rebounded to pre-crisis levels. The pandemic remains a drag on the service-sector recovery.
  • Many households are struggling to pay expenses and absent another stimulus package, the situation may deteriorate further.
  • US trucking fleets have been shrinking.
  • Declining mortgage rates have fueled the housing rally.
  • Mortgage applications remain elevated for this time of the year.
  • Inventories remain depressed.
  • First-time unemployment applications are holding above one million per week.
  • Bloomberg’s consumer sentiment index is rolling over.
  • The preliminary Markit PMI report showed robust business activity in October.
  • Service companies seem to be upbeat about the future despite the worsening pandemic.
  • While hiring continues, the pace has slowed.
  • Housing-related retail sales have been exceptionally strong.

 

The Election and the Markets

 

The three months preceding a Presidential Election election are a crucial period. According to “the presidential election cycle theory,” when the market rises between July 31 and October 31, the incumbent party tends to win the presidency. And when the market slumps, the challenging party is victorious.

Look at the 2016 election as an example. Polls strongly favored Hillary Clinton, the incumbent party’s nominee; but Mr. Market had other ideas. The S&P 500 fell 1.7 percent in the three months leading up to Election Day, and the challenging party’s nominee, Donald Trump, won the White House.

Since World War II, this trend has had a 72 percent win rate. Put another way, investors have “voted with their dollars” for the winning candidate roughly three out of every four times. Better yet, for elections after 1980 and excluding the 2000 election, the win rate increases to 100 percent. Why start after 1980? It was only in the early ‘80s that IRAs and 401Ks made stocks relevant to most of middle America. Prior to that time, stock investors were an elite minority whose votes were relatively few.

Why exclude 2000? For at least two reasons. First, while the S&P 500 was technically “up” for the three- month period, it was essentially flat having risen just 0.18 percent. And second, the election outcome was not normal, as you no doubt remember well. George W. Bush lost the popular vote and won an Electoral College vote only after the Supreme Court ruled that Florida must end its recount. A retrospective analysis indicates that Gore probably lost only because hundreds of Democrat voters in south Florida marked their ballots for Pat Buchanan while intending to vote for Gore.

So, how is Trump’s reelection bid looking so far, according to Mr. Market? As of today, October 25, 2020, the S&P 500 was up 6.4% since July 31. To know the election results before the fact, keep carefully watching this indicator.

Similarly, if we go back to 1896, a party which has won the White House has lost it 4 years later, only once. That was in 1980 when Jimmy Carter was beaten by Ronald Reagan.

Forecasts:

First, regardless of who is elected, loose monetary policy will support sustained growth. This will be great for housing and business capital investment. It will also keep the interest cost of government debt low. Price stability and full employment are the goals. Because of global deflationary trends, inflation remain stay low. In the long-term, preventing deflation is a bigger challenge than preventing inflation.

Second, little is expected to happen on the tax front. That’s because a GOP Senate majority (assuming they keep the Senate) would never let Biden, assuming he is elected, to raise taxes. Tax hikes would be dead on arrival. The one change Biden might be able to make is enlarging the deduction for state and local taxes. Many in the GOP would oppose this because it would lighten taxes more for residents of high-tax states than low tax states, but it still is a tax cut, not a hike.

What are the specific tax changes Democrats are likely to push? Biden’s team has made plenty of tax proposals, but let’s focus on what we call the Big Five:

  1. Raising the top income tax rate on regular in- come back to 39.6% from 37%
  2. Raising the corporate tax rate to 28% from 21%
  3. Ending the step-up basis at death
  4. Treating long-term capital gains and qualified dividends as regular income for those earning over $1 million, and
  5. Applying the Social Security payroll tax on incomes up to $400,000

The Biden Administration will not be able to raise taxes on capital gains, eliminate step-up basis at death or treat capital gains and ordinary dividends as regular income with a narrow 51 or 52 seat Senate majority. We will see what happens in the Senate.  Eliminating the step-up basis at death would be an administrative nightmare for some heirs who inherit assets with no records of when the assets were originally bought or at what price. And many of these heirs are far from wealthy themselves. More likely, the Senate would reduce the exemption amounts for the estate tax, instead. More troublesome from an economic growth perspective would be treating capital gains and qualified dividends as regular income for those making $1 million or more. For dividends, this would unravel about twenty years of tax policy reducing the double-taxation on dividends, caused when monies are taxed when a company earns profits and then again at the personal level. On long-term capital gains, the tax rate hasn’t been as high as 39.6% since the early years of the Carter Administration. That’s right, even Jimmy Carter thought that tax rate was too high! Raising it that high again would be a major disincentive for investors. And, given that the economy will be far from fully healed in 2021, we have serious doubts the Biden Administration could rally “moderate Democrats” to such a tax hike. Remember, President Obama had 60 Senate votes and a large majority in the House, when he was president in 2009. And yet the Bush tax cuts he inherited were not unwound until 2013. And then, only partially.

Since changing any aspect of Social Security requires 60 votes in the Senate, Biden’s proposal to impose the Social Security tax on regular earnings up to $400,000 will not be enacted under any reasonable scenario. At present, the FICA tax of 6.2% on workers and 6.2% on employers applies only to the so-called “wage base” up to $137,700 in 2020; and that wage base only goes up each year based on wage growth. Imposing an extra 12.4% tax on wages above $137,700 a year would be a large disincentive for high-income workers. Tack that on top of the official 39.6% income tax rate, plus the 2.9% Medicare tax, and we’re at more than 50%. Then add in a top tax rate of 13.3% for California, which may be going higher, and you have net marginal tax rates nearing 65%.

 

“Dr.” Copper

 

Some joke that Copper (the metal) has a Ph.D. in economics because its spot price sometimes predicts turning points in the global economy. That arises because of copper’s widespread applications in most sectors of the economy, from homes and factories to electronics and power generation. The implication from rising copper prices is, therefore, positive for the global economy. This week, the price broke out from a recent trading range, as did a couple of copper-related ETFs. The breakouts in and of themselves are not that big of a deal. When considered under the context of longer trends, though, they take on greater significance, since they add support to the view that the price of the red metal is in a primary bull market.

 

 

The Changing Economy

 

People are switching jobs and careers at an unprecedented level. USA Today has a fascinating story on people switching careers. When you realize your job will probably not come back, you adapt. We are finally seeing more people being willing to move outside their local areas to where the jobs are.

 

 

The changing consumer trend is that more people are doing things for each other and spending less money. If that continues, we will see less GDP growth. Simple illustration: If you find out that your friend can help you with your hair color and you can help her, you don’t visit the hair salon as much. Or neighbors helping each other with home repairs. Since no one is paid, it doesn’t add to GDP, even though the work was done.

Consumer behavior has changed more this year than any time since the Great Depression. That’s why we are not going back to 2019. So much has changed that we will be literally entering a new world. The airline and hospitality industries will not look the same in 2022 as they did in 2019—they will be there, but in a transformed state. Commercial real estate will be repriced as we continue to work more from home. It seems so ancient, but just three years ago we bought more food in restaurants than we made and ate in our homes. That certainly changed and will continue. Entrepreneurs will adjust. A vaccine will make a difference.

 

Market Valuation

 

The S&P 500 Index price/sales ratio is at an all-time record high.

 

 

Robinhood Accounts

 

The trading volume of “call buys to open” from small traders in the options market has skyrocketed.

In 2019, there were less than 5 million of these contracts. Today, there are around 20 million. That’s a near fourfold increase in less than a year and it’s the highest number of bullish contracts on record.

These folks will push the market higher than you could possibly imagine.

 

The Fed and Gold

 

Foreign central bank reserves at the Fed have fallen steeply even as the US still runs huge current account deficits. This makes no sense but Charles Gave has a theory that may explain it. If he’s right, it’s bullish for gold prices but terrible in other ways.

  • The US has long been the only country able to settle its current account deficit in its own currency.
  • Something like $1 trillion in foreign central bank reserves have gone missing in the last seven years.
  • Charles Gave believes these central banks are using their excess dollars to buy gold rather than store them at the Fed.
  • The result will be a collapsed banking multiplier outside the US, and lower international velocity of money.
  • France did something similar in the late 1920s/early 1930s and it helped cause the Great Depression.
  • The world monetary order is effectively reverting to a gold standard.

Gave estimates central bank activity will triple gold prices from the current level but finds this small consolation. The transition he foresees would have serious consequences.

 

Debt

 

The CBO projects that debt will continue to increase in most years, reaching 195 percent of GDP by 2050. That amount of debt will be the highest in the nation’s history, and will increase further. High and rising federal debt makes the economy more vulnerable to rising interest rates and, depending on financing of the debt, rising inflation. The growing debt burden also raises borrowing costs and slows the growth of the economy and national income. There is an increased risk of a fiscal crisis or a gradual decline in the value of Treasury securities.

 

 

The continuing expansion of debt erodes economic growth.

 

COVID Update

 

The average age of US COVID deaths is well below what we see in other advanced economies.

 

 

Market Data

 

  • The Nasdaq 100 projected EPS has peaked relative to the S&P 500. Will performance follow?

 

 

  • In March, almost all U.S. energy companies had a share price below $5. It hasn’t changed much since then. A majority have share prices even below $2. This is beyond any other extreme over the past 20 years.
  • There has been a sudden and large increase in implied volatility in bond options. While this concerns some investors, who worry about this bleeding into the stock market, historically a quick rise in bond volatility has not done so. There was a consistent pattern of the VIX dropping in the months ahead, while stocks rose.

 

 

All content is the opinion of Brian J. Decker