Dalton — Investing in stocks just got more attractive because of a policy shift announced by the Federal Reserve’s Federal Open Market Committee on Aug. 27. Details are found in the Federal Reserve’s statement of longer-run goals and monetary strategy. That statement was initially presented in 2012, but as Fed Chair Jerome Powell put it, “since the economy is always evolving, the FOMC’s strategy for achieving its goals, or policy framework, must adapt to meet the new challenges that arise.”
The gist of it is that the Fed will move from targeting an inflation rate of 2 percent to targeting an average of 2 percent. For years, the Fed’s preferred measure of inflation, the personal consumption expenditure price index, has been running below 2 percent. The Fed will strive to reach an average of 2 percent by letting inflation run “moderately” above that level “for some time” after periods when inflation has run cooler. The Fed can now juice the economy even more than it has been without violating its own rules.
Chairman Powell explained four “key economic developments” that compelled the FOMC to update its statement on monetary strategy:
- Assessments of the longer-run growth rates of the economy have declined.
- Interest rates have fallen across the world, and estimates of a neutral federal funds rate have fallen from 4.25 to 2.5 percent.
- The previous record-long expansion drove up the labor force participation despite what an aging population suggested. Without additional growth, there could be permanent structural damage to the labor market.
- The previous expansion benefited those previously left behind at a greater pace than previous expansions had. The Fed wishes to continue lifting the incomes of those typically earning less as it supports the entire economy.
Federal Reserve Chairman Jerome Powell. Photo: Bloomberg News
What does that mean? Regarding No. 4, in particular, it means that the Fed will no longer tighten monetary policy just because the unemployment rate falls below what it refers to as NAIRU (the non-accelerating inflation rate of unemployment). NAIRU is not precisely “full employment,” but it’s the closest the economy can get to full employment without inflation accelerating due to higher wages. Overall, it means that the Fed will do what it can to get the economy to run hot with less regard for inflation control than before. Stocks like a growing economy, so that’s good for stock investors.
The stock market also likes a bit of inflation. Company profits tend to increase during times of inflation. Per the graphic above, according to Fidelity Investments “inflation has typically been a tailwind for profits.” In every decade since the 1980s, an uptick in inflation has led to an acceleration in corporate earnings because companies command pricing power.
It may sound counterintuitive that inflation is supportive of better corporate earnings, but there are two considerations. Firstly, inflation is often a symptom of economic growth, so that leads to better corporate profits. Also, the alternative of deflation creates unique problems, including dragging down demand as potential buyers wait for lower prices, which creates a negative feedback loop.
Don’t sell due to political ideology
It’s at that time. Every four years, right about now, clients — Democrats and Republicans — call me and request that I liquidate their portfolio because “the other guy” is going to win, and it will most certainly be the end of the world as we know it. Well, Lenny Bruce is not afraid, and I feel fine. Let’s talk about why.
Reelection bids for sitting presidents don’t tend to go well if there is either a 20% decline or a recession in the year of their reelection attempt. In 2020, there were both. Since 1900, there have been five instances in which one of these events occurred, and in zero of those instances has the incumbent party retained the White House. Given that COVID-19 was an exogenous event that caused both the decline and the recession, there is a possibility that voters won’t blame President Trump and he’ll buck the historical trend.
Not that people necessarily vote based on the stock market’s direction, but the stock market is correlated to a level of confidence in the overall economy. The massive amount of monetary and fiscal stimulus in the system will likely continue to steady the economy and boost the market. This could help President Trump be the first incumbent party to shrug off not just one, but both a stock market crash and a recession in an election year. However, I certainly have my doubts.
According to RealClear Politics, President Trump’s job approval rating sits at 43.9 percent. President Truman won his reelection bid in 1948 with an approval rating of 39 percent, but that occurrence was anomalistic. The median approval rating of a candidate winning the presidency for the incumbency, since 1940, has been 53 percent. The median approval rating for the losers has been 40 percent. President Trump’s current approval rating is closer to that of the losers than the winners.
Stock market declines in election years have been bigger when the incumbent party loses, with the average largest correction being 18.7 percent, versus 10.6 percent when the incumbent party has won. With 62 days left until the presidential election, I feel that the “average largest correction” is behind us. And with both parties’ conventions behind us (as of Aug. 27), it’s important to note the performance of the Dow Jones Industrial Average from the date of the second convention to the day before the election. Over that period (from convention to election), since 1900, when the incumbent party has lost, the median loss for the Dow has only been -1.4 percent, versus a gain of 5.7 percent when the incumbents won.
What does this mean for 2021? Since 1900, if the incumbent Republican Party wins (i.e., Trump wins), the Dow gains 8.2 percent in the post-election year (2021 in this instance). If the incumbent Republican Party loses (i.e, Vice President Joe Biden wins), the Dow gains 15.1 percent in post-election years.
I’ve tried to impress upon investors not to bail out of the stock market due to ideological fears. I mean, you’ve probably got a whole host of reasons to sell your investments, but don’t pick that one. It can be difficult not to get emotional about investment decisions, and those emotions run high when you believe that the investment world might unravel if your party loses. Hopefully, this will help you decide what to do based on historical data instead of distaste or distrust of your political opponents. Don’t let the party you hate force you to get less than you deserve. Don’t give them that win.
This article originally appeared in The Berkshire Edge on September 2, 2020.