It’s almost Election Day in the US once again. For those who need a brief civics refresher, every two years the full US House of Representatives and one-third of the Senate are up for reelection. While the outcomes of the elections are uncertain, one thing we can count on is that plenty of opinions and prognostications will be floated in the days to come. In financial circles, this will almost assuredly include any potential for perceived impact on markets. But should long-term investors focus on midterm elections?
We would caution investors against making short-term changes to a long-term plan to try to profit or avoid losses from changes in the political winds. For context, it is helpful to think of markets as a powerful information-processing machine. The combined impact of millions of investors placing billions of dollars’ worth of trades each day results in market prices that incorporate the aggregate expectations of those investors. This makes outguessing market prices consistently very difficult.1 While surprises can and do happen in elections, the surprises don’t always lead to clear-cut outcomes for investors.
The 2016 presidential election serves as a recent example of this. There were a variety of opinions about how the election would impact markets, but many articles at the time posited that stocks would fall if Trump were elected.2 The day following President Trump’s win, however, the S&P 500 Index closed 1.1% higher. So even if an investor would have correctly predicted the election outcome (which was not apparent in pre-election polling), there is no guarantee that they would have predicted the correct directional move, especially given the narrative at the time.
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When I was growing up, our local newspaper, the Kansas City Star, was full of news and had one page for opinion. After decades of cable news and nonstop digital postings, I see more opinions these days than news. That's not a bad thing. But when it comes to investing, it's crucial to remember the difference between news and opinion, and how they are sometimes used to forecast the future.
Any time the government releases new data on unemployment or inflation or interest rate changes, people start claiming they can forecast the future. That's not necessarily a bad thing either. But most of what I hear people say isn't what I would call "forecasting."
Forecasting is when you have a high degree of confidence in an outcome based on well-proven models. The weather forecast for a few days from now is a lot better than anything I read in the Kansas City Star about investing. The weather forecast is pretty darn accurate. I'd sure call that kind of forecast the right use of the word. That's different from someone issuing a "forecast" for when the Dow will hit a certain number. Or when inflation will reach a certain level. Or which five stocks will rise the most over the next year.
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Many investors believe markets to be cyclical and search for signs of cycles in an attempt to predict which investment styles are coming into and out of favour.
People have a tendency to see patterns where they do not exist. Do a Google image search for "#iseefaces" and you will understand what I mean. This can be a problem for investors because it is one thing to interpret a startled expression in a bowling ball or a light switch, and another to think that historical stock market data can help predict the future.
Many investors believe markets to be cyclical and search for signs of cycles in an attempt to predict which investment styles are coming into and out of favour. Rolling stock returns are like a Venus flytrap for these investors, luring them to the illusion of a pattern where one may not exist. Multi-year returns expressed over overlapping, rolling periods appear cyclical because consecutive observations share many data points. For example, a five-year rolling return computed at the end of June has 59 out of 60 data points in common with the end-of-July five-year return.
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A recent news item reported that Frederick Smith intended to step down as Chairman and Chief Executive Officer of FexEx Corp., the largest air freight firm in the world.
As a Yale undergraduate in 1965, Smith wrote a term paper for his economics course outlining an overnight air delivery service for urgently needed items such as medicines or computer parts. His professor was not much impressed with the paper, but after a stint in the Air Force, Smith sought to put his classroom idea into practice. He founded Federal Express (now FexEx) in 1971, and one evening in April 1973, 14 Dassault Falcon jets took off from Memphis airport with 186 packages destined for 25 cities.
In retrospect, it was not an auspicious time to launch a new venture requiring expensive aircraft consuming large quantities of jet fuel. Oil prices rose sharply later that year following the Arab states' oil embargo, and the US economy fell into a deep recession. Most airlines struggled during the 1970s, and Federal Express was no exception.
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At some point over the past year, the financial media's inflation coverage transitioned from, "Will this high inflation persist?" to, "Here's how to cope with inflation that's here to stay!" It seems some investors have resigned themselves to a new normal of high inflation following decades of below-average consumer price changes. However, financial market data tells a different story, one of potentially softening inflation.
Breakeven inflation (BEI) rates offer a window into the market's inflation expectations. Defined as the difference between yields on nominal and inflation-protected bonds of the same maturity, BEI represents the inflation rate at which investors would be indifferent between the two. If actual inflation were to exceed BEI rates, investors would be better off with the inflation-protected bond; if inflation were less than BEI, the reverse would be true. BEI is therefore commonly interpreted as the average annual inflation rate expected over a given time horizon.
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